NAT IONAL QUALIFICAT IONS CURRICULUM SUPPORT

Accounting and Finance

Investment Appraisal
Staff Development Materials
[ADVANCED HIGHER]

This edition first published 2001 Electronic version 2001 Learning and Teaching Scotland 2001 This publication may be reproduced in whole or in part for educational purposes by educational establishments in Scotland provided that no profit accrues at any stage. Acknowledgement Learning and Teaching Scotland gratefully acknowledge thi s contribution to the Higher Still support programme for Accounting and Finance. The original writer was John McDonagh, of the Institute of Chartered Accountants of Scotland, and the publication first appeared in 1993 in the Scottish CCC series of staff d evelopment materials for the Certificate of Sixth Year Studies. ISBN 1 85955 894 1 Learning and Teaching Scotland Gardyne Road Dundee DD5 1NY www.LTScotland.com

CONTENTS

Introduction Section 1: Section 2: Section 3: Section 4: Section 5: Section 6: Section 7: Appendi x: Accounting Rate of Return (ARR) Payback Discounted Cash Flow Net Present Value (NPV) Internal Rate of Retur n ( IRR) Profitability Index (PI)

iv 1 5 7 9 13 18

Advantages and Disadvantages of the Various Methods 19 Discount Table 20

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iii

INTRODUCTION

1.

Investment appraisal is the technique used by management in deciding how money will be spent (invested) on fixed assets. Investment appraisal, also known as project appraisal, thus considers capital expenditure. The possible relationships between projects are as follows. Mutually Exclusive Projects may be mutually exclusive. This means that from a range of alternatives the choice of one totally precludes the choice of another, e.g. construction of a power station requires a decision on whether to build one powered by nuclear or fossil fuel.

2.

3.

Projects may be Independent From a given range of alternatives the decision taker may choose any single project or combination of projects, or all of the projects.

4.

Projects may be Dependent Here the installation of a new machine may require substantial alteration to the existing electrical system, or layout of the factory.

5.

Method of Investment Appraisal (a) (b) (c) (d) (e) Accounting Rate of Return Payback Net Present Value Internal Rate of Return Profitability Index

iv

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AC CO U N TI N G RA T E O F R E TU RN (A RR)

SECTION 1
1.1 The accounting rate of return compares as a percentage the average profit flowing from the project (investment) with either (a) (b) the original capital expenditure incurred or the original capital expenditure averaged over the life of the project.

1.2

Example 1 Firm X is considering the purchase of a machine which will cost 10,000. The machine will have a life of 5 years and be scrapped at the end of that time. It is estimated that the residual scrap value will be zero. The cash inflows from the investment will be as follows. Year 1 2 3 4 5 Cash Inflow 6,000 4,000 4,000 3,000 1,000 18,000

The total cash flowing in from purchasing this machine is 18,000. However, ARR deals with profit flowing from the project. It is, therefore, essential to adjust cash flows to profit. In the absence of any further information the following can be assumed to be the profits from the purchase of the machine. Year 1 2 3 4 5 Cash Inflow 6,000 4,000 4,000 3,000 1,000 Depreciation (2,000) (2,000) (2,000) (2,000) (2,000) Profit 4,000 2,000 2,000 1,000 (1,000)

The total profit, after allowing for depreciation, is 8,000.

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AC CO U N TI N G RA T E O F R E TU RN (A RR)

A quicker means of arriving at the profit is to simply de duct the total cost of the machine from the total cash flows resulting from the project. e.g. Total Cash Inflows 18,000 Less Capital Cost 10,000 Profit 8,000 ARR = Average Profits Original Capital Expenditure 8,000 = 1,600 5 1,600 x 100 = 16% 10,000

Average Profits =

ARR = or ARR =

Average Profits Original Capital Expenditure averaged over life of Project 1,600 x 100 = 80% 2,000

ARR =

The timing of the cash flows is never considered. Under ARR, profit rather than cash flows is the criterion by which projects are appraised. 1.3 Example 2 Firm Y has the choice between Projects A and B. Project A 10,000 Year Year Year Year Year Year 1 2 3 4 5 6 6,000 4,000 3,000 3,000 1,000 1,000 Project B 10,000 6,000 4,000 6,000

Capital Outlay Cash Inflows

Both Project A and Project B require a capital outlay of 10,000 each.

