CHARACTERISTICS OF CAPITAL

INVESTMENT DECISIONS
Significant cash outlay;

Long term involvement with greater risks

and uncertainty because forecasts of the

future are less reliable;
Irreversibility of some projects due to
their specialized nature, e.g., plant which
having been bought with a specific project
in mind may have little or no scrap value;
1

A significant time lag between commitment of

resources and the receipt of cash benefits;

Managements ability is often stretched with
some projects, demanding an awareness of all
relevant diverse factors;
Limited resources require priorities on capital
expenditure;
Project completion time requires adequate
continuous control information as costs can be
exceeded by a significant amount.
10/19/15

By Felix O Boateng

FACTORS TO CONSIDER IN
UNDERTAKING CAPITAL APPRAISAL
i. Initial cost of the project;

ii. The phasing of the expenditure;

iii. Estimated life of the investment;
iv. Amount and timing of resulting

net cash inflows from the project;

10/19/15

By Felix O Boateng

The effect, if any, on the rest of the

undertaking;
vi. Estimated residual value of the project
at the end of its life, if applicable;
vii. Cost of capital;
viii. Working capital requirements, if any;
ix. Taxation implications of the project;
x. Inflation rates and the effect on the
project.
v.

10/19/15

By Felix O Boateng

Capital investment appraisal is of

The
capital investment
fundamental
importance because:
appraisal process
1. It will involve the commitment of
a large amount of company
resources which necessitates
careful evaluation to be
undertaken before a decision is
reached.
10/19/15

By Felix O Boateng

2.Investment

decisions are
usually linked to strategic
and
tactical
business
decisions and therefore
need to achieve desired
long-term objectives (i.e.
maximisation
of
shareholder wealth).

10/19/15

By Felix O Boateng

3. It can be extremely expensive and

difficult to reverse an investment

decision, so care needs to be
exercised in reaching the initial
investment decision.
4. Projected future benefits and costs
are difficult to predict.
Consequently, the risk and
uncertainty of undertaking a
medium to long-term investment
can be high.
10/19/15

By Felix O Boateng

The decision-making
process
1. Initial investigation
Before the proposal is subject
to detailed evaluation, it is
useful to undertake preliminary
investigation to determine if
the proposal appears to be a
feasible project.
10/19/15

By Felix O Boateng

This initial investigation will

consider such factors as, the
resources
required,
the
technical and commercial
feasibility, the risks of the
project, and how the project
matches the firms strategic
objectives.
10/19/15

By Felix O Boateng

Detailed evaluation
If a project appears to be
feasible,
a
detailed
investigation of all facets will be
undertaken.
This
include:
attempting to forecast the
expected cash flows from the
project, and possibly calculation
of the NPV, IRR or other
relevant techniques.
2.

10/19/15

By Felix O Boateng

10

The NPV method of appraisal

should
be
used
wherever
possible, as it is consistent with
the objective of shareholder
wealth maximisation.

The

results of this analysis

should be compared with the
results of any other options
available.

10/19/15

By Felix O Boateng

11

Sensitivity analysis may be

applied to the results in order

to help assess the degree of
risk involved in the project.
In addition to the financial
analysis, sources of finance for
the project and non-financial
factors will need to be detailed.
10/19/15

By Felix O Boateng

12

Authorisation
In
the
case
of
large
investment
projects,
the
decision to accept a particular
proposal should be made by
senior
management,
or
perhaps the board of directors
if necessary.

3.

10/19/15

By Felix O Boateng

13

The decision-making body must

be satisfied that the proposal

meets the necessary profitability
criteria and is compatible with
the overall strategy of the
business. Where there are
insufficient funds to undertake all
the proposals put forward, ranking
of proposals in order of priority will
need to be employed.
10/19/15

By Felix O Boateng

14

Project implementation
Once the decision to proceed
has been taken, the appointment
of a project manager or the
assignment of responsibility
for the project will be necessary.
The person given the
responsibility will need to be
allocated the required resources
and to be given specified targets
to achieve.
4.

