Investment Appraisal Analysis - Assignment Example

Question Investment appraisal 1a Explain, in your terms, the meaning of Investment Appraisal. Investment appraisal is a method or technique used to appraise or determine good from bad investments. Based on the results of investment appraisal, business people can easily point out investments or projects that can give them the best returns as the top management officials identify the advantages and risks involved in a project. The result of investment appraisal is normally used in deciding whether or not to pursue to withdraw certain investments made by a person or a company (i.e. initial cash outlay, computed return on investment (ROI), economic rate of return (IRR), and net present value (NPV) among others). 1b Describe the advantages and disadvantages of Pay Back and Accounting Rate of Return. Aside from favouring liquidity, one of the advantages of computing for payback period is that this method is very simple and easy to compute. However, aside from ignoring the importance of cash flows, this method does not provide managers with necessary guidance on how they can determine the cut-off of payback nor is it in consistent with the need to maximize the wealth of the shareholders. Accounting rate of return is easy and simple to use. One of the advantages of accounting rate of return is that the profit values are derived from the financial statement which has already been computed by registered accountants. Aside from using profit instead of cash flows, it is unfortunate that accounting rate of return has failed to consider the importance of ‘time value of money’. As compared to profit, the use of cash flows could have been so much better because it will unfold the true potential of the company. 1c Describe your understanding of the term ‘Time Value of Money’. ‘Time value of money’ refers to the ability of money to earn more interest with time. Therefore, firms should be able to receive or earn more profit the soonest possible time. Likewise, ‘time value of money’ can also refer to the ability of invested money to earn more interest over time. 1d. Describe in detail the two main Discounting Techniques of Investment Appraisal, the Net Present Value and Internal Rate of Return. In NPV, discounting technically converts the ‘future cash flows’ into the current ‘present value’. Basically, this process makes NPV becomes the total of all future income that was converted as ‘present value’ less the initial cash outlay. After discounting, positive or higher NPV means that the project should be accepted; but not those projects with negative NPV. Discounting of IRR occurs after the adaptation of NPV. Business people should accept a project that has zero NPV after the discount rate or those with higher IRR; but not those with negative IRR. 1e How does the above satisfy the shareholders? Discounting of NPV and IRR are both favourable on the part of the shareholders because these techniques consider the importance of ‘time value of money’. Basically, the use of discounted NPV and IRR can provide the shareholders with more accurate figures needed in making important business decisions. Question 2 A Port is investigating two schemes to ease congestion and increase discharge times. Scheme 1 To build a completely new berth in an undeveloped area of the port. The development including the installation of fully automatic, computer driven handling equipment will involve a capital outlay of £10million. The operating costs for the new equipment, labour costs and other running costs for the scheme are set out below. It is expected that the new facilities will generate an increase in the users of the port resulting in extra revenue. The equipment is to be replaced after five years when it is expected to have a value of £700,000. The complete facility will be closed down after the five years. New equipment/ Labour Other Operating costs Costs Running Costs Revenue Year1 £1,100,000 £250,000 £300,000 £4,200,000 Year2 £1,150,000 £270,000 £310,000 £4,200,000 Year3 £1,180,000 £290,000 £320,000 £5,000,000 Year4 £1,210,000 £300,000 £325,000 £5,200,000 Year5 £1,230,000 £310,000 ££330,000 £5,400,000 Scheme 2 To