Project/Investment Appraisal

Investment appraisal is the process a business undertakes to evaluate potential

major projects or investments to see if it adds value to implement them.

The process involves assessing a prospective project's lifetime cash inflows

and outflows to determine whether the potential returns that would be
generated meet a sufficient target benchmark.

The following are some of the techniques used to evaluate projects.

The Payback method

The payback period tells us the number of years required to recover the initial
cash outlay from the project’s expected net cash flows. It is the ratio of the
initial cash outlay to the annual net cash flows. Let us look at the following
example.

Example: payback period with equal annual cash flows.

A firm is considering a project whose expected net, after-tax cash flows are as
follows:

Initial Investment = $ 18 000.00

Annual cash flows = $ 5 600.00 per year for the next 5 years.

The payback period = 18 000 / 5 600 = 3.2 years.

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Example: payback period with unequal annual cash flows. A project has
the following expected annual net, after-tax cash flows:

Year Expected Net Cash flow Cumulative Cash Flow

0 ($ 18 000) ($ 18 000)
1 $ 4 000 ($ 14 000)
2 $ 6 000 ($ 8 000)
3 $ 6 000 ($ 2 000)
4 $ 4 000 $ 2 000
5 $ 4 000 $ 6 00

In this example, you can see that the payback period falls between 3 years and
4 years. To get the actual payback period, we use the following formula:

Payback = year before full recovery + [unrecovered cost at start of year / cash
flow during year]

Therefore the payback period = 3 + [ 2 000 / 4 000 ] = 3.5 years.

Decision criteria

A company might have a standing policy that all projects must recover their
full cost within a certain period of time. If the payback for a particular project
falls within this stipulated period, then the project is acceptable. If, for
example, the company policy payback was 3 years, then the project would not
be accepted. In this sense therefore, the payback period may be said to be a

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rough measure of the risk associated with the project. The longer the payback,
the greater the risk, therefore the less acceptable a project is.

In the case of mutually exclusive projects, those with longer paybacks are
eliminated in favour of those with shorter paybacks. As for independent
projects, those with shorter paybacks would be ranked higher than those with
longer paybacks.

Criticism of regular payback

The regular payback does not take into account the time value of money,
assuming that cash flows received in the future are just as good as cash flows
received today. In this sense it does not take into account the cost of capital. A
project may be financed by both debt and equity and we need to factor in the
cost of obtaining these funds, using an appropriate discount rate.

The payback provides information on how long funds will be tied up in a

project. Therefore, the shorter the payback, the greater the project’s liquidity.
Since cash flows expected in the distant future are generally riskier than near-
term cash flows, the payback can be used as a crude measure of risk. The
company that is cash starved may find the method useful in gauging the early
recovery of funds invested.

By ignoring the cash flows after the payback period, the payback
discriminates against longer term projects that may turn out to be more
profitable for the shareholders. This is demonstrated for you in the following
example.

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Example: The cash flows for projects X and Y are as follows:

Project X Project Y
Year 0 (10 000) (10 000)
Year 1 1 000 5 000
Year 2 2 000 3 000
Year 3 3 000 2 000
Year 4 4 000 1 000
Year 5 8 000 500

The payback period for project X is

4 years whereas that for Y is 3 years. If these projects were mutually
exclusive, Y would be accepted and X rejected. Project Y is, however, a
shorter-term project than X in that the cash flows of X show a rising trend and
those for Y are declining drastically after the payback period.

The Net Present Value [NPV]

The net present value is the difference between the present value of the initial
cash outlays and the present value of the cash inflows of the project,
discounted at the cost of capital for the project.

The steps to be followed in evaluating a project using the NPV method are as
follows:

 Find the present value [PV] of each period’s cash flow, including both
inflows and outflows, discounted at the project’s cost of capital,
 Sum the PVs to find the NPV.
 If the NPV is positive, accept the project and if the NPV is negative, reject
the project.

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 For two or more projects, accept the project with the highest NPV, if the
projects are mutually exclusive. If the projects are independent, accept the
project with the highest NPV first and rank them accordingly.

The NPV is found by the following formula:

n
NPV =  CFt / ( 1 + k )t
t = 0

Where, CFt = the expected cash flow at time t, and t is starting from year 0 up
to year n.
and k is the project’s cost of capital. Let us start by looking at the following
example.

Example: Calculating a project’s NPV (uneven cash flows).

A project with an initial investment of $ 1000.00 has been found to have the
following expected net cash flows for the next four years:

Year 1 = $500, year 2 = 400, year 3 = 300, year 4 = $100.

If the cost of capital is 10% the NVP of the project will be found as follows:

Year Expected Cash flow x PVIF10% = Present Value.

0 - $ 1000 x 1.0000 = -$ 1000.00
1 500 x 0.9091 = 454.55
2 400 x 0.8264 = 330.56
3 300 x 0.7513 = 225.39
4 100 x 0.6830 = 68.30
NPV = $78.82

On this basis, the project should be accepted.

Rationale for the NPV.

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An NPV of zero signifies that the project’s cash flows are exactly sufficient to
repay the invested capital and to provide the required rate of return demanded
by the providers of the capital used on the project [both equity and debt].

