--l

!stvestrT?emtAPPnaiea$

The lnvestment Appraisal 1ecture will concentrate in building the knowledge required your to attempt examination standard questions. Attached are some nctes tc assist the to read recommended strongly understanding of investment appraisal. You are ihe Practice of knowledgerelevant chafter i.e, 9 in youriexi book to ensure depth end of chapter questions to reinforce your knowledge

Activtties:
Underiake investment appraisal using: o PaYback rnethod

o o

Accountirrg Rate of Retum Net Present Value and lnternal Rate of Return

ldentify various business requirements thai lead io investnrent appraisal decisions. ldentify any restrictions a buslness might have in undertaking all of the investments identifl ed? .ldentify the various methods a business has of unclertaking capital investments?

$NVESTMENT'APPRAISAL

introductlon
assets which will lose Cap1al invesiment decisions usually involve the acquisition.of fixed investments and betrnreen lag time the Also, business. value as they are used in ihe refunrswill be years ratherthan monlhs orvveeks'
There are four main iechniques for appraising capital investments:

i) D iiD iv)

PaYback

Accounting tdte of return

NetPresentvalue Intemal tate of return

to it. For e>cample, if Most capital expenditure in iact does not have any appraisal.applied as would be the case if munagement feels that the investment is a necessary expendiiure, then a nerru machine a projuction line machine finalty breaks down and can't be repaired, in 'rllese cases it even production. Howeveq maintain wih ne immediately acquired to life and lvhether it's should be poinied oui wi-retrher the replacement has a long or short relatively expensive or cheaP.

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2.'f

Referanf Cash F/orcrs

Only costs and benefits whicfr arise as a result of the invesiment should be included when appraising the investment. To be relerrant a cost or benefit must be {a) A Cash Ftow (b) Be additional{or avoidable e.g. a tax saving) (c) Relate to the future
in otherwords "A future incrernental cash flow"

2.2

Payback

Under the payback approacfr to investment appraisal we examine how quickly a project generates sufficient net casi flows to pay back the investment. We m'ay sei maximum pay back fime period, say 2 years. lf ihere ere a number of investmenb to choose from we accept the quickest (but only if it pays back within 2 years).

Lecture Exanrple:

Project

A
E

ts
100

BC
(400)

Year0 Yearl Year2 Year3 Year4

method.

(zo0) 1S0 50 1S0 -

(300) 150
100
SO

400

Using ihe payback method p$ject C will be chosen as the payback perlod is only 1 year. The above example highlights the following advantages and diiadvantages of tl.re payback

Advantage$

CIf

Fayback

1. 2. 3.
1. 2. 3.

lt is very simple. lt is a usefulguide to a ompany's liquidity - it shows how long a company will be "out-of-pockei" due to the investment. lt recognises risk by ignoring cash florivs which arise in the more distant fufure.

Disadvanta$es of Fayback
lt ignores lhe time value of money. Cash flows afterthe payback period are ignored. No cleardecision is given in a simple accept/reject sifuation.

2.3

Aecounting Rafe of Return {ARR/

vre.

The ARR method of investment appraisal is based on the additional accounting profits
ge.nerated by an-inve.stmgnt fallle-rlhan.,qaS.h
fto.

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Sxarnpte;

years net cash flows of project entaile an inilial investment of f200,000. Over five at the end of 5 years is S0,000pa are generated' The scraP vaiue of ihe machine

f50,000. Calculate the ARR'

L'rursel

by 5 = f30'000 = 300,000 -g150,000 = 150'000 divided ARR = 30,0m/200,000 X 1}0o/o=

15o/o

Advantages clf ARR.

1. 2. 3.

SimPle to calculate Uses profits which may be seen in frefinancialaccounts

Gives

by percentage measure wilich may be more readity understood calculations management and coifonns to the result of ROCE

Disadvantages of ARR

1. Z.

lgnores the time value of money

Profits are aniveU

aswe nuu"

"*"n,

takirig accruals and provisions into account' However' "t "tt*t u"*uuf .aih flows increase sharehclders'wealih' onfy

?,4

ftiscawnted

sash Ftaw Tecfunirywes of frlvesfraregaf Appraisaf

wlich iakes inio account both Dscouniing cash flows is an invesiment appnaisaltechnique. over a projed's life. the time value of money and also total profitability
Two impofiant points aboui DCF are asfollowsi

i)DCFlooksai.ihecashflowsofaproject,notiheaccouliinuprofits' them' The effect ii) if,e timing of ine cash flo*vs is taken into accouni by discouniing earlier in the
cash flovi-rs that occur of discounting is to give a bigger value per 11 for life of the Project'

investments:There are two methods of using DCF to evaluaie capital (NP\ The Net PresentValue Method tnternarCatL otneturn Method (inn) or DCF vield method''-

a)

b)

