Investment Appraisal 2

Accounting Rate of Return (ARR)

ARR = Average Profit of Investment

Average Cost of Investment

Average Profit of Investment = Total Profit of Investment

Number of Investment Years

Average Cost of Investment = Total Cost of Investment - Residual Value of Investment

Illustration: ARR

Investment X and Y were presented to a company as follows:

X (RM) Y(RM)
Initial Capital 1,500,000 1,700,000
Cash Inflow: Year 1 250,000 350,000
Year 2 300,000 370,000
Year 3 290,000 340,000
Year 4 280,000 330,000
Year 5 320,000 380,000
Year 6 270,000 450,000
Residual Value 15,000 25,000

Working 1: Annual Profits [Cash Flow - Depreciation]

Year Cash Flow X (RM) Depreciation (RM) Profit (RM)
1 250,000 7,500 242,500
2 300,000 7,500 292,500
3 290,000 7,500 282,500
4 280,000 7,500 272,500
5 320,000 7,500 312,500
6 270,000 7,500 262,500
Total 1,665,000

Working 2: Average Investment

Average Investment = Capital - Residual Value

= 1,500,000 - 15,000
= 1,485,000
0.186868686868687
ARR (X) = Average Profit / Average Investment
= 277,500 / 1,485,000
= 0.1869 OR 18.69%

Working 1: Annual Profits [Cash Flow - Depreciation]

Year Cash Flow Y (RM) Depreciation (RM) Profit (RM)
1 350,000 8,500 341,500
2 370,000 8,500 361,500
3 340,000 8,500 331,500
 4 330,000 8,500 321,500
5 380,000 8,500 371,500
6 450,000 8,500 441,500
Total 2,169,000

Working 2: Average Investment

Average Investment = Capital - Residual Value

= 1,700,000 - 25,000
= 1,675,000

ARR (Y) = Average Profit / Average Investment

= 361,500 / 1,675,000
= 0.2158 OR 21.58%

Working 1: Annual Profits [Cash Flow - Depreciation]

Year Cash Flow Z (RM) Depreciation (RM) Profit (RM)
1 295,000 10,000 285,000
2 305,000 10,000 295,000
3 278,000 10,000 268,000
4 309,000 10,000 299,000
5 407,000 10,000 397,000
6 430,000 10,000 420,000
Total 1,964,000

Working 2: Average Investment

Average Investment = Capital - Residual Value

= 2,000,000 - 55,000
= 1,945,000

ARR (Z) = Average Profit / Average Investment

= 327,333 / 1,945,000
= 0.1683 / 16.83%

Working 1: Annual Profits [Cash Flow - Depreciation]

Year Cash Flow A (RM) Depreciation (RM) Profit (RM)
1 345,700 11,003 334,698
 2 387,900 11,003 376,898
3 396,400 11,003 385,398
4 278,400 11,003 267,398
5 415,000 11,003 403,998
6 318,000 11,003 306,998
Total 2,075,385

Working 2: Average Investment

Average Investment = Capital - Residual Value

= 2,200,500 - 76,500
= 2,124,000

ARR (A) = Average Profit / Average Investment

= 345,898 / 2,124,000
= 0.1629 / 16.29%
Z (RM) A (RM)
2,000,000 2,200,500
295,000 345,700
305,000 387,900
278,000 396,400
309,000 278,400
407,000 415,000
430,000 318,000
55,000 76,500
Depreciation: 0.5% of Initial Capital

Average Profits = 1,665,000 / 6 years

= 277,500

277500

Average Profits = 2,169,000 / 6 years

= 361,500
Average Profits = 1,964,000 / 6 years
= 327,333

Average Profits = 2,075,385 / 6 years

= 345,898
Internal Rate of Return (IRR)

- refers to the rate of return internally required by the management

- it is the rate where NPV is 0
- if IRR < DF (WACC), no good
- if IRR > DF (WACC), good
Illustration: Internal Rate of Return
An Investment GF requires Initial Capital of RM500,000 and has annual returns of
RM80,000 for 8 years.

Internal Rate of Return

(Cash Inflow - Cash Outflow)
Year Cash Inflow Cash Outflow Net Cash Flow Discount Factor
(RM) (RM) (RM) 10%
0 - 500,000.00 - 500,000.00 1.000
1 80,000.00 - 80,000.00 0.909
2 80,000.00 - 80,000.00 0.826
3 80,000.00 - 80,000.00 0.751
4 80,000.00 - 80,000.00 0.683
5 80,000.00 - 80,000.00 0.621
6 80,000.00 - 80,000.00 0.564
7 80,000.00 - 80,000.00 0.513
8 80,000.00 - 80,000.00 0.467
NPV =

Calculate the IRR.

Illustration: Internal Rate of Return

An Investment PF requires Initial Capital of RM1,050,000 and has annual returns of
RM235,000 for 9 years. There is a cost payable every 2 years of RM25,000.

(Cash Inflow - Cash Outflow)

Year Cash Inflow Cash Outflow Net Cash Flow Discount Factor
(RM) (RM) (RM) 10%
0 - 1,050,000.00 - 1,050,000.00 1.000
1 235,000.00 - 235,000.00 0.909
2 235,000.00 25,000.00 210,000.00 0.826
3 235,000.00 - 235,000.00 0.751
4 235,000.00 25,000.00 210,000.00 0.683
5 235,000.00 - 235,000.00 0.621
6 235,000.00 25,000.00 210,000.00 0.564
7 235,000.00 - 235,000.00 0.513
8 235,000.00 25,000.00 210,000.00 0.467
9 235,000.00 - 235,000.00 0.424

Calculate the IRR.

