Paf Unit 1 PDF

Download as pdf or txt
Download as pdf or txt
You are on page 1of 15

UNIT-I

Topics:-
 IDENTIFICATION OF INVESTMENT OPPORTUNITIES
 INDUSTRY ANALYSIS REVIEW OF PROJECT
 PROFILES FEASIBILITY STUDY

IDENTIFICATION OF INVESTMENT OPPORTUNITIES

An investment decision in a country is based on discovering relations between the macroeconomic


development of countries and the investment attractiveness of their government regulation.
Macroeconomics refers to a branch of economics that studies how an overall economy, the market
systems that operate on a large scale behaves. Macroeconomics studies economy-wide phenomena
such as inflation, price levels, rate of economic growth, national income, gross domestic product
(GDP), and changes in unemployment.

Investment opportunities have to be identified or created they do not occur automatically. Investment
proposals of various types may originate at different levels within a firm. Most proposals of various
types may originate at different levels within a firm. Projects have a major role to play in the economic
development of a country. Since the introduction of planning in our economy, we have been investing
large amount of money in projects related to industry, minerals, power, transportation, irrigation,
education etc. with a view to improve the socio-economic conditions of the people. These projects are
designed with the aim of efficient management, earning adequate return to provide for future
development with their own resources.

Most proposals, in the nature of cost reduction or replacement or process or product improvements
take place at plant level. The contribution of top management in generating investment ideas is
generally confined to expansion or diversification projects. The proposals may originate
systematically or haphazardly in a firm. The proposal for adding new product may estimate from the
marketing department or from the plant manager who thinks be a better way of utilizing idle capacity.
Suggestions for replacing an old machine or improving the production techniques may arise at the
factory level. In view of the fact that enough investment proposals should be generated to employ the
firm’s funds fully well and efficiency, a systematic procedure for generating proposals may be evolved
by a firm.

In a number of companies, the investment ideas are generated at the plant level. The contribution of
the broad in idea generation is relatively insignificant. However, some companies depend on the
board for certain investment ideas, particularly those that are strategic in nature.
Companies use a variety of methods are:

Management sponsored studies for project identification, Formal suggestion schemes, Consulting
advice. Most companies use a combination of methods. The offer of financial incentives for
generating investment idea is not a popular practice. Other efforts employed by companies in
searching investment ideas are review of researches done in the country or abroad, conducting
market surveys, deputing executives to international trade fairs for identifying new products and
technology. Once the investment proposals have been identified, they are be submitted for scrutiny.
Many companies specify the time for submitting the proposals for scrutiny.

Project Evaluation

The evaluation of projects should be performed by a group of experts who have no axe to grind. For
example, the production people may generally interested in having the most modern type of
equipments and increased production even if productivity is expected to be low and goods cannot be
sold. This attitude can bias their estimates of cash flows of the proposed projects. Similarly, marketing
executives may be too optimistic about the sales prospects of goods manufactures and overestimate
the benefits of a proposed new product. It is, therefore, necessary to ensure that projects are
scrutinized by an impartial group and that objectivity is maintained in the evaluation process.

A company in practice should take all care in selecting a method or methods of investment
evaluation. The criterion selected should a true measure of the investments profitability (in terms of
cash flows), and it should lead to the net increase in the companies wealth (that is, its benefits should
exceed its cost adjusted for time value and risk). It should also be seen that the evaluation criteria do
not discriminate between the investment proposals. They should be capable of ranking projects
correctly in terms of profitability. The net present value method is theoretically most desirable criterion
as it is a true measure of profitability; it generally ranks projects correctly and is consistent with the
wealth maximization criterion. In practice, however, managers’ choice may be governed by other
practical considerations also.

A formal financial evaluation of proposed capital expenditures has become a common practice
among companies. A number of companies have a formal financial evaluation of almost three froths
of their investment projects. Most companies subject more than 50% of the projects to some kind of
formal evaluation. However, projects, such as replacement or worn-out equipment, welfare and
statutorily required projects below certain limits, small value items like office equipment or furniture,
replacement of assets of immediate requirements, etc., are not often formally evaluated.

