FM Chapter - Investment Appraisal - 2 PDF

CHAPTER
INVESTMENT APPRAISAL
INVESTMENT APPRAISAL TECHNIQUES
Investment
• Investment is an expenditure in the expectation of future benefits.
• Two categories; capital expenditure and revenue expenditure.
• Capital expenditure is expenditure which results in
 the acquisition of fixed assets or
 an improvement in their earning capacity.
• The expenditure is charged as a fixed asset in the statement of financial position.
Chapter
Investment Appraisal
• Revenue expenditure is expenditure which is incurred for either of the
following reasons:
 Trade of the business – this includes expenditure classified as selling
and distribution expenses, administration expenses and finance charges.
 To maintain the existing earning capacity of fixed assets.
• Revenue expenditure is charged to the income statement of the
relevant period.
Chapter
Appraisal Techniques – None Discounted Cash flow Methods
Non-discounting methods
• Payback Period
• Accounting Rate of Return.
Discounting methods
• Net Present Value (NPV)
• the Internal Rate of Return (IRR).
Chapter
Payback Period
• Defined as how long it takes the cash inflows from a capital
investment project to equal the initial cash outflows, usually
expressed in years.
• the usual decision is to accept the one with the shortest
payback.
• Payback is often used as a first screening method.
Chapter
• When calculating the payback, we take profits before
depreciation.
• Using payback we estimate the cash returns from a project
and profit before depreciation is the rough approximation of
cash flows.
Chapter
Advantages of payback
• Payback period is simple and easy to understand and compute.
• Payback period is universally used.
• Payback period gives more importance on liquidity for making
decision about the investment proposals.
• Payback period deals with risk. The project with a shortest PBP
has less risk than with the project with longest PBP.
• The short term approach of payback period is an added
advantage of calculation of capital expenditure.
Chapter
Disadvantages of Pay Back Period (PBP)
• In the calculation of payback period, time value of money is not
recognized.
• Payback period gives high emphasis on liquidity and ignores
profitability.
• Only cash flow before the payback period is considered. Cash
flow occurred after the PBP is not considered.
Chapter
•
Chapter
•
Chapter
Example 1
Project P Project Q
Capital asset K60,000 K60,000
Profits before depreciation K K
Year 1 20,000 50,000
Year 2 30,000 20,000
Year 3 40,000 5,000
Year 4 50,000 5,000
Year 5 60,000 5,000
Chapter
•
Chapter
The Accounting Rate of Return (ARR)
• Sometimes called the Return on Capital Employed (ROCE) or
the Return on Investment (ROI).
• ARR method is used to estimate the accounting rate of return
that the project should yield.
Decision rule: If it exceeds a target rate of return, the project will
be undertaken.
Chapter
•
Chapter
Example 2
A company has a target accounting rate of return of 20% and is now considering the
following project.
Capital cost of asset K80,000
Estimated life 4 years
Estimated profit before depreciation K
Year 1 20,000
Year 2 25,000
Year 3 35,000
Year 4 25,000
The capital asset would be depreciated by 25% of its cost each year, and will have no
residue value. You are required to assess whether the project should be undertaken.
Chapter
Solution
Year Profit After Mid-Year ARR in the
Depreciation Book Value Year
K K %
1 0 70,000 0
2 5,000 50,000 10
3 15,000 30,000 50
4 5,000 10,000 50
Chapter
•
Chapter
•
Chapter
ARR and Comparison of Mutually Exclusive Projects
• The ARR method can be used to compare two or more
projects which are mutually exclusive. The project with the
highest ARR would be selected provided that it is higher than
the company’s ARR.
Chapter
Example 3
A company wants to buy a new item of equipment which will be used to provide a service customers of
the company. Two models of equipment are available, one with a slightly higher capacity and greater
reliability than the other. The expected costs and profits of each item are as follows.
Equipment item X Equipment item Y
Capital cost K80,000 K150,000
Life 5 years 5 Years