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Profits from Projects Cash Inflows Less Capital Outlay Profit

A 18,000 10,000 8,000

B 16,000 10,000 6,000

Calculating ARR as

Average Profits Original Capital Expenditure 8,000 6 = 1,333 1,333 x 100 10,000 13.33% 6,000 3 2,000

x 100

Average Profits

ARR

2,000 x 100 10,000 20%

= Calculating ARR as

Average Profits Average Capital Expenditure over life of Project ARR = 1,333 x 100 1,667 80%

x 100

2,000 x 100 3,333 60%

On the assumption that firm Y calculates ARR based on Original Capital Expenditure, then if Projects A and B are mutually exclusive, Project B will be chosen. If, however, the firm calculates ARR based on the average sum invested, Project A will be chosen. It should be clear that when cash flows (or profits) are not of the same duration, then this method is totally unsuitable. Although this method does give an indication of the profitability of a project, by ignoring the timing of cash flows it should be considered inappropriate as a means of appraising investments.

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1.4

Example 3 Firm Z Project A 5,000 5,000 4,000 3,000 2,000 1,000 Project B 5,000 1,000 2,000 3,000 4,000 5,000

Capital Outlay Cash Inflows

Year Year Year Year Year

1 2 3 4 5

Total Profits Cash Inflows Less Capital Outlay 15,000 5,000 10,000 15,000 5,000 10,000

ARR as percentage of Capital Outlay 2,000 x 100 5,000 1 = 40% 2,000 x 100 5,000 1 40%

Both Projects have the same ARR but if asked which was the better Project, most people would select Project A, the reason being that it is better to collect the large sums of money as soon as possible. In other words, the timing of cash flows must have some relevance in investment appraisal. However, ARR ignores the timing of such cash flows and all s are treated as being equal.

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PAYB ACK

SECTION 2

2.1

Payback represents an assessment of the time taken by a project to recover in full the initial capital outlay. In other words it is the length of time a project takes to pay for itself. The time taken for a project to pay for itself is known as the Payback Period. Payback is a popular method because of its simplicity. The length of time that the capital is at risk is known. However, as with the accounting rate of return, the actual timing of the cash flows is ignored and there is a built-in discrimination in favour of short-term investments. It should also be observed that cash flows after the payback period are ignored.

2.2

Example

Cash Outlay Cash Inflow

Year Year Year Year Year Year Year

1 2 3 4 5 6 7

Project X 20,000 10,000 6,000 4,000 4,000 4,000 4,000 4,000

Project Y 20,000 12,000 8,000 1,000 1,000

Calculation of the payback period is as follows.

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PAYB ACK

Cash Outlay Cash Inflows Year Year Year Year Year Year Year 1 2 3 4 5 6 7 Annual 10,000 6,000 4,000 4,000 4,000 4,000 4,000

Project X 20,000 Cumulative 10,000 16,000 20,000 24,000 28,000 32,000 36,000

Project Y 20,000 Annual 12,000 8,000 1,000 1,000 Cumulative 12,000 20,000 21,000 22,000

Time taken to pay back Capital

3 Years

2 Years

The rule in investment appraisal as far as payback is concerned is that the sooner a project pays for itself the better. Thus, if two projects are mutually exclusive, the project with the shorter payback period is considered to be the superior project. If the two projects above are mutually exclusive then Project Y would be chosen. The shortcomings of payback as a means of investment appraisal, however, should be immediately apparent. While it is true that Project Y does have a shorter payback period, cash flows after the payback period are ignored. Some firms in the United Kingdom have cut-off periods for project payback. The result of this is that investments must pay for themselves within a certain period, e.g. 2 or 3 years. If a proposed project will take longer than the firms cut-off period, then it will not be considered. Unlike ARR, payback does at least consider cash flows and not profit. Because of the shortcomings of methods which ignore the timing of cash flows, attention should be turned to tech niques which recognise the concept of present value. Such methods use discounted cash flow techniques and consist of the Net Present Value model and the Internal Rate of Return model.