Methods of Project Evaluation

(1) Payback Method


(2) Internal Rate of Return (IRR)
(3) Net Present Value (NPV)
(4) Accounting Rate of Return (ARR)

The major reason for payback to be more popular than the discounted cash flow method techniques
is the executives’ lack of familiarity with discounted cash flow techniques. Other factors are lack of
technical people and sometimes unwillingness of top management to use the discounted cash flow
techniques. One large manufacturing and marketing organization, for example, thinks that conditions
of its business are such that the discounted cash flow techniques are not needed. By business
conditions the company perhaps means its marketing nature, and its products being in seller’s
markets. Another company feels that replacement projects are very frequent in the company, and
therefore, it is not necessary to use the discounted cash flow techniques for such projects. Both these
companies have fallacious approaches towards investment analysis. They should subject all capital
expenditures to formal evaluation.

The practice of companies in Asian countries regards the use of evaluation criteria is similar to that in
USA. Almost four-fifths of US firms use either the internal rate of return or net present value models,
but only about one-fifth use such discounting techniques without using the payback period or average
rate of return methods. The tendency of US firms to use native techniques as supplementary tools
has also been reported in recent studies. However, firms in USA have come to depend increasingly
on the discounted cash flow techniques, particularly internal rate of return. The British companies use
both discounted cash flow techniques and return on capital, sometimes in combination sometimes
solely, in their investment evaluation; the use of payback is widespread. In recent years the use of
discounted cash flow methods has increased in UK, and net present value (NPV) is more popular
than internal rate of return (IRR). However, this increase has not reduced the importance of traditional
methods such as payback and return on investment. Payback continuous to be employed by almost
all companies. One significant difference between practice in Asian countries and USA is that
payback is used in Asian countries as a “primary” method and IRR/NPV as a “secondary” method,
while it is just reverse in USA. Asian countries managers feel that payback is a convenient method of
communicating on investment’s desirability, and it best protects the recovery of capital-a secure
commodity in the developing countries.

Under payback method, an investment project is accepted or rejected on the basis of payback period.
Payback period means the period of time that a project requires to recover the money invested in it. It
is mostly expressed in years.

Unlike net present value and internal rate of return method, payback method does not take into
account the time value of money.

According to payback method, the project that promises a quick recovery of initial investment is
considered desirable. If the payback period of a project is shorter than or equal to the management’s
maximum desired payback period, the project is accepted, otherwise rejected. For example, if a
company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired
payback period of the company would be 5 years. The purchase of machine would be desirable if it
promises a payback period of 5 years or less.

Payback Period Method

Formula

The formula to calculate the payback period of an investment depends on whether the periodic cash
inflows from the project are even or uneven.

If the cash inflows are even the formula to calculate payback period is:

Initial Investment
Payback Period =
Net Cash Flow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula:
B
Payback Period = A +
C

Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end of the
period A; and
C is the total cash inflow during the period following period A

Cumulative net cash flow is the sum of inflows to date, minus the initial outflow.

Both of the above situations are explained through examples given below.

Example 1: Even Cash Flows

Company Vector is planning to undertake a project requiring initial investment of Rs.105 million. The
project is expected to generate Rs.25 million per year in net cash flows for 7 years. Calculate the
payback period of the project.

Solution

Payback Period
= Initial Investment ÷ Annual Cash Flow
= Rs.105 M ÷ Rs.25 M
= 4.2 years

Example 2: Uneven Cash Flows

Company Vector is planning to undertake another project requiring initial investment of Rs.50 million
and is expected to generate Rs.10 million net cash flow in Year 1, Rs.13 million in Year 2, Rs.16
million in year 3, Rs.19 million in Year 4 and Rs.22 million in Year 5. Calculate the payback value of
the project.

