Chapter 46

Investment Appraisal
To ensure the best decision is made when new capital investment projects are
considered, investment appraisal should be carried out

Investment appraisal is a collection of techniques used by a business to identify the

relationship between cost of capital invested and the expected return in a project.

There are four main methods of capital investment appraisal.

1. Accounting Rate of Return

2. Payback Period / Discounted Payback Period
3. Net Present Value method
4. Internal Rate of Return

1. Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) is the expected return of the investment made in a project
expressed as a percentage of the average investment over the period.

Formula:

ARR = Average profit x 100

Average Investment
Average profit = Total Profits / Total number of Years

Average Investment = Initial investment + Scrap value / 2

Example:
Machine A Machine B
$ $
Cost of asset 120000 210000
Estimated profits:
Year 1 50000 70000
Year 2 60000 90000
Year 3 70000 110500
Year 4 80000 88000
Year 5 60000 84000
Year 5 Scrap value 10000 40000
Required: Calculate Accounting Rate of Return and state which machine should purchase.
Answer:
Average profit = Total Profits / Total number of Years
Machine A = $320000 / 5Years = $64000
Machine B = $442500/ 5Years = $88500
Average Investment = Initial investment + Scrap value / 2

Machine A = $160000 + $10000 / 2 = $85000

Machine B = $210000 + $40000 / 2 = $125000

ARR = Average profit x 100

Average Investment

Machine A = $64000 x 100 = 75.3%

$85000
Machine B = $88500 x 100 = 70.8%
$125000
Note: Machine A will be purchased due to higher rate of return.

2. Payback Period
The payback period is the length of time it takes to recover the cost of an investment
by the cash flows generated from the investment.
Conceptually, the payback period can be viewed as the amount of time between the
date of the initial investment (cash outflow) and the date when the net cash inflow
produced by the project is equal to the initial investment.(Breakeven)
The shorter the payback period, the more attractive the investment and the better off
the company would be.
Formula:
Payback period = Years before breakeven + ( Unrecovered amount x 12 months)
Cash flow in recovery year
Example: Machine A
Years Cash flows Balance
0 (210 000) (210 000)
1 70000 (140 000)
2 80000 (60000)
3 90000

Payback period = 2 years + 60000/90000x12months

= 2 years and 8 months
Discounted Payback Period Method:
One drawback to the payback period calculation is that it ignores the time value of money (i.e.,
the opportunity cost of receiving cash earlier causes it to be worth more). This is where the
discounted payback period method comes in.
The discounted payback period is a more accurate measure, since it accounts for the fact that a
dollar today is more valuable than a dollar received in the future.

3. Net Present Value method

Net present value method (also known as discounted cash flow method) is a popular capital
appraisal technique that takes into account the time value of money. This is a method used to
determine the present value of all future cash flows generated by a project using cost of
capital.

Cost of capital:
The cost of capital is a discount rate which includes inflation, interest, taxes, dividends and any
other cost associated with the capital invested in a project.

Discount rate:
The discount rate refers to the interest rate used to determine the present value (Discounted
cash flows) of future cash flows.

Present Value of 1 Table:

Year 1% 2% 3% 4% 5% 6% 8% 10% 12%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929

2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8573 0.8265 0.7972

3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.7938 0.7513 0.7118

4 0.9610 0.9239 0.8885 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355

5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.6806 0.6209 0.5674

Example: Project A
Year Net cash flows Discount rate 10% Net Present Value
$ $ $
0 (12000) 1 (12000)
1 6000 0.909 5454
2 4000 0.826 3304
3 3500 0.751 2628
4 3000 0.683 1914
5 2000 0.621 1242
Net Present Value 2542
Note: The Net Present Value is positive, the project will be accepted.

4. Internal Rate of Return:

IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to
zero in a discounted cash flow analysis.

 p 
Formula: IRR = X +  d  
 p − n 
X = Discount rate giving positive NPV
d = Difference between two discount rates
p = value of positive NPV
n = value of negative NPV
Example:
Discount rate 8% and NPV $14000
Discount rate 20% and NPV ($6000)
Calculate Internal Rate of Return.
IRR = 8 + (12 x 14000/20000)
= 16.4%
Note: Calculation of IRR when both net present values are positive
 p 
Formula: IRR = X +  d  
 p − n 
X = Discount rate giving Higher NPV
d = Difference between two discount rates
p = value of Higher NPV
n = value of lower NPV