10/19/15

By Felix O Boateng

15

5. Monitoring the project

Once the project is underway, senior
managers should be kept informed
of progress on a regular basis.
6. Post-completion audit
Once
the
project
has
been
implemented,
a
post-completion
audit should be conducted in order
to monitor and report on project
progress as well as to identify
aspects which could be improved for
future project planning.
10/19/15

By Felix O Boateng

16

Evaluation methods
The availability of funds is likely to be
limited, consequently organisations
may not be able to undertake all
available, feasible projects.
Therefore, comprehensive analysis is
required so that alternatives can be
assessed, choices made and projects
prioritised.
Investment in a capital project can only
be justified if the additional benefits
exceed the costs of the investment.
10/19/15

By Felix O Boateng

17

There are four major methods of evaluating

investment proposals:

1. Accounting rate of return (ARR)

2. Payback period (PP)
3. Net present value (NPV) method
4. Internal rate of return (IRR).
The first two methods are the

traditional methods of appraising

investments and have been around
for many years.
The NPV method is a more recent
development.
10/19/15

By Felix O Boateng

18

This method discounts the

future cash flows associated

with the investment project
using cost of capital to the
entity, as the appropriate
discount rate.
The decision rule is that if the
net present value of the
discounted cash flows is
positive, we should accept the
project.
10/19/15

By Felix O Boateng

19

 It is important to be aware of

the advantages of this method

over the ARR and PP methods.
The most important
advantages of the NPV method
are that it:
1. takes account of the time value
of money, by discounting the
cash flows arising in the future.
10/19/15

By Felix O Boateng

20

2. It takes account of all relevant

cash flows,

3. provides a clear decision rule

concerning acceptance/rejection
of a project

4. is consistent with the objective

of maximising shareholder
wealth, which is assumed to be
the primary objective of a
business.

10/19/15

By Felix O Boateng

21

 The Internal Rate Return (IRR)

This method is the last

method listed above and is
similar to the NPV method.

It is based on the principle of

discounting future cash flows

and will normally give the
same accept/reject decisions
and will rank investment
projects in the same way as
the NPV method.

10/19/15

By Felix O Boateng

22

However, the IRR method has

difficulty in handling unconventional

cash flows and does not address the
issue of wealth maximisation as well
as the NPV method. Thus, from a
theoretical viewpoint, the IRR method
is inferior to the NPV method.
However, it seems that managers
prefer the IRR method to the NPV
method. This is perhaps because it
provides an answer that is expressed
as a percentage figure, which is
easier to understand than present
value
10/19/15

By Felix O Boateng

23

Some practical issues in

investment appraisal:
Relevant costs
Only future costs that vary
with the decision should be
included in the analysis. This
means that past costs and
committed costs should be
ignored because they cannot
vary with future decisions
concerning the investment.
10/19/15

By Felix O Boateng

24

Opportunity costs

Opportunity costs do not

result in cash movements.
Nevertheless, they should be
taken into account as they
represent real benefits
foregone.

10/19/15

By Felix O Boateng

25

Taxation

Investors are concerned with the

after-tax benefits from their
investment. This means that,
where taxation information is
provided in a question, it must be
taken into account. The aftertax cash flows from an
investment should be discounted
using the after-tax cost of
capital.
10/19/15

By Felix O Boateng

26

Cash flows
In NPV analysis, it is cash flows
rather than profit flows that are
used because it is the former that
gives a business command over
resources. In some cases
however, a question may provide
information concerning future
profits rather than future cash
flows.
10/19/15

By Felix O Boateng

27

When this occurs, it is

necessary to convert the profit
flows into cash flows, which
can be done by adding back
any non-cash items
appearing in the profit and
loss account. The most
common example of a noncash item is depreciation.
10/19/15

By Felix O Boateng

28

Working capital

Where profit flows are

converted into cash flows,
some adjustment may be
necessary in respect of the
investment in working
capital over the period of the
project.
10/19/15

By Felix O Boateng

29

Any addition to working

capital will be treated as a
cash outflow and any release
of working capital will be
treated as a cash inflow in the
period in which it occurs.

