Accounting and Finance

For Managers

Session 02 – Investment
Appraisal

1
 What is investment appraisal?
• Investment Appraisal is the use of scientific
decision-making tools to analyse whether a
proposed future investment should go ahead.

• There are techniques that all involve a

comparison of the cost of investment project
with the expected return in the future.
 The three techniques
• Payback
The time taken to recover the initial cost of the
investment.
• Average Rate of Return (ARR)
The profits earned on investment expressed as a
% of the cost of initial investment.
• Net Present Value (NPV)
The total returns from an investment in today’s
terms.
 Learning objectives
• Define, apply and critique two methods of
investment appraisal:

• Payback

• Average Rate of Return

 Payback
• Payback measures the time it will take to
payback the initial cost of the investment.

• This includes calculating the year and month

in which it will be paid back.

• Payback is the most commonly used by

businesses due to its simplicity. However,
rarely used on its own.
Payback
• Very important to a business with cash flow
problems

• Also if the business is investing in equipment

that may become out-of-date quickly.

• May be important if the business is run on

external sources of finance.
 Payback example
Year Cash out Cash in Net Cash
Flow
• A company plans to buy a new
0 machine costing £500,000
• It will bring in new revenues of
£100,000 the following year and
1 then £150,000 for each of the
following four years.
2 • There will maintenance costs of
– Year 3: £20,000
– Year 4: £30,000
3
– Year 5: £50,000
• How long will it take to repay the
4 initial investment?

5
 Payback example
Year Cash out Cash in Net Cash
Flow
• A company plans to buy a new
0 £500,000 0 (£500,000) machine costing £500,000
• It will bring in new revenues of
1 £0 £100,000 £100,000 £100,000 the following year and
then £150,000 for each of the next
four years.
2 £0 £150,000 £150,000
• There will maintenance costs of
– Year 3: £20,000
3 £20,000 £150,000 £130,000
– Year 4: £30,000
– Year 5: £50,000
4 £30,000 £150,000 £120,000 • How long will it take to repay the
initial investment?
5 £50,000 £150,000 £100,000
 Payback example
Year Cash out Cash in Net Cash We determine the payback period by calculating
Flow
the cumulative next cash flow until the initial
0 £500,000 0 (£500,000) outlay is paid off.

1 £0 £100,000 £100,000 YEAR 1

£100,000

2 £0 £150,000 £150,000 YEAR 1 + YEAR 2

£100,000 + £150,000 = £250,000

3 £20,000 £150,000 £130,000

YEAR 1 + YEAR 2 + YEAR 3
£100,000 + £150,000 = £130,000 = £380,000

4 £30,000 £150,000 £120,000

YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4
£100,000 + £150,000 + £130,000 + £120,000 = £500,000

5 £50,000 £150,000 £110,000

Investment of £500,000 is paid back in year 4

 Payback example: Machine A
Year Cash out Cash in Net Cash
Flow
Step 1: Find the year of payback
Add up net cash flows year by year until the
0 £750,000 0 (£750,000) cumulative net cash flow exceeds the initial
investment
1 £7,500 £150,000 £142,500 YEAR 1
£142,500

2 £7,500 £200,000 £192,500 YEAR 1 + YEAR 2

£142,500 + £192,500 = £335,000

3 £7,500 £260,000 £252,500

YEAR 1 + YEAR 2 + YEAR 3
£142,500 + £192,500 + £252,500 = £587,500

4 £7,500 £260,000 £252,500

YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4
£142,500 + £192,500 + £252,500 + £252,500 = £840,000

5 £7,500 £300,000 £292,000

Since the investment of £750,000 is more than
the cumulative net cash flow in year 3 but less
than in year 4, we know that the investment is
paid back sometime in Year 4. On to step 2…
 Payback example: Machine A
Year Cash out Cash in Net Cash
Flow Step 2: Find the month of payback which the
investment is paid back
0 £750,000 0 (£750,000)
a) Calculate remaining cash required
£750,000 - £587,500 = £162,500
1 £7,500 £150,000 £142,500 At end of year 3

b) Divide remaining cash required by net

2 £7,500 £200,000 £192,500 cash flow for that year and multiply by
12
3 £7,500 £260,000 £252,500
£162,500
= 0.644 x 12 = 7.728
£252,500
4 £7,500 £260,000 £252,500 months