The

FlAfl

capihl investment to a present value' they By discourriing atl payments and reryiptg from a which takes account of when the cash flows
can be compared on u
arises-

"orn*on

value basis

2.5 ffef PresentVafue {fdPW

inflov'rs and ouiflows of a capikl The NPV is the value obtained by discounting all cash or "cost of capital"' invistment project by a chosen taiget rate of retum PV of the cash ouiflows is the NPV' The Present value {PV) oi the cash inflotr.rs minus the Fage | 15

Decision Rule:
a) lf the NPV is positive it means that the cash inflows from a capital investrnentwill yield a retum in excess of the cost of capiial, and so the poject should be undertaken (if the cost of capitalis the organisations target rate of retum). b) lf the NPV is negative ..... not be underhken .........

guat4b*rl{mi"{#

c) lf NPV is zero the project wilt be onty just wortir undertaking.

-'Ilf,ffi^it L

RAIE oF ,(^

f,.sp"/

Lesture Exarnple
SB Ltd is considering a capital investment where the estimated cash flows are:Valr

Cash Flow

0 (i.e. novrr)
'l
I a I
4

(1O0,000)

60,000 80,000 40,000 30,000

The company's cost of capiial is 15%. What is the NPV of the project?

Suggested Solution

Year

Cash

Flow

at'l5Yo
1.000

Discount

Factor

psesent Value
(100,000)

0 1 2 3 4

(100,000)
S0,000

80,000 40,000 30,000

0.870 0.756
0.658 o.572

52,200 60,480 26,320

NPV

17,160

56.160

So tre PV of cash inflovus exceeds the PV of cash outflows by t56.160, which means that the project will eam a DCF yield in excess of 15a/a. The 56,160 reflects the increase in shareholder wealth that will be brought aboui by the investment. ln other words, if there are a million shares in the company then the share price will increase by 5.6p (Divide 56,160 by 1,000,000) provided the market is efficient. lt should therefore be unde'rtaken.

Annuity Tables
VVhere there is

a constant cash flow from year to year ii is quicker to calculate the present value by using the annuity factors_

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[-eut*re Exarr'tpte 4 years' lf A project costing g90,000 is expected. to yield nei cash flows of f30,00Dpa for thd c6rnpany's ;ost of capital is 12% should the project be undertaken?
Suggested Solufion

wtiichnreansthe [(90,00c)xlJ +(30,000x3.037)= (90,000)+91,111 =NPV=t1,111

project is vrrorth undertaking.

Advar:iagee 8f Net Freser"tt Va$ue

.1.1i

decision is the onty capital investment appraisal technique that gives the "correct" shareholders'wealthof advice i.e. advice that leads to th* maximisation betirueen the NPV 2.The NpV is an absotuie measure and it is easy to make a comparison of differeni investments. equity (i-e' 3.The NpV represents th* in"r*"*" in the rnarket value of the shareholders' share value) by underiaking the proiecl

Dtsadvantages of NPV

i. 2. 3. 4.

the Management may misunderstand the meaning of NPV' They 63y dispuie proftt' aclvice if it appeari ffrat another invesimeni shows a higher values)' li is a complex concept {time lt is the onty ieinnique which requites ihe decision criterion {in ihis case the discount rate) before 3rou look at the project'

Ii can be difficuii io ideritiff the apprapriate discCIunt rate.

ilnnitaiions of ttlPV

1.

capital' So coSt The higherthe risk of a projecl, the higherrnrilt bethe company's 9f

while

10% discouni rate may tre appropriate fcr one project it may be calculation of the inappropriaie for another. The riik factor iherefore tRakes the

cost of caPital difficult'

Z,

The NpV rule assumes that the NPV equates rnrith the increase in shareholders' be broken if weaith (ihrough increasing the share price). Hawever, this link may based e.g' assel shares ihe siock *"-rt"i ur*r 16** other method of valuing
valuation.

3.

will be able The NpV assumes the existence oi a "Perfect Market" i.e. that the firm can be to secure runji nec"rsary to invest in the project, at its cost of capitalwhich precisely identified. Horryever, a perfect nrarket rnigl^,t not exist. The funds might

notbeairailableasthecompanyisha:vingproblemsviifrliquidity.