10/19/15

By Felix O Boateng

30

Interest payments

Interest payments are not

deducted in arriving at the
relevant cash flows for the
investment project.
The cost of financing is taken into
account in the discount rate
(which is based on the cost of
capital) and so should not be
taken into account again when
deriving the relevant cash flows.
10/19/15

By Felix O Boateng

31

Tax effect on investment

When
considering the tax implications
appraisal
the following procedure is followed:
1.forecast the incremental cash flow
excluding taxation over the life of the
project;
2.determine the first year allowance (FYA)
and writing down allowances (WDAs)
over the life of the project and estimate
the disposal proceeds of the investment
at the end of its useful life;
3.determine the balancing allowance or
balancing charge;
10/19/15

By Felix O Boateng

32

4. offset the first year and

writing down allowances

from the incremental cash
flows and compute the tax
payable or repayable; and
5. consider the timing of the tax
payable or repayable and
adjust the incremental cash
flows.
10/19/15

By Felix O Boateng

33

Example

A company wishes to select a project from

a choice of two mutually exclusive options.

Option A: This option will generate a single
cash inflow of GHc50,000 in three years
time.
Option B: This option will generate cash
inflows of GHc14,900 per annum after one,
two and three years.
Required:
Compare the NPV of two options when cost
of capital is:
(i) 10% per annum; and
(ii) 12% per annum.
10/19/15

By Felix O Boateng

34

Solution

(i) At 10% cost of capital:

Option A
At 10% the present value is

GHc50,000 x 0.751= GHc37,550

Option B
At 10% the present value is

GHc14,900 x 2.486 = GHc37,041

10/19/15

By Felix O Boateng

35

Note: The present value of Option

B has been calculated by using the

cumulative present value (annuity)
factors.
This time saving technique can be
employed when cash flows are the
same amount for a number of
periods. To ensure you understand
the use of cumulative present value
tables, it may be worth checking the
accuracy by calculating the present
value of each year and totalling the
present values as follows:
10/19/15

By Felix O Boateng

36

Year
Cash flow
10% D. factors
Present value GHc
1 14,900
x 0.909
13,544
2 14,900
x 0.826
12,307
3
14,900
x 0.751 11,190
37,041
It is worth noting that for Option B, using
the cumulative present value factor or the
present value factors, the net present
value is the same in total (i.e.,
GHc37,041). The cumulative present value
factor is 0.909 + 0.826 + 0.751 = 2.486.
10/19/15

By Felix O Boateng

37

In conclusion, on the basis of

financial analysis, at a cost of

capital of 10% Option A is preferred
as its present value is higher by
GHc509 (GHc37,550 GHc37,041).
(ii) At 12% cost of capital
Option A
At 12% the present value is
GHc50,000 x 0.712 = GHc35,600
10/19/15

By Felix O Boateng

38

Option B
At 12% the present value is
GHc14,900 x 2.402 = GHc35,790
In conclusion, on the basis of
financial analysis, at a cost of
capital of 12% Option B is
preferred as its present value is
higher by GHc190 (GHc35,790
GHc35,600).
10/19/15

By Felix O Boateng

39

Example
Calculate the present value of the following
series of cash flows if the cost of capital is 12%.
An immediate cash outflow of GHc10,000. At
the end of each of the next three years cash
inflows of GHc2,500 p.a., thereafter at the end
of each of the subsequent three years
GHc1,500 p.a.
Year Cash flow 12% D. factors
Present
value
0 (10,000) 1.000
(10,000)
13
2,500 2.402
6,005
46
1,500 1.710
2,565
NPV
10/19/15
By(1,430)
Felix O Boateng
40

In conclusion the project is not

financially viable, as it results in a

negative present value.
Note:
The cash flows are the same for
the end of each of the first three
years, consequently the cumulative
three year12% factor can be used.
(i.e.: 0.893 + 0.797 + 0.712 =
2.402)
10/19/15

By Felix O Boateng

41

The cash flows are the same for

the end of each of the

subsequent three years (years 4
to 6), again the cumulative
present value factors can be
used to calculate the present
value of the cash flows for years
4 to 6 inclusive.
(i.e.: 0.636 + 0.567 + 0.507 =
1.71).
10/19/15

