INVESTMENT CHAPTER 4

APPRAISAL METHODS
LEARNING OBJECTIVES

 The net present value approach and why it is

consistent with shareholder goals
 The three discounted cash flows approaches – net
present values, internal rate of return and
profitability index
 The underlying strengths and limitations of the
above
 How net present value and internal rate of returns
methods can be reconciled when they conflict.
INTRODUCTION

Investing in capital projects that offer

positive NPV creates additional wealth for
the business and its owners.
However, there are a number of
alternative techniques to the NPV method.
Each strengths and limitation need to be
considered.
NET PRESENT VALUE
Wealth is maximized by accepting all projects that offer positive net
present value when discounted at the required rate of return for each
investment
DECISION MODELS FOR
EVALUATING
ALTERNATIVES
Net Present Value
 The present value of the stream of future cash flows from a project
minus the project’s net investment

an investment with a positive net present value

increases the owners’ wealth
n
NPV   NCFt
- NINV
 1 k  t
t 1

5
EXAMPLE
The management of Gazza Ltd is currently evaluating an investment
in hair dye products costing £10,000. Anticipated net cash inflows
are £6,000 received at the end of year 1 and a further £6,000 at the
end of year 2. Assuming a discount rate of 10 per cent, calculate the
project’s net present value.
n
NPV   NCFt
- NINV
 1 k  t
t 1
 
6,000 6,000
NPV = + 2 −10,000
1.1 1.1
PRESENT VALUE TABLE

Total of (Cash Flow X Discount Factor) = Net

Present Value
Discount factor will be based on the present value
interest factor (PVIF) table.
 
NPV=∑ (𝐶𝐹𝑡 ×𝐷𝐹𝑡 )
`
 EXAMPLE
The management of Gazza Ltd is currently evaluating an investment
in hair dye products costing £10,000. Anticipated net cash inflows
are £6,000 received at the end of year 1 and a further £6,000 at the
end of year 2. Assuming a discount rate of 10 per cent, calculate the
project’s net present value.

Year Cash flow Discount factor at 10% Present Value

1 6000 0.090909 5454

2 6000 0.82645 4959
173554 10413
Less initial cost (10000)
NPV 413
PRESENT VALUE
ANNUITY TABLES
 Net Present Value = (Cash flow X ) - NINV
Using PVIFA = Present value interest factor for
annuity table
This approach appropriate if the annual cash flow
are still constant.
= PVIFA at 10% for 3 years
EXAMPLE
The management of Gazza Ltd is currently evaluating an investment
in hair dye products costing £10,000. Anticipated net cash inflows
are £6,000 received at the end of year 1 and a further £6,000 at the
end of year 2. Assuming a discount rate of 10 per cent, calculate the
project’s net present value.

 Net Present Value = (Cash flow X ) – NINV

NPV = (6000 X
= (6000 – 1.7355) – 10,000
=
TUTORIAL QUESTION
The management of Gazza Ltd is currently evaluating
an investment in hair dye products costing £10,000.
Anticipated net cash inflows are £6,000 received at
the end of year 1 and a further £6,000 at the end of
year 2. Assuming a discount rate of 10 per cent,
calculate the project’s net present value.

1. repeat the exercise using 13 per cent (average risk)

and 16 per cent (high risk). (use PVIF and PVIFA
method)
PVIF

PVIFA
NET PRESENT VALUE

Decision Rule
Independent Projects
 Accept if its net present value is greater than or equal
to zero and reject if its net present value is less than
zero
Mutually Exclusive Projects
 Accept the project with the largest net present value

16
WHY NPV MAKE SENSE
Managers are assumed to act in the best interests of
the owners/shareholders.
 Seek to increase shareholders’ wealth by maximizing CF through time.

