Table of contents

Contents Page No
Main body
Investment approval should add value to the business 2
organisation
Reasons behind investment appraisal: 2

Disadvantages of conducting inadequate appraisals 3

There are few investment appraisal methods that are industry 3
standard:

Discounted Cash flow (DCF) 4

Reasons investors use discounted cash flow 4
AP Ltd., Project Investment Appraisal 5
Recommendations 8
Selected References 9
1)

‘Investment approval should add value to the business organisation’ –

To assist investment manager behind capital allocation for organisations to make better
decisions making on acquiring and disposing of assets.

The main purpose to operate a business is to maximise shareholders wealth. The time
managers are making decisions involving capital investments, the decisions must be
consistent following the objectives of the business.

Key Takeaways
Investment Appraisal
(IA) Definition,
Benefits of using IA

Definition of Investment Appraisal: Investment appraisal are conducted to check whether

it is worthwhile to make an investment. If investment involves a large initial cost
followed by later receipt of cash.

Example of an investment appraisal: An organisation could invest in marketing campaign

which might lead the venture to an increase in business growth over the following years.

Reasons behind investment appraisal:

Risk management as investment involves dealing with risks
Firms can choose alternative investments through identifying investment options and
choose the best options. Cash and other resources are invested in the most profitable
ways.

Reasons for investment appraisal includes long term decision making by accepting or
rejecting decision making and ranking/mutually exclusive decision making.

Project budgets become more realistic as project budgets can be established.

To eliminate or reduce the risks, risks arising from the investment are considered in a
standard investment appraisal.

As capital spending can differ from a day to day revenue spending cause it involves huge
expenditure and the return from a capital expenditure can come back over a long period
of time periods. These are good reasons any proposed capital spending should be
correctly appraised.

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 Key Takeaways
Disadvantages of
conducting inadequate
appraisals

Disadvantages of conducting inadequate appraisals:

If investment appraisal was done properly then resources ( ie: cash ) can be invested on
optional or unnecessary projects.

Subjective and unfair decisions may be made.

“Time”, is the essential feature of a good investment decision. Investment in a business

involves making an outlay of some of economic value, usually cash profit. This also leads
to long term economic benefits to the investment. The outlay is usually a large amount
and the benefits as series of small amount over a reasonable protected interval.

Considering all the benefits of Investment appraisal, it is clear that Investment Appraisal
should add values to the business to make it more profitable.

Key Takeaways
Investment Appraisal
Methods

There are few investment appraisal methods that are industry standard:

Net Present Value (NPV)

Internal Rate of Return Technique (IRR)
Payback method Technique (PB)
Accounting Rate of Return Technique (ARR)
Profitable Index (PI)

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Discounted Cash flow (DCF):
Net Present Value (NPV)
Internal Rate of Return (IRR)

Key Takeaways
Discounted Cash Flow
(DCF)

As listed above, Discounted Cash flow (DCF) includes

Net Present Value (NPV)
Internal Rate of Return (IRR)

Reasons investors use discounted cash flow:

Money has a time value. As the money which will come in future has a present value
because the investors have to borrow it to pay. In business most of the time, the future the
investor look to the greater the risks are. It will have to spot on to estimate the future
return of a present investment. The risk is things can change and this is the reason
discounted cash flow use discounting to reduce the concerns.

Example is, suppose we expect to receive £200 in one year’s time and use a discount rate
of 10 percent. If we put £180 deposit at 10 per cent for one year, it will be £200. In other
word, the present value for £200 is £180.

Key Takeaways
Net Present Value
(NPV) – Discounted
Cash flow

Net Present Value (NPV):

Net Present Value considers three things
Interest lost, risk, effects of inflation.

For example if Machine Costs: £100, life for the machine is 3 years, forecasts cash flows
are

Year1=£40, Year2=£70, Year3=£50, to calculate NPV the investment managers can

decide the payout as well, which can be £100, discount rate=10%.

Year 1 £40

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Year 2 £70
Year 3 £50
Total cash flow £160
- Payout (£100)
--------------------------------------------------------------------
Net Value in 3 Years £60

Year 0 -£100
Year 1
Year 2
Year 3

2) AP Ltd.,

NPV at 20%,
= - C0+[Cn*Ani]
= -449,400+[100,000*A 10 20]
= -449,400+100,000* 4.192 { from the Annuity Table }
= -449,400+ 419,200
= - 30,200

NPV at 14%
= - C0+[Cn*Ani]
= -449,400+[100,000*A10 14]
= -449,400+[100,000*5.216]
= -449,400+521,600
= 72,200

B = 72,200

We know that at IRR, the discount rate that makes NPV=0

So, Initial Investment will be,
449,400-72,200
=377,200

So, IRR = 14% +{ NPV at 14% / (NPV at 14% - NPV at 16%)} * (16%-14%)
= 14%+ { 72,200/(72,200-33,900)}*2
= 14%+3.77%
= 18%

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A = 18%

[C]
At IRR, the discount rate that makes C0 = Initial Investment
NPV=0, C1 = Annual Net Cash flow
NPV = 0
NPV at 20% = 0
-C0+[C1*A10 20] = 0
C0 = C1*4.192
= 70,000*4.192
= 293,400