5 £7,500 £300,000 £292,000 c) Round up to next month

d) Add back the number of years

Payback period is 3 years and 8 months

 Payback example: Machine B
Year Cash out Cash in Net Cash
Flow
Step 1: Find the year of payback
Add up net cash flows year by year until the
0 £310,000 (£310,000) cumulative net cash flow exceeds the initial
investment
1 £15,000 £125,000 £110,000 YEAR 1
£110,000

2 £15,000 £127,000 £112,000 YEAR 1 + YEAR 2

£110,000 + £112,000 = £222,000

3 £15,000 £140,000 £125,000

YEAR 1 + YEAR 2 + YEAR 3
£110,000 + £112,000 + £125,000 = £347,000

4 £15,000 £140,000 £125,000

Since the investment of £310,000 is more than

5 £15,000 £130,000 £115,000 the cumulative net cash flow in year 2 but less
than in year 3, we know that the investment is
paid back sometime in Year 3. On to step 2…
 Payback example: Machine B
Year Cash out Cash in Net Cash
Flow

0 £310,000 (£310,000)
a) Calculate remaining cash required
£310,000 - £222,000 = £88,000
1 £15,000 £125,000 £110,000 At end of year 2

b) Divide remaining cash required by net

2 £15,000 £127,000 £112,000 cash flow for that year and multiply by
12
3 £15,000 £140,000 £125,000
£ 88,000
= 0.704 x 12 =8.448
£125,000
4 £15,000 £140,000 £125,000 months

5 £15,000 £130,000 £115,000 c) Round up to next month

d) Add back the number of years
Payback period is 2 years and 9 months
 Average Rate of Return (ARR)
• Assesses the value of an investment by
calculating the average annual profit as a
percentage of the initial investment cost.
• Therefore the formula is…
 ARR formula
Average annual profit
x 100
Initial investment

Average Total net cash flow

annual profit =
Number of years*

* The “life” of the asset

 ARR example: Machine A
Year Cash out Cash in Net Cash
Flow Step 1: Calculate average annual net profit

0 £750,000 0 (£750,000)

Total net cash

1 £7,500 £150,000 £142,500 flow £382,500
= = £76,500
5
Life of the
2 £7,500 £200,000 £192,500
asset

3 £7,500 £260,000 £252,500 Step 2: Divide average annual profit by the initial
investment and multiply by 100
4 £7,500 £260,000 £252,500
£76,500
X 100 = 10.2%
5 £7,500 £300,000 £292,500 £750,000

£382,500
 ARR
• The higher the ARR the potentially profitable
the investment.

• Allows easy comparison to other forms of

investment like bank interest rates.

• It can be easily compared to the current or

target ROCE.
 ARR for Machine B
Year Cash out Cash in Net Cash
Flow Step 1: Calculate average annual net profit

0 £310,000 0 (£310,000)

Total net cash

1 £15,000 £125,000 £110,000 flow £277,000
= = £55,400
5
Life of the
2 £15,000 £127,000 £112,000
asset

3 £15,000 £140,000 £125,000 Step 2: Divide average annual profit by the initial
investment and multiply by 100
4 £15,000 £140,000 £125,000
£55,400
X 100 = 17.9%
5 £15,000 £130,000 £115,000 £310,000
 Net Present Value (NPV)
• Takes into account the total return from an
investment in today’s terms.
• This is done using the

DISCOUNT FACTOR
The rate by which future cash flows are reduced
to reflect the current interest rates.
 Time value of money
• Suppose I have £10 today and I put that money in
the bank for two years at an interest rate 10%.
How much will I end up with in 2012?
– £10 x 10% x 10% = £12.10
• Or more accurately,
– £10 x 1.1 x 1.1 = £12.10
• This is compound interest.
• A shorter formula for compound interest is
(1+0.1)2
 Discount factor

• How would I find out how much £12.10 in two

years’ time is worth today?
• In effect, it is the reciprocal of the compound
interest formula
• And is known as the discount factor:
• = £12.10 x 1÷ (1+0.1)2 = £10.00
• = £12.10 x 0.826446 = £10.00
 NPV Example: Machine A
Year Cash out Cash in Net Cash Flow Discount NPV
factor
0 750,000 (750,000) 1.00 (750,000)