reclaim and refurbish an old unused berth. The capital cost of this will be £4million. The running costs for this scheme have been estimated to be higher than scheme 1 and the revenue will not be as high, although it will increase. The cash flow for the scheme is as set out below. The scheme has a life expectancy of six years, with equipment being sold for £500,000 at the end of the expected life (six years) Revenue and costs have been estimated as follows New equipment/ Labour Other Operating costs Costs Running Costs Revenue Year1 £700,000 £450,000 £400,000 £2,600,000 Year2 £720,000 £480,000 £420,000 £2,800,000 Year3 £750,000 £520,000 £450,000 £3,000,000 Year4 £770,000 £570,000 £470,000 £3,200,000 Year5 £800,000 £630,000 £500,000 £3,500,000 Year6 £830,000 £700,000 £530,000 £3,500,000 The cost of capital for both schemes is 12% Required:- a) The payback period for both schemes b) The Net Present Value for both schemes. c) The PI for both schemes d) The IRR of the schemes e) On the basis of the above answers, which scheme should the board accept and explain the reasoning? PAYBACK PERIOD: Scheme 1 Payback period aims to compute for the required time in which the company can recover the cost of investment. Based on scheme 1, the payback period is 3.34 years [£2,550,000 in Year 1 + £2,470,000 in Year 2 + £3,210,000 in Year 3 = £8,230,000 in the first 3 years + £1,770,000 of the £5,200,000 that occurs in Year 4]. Solution Year New equipment / Operating cost (£) Labour Cost (£) Other Running Costs (£) Total Expenses (£) Revenue (£) Available Cash [Revenue - Total Expenses] (£) Cumulative Cash Flows 1 1,100,000 250,000 300,000 1,650,000 4,200,000 2,550,000 2,550,000 2 1,150,000 270,000 310,000 1,730,000 4,200,000 2,470,000 5,020,000 3 1,180,000 290,000 320,000 1,790,000 5,000,000 3,210,000 8,230,000 4 1,210,000 300,000 325,000 1,835,000 5,200,000 3,365,000 11,595,000 5 1,230,000 310,000 330,000 1,870,000 5,400,000 3,530,000 15,125,000 8,875,000 Available Cash X = Year 1 £2,550,000 = Year 2 £2,470,000 = Year 3 £3,210,000 Total £8,230,000 (in the first 3 years) £10,000,000 (initial investment) Less: £ 8,230,000 £ 1,770,000 Y/Z = £1,770,000 / £5,200,000 = 0.34 years Payback period = X+(Y/Z) = 3 years + 0.34 = 3.34 years PAYBACK PERIOD: Scheme 2 Based on scheme 2, the payback period is 3.352 years [£1,050,000 in Year 1 + £1,180,000 in Year 2 + £1,280,000 in Year 3 + £490,000 of the £1,390,000 that occurs in Year 4]. Solution Year New equipment / Operating cost (£) Labour Cost (£) Other Running Costs (£) Total Expenses (£) Revenue (£) Available Cash [Revenue - Total Expenses] (£) Cumulative Cash Flows 1 700,000 450,000 400,000 1,550,000 2,600,000 1,050,000 1,050,000 2 720,000 480,000 420,000 1,620,000 2,800,000 1,180,000 2,230,000 3 750,000 520,000 450,000 1,720,000 3,000,000 1,280,000 3,510,000 4 770,000 570,000 470,000 1,810,000 3,200,000 1,390,000 4,900,000 5 800,000 630,000 500,000 1,930,000 3,500,000 1,570,000 6,470,000 6 830,000 700,000 530,000 2,060,000 4,000,000 1,940,000 8,410,000 10,690,000 Available Cash X = Year 1 £1,050,000 = Year 2 £1,180,000 = Year 3 £1,280,000 £3,510,000 (in the first 3 years) £4,000,000 (initial investment) Less: £3,510,000 £ 490,000 Y/Z = £490,000 / £1,390,000 = 0.352 years Payback period = X+(Y/Z) = 3 year + 0.352 = 3.352 years NET PRESENT VALUE: Scheme 1 Considering the 12% cost of capital, the net present value of scheme 1 is £672,910. Solution To compute for the present value of scheme 1, the available cash (annual revenue – total expenses) was multiplied with the corresponding PV factor based on 12% cost of capital. After adding all present value from Year 1 to Year 5, the initial investment of £10,000,000 was deducted from the total present value (£) to get the net present value (£). Year New equipment / Operating cost (£) Labour Cost (£) Other Running Costs (£) Total Expenses (£) Revenue (£) Available Cash [Revenue - Total Expenses] (£) PV Factor Present Value 1 1,100,000 250,000 300,000 1,650,000 4,200,000 2,550,000 0.893 2,277,150 2 1,150,000 270,000 310,000 1,730,000 4,200,000 2,470,000 0.797 1,968,590 3 1,180,000 290,000 320,000 1,790,000 5,000,000 3,210,000 0.712 2,285,520 4 1,210,000 300,000 