Solution

(CASH FLOWS IN MILLIONS)


Year Annual Cumulative
Cash Flow Cash Flow
0 -50 -50
1 10 -40
2 13 -27
3 16 -11
4 19 8
5 22 30

Payback Period = 3 + 11/19 = 3 + 0.58 ≈ 3.6 years


Decision Rule

The longer the payback period of a project, the higher the risk. Between mutually exclusive
projects having similar return, the decision should be to invest in the project having the shortest
payback period. The decision whether to accept or reject a project based on its payback period
depends upon the risk appetite of the management.

Management will set an acceptable payback period for individual investments based on whether the
management is risk averse or risk taking. This target may be different for different projects because
higher risk corresponds with higher return thus longer payback period being acceptable for profitable
projects. For lower return projects, management will only accept the project if the risk is low which
means payback period must be short.

Advantages of payback period are:

1. Payback period is very simple to calculate.

2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain.

3. For companies facing liquidity problems, it provides a good ranking of projects that would
return money early.

Disadvantages of payback period are:

1. Payback period does not take into account the time value of money which is a serious
drawback since it can lead to wrong decisions.

2. It does not take into account, the cash flows that occur after the payback period. This
means that a project having very good cash inflows but beyond its payback period may be
ignored.

Internal Rate of Return (IRR)

Question:
Safeco Company and RiscoInc are identical in size and capital structure. However, the riskiness of
their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and
Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the
same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and
is of the same risk as a typical Risco project. Now assume that the two companies merge and form a
new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-
merger companies market risks, and the merger has no impact on either the cash flows or the risks of
Projects X and Y. What is true?

IRR:
This question calls for an awareness of the capital budgeting technique known as the internal rate of
return (IRR) evaluation. The IRR evaluation guides investment decisions by facilitating the
acceptance of projects that have IRRs that exceed their hurdle rates and rejecting projects that have
IRRs that fall short of their hurdle rates.
WACC:
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is commonly referred to as the
firm's cost of capital. Importantly, it is dictated by the external market and not by management.

Answer and Explanation:


The thought process for answering this question is outlined below.

- We know the average project at Risco is riskier than the average project at Safeco, because Risco's
WACC is higher (12.0% vs. 10.0%).

- We know the decision rule for the IRR evaluation is as follows: accept projects where IRR >
discount rate and reject projects where IRR < discount rate.

- Project X should be evaluated using a discount rate of 10.0% (Safeco's old WACC), because it is a
relatively low risk project. Since it has an IRR of 10.5% (> 10.0%), it will be accepted by the new
company.

- Project Y should be evaluated using a discount rate of 12.0% (Risco's old WACC), because it is a
relatively high risk project. Since it has an IRR of 11.5% (< 12.0%), it will be rejected by the new
company.

Net Present Value (NPV)

What is Net Present Value (NPV)?

Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and investment
planning to analyze the profitability of a projected investment or project.

The following formula is used to calculate NPV:


A positive net present value indicates that the projected earnings generated by a project or
investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed
that an investment with a positive NPV will be profitable, and an investment with a negative NPV will
result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that only
investments with positive NPV values should be considered.

How to Calculate Net Present Value (NPV)

Money in the present is worth more than the same amount in the future due to inflation and to
earnings from alternative investments that could be made during the intervening time. In other words,
a dollar earned in the future won’t be worth as much as one earned in the present. The discount rate
element of the NPV formula is a way to account for this.

For example, assume that an investor could choose a $100 payment today or in a year. A rational
investor would not be willing to postpone payment. However, what if an investor could choose to
receive $100 today or $105 in a year? If the payer was reliable, that extra 5% may be worth the wait,
but only if there wasn’t anything else the investors could do with the $100 that would earn more than
5%.

An investor might be willing to wait a year to earn an extra 5%, but that may not be acceptable for all
investors. In this case, the 5% is the discount rate which will vary depending on the investor. If an
investor knew they could earn 8% from a relatively safe investment over the next year, they would not
be willing to postpone payment for 5%. In this case, the investor’s discount rate is 8%.

A company may determine the discount rate using the expected return of other projects with a similar
level of risk or the cost of borrowing money needed to finance the project. For example, a company
may avoid a project that is expected to return 10% per year if it costs 12% to finance the project or an
alternative project is expected to return 14% per year.