1 7,500 150,000 142,500 0.91 129,675

2 7,500 200,000 192,500 0.83 159,775

3 7,500 260,000 252,500 0.75 189,375

4 7,500 260,000 252,500 0.68 171,700

5 7,500 300,000 292,500 0.62 181,350

Net present value 81,875

 NPV Example: Machine B
Year Cash out Cash in Net Cash Flow Discount NPV
factor
0 310,000 (310,000) 1.00 (310,000)

1 15,000 125,000 110,000 0.91 100,100

2 15,000 127,000 112,000 0.83 92,960

3 15,000 140,000 125,000 0.75 93,750

4 15,000 140,000 125,000 0.68 85,000

5 15,000 130,000 115,000 0.62 71,300

133,110
 Advantages of NPV
• Takes account of whole life of the investment
• Takes into account net cash flows for whole
period
• Takes account of the time value of money
• Takes account of the opportunity cost of the
project
 Disadvantages of NPV
• Quite complex and technical – not easily
understood by non-financial managers
• Often inaccurate discount factor over time
 Risks of investment decisions
• Sum to invest
• Source of funds
• Impact on rest of business
• Ability to reverse decision
• Impact of investment of future plans
 Uncertainties of investment decisions

• Market stability – extent of change

• Competitor reactions
• Economic environment
• Accuracy of cash flow projections
• Projected life of investment decision
 Qualitative factors
• Aims and objectives of the business
• Image- effect on reputation and brand
• Personnel: work habits, morale, culture etc.
• Consumer perceptions
• Effect on communities
• Production issues
• Cultural issues
 Net Present Value
• Capital Budgeting Decision
– Central to the success of any company is the
investment decision, also known as the capital
budgeting decision.
– Assets acquired as a result of the capital
budgeting decision can determine the success of
the business for many years.
– It is extremely important that we ensure that the
correct capital budgeting decision is made!
 Net Present Value
• Capital Budgeting Decision
– Suppose you had the opportunity to buy a Tbill
(Treasury Bill) which would be worth $400,000
one year from today.
• Interest rates on Tbills are a risk free 7%.
– What would you be willing to pay for this
investment?
-$400,000

PV today:
0 1 2

$400,000 / (1.07) = $373,832

 Net Present Value
• Capital Budgeting Decision
– You would be willing to pay $373,382 for a risk free
$400,000 a year from today.
– Suppose this were, instead, an opportunity to construct a
building, which you could sell in a year for $400,000 with
certainty (That means the project is risk free.)
– Since this investment has the same risk and promises the
same cash flows as the Tbill, it is also worth the same
amount to you:

$373,282
 Net Present Value
• Capital Budgeting Decision
– Now, assume you could buy the land for $50,000
and construct the building for $300,000. Is this a
good deal?
– Sure! If you would be willing to pay $373,382 for
this investment and can acquire it for only
$350,000, you have found a very good deal!
– You are better off by:
$373,382 - $350,000 = $23,832
 Net Present Value
• Capital Budgeting Decision
– We have just developed a way of evaluating an
investment decision which is known as Net
Present Value (NPV).
– NPV is defined as the PV of the cash flows from an
investment minus the initial investment.
NPV = PV – Required Investment (C0)
= [$400,000/(1+.07)] - $350,000
= $23,832
 Net Present Value
• Capital Budgeting Decision
– This discount rate is known as the opportunity
cost of capital.
• It is called this because it is the return you give up by
investing in the project.
• In this case, you give up the money you could have
used to buy a 7% tbill so that you can construct a
building.
– But, a Tbill is risk free! A construction project is not!
– We should use a higher opportunity cost of capital.
 Net Present Value
• Risk and Net Present Value
– Suppose instead you believe the building project is as risky
as a stock which is yielding 12%.
– Now your opportunity cost of capital would be 12% and
the NPV of the project would be:
NPV = PV – IC0
= [$400,000/(1+.12)] - $350,000
= $357,143 - $350,000 = $7,142.86
– The project is significantly less attractive once you take
account of risk.
– This leads to a basic financial principal: A risky dollar is
worth less than a safe one.
 7-36

Net Present Value

• Valuing long lived projects
– The NPV rule works for projects of any duration:
• Simply discount the cash flows at the appropriate opportunity cost of capital
and then subtract the cost of the initial investment.