325,000 1,835,000 5,200,000 3,365,000 0.636 2,140,140 5 1,230,000 310,000 330,000 1,870,000 5,400,000 3,530,000 0.567 2,001,510 Present Value (£) 10,672,910 Initial Investment (£) 10,000,000 Net Present Value (£) 672,910 NET PRESENT VALUE: Scheme 2 Considering the 12% cost of capital, the net present value of scheme 2 is £1,547,280. Solution To compute for the present value of scheme 2, the available cash (annual revenue – total expenses) was multiplied with the corresponding PV factor based on 12% cost of capital. After adding all present value from Year 1 to Year 6, the initial investment of £4,000,000 was deducted from the total present value (£) to get the net present value (£). Year New equipment / Operating cost (£) Labour Cost (£) Other Running Costs (£) Total Expenses (£) Revenue (£) Available Cash [Revenue - Total Expenses] (£) PV Factor Present Value 1 700,000 450,000 400,000 1,550,000 2,600,000 1,050,000 0.893 937,650 2 720,000 480,000 420,000 1,620,000 2,800,000 1,180,000 0.797 940,460 3 750,000 520,000 450,000 1,720,000 3,000,000 1,280,000 0.712 911,360 4 770,000 570,000 470,000 1,810,000 3,200,000 1,390,000 0.636 884,040 5 800,000 630,000 500,000 1,930,000 3,500,000 1,570,000 0.567 890,190 6 830,000 700,000 530,000 2,060,000 4,000,000 1,940,000 0.507 983,580 Present Value (£) 5,547,280 Initial Investment (£) 4,000,000 Net Present Value (£) 1,547,280 Profitability Index (PI): Scheme 1 The profitability index of scheme 1 is 1.067291. Solution PI = PV of future net cash flows / initial cost of investment = £10,672,910 / £10,000,000 = 1.067291 Profitability Index (PI): Scheme 2 The profitability index of scheme 2 is 1.38682. Solution PI = PV of future net cash flows / initial cost of investment = £5,547,280 / £4,000,000 = 1.38682 INTERNAL RATE OF RETURN (IRR): Scheme 1 Considering the 12% cost of capital, the net present value of scheme 1 is £672,910. In general, IRR is the rate that makes the NPV equals to zero. Therefore, the IRR for scheme 1 is 14.51%. Solution Year Cash Inflows Initial Investment Net Cash Flow 0 - 10,000,000 -10,000,000 1 2,550,000 - 2,550,000 2 2,470,000 - 2,470,000 3 3,210,000 - 3,210,000 4 3,365,000 - 3,365,000 5 3,530,000 - 3,530,000 Total 15,125,000 10,000,000 5,125,000 IRR 14.51% INTERNAL RATE OF RETURN (IRR): Scheme 2 Considering the 12% cost of capital, the net present value of scheme 2 is £1,547,280. Since IRR is the rate that makes the NPV equals to zero, the IRR for scheme 2 is 23.45%. Solution Year Cash Inflows Initial Investment Net Cash Flow 0 - 4,000,000 -4,000,000 1 1,050,000 - 2,550,000 2 1,180,000 - 2,470,000 3 1,280,000 - 3,210,000 4 1,390,000 - 3,365,000 5 1,570,000 - 3,530,000 6 1,940,000     Total 8,410,000 4,000,000 4,410,000 IRR 23.45% The Best Scheme the Board should Accept Scheme 1 Scheme 2 Payback Period 3.34 years 3.352 years Net Present Value £672,910 £1,547,280 Profitability Index 1.067291 1.38682 Internal Rate of Return 14.51% 23.45% Both schemes are viable because of the short payback period of 3 years, positive net present value and internal rate of return. Between these two schemes, scheme 2 is more attractive because it has a higher net present value of £1,547,280 as compared to scheme 1’s £672,910, higher profitability index of 1.38682 as compared to scheme 1’s 1.067291, and a higher internal rate of return of 23.45% as compared to scheme 1’s 14.51%. Question 3 In today’s current economic climate the banking industry may not be the main source of funding for Maritime and Logistics companies. Describe Private Equity and why this is an important alternative funding source for these industries. By nature, shipping or maritime companies are private companies that operate offshore without taxes and enjoy minimal regulatory control. Banks were among the few traditional funding sources for maritime and logistics companies. However, because of the risks of default payments and unpaid debts involved in ‘shipping lending’, a lot of banks now-a-days are reluctant in lending money to shipping companies. Today, private equity is becoming an important alternative source of funding because, technically speaking, it has no short-term liquidity. Often times, private equity funds are