Investment Appraisal

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 Objectives
Investment appraisal is sometimes referred to as
capital budgeting

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 What is Investment appraisal
Involves:
Analyses and evaluation of investment
proposals
Use of appraisal techniques e.g. Net Present
Value (NPV) to make a decision.

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 Investment Appraisal Techniques
Payback method
The payback period is the time a project will
take to pay back the money spent on it.
Decision rule:
Only select projects which pay back within the
specified time period
Choose between options on the basis of the
fastest payback

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 Investment Appraisal Techniques
Example 1 (Payback method)
A project is expected to have the following cash
flows:
Year Cash flow ($000)
0 (2,000)
1 500
2 500
3 400
4 600
5 300
6 200

What is the expected payback period?

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 Investment Appraisal Techniques
Example 1 Ans. (Payback method)

Cash flow Cumulative cash flow

Year
$0 $0
0 -2,000 -2,000
1 500 -1,500
2 500 -1,000
3 400 -600
4 600 0
5 300 300
6 200 500

The payback period is exactly 4 years.

In the table above a column is added for cumulative cash
flows for the project to date. Figures in brackets are
negative cash flows.
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 Investment Appraisal Techniques
Advantages and disadvantages of payback
Advantages Disadvantages
 It is simple  It ignores returns after the
 It is useful in certain situations: payback period
 Rapidly changing technology  It ignores time value of money
 Improving investment  It is subjective – no definitive
conditions investment signal
 It favours quick return:  It ignores project profitability.
 Helps company growth
 Minimizes risk
 Maximizes liquidity
 It uses cash flows, not accounting
profit.

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 Investment Appraisal Techniques
Discounted payback
This is an improvement on the simple payback
method in that it takes into account the time
value of money.

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 Investment Appraisal Techniques
Example 2 ( Discounted payback)
A project is expected to have the following cash
flows. The discount rate is 10%.
Year Cash flow ($000)
0 (2,000)
1 600
2 500
3 600
4 600
5 300
6 200

What is the discounted payback period?

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 Investment Appraisal Techniques
Example 2 Ans. ( Discounted payback)

Cash flow Discounted Cumulative cash flow

Year $0 Cash flow @10% $0
$0
0 -2,000 -2,000 -2,000
1 600 545 -1,455
2 500 413 -1,042
3 600 451 -591
4 600 410 -181
5 300 186 5
6 200 113 118

The payback period is about 5 years.

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 Investment Appraisal Techniques
Net present value (NPV)
Involves discounting all the relevant cash flows
associated with the project back to their PV.
Decision Rule.
If the NPV > 0 – the project is financially viable, i.e.
accepted.
If the NPV = 0 – the project breaks even.
If the NPV < 0 – the project is not financially viable, i.e.
rejected.
If the company has two or more mutually exclusive
projects under consideration it should choose the one
with the highest NPV.
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 Investment Appraisal Techniques
Example 3 (NPV)
An organization is considering a capital investment in the
new equipment. The estimated cash flows are as follows.
Year Cash flow
0 (240,000)
1 80,000
2 120,000
3 70,000
4 40,000
5 20,000

The company’s cost of capital is 9%.

Calculate the NPV of the project to assess whether it
should be undertaken.

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 Investment Appraisal Techniques
Example 3 Ans. (NPV)

Year Cash flow ($) Discounted factor at 9% PV ($)

0 -240,000 1 -240,000
1 80,000 0.917 73,360
2 120,000 0.842 101,040
3 70,000 0.772 54,040
4 40,000 0.708 28,320
5 20,000 0.65 13,000
NPV = 29,760

The PV of cash inflows exceeds the PV of cash outflows by $29,760,

which means that the project will earn a DCF return in excess of 9%,
i.e. it will earn a surplus of $29,760 after paying the cost of financing.

It should therefore be undertaken.

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 Investment Appraisal Techniques
Advantages and disadvantages of NPV

Advantages Disadvantages
 Considers the time value of  It is difficult to explain to
money managers
 Is an absolute measure of return  It requires knowledge of the cost
 Is based on cash flows not profits of capital
 Considers the whole life of the  It is relatively complex.
project
 Should lead to maximization of
shareholder wealth.

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Investment Appraisal Techniques
Internal rate of return (IRR)
The IRR is the rate of return which equates the
present value of future cash flows with the
outlay:
Outlays = Future cash flows discounted at
rate r
Thus:
CF CF2 CF3 CFn
CF0  1    ... 
1  r (1  r ) 2 (1  r ) 3 (1  r ) n

Decision Rule:
Projects should be accepted if their IRR is greater
than the cost of capital.
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 Investment Appraisal Techniques
Internal rate of return (IRR)
Calculation of IRR can be done using linear
interpolation or in practice by excel function
e.g. "=IRR(A1:A4)“
For learning purposes we will use linear
interpolation.

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 Investment Appraisal Techniques
Steps in calculating the IRR using linear interpolation
1. Calculate two NPVs for the project at two different costs
of capital. One NPV must be negative, and another one is
positive.
2. Using the following formula to find the IRR:
NL
IRR = L +  ( H  L)
NL  NH
where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest

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 Investment Appraisal Techniques
IRR as estimated by the formula above

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 Investment Appraisal Techniques
Example 4 (IRR)
A potential project’s predicted cash flows give a
NPV of $50,000 at a discount rate of 10% and –
$10,000 at a rate of 15%.