Managers should undertake all projects up to a point

at which the marginal return on the investment is
equal to the rate of interest on equivalent financial
investments in the capital market.
Management need not concern itself with
shareholders’ particular time patterns of consumption
or risk preferences.
INVESTMENT
TECHNIQUES – NET
PRESENT VALUE
Discounted cash flow (DCF) analysis is a
family of techniques, of which the NPV
method is just one variant. Two other DCF
methods are the internal rate of return (IRR)
and the profitability index (PI) approaches.
Many managers prefer to use
nondiscounting approaches such as the
payback and return on capital methods
 EXAMPLE OF NPV
Sportsman plc is a manufacturer of sports equipment. The firm is
considering whether to invest in one of two automated processes, the
Lara or the Carling, both of which give rise to staffing and other cost
savings over the existing process. The required return is 14 per cent
p.a.The relevant data relating to each are given below:
Lara Carling

Investment Outlay (payable immediately (40,000) (50,000)

Year 1 Annual cost savings 16,000 17,000

Year 2 Annual cost savings 16,000 17,000
Year 3 Annual cost savings 16,000 17,000
Year 4 Annual cost savings 12,000 17,000
Decision Models for Evaluating Alternatives

Outlay = Future cash flows discounted at rate r

  𝐶𝐹 1 𝐶𝐹 1 𝐶𝐹 1 𝐶𝐹 𝑛
𝐶𝐹 0 = + + +…+
1+ 𝑟 1+𝑟 1 ( 1+ 𝑟 ) 2 ( 1+𝑟 )𝑛

The internal rate of return, r, is the discount rate at which the net
present value is zero

  𝐶𝐹 1 𝐶𝐹 1 𝐶𝐹 1 𝐶𝐹 𝑛
𝐶𝐹 0 = + + +…+ =0
1+ 𝑟 1+𝑟 1 ( 1+ 𝑟 ) 2 ( 1+𝑟 ) 𝑛
INTERNAL RATE OF
RETURN (IRR)
Discount rate that equates makes the NPV = 0

n
NCFt
  NINV  0
 1  IRR 
t
t 1

23
EXAMPLE
Suppose a savings scheme offers a plan whereby, for an
initial investment of £100, you would receive £112 at the
year end.
n
NCFt
  NINV  0
 1  IRR 
t
t 1

£100 (1 + IRR) = £112

IRR = 12%
EXAMPLE

If another scheme offered a single payment

 

of £148 in three years’ time, from an initial

investment of £100
100 = 148

Can we calculate using traditional method

of maths?
IRR

Find rate that equates the present value of future

benefits to the initial cash outlay.
Rules:
 If k > r reject
 If k < r accept
 r= IRR, k= required rate of return.

Estimation of IRR (using linear interpolation)

IRR SUMMARY

In our earlier example, the Lara

produced an NPV of £4,252 at 14 per cent
Trying 18 per cent gives a positive NPV
of £976, while Trying 20 per cent gives a
negative NPV of £510
Clearly the IRR giving a zero NPV falls
between 18 and 20 percent
IRR SUMMARY
 IRR SUMMARY
How about Carling???

Carling

Investment Outlay (payable immediately (50,000)

Year 1 Annual cost savings 17,000

Year 2 Annual cost savings 17,000
Year 3 Annual cost savings 17,000
Year 4 Annual cost savings 17,000
 Example Interpolation

9174
 

𝐼𝑅𝑅=9+ (
9174+90909 )
× ( 10−9 )
EXAMPLE – SPORTSMAN
PLC

Lara proposal: NPV–IRR graph

PROFITABILITY INDEX


  Also called as Benefit-cost ratio

Ratio of the present value of project benefits to

the present value of initial costs.
Decision rule:
PI >1.0 ACCEPTABLE
NPV > 0 ACCEPTABLE

Profitability Index formula:

EXAMPLE
 LARA

Lara is acceptable on the financial grounds as PI

exceeds 1. The higher the PI the more attractive
the project is.
CARLING?
RECAP

WHAT ARE THE THREE MAIN DCF METHODS?

HOW DO YOU KNOW WHEN TO ACCEPT A CAPITAL
PROJECT WITH EACH
PAYBACK PERIOD
The payback period for a capital investment is the length
of time before the cumulated stream of forecasted cash
flows equals the initial investment.

•Payback
Project A: 4 years, Project B: 4 years, Project C: 5 years.
 Tradfirm: Net Present Values (£m)

Exhibit 4.4 Tradfirm: Net Present Values (£m)

 PAYBACK FOR
SPORTSMAN PLC
Compute Payback period
Lara Cash Flow Cumulative

Year 0 (40,000) (40,000)

Year 1 16,000 (24,000)

Year 2 16,000 (8,000)
Year 3 16,000 8000
Year 4 12,000 20,000
 EXAMPLE SPORTSMAN
PLC
 If all projects are required to pay back within 3 years
both projects are to be accepted.
 