By Felix O Boateng

42

NPV: Illustrative Question 2

Two mutually exclusive projects, Q and R, have the

following estimated cash flows in Ghana Cedis over its life

span of 5 years.
Year
Project Q
Project R

1
5,000
1,000

2
5,000
2,000

3
4,000
3,000

4
1,000
5,000

5
1,000
6,000

Required:
If the initial capital outlay is GHc11,500 and the cost of

capital is 10%, calculate the NPV of Projects Q and R. Advise

management if they should undertake any of the projects.
10/19/15

By Felix O Boateng

43

Suggested Solution to |Illustrative Question 2

_________________________________________________________________
Year
1
2
3
4
5

Project Q
Cash Flow
GHc
5,000
5,000
4,000
1,000
1,000

Discount
Factor
PV
GHc
0.909
4,545
0.826
4,130
0.751
3,004
0.683
683
0.621
621

Present Value of Inflows

Present Value of Outflows
Net Present Value

Project R
Cash flow
GHc
1,000
2,000
3,000
5,000
6,000

Discount
Factor
PV
GHc
0.909
909
0.826
1,652
0.751
2,253
0.683
3,415
0.621
3,726

= 12,983
= (11,500)

11,955
= (11,500)

1,483

455

Decision: Projects Q and R both have positive NPVs, but since the two
are mutually exclusive and both cannot be executed, management
should go in for Project Q which has a higher positive NPV.
44

INTERNAL RATE OF RETURN (IRR)

Often an entity would want to establish its

internal rate of a project for various reasons e.g.,

for decision-making purposes. By IRR, we mean
a rate that will be used to discount future cash
inflows to make the total of the present values
equal the cost of the project.
The attempt made under IRR is ti find a rate that

will equate the NPV of a project to be zero.

10/19/15

By Felix O Boateng

45

The IRR therefore is the maximum rate

of discount that will be used to finance a

project without making a loss from it.
In a mutually exclusive situation, the
project that has the highest IRR is the
one to recommend, the reason being that
the IRR is showing the highest rate that
can be used to finance a project without
incurring a loss from it.
The IRR can be referred to as the breakeven rate.
46

Illustrative Question

Senior

management of
Offshore
Exploration (Ghana) Limited have
identified that there is a strategic need for
a replacement machine to be acquired in
one of their production departments. They
have to make a choice between two
models of the machine Model 1 (Super)
and Model 2 (De Luxe).
10/19/15

By Felix O Boateng

47

They are unsure as to which of the

two models they should buy.

They have given you the following
profiles of the two models. They want
you to use the two investment
appraisal techniques, NPV and IRR.

10/19/15

By Felix O Boateng

48

You are required to recommend

which of the two models is better

under each appraisal technique and to
explain briefly why you have
recommended one in place of the
other under each technique.
You are told that funds are only
available for only one model.
10/19/15

By Felix O Boateng

49

Cost
Net Cash inflow
Year
1
2
3
4
5
6
Scrap value

Super
GHc500,000
GHc
250,000
100,000
100,000
50,000
150,000
100,000
20,000

Deluxe
GHc800,000
GHc
150,000
200,000
250,000
100,000
100,000
250,000
80,000
50

The cost of capital is 12%. (Note:

Discount factors readable from

financial tables)

10/19/15

By Felix O Boateng

51

10/19/15

By Felix O Boateng

52

Solution, using NPV technique: Discount rate =12%

Super Model
Deluxe Model
Year
Cash
Disc
PV
Cash
Flows
factors
values
Flows
0
(500,000) 1.000
(500,000)
(800,000)
1
250,000 0.893
233,250
150,000
2
100,000 0.797
79,700
200,000
3
100,000 0.712
71,200
250,000
4
50,000 0.636
31,800
100,000
5
150,000 0.567
85,050
100,000
6
100,000 0.507
60,840
250,000
+ 20,000
______
+ 80,000
Therefore NPVs = 51,840

PV
values
(800,000)
133,950
159,400
178,000
63,600
56,700
167,310
______
(41,040)