Calculate the IRR.

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 Investment Appraisal Techniques
Example 4. Ans. (IRR)

50,000
IRR = 10% +  (15%  10%) = 14.17%
50,000  10,000

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 Investment Appraisal Techniques
Advantages and disadvantages of IRR
Advantages
 Considers the time value of
money
 Is a percentage and therefore
easily understood
 Uses cash flows not profits
 Considers the whole life of the
project
 Means a firm selecting projects
where the IRR exceeds the cost
of capi tal should increase
shareholders’ wealth.
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Disadvantages
 It is not a measure of absolute
profitability.
 Interpolation only provides an
estimate and an accurate estimate
requires the use of a spreadsheet
program
 It is fairly complicated to
calculate
 Non-conventional cash flows may
give rise to multiple IRRs.
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 Investment Appraisal Techniques
Accounting rate of return (ARR)
This is also known as return on capital
employed (ROCE) or return on investment
(ROI).
Decision rule
If the expected ARR for the investment is greater
than the target or hurdle rate then the project
should be accepted.

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 Investment Appraisal Techniques
Example 5 (ARR)
There 3 versions to this

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 Investment Appraisal Techniques
Example 5 (ARR)

(5,000  5,000  5,000) / 3

ARR =  100% = 33.33%
15,000

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 Investment Appraisal Techniques
Advantages and disadvantages of ARR
Advantages Disadvantages
 It is a quick and simple  It is based on accounting profit
calculation and not cash flows. Accounting
 It involves the familiar concept of profits are subject to a number of
a percentage return different accounting treatments.
 It looks at the entire project life  It is a relative measure rath er than
an absolute measure and hence
takes no account of the size of the
investment
 Like the payback method, it
ignores the time value of money.

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 Investment Appraisal
Relevant Cash Flows
Only relevant cash flows should be considered. These are:
 Future
 Incremental / Changes
 Cash-based.

We should ignore the following costs:

 sunk costs
 committed costs
 non-cash items
 allocated costs.

On the other hand, in capital investment appraisal it is more appropriate to

evaluate future cash flows than accounting profits, because:
 profits cannot be spent
 profits are subjective
 Cash is required to pay dividends.

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 Tax Implications
Taxation can have an important impact on
project viability.
In investment appraisal the after-tax cash
flows of a project are used.
Payments of tax, or reductions of tax
payments, are cash flows and ought to be
considered in DCF analysis.

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 Tax Implications
The following assumptions which may be stated
in DCF questions:
Tax is payable in the year following the one in
which the taxable profits are made.
Net cash flows from a project should be
considered as the taxable profits (not just the
taxable revenues) arising from the project.
Capital allowances reduce taxable profits, so
should be treated as a cash saving from the
acceptance of a project.
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 Tax Implications
Example 7
ABC Ltd is considering a project which will require the purchase of a machine for
$1,000,000 at time zero. This machine will have a scrap value at the end of its four-year life:
this will be equal to its income tax value (ITV) . Zimbabwe Revenue Authority (ZIMRA)
permits a wear and tear allowance of 25% on the machine each year. Corporation tax, at a
rate of 30% of taxable income, is payable. ABC Ltd ’s requi red rate of return is 12%.
Operating cash flows, excluding depreciation, and before taxation, are forecast to be:

Time (year) 1 2 3 4
$ $ $ $
Cash flows before tax 400,000 400,000 220,000 240,000

Note: All cash flows occur at year ends.

Calculate NPV

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 Tax Implications
Example 7. Ans.
In order to calculate the NPV, first calculate the annual capital allowance . Note that each year
the capital allowance is equal to 25% of the asset value at the start of the year.

Years Annual capital allowance ($) Income Tax Value (ITV)

($)
0 0 1,000,000
1 1,000,000 × 25% = 250,000 750,000
2 750,000 × 25% = 187,500 562,500
3 562,500 × 25% = 140,625 421,875
4 421,875 × 25% = 105,469 316,406

The next step is to derive the project ’s incremental taxable income and to calculate the tax
payments.

Time (year) 1 2 3 4
$ $ $ $
Net income before capital
allowance and tax 400,000 400,000 220,000 240,000
Less: Capital allowance 250,000 187,500 140,625 105,469
Taxable profit 150,000 212,500 79,375 134,531
Tax payable at 30% 45,000 63,750 23,813 40,359
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 Tax Implications
Example 7. Ans.
Finally, the total cash flows and NPV are calculated.