Profits before depreciation K K
Year 1 50,000 50,000
Year 2 50,000 50,000
Year 3 30,000 60,000
Year 4 20,000 60,000
Year 5 10,000 60,000
Disposal value 0 0
Chapter
Solution
Item X Item Y
K K
Total profit over life of equipment;
Before depreciation 160,000 280,000
After depreciation 80,000 130,000
Average annual profit after depreciation 16,000 26,000
Average net book value (Capital cost + disposal value)/2 40,000 75,000
Therefore ARR 40% 34.7%
Chapter
• Both projects would earn a return greater than 30%. However,
these are mutually exclusive projects, meaning only one project
can be adopted and in this case project X would be preferred
since it has a higher ARR.
Chapter
Advantages of ARR
• ARR is based on accounting information, therefore, other special reports
are not required for determining ARR
• ARR method is easy to calculate and simple to understand
• ARR method is based on accounting profit hence measures the
profitability of investment
Disadvantages of ARR
• ARR ignores the time value of money
• ARR method ignores the cash flow from investment
• ARR method does not consider terminal value of the project
Chapter
• Appraisal Techniques – Discounted Cash flow (DCF) Methods
• Discounted Cash Flow (DCF) is an investment appraisal technique
which takes into account both the timings of cash flows and also
total profitability over a project’s life.
• Two important points about DCF are as follows;
 DCF looks at the cash flows of a project, not the accounting
profits.
 The timing of cash flows is taken into account by discounting
them with the effect that it assigns bigger values to cash flows
that occur earlier.
Chapter
Timing of Cash Flows in DCF
a) A cash outlay to be incurred at the beginning (‘now’) of an
investment project occurs at year 0. The present value of K1 now, in
year 0, is K1 regardless of the value of r (rate of return or cost of
capital).
b) A cash outlay, saving or inflow that occurs during the course of a
particular period (say, year 1) is assumed to occur all at once at the
end of the particular time period (at the end of year 1 for example).
c) A cash outlay or receipt which occurs at the beginning of a time
period (say at the beginning of one year) is taken to occur at the end
of the previous year. Therefore, a cash outlay of K4,000 at the
beginning of year 2 is taken to occur at the end of year 1.
Chapter
The Net Present Value (NPV) Method
• NPV is the value obtained by discounting all cash outflows and
inflows of a capital investment project by a chosen target rate of
return or cost of capital.
• NPV method compares the present value of all the cash flows from
an investment with the present value of all the cash outflows from
an investment.
• Positive NPV means the cash inflows from capital investment will
yield a return in excess of the cost of capital, and so the project
should be adopted.
Chapter
• Negative NPV it means the cash inflows from capital
investment will yield a return below the cost of capital, and
so the project should be rejected.
• If NPV is exactly zero the cash flow will yield a return which
is exactly the same as the cost of capital and if the cost of
capital is the organisation’s target rate of return, the project
will be only just worth undertaking.
Chapter
Example 4
A company manufactures product X which sells for K5 per unit. Variable
costs of production are currently K3 per unit, and fixed costs K0.50 per
unit. A new machine is available which would cost K90,000 but which
could be used to make product X for a variable cost of only K2.50 per
unit. Fixed costs, however, would increase by K7,500 per annum as a
direct result of purchasing the machine. The machine would have an
expected life of 4 years and a resale value after that time of K10,000.
Sales of product X are estimated to be 75,000 units per annum. The
company expects to earn at least 12% per annum from its investments.
You are required to decide whether the company should purchase the
machine or not.
Chapter
Solution;
1. Savings are 75,000(K3 – K2.50) = K37,500 per annum
2. Additional costs = K7,500 per annum
Therefore net savings = K37,500 –K7,500 = K30,000
Year Cash Flow PV Factor PV of Cash Flow