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DI SC O U N T ED CA SH F LO W

SECTION 3

3.1

Assume you have 1.00 and inflation runs at 10% for 1 year. How much will you pay in one years time for an item costing 1.00 now? 1.00 x 1.10 = 1.10

3.2

Assume inflation continues to run at 10% for another year. How much will you have to pay at the end of the second year for an item costing 1.00 just now? 1.10 x 1.21

3.3

If inflation runs at 10% for a third year how much will you pay for an item costing 1.00 just now? (1.21 x 1.10) = (1.10 x 1.10 x 1.10) = (1.10) 3 = 1.331

3.4

This is known as Compounding. However, when we discount we simply reverse the procedure. If inflation runs at 10%, an item costing 1.00 in one years time will cost how much just now? 1 The answer is 1.10 = 0.9090 If inflation runs at 10% for a second year, an item costing 1.00 in 2 years time will cost how much just now? 1 The answer is 1.10 2 = 0.8264 Again, if inflation continues to run at 10% for a third year then an item costing 1.00 in 3 years time costs how much just now? 1 The answer is 1.10 3 = 0.7513 What this means to business people is that if inflation is at 10%, 1.00 received in one years time is exactly the same as being given 0.9090 just now. Also, 1.00 being received in 2 years time is exactly the same as receiving 0.8264 just now and 1.00 received in 3 years time is the same as receiving 0.7513 just now.

3.5

3.6

3.7

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3.8

This is described as Present Value and is stated thus at 10%, 1.00 in one years time has a present value of 0.9090 1.00 in two years time has a present value of 0.8264 1.00 in three years time has a present value of 0.7513 Investment appraisal can make use of present values by converting all future cash flows back to present value and thus comparisons can be made between projects in which all cash flows and the timing of the cash flows are considered.

3.9

3.10 The conversion of future cash flows into present value amounts is done through discount factors. The discount factor a firm uses to convert future s to present value is based on the cost of borrowing to that firm and is known as the cost of capital.

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NE T PR E S EN T VA L U E ( N PV )

SECTION 4

4.1

The Net Present Value (NPV) model as a means of investment appraisal considers all future cash flows but converts all future s to their worth at this moment in time. The result of this procedure is that all cash flows from a project are considered and, since all future cash flows are converted to present values, then a true comparison can be made between competing projects. Example 1 Cost of Project Years 1 2 3 4 5 20,000 Cash Inflows 10,000 6,000 4,000 4,000 4,000

4.2

4.3

Discount (or present value) factors are used to convert future s to present value. Present value tables are provided in the Appendix on page 20. The present values are based on the cost of borrowing to the firm. Assume this to be 10%. Looking at the present value table, we move to the 10% column and not the discount factors for the 5 years of the project. These are: Years 1 2 3 4 5 Discount factor .9091 .8264 .7513 .6830 .6209

4.4

In other words at 10%, 1 in 1 years time has a present value of 0.9091 just now. At 10%, 1 in 2 years time has a present value of 0.8264 just now and so on.

