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2 - Investment Appraisal
2 - Investment Appraisal
ENGINEERING
Lecture No. 02
INVESTMENT APPRAISAL
By
Ch. QS. Gayan Fernando
Chartered Quantity Surveyor/ Lecturer
B.Sc. (Hons) in QS, LLB (Hons)
M.Sc. in CL&DS, Dip. in Arb., AIQSSL.
CAPITAL AND CAPITAL
BUDGETING
⚫ Capital
Stock of assets that will generate a flow of income in
the future.
⚫ Capital budgeting
Planning process for allocating all expenditures that
will have an expected benefit to the firm for more than
one year
2
Nature of Investment
Decisions
⚫ The investment decisions of a firm are generally known as
the capital budgeting, or capital expenditure decisions.
4
Net Present Value Method
⚫ Cash flows of the investment project should be
forecasted based on realistic assumptions.
⚫ Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate
discount rate is the project’s opportunity cost of
capital.
⚫ Present value of cash flows should be calculated using
the opportunity cost of capital as the discount rate.
⚫ The project should be accepted if NPV is positive
(NPV > 0).
5
Net Present Value Method
⚫ Net present value should be found out by subtracting
present value of cash outflows from present value of cash
inflows. The formula for the net present value can be
written as follows:
C1 C2 C3 Cn
NPV = + + + + n
− C0
(1 + k ) (1 + k ) (1 + k ) (1 + k )
2 3
n
Ct
NPV =
where:
− C
+ t 0
t =1 (1 k ) C0 = initial cash outlay on project
Ct = net cash flow generated by project at time t
n = life of the project
k = required rate of return
6
Acceptance Rule
⚫ Accept the project when NPV is positive
NPV > 0
⚫ Reject the project when NPV is negative
NPV < 0
⚫ May accept the project when NPV is zero
NPV = 0
⚫ The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.
7
Questions - NPV
11
Calculation of IRR
Trial and Error Method
⚫ The approach is to select any discount rate to compute
the present value of cash inflows.
⚫ If the calculated present value of the expected cash
inflow is lower than the present value of cash outflows,
a lower rate should be tried.
⚫ On the other hand, a higher value should be tried if the
present value of inflows is higher than the present value
of outflows.
⚫ This process will be repeated unless the net present
value becomes zero.
12
Calculation of IRR
Graph Method
13
Questions - IRR
14
Evaluation of IRR Method
⚫ IRR method has following merits:
⚫ Time value
⚫ Profitability measure
⚫ Acceptance rule
⚫ Shareholder value
⚫ IRR method may suffer from:
⚫ Multiple rates
⚫ Mutually exclusive projects
⚫ Value additivity
15
Benefit Cost Ratio (Profitability
Index)
16
Acceptance Rule
⚫ The following are the PI acceptance rules:
⚫ Accept the project when PI is greater than one. PI > 1
⚫ Reject the project when PI is less than one. PI < 1
⚫ May accept the project when PI is equal to one. PI = 1
⚫ The project with positive NPV will have PI greater than
one. PI less than means that the project’s NPV is
negative.
⚫ [Explore the relationship among NPV, IRR, and PI]
17
Questions - PI
20
Payback Period
⚫ In case of un-equal cash flows, payback period can be
found out adding up cash inflow until the total is equal to
initial out lay.
For Unequal Cash Floor
21
Acceptance Rule
⚫ The project would be accepted if its payback period is
less than the maximum or standard payback period set
by management.
22
Question - Payback Period
i. Assume that a project requires an outlay of Rs 50,000 and
yields annual cash inflow of Rs 12,500 for 7 years.
Calculate the payback period for the project? Assume a 10
per cent rate of discount.
25
Question – Discounted Payback
i. Assume that a project requires an outlay of Rs 50,000 and
yields annual cash inflow of Rs 12,500 for 7 years.
Calculate the discounted payback period for the project?
Assume a 10 per cent rate of discount.
28
Question - ARR
i. Dunlop (Pvt.) Ltd decided to invest in a project. Their cash
inflows and outflows are as follows:
Year 0 1 2 3
Cash outflow 240
Salvage 20
Value
29
Question - ARR
ii. XYA distributors is considering opening a new sales outlet in
Galle. Two possible sites have been identified. Site A has a
capacity of 30,000m². It sill require an average investment of LKR
6 million and will produce an average profit of LKR 600,000 a
year. Site B has a capacity of 20,000m². It will require an
investment of LKR 4 million and will produce an average profit of
LKR 500,000 per year.
What is the ARR of each investment opportunity?
Which site would you select and why?
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Evaluation of ARR Method
⚫ The ARR method may claim some merits
⚫ Simplicity
⚫ Accounting data
⚫ Accounting profitability
⚫ Serious shortcoming
⚫ Cash flows ignored
⚫ Time value ignored
⚫ Arbitrary cut-off
31
Exercise
Q.
SKL (Pvt.) Ltd., a property developer is considering four investment option A, B,
C and D. All options incur same initial investment of LKR 80 Mn. Net cash flow
of each option for next five years are given below.
You are working at SKL (Pvt.) Ltd. as a manager (project operation). You are
expert in project appraisal area. The Developer seeks your advice to choose
profitable option.
•Rank the projects in accordance with Payback Period, Discounted Payback
Period, Net Present Value, Internal Rate of Return, Profitability Index and
Accounting Rate of Return. Assume discount rate is 10%.
•If all projects are independent, which project your going to recommend for your
organization. Prove your answer with reasons.
Net cash flow (LKR Mn.)
Projects
1st year 2nd year 3rd year 4th year
A 20 25 34 42
B 20 20 23 22
C 28 28 28 28
32
D 19 25 38 36