K 12% K
0 (90,000) 1.000 (90,000)
1 30,000 0.893 26,790
2 30,000 0.797 23,910
3 30,000 0.712 21,360
4 40,000 0.636 25,440
NPV = 7,500
NPV is positive. Therefore, project to earn more than 12% annum and is therefore acceptable.
Chapter
Annuity tables
• Where there is a constant cash flow from year to year, it is quicker
to calculate the present value by adding together the discount
factors for the individual years. These total factors could be
described as
 ‘same cash flow per annum’ factors,
 ‘cumulative present value’ factors or
 ‘annuity factors.
Chapter
Example 5
A company is considering the manufacture of a new product which would
involve the use of both a new machine (costing K150,000) and an existing
machine, which cost K80,000 two years ago and has a current net book
value of K60,000. There is sufficient capacity on this machine, which has so
far been under-utilised. Annual sales of the product would be 5,000 units,
selling at K32 per unit. Unit costs would be as follows;
K
Direct labour (4 hours at K2 per hour) 8
Direct materials 7
Fixed costs including depreciation 9
24
Chapter
The project would have a five-year life, after which the new machine
would have a net residual value of K10,000. Because direct labour is
continually in short supply, labour resources would have to be diverted
from other work which currently earns a contribution of K1.50 per direct
labour hour. The fixed overhead absorption rate would be K2.25 per hour
(K9 per unit) but actual expenditure on fixed overhead would not alter.
Working capital requirements would be K10,000 in the first year, rising to
K15,000 in the second year and remaining at this level until the end of
the project, when it will all be recovered. The company’s cost of capital
is 20%.
You are required to assess whether the project is worthwhile.
Chapter
Solution
1. Relevant cashflows (CF) K
(a) Year 0 (purchase of new machine) 150,000
(b) Years 1 – 5 [contributions - new product:(5,000 unit x (32-15)] 85,
000
Less contributions foregone: 5,000 units x (4x1.50) 30,000
55,000
Chapter
Working Net Discount PV of Net
Year Equipment Capital Contribution Cash flow factor Cash flow
K K K K 20% K
0 (150,000) (10,000) (160,000) 1.000 (160,000)
1 (5,000) (5,000) 0.833 (4,165)
1–5 55,000 55,0002.999 164,505
5 10,000 15,000 25,0000.402 10,005
NPV = 10,390
NPV positive, project is worthwhile.
Chapter
Cash Flows in Perpetuity
You need to know how to calculate the cumulative present value
of K1 per annum for every year in perpetuity (that is, forever).
When the cost of capital is r, the cumulative PV of K1 per annum
in perpetuity is K1/r.
For example, the PV of K1 per annum in perpetuity at a discount
rate of 15% would be K1/0.15 = K6.67 and at a discount rate of
20% it would be K1/0.20 = K5.
Chapter
Example 6
An organisation with a cost of capital of 14% is considering
investing in a project costing K500,000 that would yield cash
inflows of K100,000 per annum in perpetuity.
Required
Assess whether the project should be undertaken.
Chapter
•
Chapter
Advantages of using NPV
• Takes account of time value of money, placing emphasis on earlier cash flows
• Looks at all the cash flows involved through the life of the project
• Use of discounting reduces the impact of long-term, less likely cash flows
• Has a decision-making mechanism – reject projects with negative NPV
Disadvantages of using NPV
• More complicated method – users may find it hard to understand
• Difficult to select the most appropriate discount rate – may lead to good
projects being rejected
• The NPV calculation is very sensitive to the initial investment cost
Chapter
The Internal Rate of Return (IRR) Method
• IRR method is used to calculate the exact DCF rate of return
which the project is expected to achieve, in other words the
rate at which the NPV is zero.
• If the expected rate of return (IRR or DCF yield) exceeds a
target rate of return, the project would be worth undertaking.
Chapter
Procedure for computing IRR:
Choosing rates for cost of capital which will give an NPV close to
zero is a hit-and-miss exercise, and several attempts maybe
needed to find satisfactory rates. As a rough guide, try starting at
a return figure which is about two thirds or three quarters of the
accounting return on investment or accounting rate of return (ARR)
.
Chapter
Example 7
A company is trying to decide whether to buy a machine for K80,
000 which will save costs of K20,000 per annum for 5 years and
which will have a resale value of K10,000 at the end of 5 years.
If it is the company’s policy to undertake projects only if they are
expected to yield a DCF return of 10% or more, ascertain
whether this project be undertaken.
Chapter
•
Chapter
NPV @ 9%
Year CF PV Factor PV of CF
K 9% K
0 (80,000) 1.000 (80,000)
1–5 20,000 3.890 77,800
5 10,000 0.650 6,500
NPV = 4,300
Chapter
Try NPV @ 12%
Year CF PV Factor PV of CF
K 12% K
0 (80,000) 1.000 (80,000)
1–5 20,000 3.605 72,100
5 10,000 0.567 5,670
NPV = (2,230)
Chapter
•
Chapter
•
Chapter
Example 8
Find the IRR of the project given below and state whether the project
should be accepted if the company requires a minimum return of 17%.
There is no scrap value.
Time K
0 Investment (4,000)
1 Receipts 1,200
2 “ 1,410
3 “ 1,875
4 “ 1,150
Chapter
•
Chapter
Two third of 20% is approximately 14%
Therefore;
NPV @ 14% and 16%
Time CF DF@14% PV DF@16% PV
0 (4,000) 1.000 (4,000) 1.000 (4,000)
1 1,200 0.877 1,052 0.862 1,034