– The critical problems in any NPV problem are to determine:

• The amount and timing of the cash flows.
• The appropriate discount rate.
NPV Rule: Accept Projects with Positive NPVs
Net Present Value
 Other Investment Criteria
• Net Present Value vs Other Criteria
– Use of the NPV criterion for accepting or rejecting
investment projects will maximize the value of a
firm’s shares.
– Other criteria are sometimes used by firms when
evaluating investment opportunities.
• Some of these criteria can give wrong answers!
• Some of these criteria simply need to be used with care
if you are to get the right answer!
 7-39

Other Investment Criteria

• Internal Rate of Return (IRR)
– IRR is simply the discount rate at which the NPV of the project equals
zero.

– You can calculate the rate of return on a project by:

1. Setting the NPV of the project to zero.
2. Solving for “r”.
– Unless you have a financial calculator, this calculation must be done by
using trial and error!
 Other Investment Criteria
• Internal Rate of Return (IRR)
– To go back to our office example, we
discovered the following:
Discount Rate NPV of Project
7% $23,382
12% $7,143

At what rate of return will the NPV

of this project be equal to zero?
 7-41

Other Investment Criteria

• Internal Rate of Return (IRR)
– If we solve for “r” in the equation below, we find
the IRR for this project is 14.29%:

• IRR Decision Rule: Accept Projects with IRR which

r
exceeds the opportunity cost of capital
 Other Investment Criteria
• Internal Rate of Return (IRR)
– Another way of solving for IRR is to graph
the NPV at various discount rates.
– The point where this NPV profile crosses the
“x” axis will be the IRR for the project.
 IRR BY GRAPH
NPV Profile for this Project
$60,000
$50,000
IRR = 14.3%
$40,000 (occurs where NPV = 0)
$30,000
NPV ($)

$20,000
$10,000
$0
($10,000) 5% 10% 15% 20%
($20,000)
Discount Rate
 Other Investment Criteria
• Internal Rate of Return (IRR) vs NPV:
– The NPV Rule states that you invest in any project which has a
positive NPV when its cash flows are discounted at the
opportunity cost of capital.
– The Rate of Return Rule states that you invest in any project
offering a rate of return which exceeds the opportunity cost of
capital.
• i.e., if you can earn more on a project than it costs to undertake, then
you should accept it!
– The NPV and IRR rules will give the same accept/reject answer
about a project as long as the NPV of a project declines
smoothly as the discount rate increases.
– Do not confuse IRR and the opportunity cost of capital
 Other Investment Criteria
• Discounted Payback
– Discounted payback is the time period it takes for the
discounted cash flows generated by the project to cover
the initial investment in the project. a

• It offers an important advantage over Payback: if a project is

acceptable with the Discounted Payback, it must have a positive
NPV (if the ignored Cashflows are all positive!)
– Although better than payback, it still ignores all cash flows
after an arbitrary cutoff date.
• Therefore it will reject some positive NPV projects.
– NPV is thus always preferable to discounted payback in
evaluating projects!
Discounted Payback Example
(OCC=10%, cut-off = 4 years)
 Capital Rationing
• Capital Rationing
– Occurs when a limit is set on the amount of funds
available to a firm for investment.
• Soft Rationing
– Occurs when these limits are imposed by senior
management.
• Hard Rationing
– Occurs when these limits are imposed by the
capital markets.
 Capital Rationing
• Rules for Project Selection
– A firm maximizes its value by accepting all positive
NPV projects.
• With capital rationing, you need to select a group of
projects which is within the company’s resources and
gives the highest NPV.
– This is done with the Profitability Index (PI)
• pick the projects that give the highest NPV per dollar of
investment.

PI = NPV / Initial Investment

 Capital Rationing
• Profitability Index (PI)
– For example: Suppose your firm had the following projects
and only $20 million to spend:
NPV @
Project C0 C1 C2 10%
L -3.00 2.20 2.42 1.00
M -5.00 2.20 4.84 1.00
N -7.00 6.60 4.84 3.00
O -6.00 3.30 6.05 2.00
P -4.00 1.10 4.84 1.00
Budget -25.00

Which Projects should your firm select?

 Capital Rationing
• Profitability Index
NPV @
Project C0 10% PI
L 3.00 1.00 1/3 = 0.33 ACCEPT

M 5.00 1.00 1/5 = 0.20

N 7.00 3.00 3/7 = 0.43 ACCEPT

O 6.00 2.00 2/6 = 0.33 ACCEPT

P 4.00 1.00 1/4 = 0.25 ACCEPT