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NE T PR E S EN T VA L U E ( N PV )

4.5

We can use these present value factors to convert the future cash inflows into present value as follows. Years 0 1 2 3 4 5 Cash Flows x Discount Factor @ 10% = Present Value (20,000) 1.00 (20,000) 10,000 .9091 9,091 6,000 .8264 4,958 4,000 .7513 3,005 4,000 .6830 2,732 4,000 .6209 2,484 Net Present Value Points to Note All cash flows are considered, including the cash outflow (the investment) as well as the cash inflows. The cash outflow to fund the project is made now in Year 0. Year 1 cash inflows come into the firm one year from now. Thus the discount factor in Year 0 (now) is always 1.00. All cash flows are converted into present value by multiplying the cash flows by the appropriate discount (present value) factor. Net Present Value is found by adding together all cash inflows and deducting all cash outflows. In this example the net present value of the project is 2,270. This means that shareholders wealth is increased by 2,270. If an investment gives a positive NPV then the project should be accepted (unless we are dealing with mutually exclusive projects). The greater the net present value the greater is the increase in shareholders wealth. Thus, if there are two projects which are mutually exclusive, the project providing greater NPV will be chosen. If NPV is found to be negative, then the project should not be accepted because shareholders wealth is, in effect, reduced. 2,270

10

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NE T PR E S EN T V A L U E ( NPV )

4.6

Example 2 A project will cost 20,000 and will bring in the following cash flows. Years 1 2 3 4 5 Cash Inflows 15,000 10,000 6,000 3,000 (8,000)

The firms cost of capital is 12%. Before deciding on whether the project should be accepted or rejected, it should be noted that Year 5 cash flow is bracketed, thereby denoting that it is a cash outflow. Such a situation is becoming more common nowadays as environmental issues become more important. A cash outflow at the end of a project may come about because a firm has to restore land to the way it was prior to the project being carried out, e.g. restoring countryside after the laying of a pipe line, or removin g an oil platform from the North Sea after depleting the oil reserves. Calculations are as follows. Years Cash Flows (20,000) 15,000 10,000 6,000 3,000 (8,000) Discount Factor @ 12% Present Value (20,000) 13,394 7,969 4,271 1,907 (4,539) 3,002

0 1 2 3 4 5

1.00 .8929 .7969 .7118 .6355 .5674 Net Present Value

This project should therefore be accepted. Now assume interest rates rise to 18%. The project must be recalculated at the new cost of capital.

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NE T PR E S EN T VA L U E ( N PV )

Years

Cash Flows (20,000) 15,000 10,000 6,000 3,000 (8,000)

Discount Factor @ 18%

0 1 2 3 4 5

1.00 .8475 .7182 .6086 .5158 .4371

Present Value (20,000) 12,713 7,182 3,562 1,547 (3,497) 1,507

Net Present Value

NPV is reduced from 3,002 to 1,507. If interest rates do increase, many positive NPVs are transferred into negative NPVs and projects are not undertaken, e.g. machines are not bought, new oil drilling is not carried out. High interest rates can contribute to a firms stagnation or even contraction.

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IN T E RN A L R A T E O F RE T UR N ( IR R)

SECTION 5

5.1

Like NPV, Internal Rate of Return (IRR) considers the timing of cash flows and uses discount factors to convert future s to present value. However, IRR finds the rate of return which brings the net present value of all cash inflows and outflows to zero. The rate of return which achieves this is known as the yield of the project. The yield obtained is compared to the firms cost of capital and if the yield of the project is greater than the cost of the capital the project should be accepted. The IRR method of investment appraisal is also known as the yield method. A project requires an initial investment of 10,000 and will produce the following cash inflows. The firms Cost of Capital is 23%. Years 1 2 3 4 5 Cash Inflows 6,000 4,000 4,000 3,000 1,000

5.2

The first stage is to create a table similar to that prepared when using NPV. The only difference is that, instead of using the cost of capital, a discount factor is chosen which, it is hoped, will bring all future cash inflows and outflows to an NPV of zero. Years 0 1 2 3 4 5 Cash Flows (10,000) 6,000 4,000 4,000 3,000 1,000 Discount Factor @ 24% 1.00 .8065 .6504 .5245 .4230 .3411 Net Present Value Present Value (10,000) 4,839 2,602 2,098 1,269 341 1,149

Since 24% has not brought NPV to zero, another discount factor must be chosen. The NPV produced is 1,149. A discount factor lower than 24% would produce a higher NPV than 1,149, thus the second discount factor must be greater than 24%.