2 1,410 0.769 1,084 0.743 1,048
3 1,875 0.675 1,266 0.641 1,202
4 1,150 0.592 681 0.552 635
NPV = 83 NPV = (81)
Chapter
•
Chapter
Advantages of IRR
• It considers the time value of money even though the annual cash inflow
is even and uneven.
• The profitability of the project is considered over the entire economic life
of the project. In this way, a true profitability of the project is evaluated.
• There is no need of the pre-determination of cost of capital or cut off rate.
Hence, it is better than NPV method.
• Sometimes, the pre-determination of cost of capital is very difficult. At
that time, IRR can be used to evaluate the project.
• It provides for maximizing profitability.
• Internal Rate of Return takes into account the total cash inflow and
outflows.
Chapter
Disadvantages of IRR
 This method assumed that the earnings are reinvested at the internal
rate of return for the remaining life of the project.
 It involves tedious calculations.
 This method gives importance only to the profitability but not consider
the earliest recouping of capital expenditure. Under the conditions of
future uncertainty, sometimes the full capital expenditure cannot be
recouped if Internal Rate of Return followed.
 The results of Net Present Value method and Internal Rate of
Return method may differ when the projects under evaluation
differ in their size, life and timings of cash inflows.
Chapter
Mutually Exclusive Projects
• Mutually exclusive projects are two or more projects from
which only one can be chosen.
• Examples include the choice of a factory location or the
choice of just one of a number of machines.
• The IRR and NPV methods can, however, give conflicting
rankings as to which project should be given priority.
Chapter
• Note: with mutually exclusive projects, only one project can be
accepted and therefore the ranking is crucial and when there is
conflict between the outcomes of the NPV and IRR appraisal
methods, NPV method is to be preferred.
Chapter
Example 9
Suppose a company is considering two mutually exclusive options, option A
and option B. The cash flows for each would be as follows;
Year Option A Option B
K K
0 Capital outlay (10,200) (35,250)
1 Net cash flow 6,000 18,000
2 Net cash flow 5,000 15,000
3 Net cash flow 3,000 15,000
The company’s cost of capital is 16%. Advise on the project that should be
prioritised.
Chapter
Solution:
NPV of each project
Option A Option B
Time DF@ 16% CF PV CF PV
0 1.000 (10,200) (10,200) (35,250) (35,250)
1 0.862 6,000 5,172 18,000 15,516
2 0.743 5,000 3,715 15,000 11,145
3 0.641 3,000 1,923 15,000 9,615
NPV = 610 NPV = 1,026
IRR of option A is 20% and option B is only 18%. On a comparison of NPVs, option B would be
preferred, but on a comparison of IRRs, option A would be preferred.
NPV method is preferred.
Chapter
Comparison between NPV and IRR
• The IRR method is more easily understood.
• NPV is technically superior to IRR and simpler to calculate.
• IRR ignores the relative sizes of investments.
• When cash flow patterns are non-conventional, there may be several IRRs and
decision makers should be aware to avoid making wrong decisions.
• Where there is conflict between NPV and IRR, NPV is always superior for ranking
mutually exclusive projects in order of attractiveness.
• Reinvestment assumptions under IRR cannot be substantiated.
• Variations in discount rates during the life of a project can easily be incorporated
in the NPV calculations but not into the IRR calculations.
• Despite advantages of NPV method over IRR, the IRR method is widely used in
practice.
Chapter
Advantages of the DCF Methods of Project Appraisal
• They take account of the time value of money by discounting
cash flows.
• The methods uses all cash flows related to the project.
• They allows for the timing of the cash flows.
• There are universally accepted methods of calculating the
NPV and the IRR.
Chapter
Allowing for Inflation
• As inflation rate increases so will the minimum return required
by an investor. For example, an investor may be happy to
receive a return of 5% in an inflation-free economy, but if
inflation was running at 12% the investor would expect to
receive a greater yield.
• We must decide on which rate to use for discounting, the real
rate or the money rate. The rule is a follows.
Chapter
a) If the cash flows are expressed in terms of the actual number of
currency units that will be received or paid on the various future
dates, we use the money rate for discounting.
b) If the cash flows are expressed in terms of the value of the
kwacha at the time 0 (that is, in constant price level terms), we
use the real rate.
• The two rates of return and inflation rate are linked by the equation;
(1 + money rate) = (1 + real rate) x (1 + inflation rate)
Chapter
Example 10
A company is considering investing in a project with the following cash flows.
Time Actual cash flows
K
0 (15,000)
1 9,000
2 8,000
3 7,000
The company requires a minimum return of 20% under the present and anticipated
conditions. Inflation is currently running at 10% a year, and this rate of inflation is
expected to continue indefinitely. Should the company go ahead with the project?
Chapter
Solution
1.Using the money rate.
Discount
Time Cash flow factor PV
K 20% K
0 (15,000) 1.000 (15,000)
1 9,000 0.833 7,497
2 8,000 0.694 5,552
3 7,000 0.579 4,053
NPV = 2,102
Project has a positive net present value of K2,102. Project can be