Time (year) 0 1 2 3 4
$ $ $ $ $
Incremental cash flow
before tax (1,000,000) 400,000 400,000 220,000 240,000
Sale of machine 316,406
Tax payable 0 (45,000) (63,750) (23,813) (40,359)
Net cash flows (1,000,000) 355,000 336,250 196,187 516,047
Discount factor @12%
1 0.8929 0.7972 0.7118 0.6355
Discounted cash flow
(1,000,000) 316,980 268,059 139,646 327,948

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 Incorporating Working Capital
Investment in a new project often requires an
additional investment in working capital, i.e. the
difference between short-term assets and liabilities.
The treatment of working capital is as follows:
Initial investment is a cost at the start of the
project.
If the investment is increased during the project,
the increase is a relevant cash outflow
At the end of the project all the working capital is
released and treated as cash inflow.
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 Incorporating Working Capital
Example 8
A company expects sales for a new project to be $225,000 in the first year growing at
5% pa. The project is expected to last for 4 years. Working capital equal to 10% of
annual sales is required and nee ds to be in place at the start of each year.

Calculate the working capital flows for incorporation into the NPV calculation.

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 Incorporating Working Capital
Example 8. Ans.
Calculate the absolute amounts of working capital needed over the project:
Year 0 1 2 3 4
$ $ $ $ $
Sales 225,000 236,250 248,063 260,466
Working capital 22,500 23,625 24,806 26,047
(10% sales)

Work out the incremental investment required each year (remember that the full
investment is released at the end of the project):
Year 0 1 2 3 4
$ $ $ $ $
Working 23,625 – 24,806 – 26,047 –
22,500 23,625 24,806
Working capital
investment (22,500) (1,125) (1,181) (1,241) 26,047

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 Leasing/replacement decisions
a) Lease or Buy Decisions
Rather than buying an asset outright, using
either available cash resources or borrowed
funds, a business may lease an asset.

b) Asset Replacement Decisions

Involves replacing an asset with identical asset
or different asset

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 Lease or Buy Decisions
The decision whether to lease or buy involves
two steps:
1. The acquisition decision – is the asset worth
having? Test by discounting project cash
flows at a suitable cost of capital.
2. The financing decision – if the asset should
be acquired, compare the cash flows of
purchasing and leasing or hire-purchase (HP)
arrangements. The cash flows can be
discounted at an after-tax cost of borrowing.
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 Asset Replacement Decisions
DCF techniques can assist asset replacement
decisions.
When an asset is being replaced with an
identical asset, the equivalent annual cost
method can be used to calculate on optimum
replacement cycle.

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 Asset Replacement Decisions
Replacement cycles
This is when assets are replaced on regular intervals
The equivalent annual cost method is the quickest
method to use in a period of no inflation.

Step 1: Calculate the present value of costs for each replacement cycle over one cycle only.
Step 2: Turn the present value of costs for each replacement cycle into an equiv alent annual
cost (an annuity).

The equivalent annual cost is calculated as follows.

Equivalent annual cost =
PV of costs
Annuity factor for the number of years in the cycle

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 Capital Rationing
Capital rationing occurs when funds are not
available to finance all wealth-enhancing
projects. There are two types namely:
a) Soft capital rationing – is internal
management-imposed limits on investment
expenditure.
b) Hard capital rationing – relates to capital
from external sources. (e.g. shareholders
and bank)
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 Capital Rationing
Single period capital rationing
This occurs when rationing occurs when limits
are placed on finance availability for only one
year.
There are two possibilities:
a) Divisible projects – when project can be done in
fractions.
b) Indivisible projects – this is when project is
impossible to take in fractions
When capital rationing occurs in a single period,
projects are ranked in terms of profitability
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 Capital Rationing
Profitability Index
 Profitability index is the ratio of the PV of the
project’s future cash flows (not including the
capital investment) divided by the present
value of the total capital investment.

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 Capital Rationing
Example 9
Suppose that ABC Co is considering four projects, W, X, Y and Z.
Relevant details are as follows.
Project Investment PV of NPV PI Ranking Ranking
required cash as per as per PI
inflows NPV
$ $ $
W (10,000) 11,240 1,240 1.12 3 1
X (20,000) 20,991 991 1.05 4 4
Y (30,000) 32,230 2,230 1.07 2 3
Z (40,000) 43,801 3,801 1.10 1 2

Without capital rationing all four projects would be

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 Capital Rationing
Example 9. Cont.
Suppose, however, that only $60,000 was available for capital
investment. Let us look at the resulting NPV if we select projects in the
order of ranking per NPV.
By NPV:
Project Priority Outlay NPV
Z 1st 40,000 3,801
Y (balance)* 2nd 20,000 1,487 (2/3 of $2,230)
60,000 5,288

By PI:
Project Priority Outlay NPV
W 1st 10,000 1,240
Z 2nd 40,000 3,801
Y 3rd 10,000 743 (1/3 of $2,230)
60,000 5,784

* Projects are divisible. By spending the balancing $20,000 on project

Y, two thirds of the full investment would be made to earn two thirds
of the NPV.
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 Capital Rationing
Single period rationing with non-divisible
projects
 If the projects are not divisible then the best
way to deal with this situation is to use trial
and error and test the NPV available from
different combinations of projects.
 This can be a laborious process if there are a
large number of projects available.

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 Capital Rationing
Multi-period capital rationing
 This happens when there is a shortage of
funds in more than one period.
 In such a situation we must employ a linear
programming model to identify the profit
maximizing mix of investments since we have
many outputs

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 END

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