If the NPV is positive, the project’s cash flows are generating more than the
required rate of return [RRR]. Since the return to bond holders [the providers
of debt capital] is fixed [ the interest on debt], the extra return accrues solely
to the firm’s stock holders [the providers of equity capital,] who receive their
return [dividend] only after the bond holders have been paid their fixed
amount. It therefore follows that if a firm takes on a zero-NPV project, the
position of the shareholders remains unchanged. The firm only becomes larger
to the extent of the size of the project, but the wealth of the shareholders, that
is the price of the company’s shares, remains constant.

If the firm takes on a positive-NPV project, the position of the shareholders is

improved by the amount of the NPV. Thus, if the firm takes on the project, the
wealth of the shareholders is increased directly by $78.82, thus enhancing the
share price of the firm

The Internal Rate of Return [IRR].

The IRR is the yield or rate of return generated by the project’s cash flows. It
is the discount rate which equates the present value of the project’s expected
cash inflows to the present value of the outflows, thereby producing an NPV
of zero.

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As illustrated below, suppose we had a project with an initial cash outlay of
$1 000 and cash flows expected over a period of four years. If we bring back
the cash flows back to the present, that is year 0, by discounting them at the
cost of capital, these would be equal to $1 000.

Year 0 1 2 3 4

( 1 000) 500 400 300 100

= 1 000 

Now, let us work through the following example.

A company is trying to decide whether to buy a machine for $ 80 000.00. The

machine will save the company costs of $ 20 000 per year for five years and
have a resale value of $ 10 000 at the end of that period. What is the IRR?
(Ignoring tax effects).

The IRR is found by trial and error [interpolation] if one is not using a
financial calculator. We apply different discount rates to the cash flows until
we get one which produces an NPV of zero.

Try 9%:
Year Cash flow x PVIF = present value
0 (80 000) x 1.000 = (80 000)
1 –5 20 000 x 3.890 = 77 800
5 10 000 x 0.650 = 6 500

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 NPV = 4 300

Since this is a positive NPV, we try a higher discount rate, say 12%:

NPV = [ 20 000 ( 3 605 ) + 10 000 ( 0.567 ) ] - 80 000

= - 2 230.

Since the NPV is negative, the required discount rate lies somewhere between
12 % and 9 %, as shown in the following diagram, known as the NPV profile
of the project:

FIGURE 4.1. : THE INTERNAL RATE OF RETURN

NPV ($)

IRR = 10.98%

$ 4 300

$0.00
9% 12%
Discount Rate (%)
-$ 2 230

The IRR is the discount rate that will result in a zero NPV, therefore lies
somewhere between 9% and 12%. It is found by the following formula:

IRR = A + [ a / (a + b ) ] [ ( B – A ) ]

Where A = the lower discount rate which produces a positive

NPV,
a = the NPV resulting from a discount rate of A%,
B = the higher discount rate which produces a negative NPV,

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 b = the NPV resulting from a discount rate of B%.

Thus, in this example, the IRR is equal to 10.98%, which is approximately

11%.

The decision rule for the IRR is that we should accept the project if the IRR is
greater than the RRR that is the cost of capital. If the IRR is less than the
RRR, then the project should be rejected. If we are comparing two mutually
exclusive projects, we would take the one with the higher IRR.

Rationale for the IRR.

The IRR is the return that is expected to be generated by the project's net cash
flows, assuming that all the cash flows are reinvested into the project. If the
IRR exceeds the cost of the funds used to finance the project [the RRR], a
surplus remains after paying for the funds, and this surplus belongs to the
firm’s shareholders. Therefore, taking on a project whose IRR exceeds the
cost of capital increases the shareholders’ wealth.

The decision criteria is therefore that if the project's internal rate of return
exceeds the required rate of return, the project should be accepted.

The decision criteria for independent projects is to take those projects with a
higher IRR first. If the projects are mutually exclusive, we take on those
projects with a higher IRR and reject those with a lower IRR.

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Problems with IRR.
The use of IRR in appraising projects is fraught with problems. Firstly, the
IRR ignores the relative size of the projects, as shown in the following
example:

Project A Project B
Year 0 (350 000) (35 000)
Year 1 – 6 100 000 10 000

Project A is 10 times bigger than project B, therefore more profitable, but both
have the same IRR of 18%.
Secondly, the IRR is not effective when it comes to unconventional cash
flows. Study the following two projects.

PROJECT A PROJECT B
Cash flows ($) Cash flows ($)
YEAR
0 (100 000) (120 000)
1 (50 000) 50 000
2 60 000 80 000
3 90 000 (50 000)
4 80 000 20 000

Project B is not a conventional project. As you can see, we have an outflow in

year 0 which is followed by two inflows before we get another outflow in year
3, which is followed by another inflow in year 4. If the cash flows from the
project are not conventional [out flows followed by inflows, as in project A],
there may be more than one IRR.

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The equation for the IRR is a polynomial of n degrees, therefore it has n
different roots or solutions. All except one of the roots are imaginary numbers
when the cash flows are normal, therefore in the normal case only one value
of IRR appears. For non-conventional cash flows, there are multiple real roots,
hence multiple IRRs. In the case of project B, there would be two internal
rates of return.

Thus, the IRR is inferior to the NPV method.

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