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IN T E RN A L R A T E O F RE T UR N ( IR R)

Years 0 1 2 3 4 5

Cash Flows (10,000) 6,000 4,000 4,000 3,000 1,000

Discount Factor @ 32% 1.00 .7576 .5739 .4348 .3294 .2495 Net Present Value

Present Value (10,000) 4,546 2,296 1,739 988 250 (181)

A discount factor of 32% produces negative NPV of 181. The result of this is that the discount factor which will bring all cash flows to zero must lie between 24% and 32%. To find the discount factor bringing cash flows to zero we could try 25%. If this did not work we could move to 26% and so on. However, by means of interpolation we are able to ascertain the discount factor giving zero for the cash flows. 24% gives an NPV of +1,149 32% gives an NPV of 181 8% difference leads to difference of 1,330 To find discount factor giving zero 24% + 1,149 x difference (between percentages) 1,330 = 24% + 1,149 x 8 1,330 = 30.9% Alternatively = 32% 181 x 8 1,330 = 30.9% Alternatively the following formulae can be used.

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IN T E RN A L R A T E O F RE T UR N ( IR R)

Positive rate + (Positive NPV (Positive NPV + Negative NPV) x Range of rates)% 24% + (1,149 (1,149 + 181) x 24% + ((1,149 1,330) x 8)% 24% + (0.8639 x 8)% 24% + 6.91% 30.91% or Negative rate (Negative NPV (Positive NPV + Negative NPV) x Range of rates)% 32% (181 (1,149 + 181) x 8)% 32% ((181 1,330) x 8)% 32% (0.1361 x 8)% 32% 1.09% 30.91% The figure of 30.9% is the yield of the project and it is now compared to the cost of capital. If it is greater than the cost of capital, then the project should be accepted. If it is less than the cost of capital, then the project should be rejected. 5.3 Note that IRR is only useful when comparing projects of the same scale. Scale is a function of (a) (b) (c) outlay cash flow patterns life. 24)%

If projects being compared and assessed differ in any of the above three areas, then IRR should not be used and firms should look to NPV as a means of assessing projects.

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IN T E RN A L R A T E O F RE T UR N ( IR R)

5.4

Outlays An example of the scale problem with regard to capital outlays is to make a decision between two mutually exclusive options. Option 1: Give me 1 just now and in an hour I will give you back 1.50. Option 2: Give me 10 just now and at the end of the hour I will give you back 11. An analysis of these two alternatives reveals the following: Option 1 *NPV IRR 1 50% Option 2 10 10%

*No rate is used as the transaction was almost instantaneous. The question centres on whether people (or shareholders) would prefer to be 1.00 richer rather than 50p richer. In other words, absolute values a re better indications of increases in wealth than percentages. It follows, therefore, that IRR may lead to a wrong decision in business. In the above example, the capital outlays were different and where this is the case IRR should not be used. 5.5 Cash Flow Patterns Assume a firm has a cost of capital of 10%. Two mutually exclusive projects have to be considered and are detailed below. Years 0 1 2 Project 1 (100) 144 Project 2 (100) 100 30

Calculation of the IRR is 20% for Project 1 an d 24% for Project 2. Thus, if IRR was the method of appraising investments, then Project 2 would be chosen in preference to Project 1. However, if the NPV is calculated (using the cost of capital of 10%), it is found that in absolute terms Project 1 has an NPV of 19 whilst Project 2 has an NPV of 16.