funds that come from a portfolio of different investments being managed by the private equity managers. For this reason, the maritime and logistics companies are free to expect higher long-term returns by trading short-term liquidity. Classified as illiquid asset class, private equity has no public market within the company or fund level. Since banks have imposed restrictions in shipping lending, the private equity has become the next best source of funding for these industries. Find and then Investigate a Private Equity company and show, in a report format, how this company is providing funds for the Maritime or Logistics Industry. This may be to individual companies or a group. Give named examples. Oaktree Capital Management is a private company in the United States that offers investment options related to private equity. Recently, Oaktree purchases shipping loans from either Lloyds Banking Group or the Royal Bank of Scotland. In line with this, Oaktree is able to hedge funds by using private equity funds in purchasing vessels directly or jointly from either a shipping company or the banks. For example, sometime in October 2013, Oaktree purchased a total of 14 chemical tankers worth €280 million of non-performing loans directly from Commerzbank (Agnew, 2014; Saul, 2013). Since Oaktree is purchasing vessels at a much lower price, this particular private equity firm has the option to sell these vessels at a much higher price as soon as the economy recovers from serious economic recession. Investing on distressed debts is only one type of investment option for Oaktree. As part of its diverse investment portfolio, this particular private equity firm also invest on ‘emerging market equities, real estate management, mezzanine financing, and power infrastructure’ (Bison, 2014). As a result of having diverse investment portfolio, this particular private equity firm managed to own assets such as: corporate debt, convertible securities, control investing, real estate, and listed equities (Oaktree, 2014). Source: Oaktree, 2014 As of 14th of November 2014, the stock value of Oaktree was 0.33% lower at US$45.75 (Bloomberg, 2014). It simply means that other than generating funds from its public investors, this particular private equity firm provide funds for maritime or logistics industry from its other assets. Source: Bloomberg, 2014 With IRR totalling to 29.7% (gross) and 18.5% (net) (Distressed Debt Investing, 2011), it seems that Oaktree has been doing a good job when it comes to managing distressed debts. As mentioned earlier, should be higher than zero value. Even though Oaktree’s IRR is much lesser as compared to other private equity firms such as the Special Account A that has gross IRR of 51.2% and net IRR of 40.5% as of the same year end (Distressed Debt Investing, 2011), the fact that Oaktree’s IRR is positive and higher than zero values means that the process of managing distressed debts can provide this particular private equity firm with good returns. Source: Distressed Debt Investing, 2011 . References Agnew, H. (2014, March 17). Alternative investors set sale for shipping upturn. Financial News. [Online] Available at: http://www.efinancialnews.com/story/2014-03-17/hedge-funds-private-equity-shipping?ea9c8a2de0ee111045601ab04d673622 [Accessed 15 November 2014]. Bison. (2014). Oaktree Capital Management. [Online] Available at: https://www.bison.co/firm/1181/oaktree-capital-management [Accessed 15 November 2014]. Bloomberg. (2014). Oaktree Capital Group LLC. [Online] Available at: http://www.bloomberg.com/quote/OAK:US [Accessed 15 November 2014]. Distressed Debt Investing. (2011, July 21). My Favorite Takeaways from the Oaktree S-1. [Online] Available at: http://www.distressed-debt-investing.com/2011/06/my-favorite-takeaways-from-oaktree-s-1.html [Accessed 15 November 2014]. Saul, J. (2013, December 18). Funds buy shipping loans from capital-conscious banks. Eruters. [Online] Available at: http://www.reuters.com/article/2013/12/18/shipping-banks-idUSL6N0JV2JF20131218 [Accessed 15 November 2014]. Oaktree. (2014). Official Website. [Online] Available at: http://www.oaktreecapital.com/about/ [Accessed 15 November 2014]. Read More