TOPIC

Mathematics of Finance
Capital Investment Appraisal Methods

Introduction
This chapter explains the basis for evaluating capital investment opportunities. It
is often referred to as capital investment projects. Capital investment decision has
a direct effect on the film’s future profitability because it will either result in an
increase in revenue or will bring about an increase in efficiency and a reduction in
costs. It is always proper to evaluate and find the worth of a project before
decision in made to go ahead with its expenditure
Capital expenditure differs from day to day for the following reasons:-
(i) They involve a bigger outlay of money
(ii) The benefits will occur over a long period of time, usually above one
year.

Capital investment appraisal methods

The following measures of investment performance can be used in capital
investment appraisals.
i) The payback period
ii) Return on investment (ROI) or accounting rate of return (ARR)
iii) Net present value
iv) The internal rate of return
v) Profitability index (PI) or cost benefit ratio (CBR)

The basic information required for investment appraisal are:-

i) The cost of the investment project
ii) The estimated life of the project
iii) The estimated net cash flows from the project
iv) The estimated residual/scrap value of the project at the end of its life
v) The cost of capital
vi) Tax implication of the project where necessary
vii) Inflation rates and its effect on the projects.

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 i) The payback period
It is the time it takes the cash inflow from a capital investment project to equal
the cash out flow from that project. When deciding between two or more
competing project the usual decision is to accept the one with the shortest
payback period. The pay back is often used as the first screening method.

Example
Below is the information on two mutually exclusive projects A and B

Project A Project B
Capital investment: Shs. 600,000 Shs 600,000
Cash flows. shs. Shs.
Year I 200,000 500,000
2 300,000 200,000
3 400,000 50,000
4 500,000 50,000
5 600,000 50,000

Solution
Cumulative Net cash flows
Project A Project B A B
Capital investment: 600,000 Shs 600,000 (600,000)
(600,000)
Cash flows. shs. Shs.
Year I 200,000 500,000 (400,000) (100,000)
2 300,000 200,000 (100,000) 100,000
3 400,000 50,000 300,000 150,000
4 500,000 50,000 800,000 200,000
5 600,000 50,000 1,400,000 250,000

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Project A pays back in year 3 (about one quarter of the way through year 3
project B pays back half way through year 2.

Project B will be preferred over A but project A has higher return over its life than
B. A will earn a total profit before depreciation of 1.400.000 on an investment of
shs 600,000 and B will earn shs 250,000 on an investment of shs 600,000. So you
should always be cautious when making investment decision on the basis of pay
back decision on the basis of payback period only.

Read advantages and advantages of payback period and make notes

ii) The accounting rate of return (ARR).

This is also called return on capital employed (ROCE) or return on investment
(ROI). It is the average profits from an investment as a % the project cost. The
profit is accounting profits less depreciation and tax. The average investment is
got as the average of the initial cost and the average value of the investment at
the end of its useful life.

ARR Estimated average π X 100

Estimated average investment
The ARR calculated in this way is compared with predetermined company’s target
rate of return. An investment is accepted if the ARR calculated meets or exceeds
the predetermined target
Example 1
A firm has a target accounting rate of return of 20% and now considering the
following project for investment.

Cost of capital shs 80,000

Estimated life 4 yrs

Estimated is before profit before depreciation

Year 1 shs 20,000
Year 2 “ 25,000

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Year 3 “ 35,000
Year 4 “ 25,000

The capital assets will be depreciated by 25% and will have no residual value

Required
Assess whether the project should be under taken on the basis of ARR.

Solution
(i) Annual depreciation charged is 25% of 80,000 = shs 20,000
(ii) Total depreciation over 4 years is (4*20,000) = 80,000
(iii) Total profits before depreciation over 4 years will be shs 105.000
(iv) Total profits after depreciation over 4 years will be 105,000 – 80,000 =
shs 25,000
(v) Average profit after depreciation over 4 years is 25,000/4 shs 6,250=
(vi) Average investment over 4 years is the cost of capital less residual
values/2.
= shs 80,000 – 0 shs 40,000
2

Therefore ARR = Average profits after depreciation X 100

Average investment

= 6,250 X 100 = 15.6%

40,000

The project will not be under taken because it will fail to yield the target rate of
return of 20%.

Example 2
A firm wants to buy the item of equipment which will be used to provide services
to the customers of the firm. Two models of the equipment are available, one
with a higher capacity and greater reliability than the other, but both have zero
disposable value. The expected costs and profits of each item are as follows:-

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Equipment items A B
Capital cost shs 80,000 150,000
Life span 5 yrs 5yrs
πs before depreciation
Yr 1 50,000 50,000
Yr 2 50,000 50,000
Yr 3 30,000 60,000
Yr 4 20,000 60,000
Yr 5 10,000 60,000

Required
Decide which item of equipment should be selected if the firms ARR is 30% and it
depreciates its assets on a straight line basis.