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IN T E RN A L R A T E O F RE T UR N ( IR R)

Project 1 clearly increases shareholders wealth more than does Project 2 and it is clearly advantageous to choose Project 1, yet IRR would have provided the wrong signals to management regarding which project to accept. 5.6 Life Again it can be shown that IRR is unsuitable when deciding on projects which are of different lengths. Example Two mutually exclusive projects require an initial investment of 100 each. The cash flows are as follows. Assume cost of capital is 10%. Years Cash Inflows Project 1 (100) 144

0 1 2

Project 2 (100) 126

The IRR for the projects work out at 20% for Project 1 and 26% for Project 2. Thus using an IRR model as the decision -making tool, management would choose Project 2. However, the NPV for the projects stands at 19 for Project 1 and 15 for Project 2. In absolute terms Project 1 should be chosen in preference to Project 2. Again IRR gives the wrong signals to management regarding which project to choose.

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PRO F I TAB I L I TY I ND EX ( P I)

SECTION 6

6.1

The Profitability Index (or PI) is based on the comparison of the net present value of the cash flow with the amount of the original investment. It is, therefore, a measure of the percentage increase in the capital sum that the net present value represents. Projects are thus ranked in order of profitability. The profitability index is calculated in the following manner. Net present value of cash flows = profitability index Original amount invested

6.2

The higher the profitability index, the higher the return earned on the project. The lower the profitability index, the less profitable the project and if the index falls below 1, this means that the project has failed to meet the required rate of return.

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AD VA N TA G E S A N D D IS AD V AN TA G E S O F T H E VA R I O U S M E TH O DS

SECTION 7
7.1 Accounting Rate of Return Advantages - Simple to understand - Easy to calculate - Ignores the timing of cash flows - Based on profitability rather than cash flows

Disadvantages

7.2

Payback Advantages - Simple to understand - Easy to calculate - Indicates length of time capital outlay is at risk - Ignores cash flows after payback period - Ignores timing of cash flows - Biased in favour of short-term projects

Disadvantages

7.3

Net Present Value Advantages - Considers the time value of money - Considers all cash flows - Answer is in absolute terms of increase (or decrease) in shareholders wealth - May be difficult to calculate

Disadvantages 7.4

Internal Rate of Return Advantages - Considers the time value of money - Considers all cash flows - Cannot be used to compare projects of different scales - Can give more than one answer - Confusing

Disadvantages

7.5

Profitability Index This is a derivative of the Net Present Value model and has the same advantages and disadvantages as NPV.

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DI SC O U N T TAB L E

APPENDIX

Present value of 1 received after n years discounted at 1% i n 1 2 3 4 5 6 1 .9901 .9803 .9706 .9610 .9515 .9420 2 .9804 .9612 .9423 .9238 .9057 .8880 3 .9709 .9426 .9151 .8885 .8626 .8375 4 .9615 .9246 .8890 .8548 .8219 .7903 5 .9524 .9070 .8638 .8227 .7835 .7462 6 .9434 .8900 .8396 .7921 .7473 .7050 7 .9346 .8734 .8163 .7629 .7130 .6663 8 .9259 .8573 .7938 .7350 .6806 .6302 9 .9174 .8417 .7722 .7084 .6499 .5963 10 .9091 .8264 .7513 .6830 .6209 .5645

i n 1 2 3 4 5 6

11 .9009 .8116 .7312 .6587 .5935 .5346

12 .8929 .7969 .7118 .6355 .5674 .5066

13 .8850 .7831 .6931 .6133 .5428 .4803

14 .8772 .7695 .6750 .5915 .5194 .4556

15 .8696 .7561 .6575 .5718 .4972 .4323

16 .8621 .7432 .6407 .5523 .4761 .4104

17 .8547 .7305 .6244 .5337 .4561 .3910

18 .8475 .7182 .6086 .5158 .4371 .3704

19 .8403 .7062 .5934 .4987 .4190 .3521

20 .8333 .6944 .5787 .4823 .4019 .3349

20

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