Imagine a company can invest in equipment that will cost $1,000,000 and is expected to generate
$25,000 a month in revenue for five years. The company has the capital available for the equipment
and could alternatively invest it in the stock market for an expected return of 8% per year. The
managers feel that buying the equipment or investing in the stock market are similar risks.

STEP ONE: NPV OF THE INITIAL INVESTMENT

Because the equipment is paid for up front, this is the first cash flow included in the calculation. There
is no elapsed time that needs to be accounted for so today’s outflow of $1,000,000 doesn’t need to be
discounted.

Identify the number of periods (t)

The equipment is expected to generate monthly cash flow and last for five years, which means there
will be 60 cash flows and 60 periods included in the calculation.
Identify the discount rate (i)

The alternative investment is expected to pay 8% per year. However, because the equipment
generates a monthly stream of cash flows, the annual discount rate needs to be turned into a periodic
or monthly rate. Using the following formula, we find that the periodic rate is 0.64%.

STEP TWO: NPV OF FUTURE CASH FLOWS

Assume the monthly cash flows are earned at the end of the month, with the first payment arriving
exactly one month after the equipment has been purchased. This is a future payment, so it needs to
be adjusted for the time value of money. An investor can perform this calculation easily with a
spreadsheet or calculator. To illustrate the concept, the first five payments are displayed in the table
below.

The full calculation of the present value is equal to the present value of all 60 future cash flows, minus
the $1,000,000 investment. The calculation could be more complicated if the equipment was
expected to have any value left at the end of its life, but, in this example, it is assumed to be
worthless.
In this case, the NPV is positive; the equipment should be purchased. If the present value of these
cash flows had been negative because the discount rate was larger, or the net cash flows were
smaller, the investment should have been avoided.

Accounting Rate of Return – ARR

What Is the Accounting Rate of Return – ARR?

The accounting rate of return (ARR) is the percentage rate of return expected on investment or asset
as compared to the initial investment cost. ARR divides the average revenue from an asset by the
company's initial investment to derive the ratio or return that can be expected over the lifetime of the
asset or related project. ARR does not consider the time value of money or cash flows, which can be
an integral part of maintaining a business.

How to Calculate the Accounting Rate of Return – ARR

Calculate the annual net profit from the investment, which could include revenue minus any annual
costs or expenses of implementing the project or investment.

If the investment is a fixed asset such as property, plant, or equipment, subtract any depreciation
expense from the annual revenue to achieve the annual net profit.

Divide the annual net profit by the initial cost of the asset, or investment. The result of the calculation
will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.
What Does ARR Tell You?

The accounting rate of return is a capital budgeting metric useful for a quick calculation of an
investment's profitability. ARR is used mainly as a general comparison between multiple projects to
determine the expected rate of return from each project.

ARR can be used when deciding on an investment or an acquisition. It factors in any possible annual
expenses or depreciation expense that's associated with the project. Depreciation is an accounting
process whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life
of the asset.

Depreciation is a helpful accounting convention that allows companies not to have to expense the
entire cost of a large purchase in year one, thus allowing the company to earn a profit from the asset
right away, even in its first year of service. In the ARR calculation, depreciation expense and any
annual costs must be subtracted from annual revenue to yield the net annual profit.

Example of How to Use the Accounting Rate of Return – ARR

A project is being considered that has an initial investment of $250,000 and it's forecasted to generate
revenue for the next five years. Below are the details:

 Initial investment: $250,000

 Expected revenue per year: $70,000

 Time frame: 5 years

 ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)

 ARR =0.28 or 28% (0.28 * 100)

What is Industry Analysis?

Industry analysis is a market assessment tool used by businesses and analysts to understand the
competitive dynamics of an industry. It helps them get a sense of what is happening in an industry,
i.e., demand-supply statistics, degree of competition within the industry, state of competition of the
industry with other emerging industries, future prospects of the industry taking into account
technological changes, credit system within the industry, and the influence of external factors on the
industry.

