BF3326 Corporate Finance

Investment Appraisal
Why Investment Appraisal?
1. Understand how to identify the sources and types of profitable investment
opportunities
2. Describe the importance of capital investments and the capital budgeting
process
3. Use the payback and the accounting rate of return methods to make capital
investment decisions
4. Use the time value of money to compute the present values of lump sums and
annuities
5. Use discounted cash flow methods to make capital investment decisions
6. Use the profitability index, internal rate of return, and payback criteria to
evaluate investment opportunities
7. Understand current business practice with respect to the use of capital
budgeting criteria
Good Investment Projects?

• It is not easy to find profitable investment opportunities

in competitive markets.

• Good investments are most likely to be found in

markets that are less competitive where barriers to
new entrants are sufficiently high to keep out would-be
competitors.
Investment Projects

1. Revenue enhancing Investments (for example,

entering a new market)
2. Cost-reduction investments (for example, installing a
more efficient equipment)
3. Mandatory investments that are a result of
government mandate (for example, installing
mandatory safety features in a car)
Investment Analysis
• Commitment of large amounts of resources

• Long period of risk

– Capital assets often mean technological risk
– Strategic considerations
– Exit barriers

• Time value of money considerations

• Important analytical tool
• Not the primary consideration of analysis
Investment Decision
• The objective of the corporation is to Maximise
Shareholders Wealth
• To do this we need to invest in those projects that
will give the correct rate of return for the risk
involved
• To do this we need to be able to properly evaluate
investment opportunities and make an informed
decision
Investment Decision
HOW?
1. Identify suitable investment opportunities
2. Decide on the best selection method
3. Identify the cash flows that will be generated by those
investments
4. Discount them at the correct cost of capital
5. Choose the best one or ones from those available
Investment Decision
The ideal selection method will

• Select the project that maximises shareholders wealth

• Consider all cash flows
• Discount the cash flows at the appropriate market
determined opportunity cost of capital
• Will allow managers to consider each project
independently from all others
Investment Proposal
• Investment ideas can range from simple upgrades
of equipment, replacing existing inefficient
equipment, through to plant expansions, new
product development or corporate takeovers.
• Generation of good ideas for investment
is better facilitated if a systematic means of
searching for and developing them exists.
• This may be assisted by financial incentives
and bonuses for those who propose successful
projects.
Investment Proposal
• Consideration for a good investment proposal:
– Brief description of the proposed investment.
– Statement as to why it is desirable or necessary.
– Estimate of the amount and timing of the cash outlays.
– Estimate of the amount and timing of the cash inflows.
– Estimate of when the proposal will come into operation.
– Estimate of the proposal’s economic life.
Investment Planning
Investment Cash Flow
Investment Cash Flow
Investment Lesson
Case
• Disney’s decision to invest $17.5 million to build Disneyland park
in California is an example of investment decision.
• Subsequently, Disney opened theme parks in Orlando, Tokyo, Paris
and most recently invested $3.5 billion to build a theme park in Hong
Kong. Today parks and resorts account for over 30% of
Disney’s Revenue.
Investment Lesson
Case
1. Capital budgeting decisions are critical in defining a
company’s success.
2. Very large investments are frequently the result of many
smaller investment decisions that define a business
strategy.
3. Successful investment choices lead to the development
of managerial expertise and capabilities that influence
the firm’s choice of future investments.
Financial Decision Tools
• Different methods of Financial Investment evaluation tools
include:
– Payback period (PP).
– Accounting rate of return (ARR).
– Benefit-cost ratio (profitability index).
– Net present value (NPV).
– Internal rate of return (IRR).
Financial Investment Criteria
Non - Discounting Method
• Two capital investment analysis methods which are not
discounted, that companies use to evaluate shorter
capital investments are:
– Payback
– Accounting rate of return

• Payback is a capital investment analysis method that

measures the length of time it takes to recover, in net
cash inflows, the cost of the initial investment.
Payback Method
Payback with Equal Annual Cash Flow

• Smart Touch Learning is considering investing

$240,000 in:
– Hardware and software to provide a business-to-
business (B2B) portal. Smart Touch Learning expects
the portal to save $60,000 per year for each of the
six years of its useful life.
Payback Method
Payback with Equal Annual Cash Flow

• Net cash flows arise from an increase in revenues, a decrease in

expenses, or both.
• When net cash inflows are equal each year, managers compute the
payback with the following formula:
Payback Method
Payback with Equal Annual Cash Flow