adopted.
Chapter
•
Chapter
•
Chapter
Costs and Benefits which Inflate at different Rates
• Not all costs and benefits will rise in line with the general level of
inflation. In such cases, we can apply the money rate to inflated
values to determine a project’s NPV.
Example 11
A company is considering a project which would cost K5,000 now. The
annual benefits, for four years, would be a fixed income of K2,500 a
year, plus other savings of K500 a year in year 1, rising by 5% each year
because of inflation. Running costs will be K1,000 in the year, but
would increase at 10% each year because of inflating labour costs.
The general rate of inflation is expected to be 7.5% and the company’s
required money rate of return is 16%. Is the project worthwhile?
Chapter
Solution
The cash flows at inflated values are as follows;
fixed other Running Net cash
Year income savings costs flow
K K K K
1 2,500 500 1,000 2,000
2 2,500 525 1,100 1,925
3 2,500 551 1,210 1,841
4 2,500 579 1,331 1,748
Chapter
Therefore, NPV is:
Discount
Year Cash flow factor PV
K 16% K
0 (5,000) 1.000 (5,000)
1 2,000 0.862 1,724
2 1,925 0.743 1,430
3 1,841 0.641 1,180
4 1,748 0.552 965
NPV = 299
Project has a positive net present value. Project worthwhile.

