Professional Documents
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Credit Appraisal - Project Risk
Credit Appraisal - Project Risk
investment appraisal
Managing financial resources & decisions
(H/601/0548)
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Investment Appraisal
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Investment Appraisal
• Why do companies invest?
• Importance of remembering investment as the purchase of productive
capacity NOT buying stocks and shares or investing in a bank!
Payback
Net
Discounted
Present
payback
Value
Proposed
Capital
Project
Internal Accounting
Rate of Rate of
Return Return
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1. The PAYBACK method
• The payback method is an attempt to estimate how long it would take
before a project begins to pay for itself.
• Example : If a company was going to spend RM 300,000 on purchasing some
new plant, the accountant would calculate how many years it would take
before RM 300,000 had been received back in cash.
• The recovery of an investments in a project is usually measured in terms of
net cash flow.
Net cash flow is the difference between cash received and cash paid during a
defined period of time.
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The PAYBACK method
• The Newland City Council has investigated the possibility of investing in a new
project, and the following information has been obtained.
RM RM
Total cost project 500,000
Expected net cash flows:
Year 1 20,000
2 50,000
3 100,000
4 200,000
5 300,000
6 30,000 (700,000)
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Net Return 200,000
The PAYBACK method
Year Net cash flow Cumulative net cash
flow
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The PAYBACK method
• By the year end of fifth year, the original investment of RM 500,000 will
have been covered.
• However, the exact years that investments will be covered is 4 years and 5
months [(RM 130,00 / RM 300,000) x 12 months].
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2. The DISCOUNTED PAYBACK method
Year Net Cash Flow Discount Present Value at 8 % Cumulative
factors [Column (2) x Column (3)] present value
(1) (2) (3) (4) (5)
• By the year end of sixth year, the original investment of RM 500,000 will
have been covered.
• However, the exact years that investments will be covered is 5 years and 5
months [(RM 8,000 / RM 19,000) x 12 months].
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Accounting Rate of Return
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3. Accounting Rate of Return
ARRs Comments
< minimum acceptable rate Reject project
= minimum acceptable rate Accept project
> minimum acceptable rate Accept project
Highest Choose highest ARR
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4. Net Present Value
• The NPV method recognizes that cash received today is preferable to cash
receivables sometimes in the future.
• When facing different investment proposals, the management should
choose the project that can generate the greatest addition of value to the
company.
• Net present value (NPV) method is a process that uses the discounted cash
flow of a project to determine whether the rate of return on that project is
equal to, higher than, or lower than the desired rate of return
• With the NPV method, we can compare the return on investment in capital
projects with the return on an alternative equal risk investment in securities
traded in financial market
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Steps to be considered in calculating NPV
• 1. Calculate the annual net cash flows expected to arise from the projects.
• 2. Select an appropriate rate of interest, or required rate of return.
• 3. Compare the total net present value with the initial outlay.
• 4. Accept the project if the total NPV is positive.
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Net Present Value
Project ALPHA BETA
Estimated life 3 years 5 years
Commencement date 1.1.2001 1.1.2001
Project cost at year 1 100,000 100,000
Estimated net cash flows:
Year 1 20,000 10,000
2 80,000 40,000
3 40,000 40,000
4 0 40,000
5 0 20,000
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140,000 150,000
Net Present Value
Year ALPHA BETA
Net Cash Discount Present Net Cash Flow Discount Present
Flow Factor Value RM Factor Value
RM 10 % RM 10% RM
(1) (2) (3) (4) (5) (6) (7)
1 20,000 0.9091 18,182 10,000 0.9091 9,091
2 80,000 0.8264 66,112 40,000 0.8264 33,056
3 40,000 0.7513 30,052 40,000 0.7513 30,052
4 - 0 - 40,000 0.6830 27,320
5 - 0 - 20,000 0.6209 12,418
Total present value 114,346 111,937
Less : Initial cost (100,000) (100,000) 19
Net present value 14,346 11,937
Interpreting the NPV derived as follows:
NPVs Comments Reasons
<0 Reject the project The rate of return from the project is
small than the rate of return from an
equivalent risk investment
=0 Indifferent to accept The rate of return from the project is
equal to the rate of return from an
or reject the project equivalent risk investment
>0 Accept the project The rate of return from the project is
greater than the rate of return from an
equivalent risk investment
Highest Accept the project If various project are considered, the
project with highest positive NPV 20
should be chosen
Internal Rate of Return
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Internal Rate of Return
Example :
• Bruce Limited is considering whether to invest RM 50,000 in a new project. The
project’s expected net cash flows would be as follows:
Year RM
1 7,000
2 25,000
3 30,000
4 5,000 22
Internal Rate of Return
Year Net Cash Flow Discount Factors Present Value
= 12.76%
INVESTMENT APPRAISAL
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The PAYBACK Method
Advantages Disadvantages
1. Payback can be important: long payback 1. It ignores the timing of cash flows within
means capital tied up and high investment the payback period, the cash flows after the
risk. end of payback period and therefore the total
project return.
2. The method also has the advantage that it 2. It ignores the time value of money. Only
involves a quick, simple calculation and an suitable for short-term only.
easily understood concept.
3. Can be used as a supplementary. It focuses 3. It is unable to distinguish between projects
on the cash recovery of an investment. with the same payback period.
4. It may lead to excessive investment in 26
short-term projects.
Accounting Rate of Return
Advantages Disadvantages
1. The method is compatible with a similar 1. Does not take account of the time value of
accounting ratio used in financial accounting. money
2. It is relatively easy to understand and not 2. ARR method seems to be less reliable than
difficult to compute. the NPV method. It adopts the accounting
profit instead of cash flows calculation. The
change of depreciation method may also alter
the accounting profit