Industry analysis, for an entrepreneur or a company, is a method that helps it to understand its
position relative to other participants in the industry. It helps them to identify both the opportunities
and threats coming their way and gives them a strong idea of the present and future scenario of the
industry. The key to surviving in this ever-changing business environment is to understand the
differences between yourself and your competitors in the industry and using it to your full advantage.
Types of Industry Analysis

There are three commonly used and important methods of performing industry analysis. The three
methods are:

1. Competitive Forces Model (Porter’s 5 Forces)


2. Broad Factors Analysis (PEST Analysis)
3. SWOT Analysis

COMPETITIVE FORCES MODEL (PORTER’S 5 FORCES)

One of the most famous models ever developed for industry analysis, famously known as Porter’s 5
Forces, was introduced by Michael Porter in his 1980 book “Competitive Strategy: Techniques for
Analyzing Industries and Competitors.”

According to Porter, analysis of the five forces gives an accurate impression of the industry and
makes analysis easier. In our Corporate & Business Strategy course, we cover these five forces and
an additional force — power of complementary good/service providers.

1. Intensity of Industry Rivalry

The number of participants in the industry and their respective market shares are a direct
representation of the competitiveness of the industry. These are directly affected by all the factors
mentioned above. Lack of differentiation in products tends to add to the intensity of competition. High
exit costs like high fixed assets, government restrictions, labor unions, etc. also make the competitors
fight the battle a little harder.
2. Threat of Potential Entrants

This indicates the ease with which new firms can enter the market of a particular industry. If it is easy
to enter an industry, companies face the constant risk of new competitors. If the entry is difficult,
whichever company enjoys little competitive advantage reaps the benefits for a longer period. Also,
under difficult entry circumstances, companies face a constant set of competitors.

3. Bargaining Power of Suppliers

This refers to the bargaining power of suppliers. If the industry relies on a small number of suppliers,
they enjoy a considerable amount of bargaining power. This can affect small businesses because it
directly influences the quality and the price of the final product.

4. Bargaining Power of Buyers

The complete opposite happens when the bargaining power lies with the customers. If
consumers/buyers enjoy market power, they are in a position to negotiate lower prices, better quality,
or additional services and discounts. This is the case in an industry with more competitors but with a
single buyer constituting a large share of the industry’s sales.

5. Threat of Substitute Goods/Services

The industry is always competing with another industry in producing a similar substitute product.
Hence, all firms in an industry have potential competitors from other industries. This takes a toll on
their profitability because they are unable to charge exorbitant prices. Substitutes can take two forms
– products with the same function/quality but lesser price, or products of the same price but of better
quality or providing more utility.

BROAD FACTORS ANALYSIS (PEST ANALYSIS)

Broad Factors Analysis, also commonly called the PEST Analysis stands for Political, Economic,
Social and Technological. PEST analysis is a useful framework for analyzing the external
environment.
To use PEST as a form of industry analysis, an analyst will analyze each of the 4 components of the
model. These components include:

1. Political

Political factors that impact an industry include specific policies and regulations related to things like
taxes, environmental regulation, tariffs, trade policies, labor laws, ease of doing business, and the
overall political stability.

2. Economic
The economic forces that have an impact include inflation, exchange rates (FX), (FX interest rates, GDP
growth rates, conditions in the capital markets (ability to access capital), etc.

3. Social
The social impact on an industry refers to trends among people and includes things such as
population growth, demographics (age, gender, etc
etc),
), and trends in behavior such as health, fashion,
and social movements.

4. Technological
The technological aspect of PEST analysis incorporates factors such as advancements and
developments that change the way a business operates and the ways in which people
pe live their lives
(i.e. advent of the internet).

SWOT ANALYSIS

SWOT Analysis stands for Strengths, Weaknesses, Opportunities, and Threats. It can be a great
way of summarizing various industry analysis methods and determining their implications for the
business in question.
1. Internal

Internal factors that already exist and have contributed to the current position and may continue to
exist.

2. External

External factors which are contingent events. Assess their importance based on the likelihood of them
happening and their impact on the company. Also, consider whether management has the intention
and ability to take advantage of the opportunity/avoid the threat.