 IRR = ra + (NPVa / NPVa - NPV b) X (rb - ra)

(Net CF X DF) (Net CF X DF) = 5% + (17,120 / 171,120 - (73,280)) X (10% - 5%)

Present Value (PV) Discount Factor Present Value (PV)
(RM) 5% (RM) = 5.9469% OR 5.95%
(500,000.00) 1.000 (500,000.00)
72,720.00 0.952 76,160.00
66,080.00 0.907 72,560.00
60,080.00 0.864 69,120.00
54,640.00 0.823 65,840.00
49,680.00 0.784 62,720.00
45,120.00 0.746 59,680.00
41,040.00 0.711 56,880.00
37,360.00 0.677 54,160.00
(73,280.00) NPV = 17,120.00

(Net CF X DF) (Net CF X DF)

Present Value (PV) Discount Factor Present Value (PV) IRR = 10% + [239,630 / (239,630 - (146,315)) X (20%-10
(RM) 20% (RM) = 10% + 6.21%
(1,050,000.00) 1.000 (1,050,000.00) = 16.21%
213,615.00 0.833 195,755.00
173,460.00 0.694 145,740.00
176,485.00 0.579 136,065.00
143,430.00 0.482 101,220.00
145,935.00 0.402 94,470.00
118,440.00 0.335 70,350.00
120,555.00 0.279 65,565.00
98,070.00 0.233 48,930.00
99,640.00 0.194 45,590.00
239,630.00 (146,315.00)
NPV b) X (rb - ra)

0 - (73,280)) X (10% - 5%)

,630 - (146,315)) X (20%-10%)

Tutorial 1: IRR
An Investment 1F requires Initial Capital of RM970,000 and has annual returns of
RM96,000 for 7 years.
(Cash Inflow - Cash Outflow)
Year Cash Inflow Cash Outflow Net Cash Flow Discount Factor
(RM) (RM) (RM) 12%
0 - 970,000 (970,000) 1.000
1 96,000 - 96,000 0.893
2 96,000 - 96,000 0.797
3 96,000 - 96,000 0.712
4 96,000 - 96,000 0.636
5 96,000 - 96,000 0.567
6 96,000 - 96,000 0.507
7 96,000 - 96,000 0.452
NPV =
Find the IRR.

Tutorial 2: IRR
An Investment 2F requires RM698,000 to start. The investment reaps annual income of
RM196,000 for 8 years while a servicing cost of RM25,000 is payable annually.

(Cash Inflow - Cash Outflow)

Year Cash Inflow Net Cash Flow Discount Factor
(RM) (RM) (RM) 9%
0 - 698,000 (698,000) 1.000
1 196,000 25,000 171,000 0.917
2 196,000 25,000 171,000 0.842
3 196,000 25,000 171,000 0.772
4 196,000 25,000 171,000 0.708
5 196,000 25,000 171,000 0.650
6 196,000 25,000 171,000 0.596
7 196,000 25,000 171,000 0.547
8 196,000 25,000 171,000 0.502
NPV =
Find the IRR

Tutorial 3: IRR
An Investment 3F requires RM1,750,000 to start. The investment reaps annual income of
RM350,000 for 8 years while a servicing cost of RM45,000 is payable annually. There is a special
maintenance cost of RM35,000 payable every 3 years.

Year Cash Inflow Net Cash Flow Discount Factor

 (RM) (RM) (RM) 10%
0 - 1,750,000 (1,750,000) 1.000
1 350,000 45,000 305,000 0.909
2 350,000 45,000 305,000 0.826
3 350,000 80,000 270,000 0.751
4 350,000 45,000 305,000 0.683
5 350,000 45,000 305,000 0.621
6 350,000 80,000 270,000 0.564
7 350,000 45,000 305,000 0.513
8 350,000 45,000 305,000 0.467
NPV =

Find the IRR.

 (Net CF X DF) (Net CF X DF)
Present Value (PV) Discount FPresent Value (PV) IRR =
(RM) 1% (RM)
(970,000) 1.000 (970,000)
85,728 0.99 95,040
76,512 0.98 94,080
68,352 0.971 93,216
61,056 0.961 92,256
54,432 0.951 91,296
48,672 0.942 90,432
43,392 0.933 89,568
(531,856) NPV = (324,112)

There is no IRR as event at 1% DF, the NPV is still Negative (-ve)

al income of

(Net CF X DF) (Net CF X DF)

Present Value (PV) Discount FPresent Value (PV)
(RM) 20% (RM)
(698,000) 1.000 (698,000) IRR around 18%
156,807 0.833 142,443
143,982 0.694 118,674
132,012 0.579 99,009
121,068 0.482 82,422
111,150 0.402 68,742
101,916 0.335 57,285
93,537 0.279 47,709
85,842 0.233 39,843
248,314 NPV = (41,873)

ual income of
ually. There is a special

Present Value (PV) Discount FPresent Value (PV)

(RM) 5% (RM)
(1,750,000) 1.000 (1,750,000) IRR around 7.5%
277,245 0.952 290,360
251,930 0.907 276,635
202,770 0.864 233,280
208,315 0.823 251,015
189,405 0.784 239,120
152,280 0.746 201,420
156,465 0.711 216,855
142,435 0.677 206,485
(169,155) NPV = 165,170