Chapter
Variations in the Expected Rate of Inflation
• If the rate of inflation is expected to change, the calculation of
the money cost of capital is slightly more complicated.
Example 12
Mr T as just received a dividend of K1,000 on his shareholding in
Carling Inc. The market value of shares is K8,000 ex div. What is
the (money) cost of the equity capital, if dividends are expected
to rise because of inflation by 10% in years 1, 2 and 3, before
levelling off at this year 3 amount?
Solution
The money cost of capital is the internal rate of return of the following cash
flows.
Year Cash flow PV @ 15% PV @ 20%

K K K
0 (8,000) (8,000) (8,000)
1 1,100 957 916 2 1,210 915 840
3 1,331 p 6,709 4,621
581 (1,623)
Chapter
•
Chapter
Allowing for Taxation
• Payment of tax or reductions of tax payments, are cash flows and
ought to be considered in DCF analysis. Typical assumptions may be;
a) Corporate tax is payable in the year following the one in which
taxable profits are made. For example, if a project increases
taxable profits by K10,000 in year 2, and at 30% corporate tax, there
will be a tax payment of K3,000 in year 3.
b) Net cash flows from a project should be considered as the taxable
profits arising from the project (unless an indication is given to the
contrary).
Chapter
Capital Allowances
• Capital allowance reduces taxable profits, and the consequent
reduction in a tax payment should be treated as a cash saving
arising from the acceptance of the project.
• Writing down allowances are generally allowed on the cost of
plant and machinery at the rate of 25% on a reducing balance
basis or straight line basis.
• Thus if a company purchases plant costing K80,000, the
subsequent writing down allowances would be as follows.
Chapter
Years Capital allowances Reducing balance
K K
1 (25% of cost) 20,000 60,000
2 (25% of RB) 15,000 45,000
3 (25% of RB) 11,250 33,750
4 (25% of RB) 8,438 25,312
Chapter
• When the plant is eventually sold, the difference between the
sales price and the reducing balance amount at the time of sale
will be treated as a taxable profit if the sale price exceeds the
reducing balance, and as a tax allowable loss if the reducing
balance exceeds the sales price.
• The cash saving on the capital allowances (or the cash payment
for the charge) is calculated by multiplying the allowance (or
charge) by the incorporation tax rate.
Chapter
Capital assumptions
• There are two possible assumption about the time when capital
allowances start to be claimed.
a) It can be assumed that the first claim for capital
allowances occurs at the start of the project (at year 0) and
so the first tax saving occurs one year later (at year 1).
b) Alternatively it can be assumed that the first claim for
capital allowances occurs later in the first, so the first tax
saving occurs one year later, that is, year 2.
Chapter
Example 13
A company is considering whether or not to purchase an item of machinery
costing K40,000 in 2020. It would have a life of four years, after which it
would be sold for K5,000. The machinery would create annual cost savings
of K14,000.
The machinery would attract writing down allowances of 25% on the
reducing balance basis which could be claimed against taxable profits of
the current year, which is soon to end. A balancing allowance or charge
would arise on disposal. The rate of corporation tax is 30%. Tax is payable
one year in arrears. The after-tax cost of capital is 8%. Assume that tax
payments occur in the year following the transactions.
Should the machinery be purchased?
Chapter
Solution
The first capital allowance is claimed against year 0 profits. Therefore,
capital allowance computation at cost K40,000.
Year allowance Reducing Balance
K K
0 (2020) (25% of cost) 10,000 30,000
1 (2021) (25% of RB) 7,500 22,500
2 (2022) (25% of RB) 5,625 16,875
3 (2023) (25% of RB) 4,219 12,656
4 (2024) (25% of RB) 3,164 9,492
Chapter
K
Sales proceeds, end of fourth year 5,000
Less: reducing balance, end of fourth year 9,492
Balancing allowance 4,492
Note: the year of cash flow is one year after the year for which the
allowance is claimed.
Chapter
Tax Savings – Computations
Year of tax
Year of claim Allowance Tax saved payment/saving
K K
0 10,000 3,000 1
1 7,500 2,250 2
2 5,625 1,688 3
3 4,219 1,266 4
4 7,656 2,297 5
35,000*
* Net cost K(40,000 – 5,000) = K35,000
Chapter
Therefore, NPV:
Yr Equip’ Savings TS TSCA NCF DF PV
K K K K K 8% K
0 (40,000) (40,000) 1.000 (40,000)
1 14,000 3,000 17,000 0.926 15,742
2 14,000 (4,200) 2,250 12,050 0.857 10,327
3 14,000 (4,200) 1,688 11,488 0.794 9,121
4 5,000 14,000 (4,200) 1,266 16,066 0.735 11,809
5 (4,200) 2,297 (1,903) 0.681 (1,296)
NPV = 5,703
The NPV is positive, purchase worthwhile.
Chapter
• Alternative method – tax computation combined
Year 1 2 3 4 5
K K K K K
Cost saving 0 14,000 14,000 14,000 14,000
Capital all’ 10,000 7,500 5,625 4,219 7,656
(10,000) 6,500 8,375 9,781 6,344
Tax @ 30% 3,000 (1,950) (2,512) (2,934) (1,903)
Chapter
Net Cash Flow and NPV:
Yr Equip’ Savings Tax NCF DF PV
K K K K 8% K
0 (40,000) (40,000) 1.000 (40,000)
1 14,000 3,000 17,000 0.926 15,742
2 14,000 (1,950) 12,050 0.857 10,327
3 14,000 (2,512) 11,488 0.794 9,121
4 5,000 14,000 (2,934) 16,066 0.735 11,809
5 (1,903) (1,903) 0.681 (1,296)
NPV = 5,703
The NPV is positive, purchase worthwhile.
END OF CHAPTER

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CHAPTER

Year Cash Flow PV Factor PV of Cash Flow

Project has a positive net present value of K2,102. Project can be

Project has a positive net present value. Project worthwhile.

Year Cash flow PV @ 15% PV @ 20%

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