• Smart Touch Learning computes the investment’s

payback as:
Payback Method
Payback with Equal Annual Cash Flow

• Assume Smart Touch Learning is considering whether to, instead,

invest $240,000 to upgrade its Web site. The company expects the
upgraded Web site to generate $80,000 in net cash inflows each
year of its three-year life. The payback is:
Payback Method
Payback with Equal Annual Cash Flow
Payback Method
Payback with Unequal Annual Cash Flow

Assume that Smart Touch Learning is considering an alternate investment, the Z80
portal. The Z80 portal differs from the B2B portal and the Web site upgrade in two
respects. First, it has unequal net cash inflows during its life; second, it has a $30,000
residual value at the end of its life. The Z80 portal will generate net cash inflows of
$100,000 in year 1, $80,000 in year 2, $50,000 each year in years 3 and 4, $40,000 each
in years 5 and 6, and $30,000 in residual value when the equipment is sold at the end of
the project’s useful life.

By the end of year 3, the company has recovered $230,000 of the $240,000 initially
invested, so it is only $10,000 short of payback. Because the expected net cash inflow in
year 4 is $50,000, by the end of year 4, the company will have recovered more than the
initial investment. Therefore, the payback is somewhere between three and four years.
Payback Method
Payback with Unequal Annual Cash Flow
Payback Method
Payback with Unequal Annual Cash Flow

• For the payback with unequal cash flows, the payback period is calculated
using the following formula:

• The shortest payback period is for the Web site:

Payback Method - Decision

Is this the right choice?

Has it maximize the income for the
company?
Payback Method - Drawbacks

Project Choice
Accounting Rate of Return Method

The accounting rate of return (ARR) is a capital investment

analysis method that measures profitability of an
investment.
Accounting Rate of Return Method

Before calculating the ARR, first determine the average annual

operating income using the following formula:
Accounting Rate of Return Method

Assume the B2B portal’s average annual operating income and ARR are as
follows:
Accounting Rate of Return Method
Assume the Z80 portal’s average annual operating income and ARR
are as follows:
Accounting Rate of Return - Decision
Discounted Method
• Neither payback nor ARR recognizes the time
value of money.
• The methods incorporating compound interest
are:
– Net present value (NPV)
– Benefit Cost Ration (Profit Index)
– Internal rate of return (IRR)
Net Present Value

• Net present value (NPV) is a capital investment

analysis method that measures the net difference
between the present value of an investment’s net cash
inflows and the investment’s initial cost.

• The discount rate is management’s minimum desired

rate of return on a capital investment.
Net Present Value
Smart Touch Learning considers expanding products to include laptop and/or Desktop computers.
Compare two projects: produce laptop computers or produce desktop computers. Assume the foll
owing cash flows:
Net Present Value
Smart Touch Learning expects the laptop project to generate
$305,450 of net cash inflows each year for five years. [Equal cash
flow]
The NPV is $48,610 calculated as follows:
Net Present Value
Net Present Value
Assume Smart Touch Learning expects the desktop project to
generate the following cash flow fore the next 5 years. [Unequal cash
flow]
Net Present Value
Suppose Smart Touch Learning expects that the laptop project equipment will be
worth $100,000 at the end of its five-year life. The revised NPV is as follows:
Net Present Value – Other Consideration

Different Projects, Different Cash flows, Different Outlay

Which Project to invest?

Discuss the pros and cons
Benefit Cost Ratio (Profitability Index)

• Choose the project with the highest NPV when comparing

projects with similar investments.
• Use the profitability index when initial investment amounts differ.
Benefit Cost Ratio (Profitability Index)

The profitability index is computed as follows:

Benefit Cost Ratio (Profitability Index)

Calculating the profit index from the previous example

Benefit Cost Ratio (Profitability Index)

Comparison of the laptop and desktop projects (without residual value) using the
profitability index is as follows:
Internal Rate of Return (IRR)

•The internal rate of return (IRR) is the rate of return,

based on discounted cash flows, of a capital
investment.

•It is the interest rate that makes the NPV of the

investment equal to zero.
Internal Rate of Return (IRR)

Smart Touch Learning’s laptop project would cost $1,000,000 with

five equal yearly cash inflows of $305,450.
Use the following formula to find the annuity factor:

Then look up the factor to determine the applicable interest rate.

Internal Rate of Return (IRR) - Decision
Internal Rate of Return (IRR) - Decision
Comparing Methods