Recommendation: Under the NPV method Super has a positive NPV of GHc51,840

whilst De Luxe has a negative NPV of GHc41,040. Super Model is therefore

recommended to management.
53

Using IRR technique:

Super Model, using |Discount rate of say, 20% , to enable
us obtain a negative NPV so we can apply the IRR
formula:
Year Cash Flow
0
(500,000)
1 250,000
2 100,000
3 100,000
4 50,000
5 150,000
6 100,000
+ 20,000

PV factors
1.000
0.833
0.694
0.579
0.482
0.402
0.335
NPV =

PV value
500,000
208,250
69,400
57,900
24,100
60,300
40,200
______
(39,850)
54

Applying the IRR formula,

IRR = A +

( a / (a + b) x (B A)

Where:
A = Lower discount rate that gives positive NPV
B = Higher discount rate that gives negative
NPV
a = Value of positive NPV
b = Value of negative NPV
IRR = 12 + (51,840/(51,840 + 39850) x (20 12)
= 12 + 4.52
IRR for Super model = 16.52%
55

IRR for Deluxe model, using Discount rate of say, 4%, to obtain a

positive NPV.
Year
Cash Flow
0
(800,000)
1
150,000
2
200,000
3
250,000
4
100,000
5
100,000
6 250,000 + 80,000

Disc factors
PV values
1.000
(800,000)
0.962
144,300
0.925
185,000
0.889
222,250
0.855
85,500
0.822
82,200
0.790
260,700
NPV
=
179,950
Therefore IRR = 4 + 179,950/(179,950 + 41,040)
= 4 + 6.51
IRR for Deluxe Model = 10.51%

x (12 4)

56

Recommendation:

The DeLuxe Model has an IRR

of 10.51%. As this is lower than
the Super Models 16.52%, the
latter will be recommended.

57

DISCOUNTED CASH FLOWS UNDER INFLATION

Inflation may be defined as a general increase

in prices, leading to a general decline in the

real value of money.
There will be two impacts of inflation on DCF
project appraisal as follows:
The discount rate given may include an
allowance for a general rate of inflation.
The cash flows may be subject to inflation,
possibly at different rates for different cash
flows.
10/19/15

By Felix O Boateng

58

Effect of inflation on the discount rate

The discount rate used in investment
appraisal reflects the finance providers
required rate of return (e.g. the rate of
interest on a loan raised, or shareholders
required return if financed by equity).
In times of inflation, the fund providers will
require a return made up of two elements:
A return to compensate for inflation (to
maintain purchasing power)
10/19/15

By Felix O Boateng

59

A real return on top of this for the use of

their funds.
The required return that incorporates both
of these elements is known as a money
return.

10/19/15

By Felix O Boateng

60

Illustrative Question 1
An investor is prepared to invest
GHc100 for one year. He requires a
real return of 10%, in addition to an
allowance for inflation, currently
running at 5%.
Required: What is the investors
money rate of return?
10/19/15

By Felix O Boateng

61

Solution
To compensate for inflation, his money
needs to increase by 5%, which is GHc100
x 1.05 = GHc105
To give a return on top of this, it must
further increase by 10%, to GHc105 x 1.1
= GHc115.5
Hence the investors money must increase
overall by 1.05 x 1.1 = 1.55, i.e. by 15.5%.
10/19/15

By Felix O Boateng

62

Therefore, the investors money rate

of return = 15.5%
Including inflation in DCF appraisals
DCF analysis can take place in either
money or real terms, as long as the two
are not confused.
Real rates of return are obtained, using
the following equation:
10/19/15

By Felix O Boateng

63

1 + m = (1 + r) (1 + i)

Where:
m = money discount rate
r = real discount rate, and
i = inflation rate

10/19/15

By Felix O Boateng

64

Illustrative Question 2

A project has the following cash flows before

allowing for inflation:

Year
Cash flow (GHc)
0
(750)
1
330
2
242
3
532
The money discount rate is 15.5%. The general
rate of inflation is expected to remain constant at
5%.
10/19/15