Importance of Industry Analysis

Industry analysis, as a form of market assessment, is crucial because it helps a business understand
market conditions. It helps them forecast demand and supply and consequently, financial returns from
the business. It indicates the competitiveness of the industry and costs associated with entering and
exiting the industry. It is very important when planning a small business. Analysis helps to identify
which stage an industry is currently in; whether it is still growing and there is scope to reap benefits,
or has it reached its saturation point.
With a very detailed study of the industry, entrepreneurs can get a stronghold on the operations of the
industry and may discover untapped opportunities. It is also important to understand that industry
analysis is a very subjective method and does not always guarantee success. It may happen that
incorrect interpretation of data leads entrepreneurs to a wrong path or into making wrong decisions.
Hence, it becomes important to understand one’s motive and collect data accordingly.

What is a Feasibility Study?

As the name implies, a feasibility analysis is used to determine the viability of an idea, such as
ensuring a project is legally and technically feasible as well as economically justifiable. It tells us
whether a project is worth the investment—in some cases, a project may not be doable. There can be
many reasons for this, including requiring too many resources, which not only prevents those
resources from performing other tasks but also may cost more than an organization would earn back
by taking on a project that isn’t profitable. A well-designed study should offer a historical background
of the business or project, such as a description of the product or service, accounting statements,
details of operations and management, marketing research and policies, financial data, legal
requirements, and tax obligations. Generally, such studies precede technical development and
project implementation.

Types of Feasibility Study

A feasibility analysis evaluates the project’s potential for success; therefore, perceived objectivity is
an essential factor in the credibility of the study for potential investors and lending institutions. There
are five types of feasibility study—separate areas that feasibility study examines, described below.

Technical Feasibility

This assessment focuses on the technical resources available to the organization. It helps
organizations determine whether the technical resources meet capacity and whether the technical
team is capable of converting the ideas into working systems. Technical feasibility also involves the
evaluation of the hardware, software, and other technical requirements of the proposed system. As
an exaggerated example, an organization wouldn’t want to try to put Star Trek’s transporters in their
building—currently, this project is not technically feasible.

Economic Feasibility

This assessment typically involves a cost/ benefits analysis of the project, helping organizations
determine the viability, cost, and benefits associated with a project before financial resources are
allocated. It also serves as an independent project assessment and enhances project credibility—
helping decision-makers determine the positive economic benefits to the organization that the
proposed project will provide.

Legal Feasibility

This assessment investigates whether any aspect of the proposed project conflicts with legal
requirements like zoning laws, data protection acts or social media laws. Let’s say an organization
wants to construct a new office building in a specific location. A feasibility study might reveal the
organization’s ideal location isn’t zoned for that type of business. That organization has just saved
considerable time and effort by learning that their project was not feasible right from the beginning.

Operational Feasibility

This assessment involves undertaking a study to analyze and determine whether—and how well—the
organization’s needs can be met by completing the project. Operational feasibility studies also
examine how a project plan satisfies the requirements identified in the requirements analysis phase of
system development.

Scheduling Feasibility

This assessment is the most important for project success; after all, a project will fail if not completed
on time. In scheduling feasibility, an organization estimates how much time the project will take to
complete.
When these areas have all been examined, the feasibility analysis helps identify any constraints the
proposed project may face, including:
 Internal Project Constraints: Technical, Technology, Budget, Resource, etc.
 Internal Corporate Constraints: Financial, Marketing, Export, etc.
 External Constraints: Logistics, Environment, Laws, and Regulations, etc.

Importance of Feasibility Study

The importance of a feasibility study is based on organizational desire to “get it right” before
committing resources, time, or budget. A feasibility study might uncover new ideas that could
completely change a project’s scope. It’s best to make these determinations in advance, rather than
to jump in and to learn that the project won’t work. Conducting a feasibility study is always beneficial
to the project as it gives you and other stakeholders a clear picture of the proposed project.
Below are some key benefits of conducting a feasibility study:

You might also like