BU7753 Finance for Managers

Capital Investment Appraisal

Objectives of the Session

At the end of the session you will be able to

• Appraise different long term opportunities that an organisation may

face

• Critically evaluate different investment appraisal methods

• Consider which method is suitable for different scenarios

• Consider non financial aspects of the long term decision and the
impact the decision may have on the organisation

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 Capital investment appraisal (CIA)
CIA is the application of a set of methodologies whose
purpose is to give guidance to managers with respect to
decisions as to how best to commit long-term investment
funds (CIMA, 2000)

CIA is the decision making process used by organisations to decide

on which fixed assets to purchase, which contracts to accept or
which projects to undertake

Managers must decide whether investment will be worthwhile and if

there is a choice of projects which one to choose (Capital Rationing)

Over the years, several methods to determine the best choice, have
been developed
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CIA decisions
Businesses consider investment requirements with regard to:
• Asset replacement
• Cost saving
• Expansion
• New contracts
• Reactive investment

Information needed for CIA

Initial investment in the project
Expected life of the project
Expected rate of return from the project
Estimated future profits or cash flows
Risk assessment

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 Payback period

It calculates how long it will take for the business to

recoup its initial investment

Payback period is a useful measure of risk (liquidity)

Uncertainty increases the further you go into the

future, so selecting a project with the shortest PBP
minimises risk

Businesses often use payback in conjunction with

other capital investment appraisal methods

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Payback period - example

• Suppose an organisation makes a £24,000

investment in a project. The project has the
following cash flows per annum (p.a.)

Year Cash flow

1 £10,000
2 £10,000
3 £10,000

Determine the payback period

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 Payback period - decision rule

Companies set a minimum payback period for all capital expenditure

proposals

Most companies set different payback periods for different types of

projects.....for riskier projects a company will want a quick payback

If the required payback period is 3 years, the project is accepted but if it
were 5 years it would be rejected.

Why might you want to reject a project even if the project were
overall profitable?

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Advantages & disadvantages of payback period
Advantages

• easy to calculate and understand

• gives a useful insight into the project’s risk/liquidity
• Recognises value of receiving a quick return from the initial investment
• Useful measure for companies with limited cash

Disadvantages
• ignores cash flows after the payback period
• ignores the time value of money
• ignores a project’s profitability

To name just a few!!

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Accounting rate of return (ARR)
•ARR calculates a project’ profitability

•It is calculated as follows:

= average annual profit x 100

initial investment

•Note that sometimes the average investment is

used instead of initial investment, e.g. if there is a
sale of equipment at the end of the project
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Non-Cash Cost
A non-cash cost is a cost taken in to consideration when
calculating the profit over each period but the full cost has
already been paid by the organisation

For Example:
If a company is going to buy a piece of equipment for
£100,000 and expects this to last for 5 years.

The £100,000 will be paid immediately out of the bank

But in the accounts the cost is shown as £20,000 each year.

The £20,000 is termed as depreciation

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 Accounting rate of return
•The initial investment in a project with a 3 year life is
£24,000. Calculate the accounting rate of return?
•The project’s forecast annual profit is given below:
£ per annum
Sales 20,000
Material (2,000)
Labour (3,000)
Specific overheads (5,000)
Depreciation (8,000)Non-cash
Profit 2,000
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Accounting rate of return - solution

ARR = average annual profit x 100

initial investment

= 2,000 x 100
24,000

= 8.3 %
Would you accept this project? What other information might
you need?
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Advantages and disadvantages of ARR

Advantages
• easy to understand
• Easy to calculate
• Information for the calculation usually available
• Uses the whole life of the project in the calculations
• Popular with small organisations

Disadvantages
• uses accounting profit which is distorted by accounting conventions
• does not consider the time value of money; when returns comes in
• Only useful with simple decisions

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Deficiency of ARR

•Comparison of two projects, each with £24,000

investment
Project A B
Profit Profit
£ £
Yr 1 2,000 4,000
Yr 2 2,000 1,000
Yr 3 2,000 1,000
ARR 8.3% 8.3%
• Note: the ARR averaging process eliminates relevant information about the
timing of the returns
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Contemporary CIA

Contemporary techniques
•Net present value (NPV) Discounted cash
flow
•Internal rate of return (IRR) methods