Solution: Equipment A
(i) Annual depreciation charge is 80,000/5= 16,000
(ii) Total depreciation charges over 5 years = 16,000 x 5 = 80,000
(iii) Total πs before depreciation over 5 years = 160,000
(iv) Total πs after depreciation over 5 years is 160,000 -80,000 = 80,000
(v) Average profit after depreciation is 80,000/5= 16,000
(vi) Estimate average investment over 5 years is
80,000 - 0 = 40,000
2
ARR Average profit after depreciation X100
Average investment
= 16,000 X 100 = 40%
40,000

Equipment B
(i) Annual depreciation charge is 1/5 of 150,000 = 30,000
(ii) Total depreciation charges over 5 years = 30,000 x 5 = 150,000
(iii) Total πs before depreciation over 5 years = 280,000
(iv) Total πs after depreciation over 5 years = 280,000 – 150,000 = 130,000

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 (v) Average profit after depreciation is 130,000/5= 26,000
(vi) Estimates average investment over 5 years is

150,000 - 0 = 75,000
2
ARR = Average profit after depreciation X 100
Average investment

= 26,000 x 100 = 34.7%

75.000

Comment: Both equipment will earn a return in excess of 30% but equipment A
will be preferred because is earn a higher ARR of 40%.

NB: Make notes on the disadvantages and advantages of ARR.

Discounted cash flows analysis

Discounted cash flow analysis determined the net value of a project in terms of
today’s money. It identifies all the cash flows associated with the project and
calculates their present values so that they can be assessed as they exist at the
time. Normally the cash out flows are denoted as negative and the cash inflows
are positive. It should be noted that

i) DCF methods take into account all cash inflows and out flows associated
with the project over its life as and when they occur.
ii) The timing of cash flows is taken into account by discounting them. On
the above two basis, DCF methods gives a better picture of the
profitability of project than the other method discussed earlier.

Three methods of using DCF to evaluate capital investment are:

i) Net present value (NPV)
ii) The internal rate of return (IRR)
iii) The profitability index or cost benefit ratio.

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(i). Net present value (NPV)
This is the value obtained as the sum of all the discounted cash out flows and
inflows of capital investment project using a chosen target rate of return as the
discount rate.

If NPV is positive, the project should be accepted if NPV is negative, the project
should not be accepted if NPV is zero, Cash inflows yield a return equals to the
costs of capital, the project can be accepted or rejected depending on the
organization target.

Example 1.
A project has an initial cost of investment of shs 10,000,000 in a machine and the
cash inflows are as below.

Year I shs 6,000,000, year 2 shs 6,000,000, year 3 shs 6,000,000 year 4 shs
5,000,000 and years 5 shs 5,000,000. No scrap value is expected from the
machine. The cost of capital is 10% throughout the five years of the project life.

Required
On the basis of NPV, advice whether the project should be accepted or not.

Solution
Year Cash flows Discounting Present value
shs factor at 10% shs
0 (10,000,000) 1.00 (10,000,000)
1 6,000,000 0.909 5,454,000
2 6,000,000 0.826 4,956,000
3 6,000,000 0.751 4,506,000
4 5,000,000 0.683 3,415,000
5 5,000,000 0.631 3,105,000
NPV 11,436,000

The project should be accepted because it has a positive NPV.

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NB: If the level of cash flows is uniform from year to year, there is an easier
method of calculating the NPV than using the discounted factor tables.

This method is called annuity or cumulative discount factor, which are the sums of
discount factors for one unit of currency over a number of years.

Example II
A firm is considering a capital investment project whose initial cost is shs
10,000,000 and will generate annual cash inflow of shs 3,300,000 in each of the 5
years of the project useful, evaluate the viability of the project if the cost of
capital is 12%.

Solution
The expected streams of cash inflows in uniform and therefore they are annuities.
it is therefore approached as below:-

Year Cash flows Annuity discount Present value

shs factor 12% shs
0 (10,000,000) 1.00 (10,000,000)
1-5 3,300,000 3.605 11,896,500
1,896,500
Example III
A company is considering investing in a project whose cost is shs 5,000,000 and
will yield cash inflows of shs 2,000,000 in year 1 and shs 3,000,000 in each of the
remaining 3 years. There is no scrap value at the end of the project and the
company cost of capital is 10% should the project be accepted?

Solution
The inflows in years 2, 3 and 4 are annuities at a discount rate of 10%, the annuity
discounted factor is 3.1699 and the discount factor for 1 year is 0.9091. Therefore
the annuity discount factor for year 2, 3 and 4 is 3.1699 – 0.9091 = 2.2608, the
working is in the table below.

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Year Cash flows Discount Present value
shs factors 10% shs
0 (5,000,000) 1.00 (5,000,000)
1 2,000,000 0.9091 1.818.200
2-4 3,000,000 2.2608 6,782,400
NPV 3,600,600
(ii), Internal rate of return (IRR) method.
The IRR of a project is the costs of capital or discount rate that makes the Net
present values of a project zero. The graph of NPV against cost of capital shows
the point where the graph of NPV cuts the horizontal axis. The value of the cost of
capital at this point is the IRR as shown in the graph here. Since the graph of NPV
shops down wards, it then follows that:-
i) If the cost of capital is greater than the IRR, then the NPV is negative,
and the project is rejected
ii) If the cost of capital is less than the IRR, then the NPV is +ve, the project
is accepted.