By Felix O Boateng

65

Required: Value the project in terms of:

Real cash flows and discount rates

(b)Money cash flows and discount rates.
Solution
(a)Real cash flows and discount rates
Discount rate, 15.5%, as per the
question includes investors/lenders
inflation expectation of 5%.
(a)

10/19/15

By Felix O Boateng

66

Hence real discount rate, r, is given

by
1 + r = (1 + m)/(1 + i)
1 + r = (1 + 0.155)/(1 + 0.05)
1 + r = 1.10
Therefore r = 10%

10/19/15

By Felix O Boateng

67

Year Cash Flow

GHc
0
(750)
1
330
2
242
3
532

10/19/15

PV factor

By Felix O Boateng

1.000
0.909
0.826
0.751
NPV

Present value
GHc
(750)
300
200
400
150

68

(b) Money cash flows and discount

rates
The discount rate, 15.5%, as per
the question is the money discount
rate. Cash flows, however, need to
be increased by 55 compound each
year 0, to allow for inflation.

10/19/15

By Felix O Boateng

69

Year Real cash Inflation Money

Discount
Present
flow
factor
cash flow factor @ 15.5% value
(i) (ii)
(iii)
(iv) = (ii) x (iii)
GHc
GHC
0
(750)
1.000
(750)
1.000
(750)
1
330
1 + 0.05
346
0.866
300
2
242
1 + 0.05)2 267
0.750
200
3 532
1 + 0.05)3 616
0.649
400
NPV
=
150
Note: Figures have been rounded up to next whole
number.

10/19/15

By Felix O Boateng

70

You are the Finance Manager of a

manufacturing company, Olusegun
Manufacturing plc, a dealer in Iron Rods.
Your company plans to buy a new
Comprehensive
machine
to meet identified market
demand
for a new product. This machine
example:
will cost GHc1,500,000 and the machine
will last for four years, at the end of the
four years, the machine will be sold for
GHc100,000. Olusegun Manufacturing
plc expects variable cost and sales for
the product to be as follows:
10/19/15

By Felix O Boateng

71

Year
1 23
Sales (units):43,300
33,800

4
50,900

65,600

The units produced is the units sold and

selling price per unit is GHc25 for year 1

and this is expected to increase by 7%
every year. Variable cost of production
per unit is GHc12 for year 1 and this is
expected to increase by 2% every year.
Incremental fixed cost for year 1 is
expected to be GHc27,000 and this is
expected to increase by 6% every year.
10/19/15

By Felix O Boateng

72

The rate of tax depreciation or written

down allowance applicable to the new

machine is 25% per annum on a
reducing balance basis.
Prior to the managements decision as
whether to undertake this expansion or
otherwise, the management contracted
a market research company, Data
Gathering limited to conduct research
on the existence of demand for the new
products. The fees charged to Olusegun
Manufacturing Plc amounted to
GHc300,000.
10/19/15

By Felix O Boateng

73

Olusegun Manufacturing Plc pays tax

at an annual rate of 30%, but one

year in arrears. The appropriate after
tax cost of capital (discount rate) is
11%.
Required:
Calculate the net present value of
buying the new machine and advise
management of Olusegun
Manufacturing Plc base on your
findings.
10/19/15 marks) By Felix O Boateng
(25

74

Case study

Richard

Noble Ltd is a firm of

agricultural engineers and plan to invest
GHc25,000 in a special delivery vehicle.
The vehicle will be purchased in January
2000 and has an estimated useful life of
5 years, after which its estimated sales
value will be GHc5,600.
Net savings on current contracted out
delivery costs will result in incremental
income; excluding depreciation and the
effects of taxation of GHc8,500,
GHc9,500, GHc6,000, GHc6,000 and
GHc3,000.
10/19/15

By Felix O Boateng

75

The business pays its tax in the

year following that in which

profits are earned, at a rate of
30% of taxable profit.
The business makes a net of
tax return on capital of 15%,
which, for the purposes of
capital appraisals is considered
to be its cost of capital.
Should this project be
undetaken?
10/19/15

By Felix O Boateng

76