C = 293,400

[D]
NPV at 14%,
-293,440+[70,000 * A 10 14]
= -293,440+365,120
= -71,680
D = 71,680

[E]
At IRR, the discount rate that makes, at 14%,
So, -C0+[C1*A 10 14] = 0
So, C0 = C1* A 10 14
So, C1 = 200000 / A 10 14
So, C1 = 200000 / 5.216
So, C1 = 38,343.56
So, C1 = 38344
E = 38,344

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[F]
NPV at F,
-C0+[Cn * Anf] = 39000

Accumulated Discounting Factor= NPV +Initial Investment / NCF

= (35,624 + 200,000)/ 38,343

=6.145= 10% { * From the discount factor table }

F = 10%

[G]
NPV at 12% is 39000
39000= -C0+[Cn * A 10 12]
Cn*5.650=-300,000+39000
Cn = 339,000/5.650
Cn = 60,000
G = £60,000

[H]
As it is given for Project 4, NPV at 12% = 39,000

As to calculate H, we basically calculating the Internal

Rate of Return(IRR) where the discount rate is zero and
the relation between the NPV and IRR methods, the NPV
would be the summation of the net cash flow. It is
basically a linear interpolation where NPV=0.

We can take a higher cost of capital,

If we take 20% as cost of capital, C0 = Initial Investment

Cn = Annual Net Cash flow
NPV at 20%, A 10 20 is Annuity from the
= -C0+Cn* A 10 20 Annuity table for 10 years
= -£300,000+£60,000*A 10 20 period and 20% discount
= -£300,000+£60,000*4.192 rate
= -48,480

So, IRR will be,

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= N P V 1a 2t% − N P V a2 t0% × (2 0− 1 2)
N P V 1a 2t%

= 12% + 60,000 / ( 60,000-(-48,480)) * 8

= 12% + 4.42%
= 16%

H = 16%

Project 1,2,3,4 with their initial investments, cost of capital, internal rate of return
and their associated annual net cash flow and net present values.

Project Annual Net Initial Cost of IRR NPV

Cash flow Investment Capital
1 £100,000 £449,400 14% 18% 72,200
2 £70,000 293,400 14% 20% 71,680
3 £38,344 200,000 10% 14% £35,624
4 £60,000 £300,000 12% 16% £39,000

Recommendations:
So far, we were looking at different methods of investment appraisals for evaluating
investment opportunities. As investment process can be seen as a series of 6 steps, each
needed careful calculations and considerations involving Determine the availability of
investment funds, identify the most profitable project, define and classify the appropriate
projects, evaluate the best project, monitor and control the taken project(s).

Availability of the funds: compare to project 1, 3, and 4 it can be seen that the initial
investments on project are sitting in the middle which can be good news for AP Ltd.

As net present value determines the present value for the money which is investment for
future return and compare to project 3 and project 4, for project 2, NPV £71,680, is
better.

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Annuity Table

This represents £1 at a 1% – 30% percentage for 1 – 10 years

Use the table to find the appropriate multiplier to use in your NPV calculation

Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192

21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 0.826 0.820 0.813 0.806 0.800 0.794 0.787 0.781 0.775 0.769
2 1.509 1.492 1.474 1.457 1.440 1.424 1.407 1.392 1.376 1.361
3 2.074 2.042 2.011 1.981 1.952 1.923 1.896 1.868 1.842 1.816
4 2.540 2.494 2.448 2.404 2.362 2.320 2.280 2.241 2.203 2.166
5 2.926 2.864 2.803 2.745 2.689 2.635 2.583 2.532 2.483 2.436
6 3.245 3.167 3.092 3.020 2.951 2.885 2.821 2.759 2.700 2.643
7 3.508 3.416 3.327 3.242 3.161 3.083 3.009 2.937 2.868 2.802
8 3.726 3.619 3.518 3.421 3.329 3.241 3.156 3.076 2.999 2.925

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 9 3.905 3.786 3.673 3.566 3.463 3.366 3.273 3.184 3.100 3.019
10 4.054 3.923 3.799 3.682 3.571 3.465 3.364 3.269 3.178 3.092

Selected References:

The Intelligent Investor, Graham, B, Practical Counsel, 1997

http://goliath.ecnext.com/coms2/gi_0199-5221627/Investment-appraisal-Checklist-
181.html

http://www.businesslink.gov.uk/bdotg/action/detail?
r.s=sc&r.l1=1073858790&r.lc=en&r.l3=1081822141&r.l2=1073858944&r.i=108182220
6&type=RESOURCES&itemId=1081822742&r.t=RESOURCES

Financial Management for decision makers, Artill, P., FT Prentice Hall – 5th Edition 2000

Capital Investment Decision-Making (Advanced Management Accounting & Finance),

Northcott, D., Cengage Lrng Business Press, 1992

The Financial Times Guide to Investing, Arnold G., FT Prentice Hall - 2nd Edition, 2009

Effective Financial Management - Creating Success series, Finch, B., Kogan Page Ltd ,
2010

The Fundamentals of Investment Appraisal (Paperback), Lumby S., Jones C., Thomson
Learning, 1991

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