+
NPV

0 cost of capital (r)

IRR
-
NPV

The computation of IRR is by trial and error. NPVs are calculated at different
discount rates until a discount rate is found that makes the NPV zero or closer to
zero. A better method is to calculate NPV at 2 discount rates and use these two
values to calculate the discount rate that gives a NPV of zero, this method is
known as interpolation.

By this method,
IRR = A + a x (B – A)
a-b
Where A is the lower rate of return with +ve NPV, B is the higher rate of return
with a –ve, a is the amount of +ve NPV and b is the amount of –ve NPV.

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The starting point is 1st to get the project’s ARR, a discount rate equal to 2/3 of
the project’s ARR is found and treated as a lower discount rate A, B can be found
by guess.

Example
A firm is trying to decide whether to buy a machine for shs 80,000,000 which will
save cost of shs 20,000,000 per annum for 5 years and have a resale value of shs
10,000,000 at the end of 5 years. It is the firm’s policy to take project only if it
yields a discounting cash flow at a rate of 10% or more.

Required
Advise the firm on the bass of IRR.

Solution
Our aim is to find the discounting rate that makes the NPV of the project zero

We begin by finding the ARR that will be used to estimate the rates to be used in
the interpolation formula.

ARR = Average πs after depreciation x 100%

Average investment cost

 Annual depreciation charge is (80,000 – 10,000)/5 = 14,000,000

 Accumulated depreciation = 14,000,000 x 5 = 70,000,000
 Total πs after depreciation = total cash flows – accumulated depreciation
 Total cash flows = 20,000,000 x 5 = 100,000,000
 Total cash profits after depreciation therefore is = 100,000,000 –
70,000,000
= 30,000,000
 Avarege profit after depreciation is 30,000,000/5 = 6,000,000
 Average investment = 80,000,000 - 10,000,000 = 45,000,000
2
 ARR = 6,000,000 X 100 = 13.3%
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 45,000,000

Therefore, the starting rate of return is 2/3 of 13.3 = 8.7 in 9% = r1

We can start with r1 = 9% and calculate NPV.

Year Cash flows PV. Factor at 9% Present value

0 (80,000,000) 1.00 (80,000,000)
1-5 20,000,000 3.890 77,800,000
5 10,000,000 0.650 6,500,000
NPV 4,300,000

The NPV is +ve and close to zero, which means that the IRR is more than 9% we
need to increase the rate of return in order to get a –ve NPV. Let’s try 12% and
calculate the NPV.

Year Cash flows Discount factor at 12% Percent value

0 (80,000,000) 1.00 (80,000,000)
1-5 20,000,000 3.605 72.100.000
5 10,000,000 0.567 5,670,000
(2,230,000)

The NPV is negative and it means that the IRR is less than 12%.
We can estimate the IRR by interpolation formula.

IRR = A+ a x (B – A)
a-b

Where A = 9%, B = 12%, a = 4,300,000 b = -2,230,000

IRR = 9% + 4,300,000 X 12% - 9%

4,300,000 – (-2,230,000)

= 9% + 4,300,000 x 3% = 10.98 which is approximately 11%

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 6,530,000
This project should be accepted since the policy is that any project with an IRR of
10% or more is accepted.

NB: For mutually exclusive projects, a project with lower IRR is preferred over a
project with higher IRR

Read and make notes on that advantages and disadvantages of IRR (ii) The
difference between NPV and IRR methods.

(iii), Profitability index (PI) or cost-benefit ratio

PI = Present value of future cash inflows
Present value of initial investment cash outflows

A project with A PI greater than 1.0 should be accepted. For competing projects, a
project with greater PI is preferred.

Example 1
A firm is considering two competing projects whose expected annual cash flows
are as follows.

Year Cash flows (shs)

Project A Project B
0 (8,000,000) (8,000,000)
1 3.000.000 5.000.000
2 4.000.000 4.000.000
3 5.000.000 3.000.000
Required
Compute the PI for each project and recommend which project should be
undertaken if the firm’s required rate of return is 10%.

Solution
We shall determine the present value of the cash inflows of each project as
below:-

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Project A
Year Cash flows Discount factors at 10% Present value
1 3,000,000 0.909 2,727,000
2 4,000,000 0.826 3,304,000
3 5,000,000 0.751 3,755,000
PV = 9,786,000

PI = 9,786,000 = 1.22
8,000,000

Project B
Year Cash flows Discount factors at 10% Present value
1 5,000,000 0.909 4,545,000
2 4,000,000 0.826 3,304,000
3 3,000,000 0.751 2,253,000
PV = 10,102,000

P1 = 10,102,000 = 1.26
8,000,000

Both projects have a PI greater than one and therefore they are viable. But
project B has a higher P1 than A and therefore the firm with undertake B.

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