2.6

lwternal Rafe

of Return #RRl

{Lfieftuart

by discounting'at a target urrdei ti-re Npv method of DCF, present values are calculated of capital. ln contrast, the IRR methoci calculates the exact DCF rate of retum, ol- u

*rt

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raie of return which the project is expected to yield i.e. ihe rate at which the NpV is O. The decision criterion using the IRR method is ffrat if tlre IRR exceeds a hrget raG of return ffren the project should be accepted.

Steps in calculating the IRR of a Project l.Calculate the NPV of a project using a low discount rate (say 5%). This should give you
a positive NPV.

2,Calculate the NPV of the prolect using a high discount rate (say 20%). lt is preferable, thouch not essential, that this should give you a negative NPV. 3.Use the following formula

I/U :

x ffiR 6*l ---npJiuINPV n- NPY in

LR)l 'J

\Aftrere:-

LR -

HR = the higher rate used

NPVR = the NPV of the proiect at the lorner rate NPV6p= the NPV of the project atthe higher nate

the lower rate used

Exarnple

X Ltd is considering invesiing in a 100,000 project that will provide the following cash
flovrtsi

Year 1 2

Gash Flow 40,000 60,000 4o,ooo

Calculate fre lnternal Rate of Retum.

$tep
At

5olo

Discount Rate

NPV = (e100,000) +f27,068

Step 2

x 1 + (40,000 x 0.952) + (60,000 x 0.907) + (40,000 x 0.864) =

At20o/o Discount Rate

\?Y:

(:109,9m) r.1 *.

$9,9m T.9.9991* (qo,W x 0.6e4) + (40,000

x 0.5787) =

1856

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$tep 3
Substitute into the fotmula

[RR=IR+

l-

lro n Nrv INPY rc'- IdPl/

x(HR
nn

t*l

IRR:

27068 .a0-,)7 :n*l 27A65 -(-t856)

L

:5%o+

zr.oos - -l I ' :c ij L28,924 J

I

solo

+lo.l sr

/sJ: 5% + I 3 -95% :

B-9,5%

'18.95% per annum This tells us that the return on ihis particular project averages out at overthe ihree Years.

2.7 tnterr"af Rafe of Retsrn

and The lnternal Rate of Refum gives an aveEge measure of the Retunr on an invesiment greaterthan eost of capital. ihe is ihe IRR if acceged uses the rule that a project siouu be
However, it is crii:icised as:

1) its merely a regative measure

arrci cioes not cieai adequaieiy wiih difiereni sized projects. For exarnple, which is betbr? 12o/a ot 15%- What about 12olo of 1200,000 and 15% of 10,000?

Z) '

Also, !t assurnes that all cash flo'ns can be teinvested immediately on receipt in some

other project io yield a return equal io the lRR. But the IRR hrvestmen"r and mightnot be available anywhere else'

is unique to

each

The NpV meihod is an absolute money measure which takes eccount of the scale of the provide investrneni as iivell as tfrffitity. The other methods (paybaclq ARR arrcl IRR) of measures which express retums relaiive io the invesimeni. Thus, lnvestmenis an eomparabte rqlaiive qualiiy r,vill have ihe same reiurn regardless of size. For example, annual protit-&Eb bn an investment of 100 will have the same relative return as an annual profit of 1200,000 on an inrrestment oi f1,000,000 i'e" 20olo' of the 3 relative So if you are merely concemed with the quality of an investrnent then one measures will provide the ranking.
be However, if the objective is to generate wealth, the desirability of an investmeni should capital. cost of measured by the surplus net pieseni value generated over and aborre'rhe

Of ihe'va'rious methods oi invesimeni appralsal i.e" Accountiirg Rate of Reium, payback, lntenral Rate of Return and lrlet Fresent Vatue the preferred methods are
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re-

-::. :f-?=r.==1-':':'

earlier years e.g. it's better to receive g10,OO0 in yaar 1 than f10,0Ci0 in year 4 as the former arnount could be reinvested to yield inteiest in the interim e y6ari. gtt tne most importan!trring to remember is thit, while you may be fairly confrdent that you will receive e10,000 in one year you will be less confident about ieceiving tO,Ogb in five years due to changed conditions or simply that you are not good at-forecasting. So the smaller value given to tre more distani cash flow also reflects the risk of not receiving it.

the ones that use a discount raie io take into account the time value of money. Money has a time value as cash flows are more vatuable if they ,r" r*"*Gd in

When cash inflows and oufflows have been discounted to present values, they can be treated in a similar way i.e. netted off io provide a Net present Value.

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