Features of contemporary techniques

•developed to overcome the deficiency with ARR
•It uses cash not profits
•focus of DCF is on - the use of cash flows
- the ‘time value of money’
- the ‘true’ return

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 Time value of money
Time value of money
•a sum of money now has greater value than the same sum in
a year’s time because it can be invested to earn interest
•this fundamental principle is the backbone of DCF methods

Future value
•is the predicted value of a current cash flow using the
compound interest process

Present value
•is the current value of a future cash flow using the
discounting process

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Compounding and discounting

Compounding Now Yr.1 Yr.2 Yr.3

Cash flows shown
at future values

future value

Discounting Now Yr.1 Yr.2 Yr.3

Cash flows shown
at present values

present value

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Determining the relevant discount factor
To use the NPV technique, the relevant discount factor must
be known

The discount factor (DF) is the company’s required rate of

return

This rate is represented by the company’s cost of capital;

and its opportunity cost for investments

Cost of capital is how much it pays to its shareholders

(dividends) and how much does it pay on it loans (interest
rate)
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Net present value (NPV)

NPV is an investment appraisal method that

calculates a project’s profit by comparing cash flows
at the same time

It does this by discounting expected future cash

flows to present values, and then comparing these
with the initial investment
(Hansen, 2004)

Often referred to as Discounted Cash Flow (DCF)

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Net present value - example

•Remember: The initial investment in a machine is

£24,000 The company’s required rate of return is 10%.
The project’s cash flows are:
Year Cash flow
£
1 10,000
2 10,000
3 10,000

•Calculate the NPV for the project. Should the machine

be purchased?

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Net present value - solution

Discount Present
Year Cash flow factor 10% value
1 10,000 0.909 9,090
2 10,000 0.826 8,260
3 10,000 0.751 7,510
24,860
Initial investment 24,000
NPV 860

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 Net present value - decision rule
If NPV is positive, the investment is profitable and
acceptable:
•the initial investment will be recovered and
•the required rate of return will be achieved

If the NPV is negative, reject the investment as it will

earn less than the required rate of return

To select a project with a positive NPV, increases

wealth

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Advantages and disadvantages of NPV
Advantages

•remedies the deficiencies of ARR

•uses cash flows, rather than profit
•considers time value of money; when cash comes in

Disadvantages

•all cash flows assumed to occur on last day of the year

•difficult for the layperson to understand the meaning of the
NPV £

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 Internal Rate of Return
• If the discount rate was altered continually to a point where the NPV = 0,
that rate used would be the Internal Rate of Return (IRR).
• It gives a percentage rate of return as opposed to an absolute figure.
• One would always require an IRR that is higher than the cost of capital %
for a project to be feasible.
• It can produce strange results if the cash flows fluctuate from negative to
positive so the rate should always be tested in an NPV calculation
• The IRR which is a %age is best used alongside the NPV to help decision-
making although for similar sized projects will usually give the same
decision as an NPV calculation.
• It is quite possible to have a smaller project producing a higher IRR% and
lower NPV than a larger project!
• IRR is compared with the cost of capital percentage whereas the NPV
allows for the cost of capital.

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Interest payments, loans and DCF

For DCF calculations, exclude interest payments from cash flow

calculations

Interest is accounted for when discounting cash flows

If interest charges are included in cash flow calculations, double

counting occurs

If we recognise time value of money is critical. How can we include

this in the payback method to reduce its limitations?

Discounted Payback!!!

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Discounted payback calculation

• Remember: £24,000 investment in a project. Determine the

discounted payback period

Year Cash flow Discount factor Disc value

1 £10,000 0.9090 9,090

2 10,000 0.826 8,260
3 10,000 0.751 7,510
24,860

Payback period = 2.89 years

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 Qualitative factors
Strategic Decisions
Does the project align itself with the long term objectives and vision of the
organisation?
If we use resources for this project which other projects may not be able to go
ahead?
Is there a long term market for the output the new machine produces
Operational Decisions
Does the organisation have the capacity, skills and knowledge to complete the
project/contract
If the organisation is purchasing a machine – what is the reliability of machine, the
quality of output from machine
Will there be an effect on staff morale, will staff require training, are the skills
available to complete the project
Economic/Political Factors: Consider the risks associated with the project –
assumptions around interest rates, exchange rates, political uncertainty home and
abroad
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