Compute CARLING…
DRAWBACKS OF
PAYBACK
It makes no allowance/take into
account for the time value of money
Receipts beyond the payback
period are ignored
Arbitrary selection of the cut-off
point.
 DISCOUNTED PAYBACK
PERIOD
Discounts each of the estimated cash flows and
determines the payback period from those discounted
flows
It calculates how quickly discounted cash flows recoup
the initial investment

 
 Discounted payback: Tradfirm plc (£m)

Exhibit 4.5 Discounted payback: Tradfirm plc (£m)

 Lara Present Value 14% Cumulative

Year 0 (40,000) (40,000)

Year 1 14,035 (25,965)

Year 2 12,312 (13,653)
Year 3 10,800 (2,853)
Year 4 7,105 4,252

Compute CARLING…AGAIN…..
 REASONS FOR
CONTINUING
POPULARITY OF
PAYBACK
•Supplements the more sophisticated methods
•E.g. an early stage filter
•It is simple and easy to use
• Projects which return their outlay quickly reduce the
exposure of the firm to risk
• If funds are limited, there is an advantage in receiving a
return on projects earlier rather than later
• It is often claimed that the cash flows in the first few years
of a project provide some indication of the cash flows in
later years
ACCOUNTING RATE OF
RETURN
The accounting rate of return (ARR) method may
be known by other names such as the return on
capital employed (ROCE) or return on investment
(ROI).
ARR is a ratio of the accounting profit to the
investment in the project, expressed as a
percentage.
The decision rule is that if the ARR is greater than,
or equal to, a hurdle rate then accept the project.
FORMULA
 
 Timewarp plc
•Invest £30,000 in machinery: life of three years
 Time warp plc (Continued)

 
 EXAMPLE SPORTSMAN
PLC
Suppose the depreciation policy is to depreciate assets over their
useful lives on a straight-line basis. The annual depreciation for the
Lara will be £10,000 for 4 years and for the Carling, £12,500 for 4
years. The annual profit from the proposals will be the annual cash
saving less the annual depreciation.
Year Lara Carling
Year 1 CF 16,000 17,000
Year 2 CF 16,000 17,000
Year 3 CF 16,000 17,000
Year 4 CF 12,000 17,000
EXAMPLE SPORTSMAN
PLC
Calculate ARR for total investment for both Lara and Carling.
Calculate ARR for average investment for both Lara and Carling.
DRAWBACKS OF
ACCOUNTING RATE OF
RETURN
Wide-open field for selecting profit and asset
definitions
Profit figures are very poor substitutes for cash
flow
Fails to take account of the time value of money
High degree of arbitrariness in defining the cut-
off or hurdle rate
DRAWBACKS OF
ACCOUNTING RATE OF
RETURN (CONTINUED)
Accounting rate of return can lead to some
perverse decisions
Suppose that Timewarp uses the second
version, the total investment ARR, with a hurdle
rate of 15 per cent
The appraisal team discover that the machinery
will in fact generate an additional profit of £1,000
in a fourth year
• Original
  situation
(5,000 + 5,000 + 5,000)/3
ARR = –––––––––––––––––––––– = 16.67%.
Accepted 30,000
• New situation

(5,000 + 5,000 + 5,000 + 1,000)/4

ARR = ––––––––––––––––––––––––––– = 13.33%.
Rejected 30,000

Suppose the Lara proposal is expected to continue into Year 5, yielding a profit of £1,000 in that
year.
REASONS FOR THE
CONTINUED USE OF
ACCOUNTING RATE OF
RETURNS
Managers are familiar with this
ancient and extensively used
profitability measure.
Divisional performance and the
entire firm is often judged on a profit-
to-assets employed ratio.
INTERNAL RATE OF
RETURN: REASONS FOR
CONTINUED
POPULARITY
Psychological – familiar with expressing
financial data in the form of percentage
IRR can be calculated without knowledge
of the required rate of return
Ranking – not familiar with the drawbacks
of IRR and believe that ranking is the most
accurately and most easily carried out using
the percentage based IRR method.
WHICH METHOD?? NPV
OR IRR??
No investment effect – personal
preference.
Under certain circumstances, the choice
matters
Mutually exclusive projects
Variable discount rates –
 NPV different rates can be set for each period.
 IRR is compared against a single required rate of return (CANNOT handle
variable rates)
Unconventional cash flows
 COMPARISON OF
VARIOUS APPRAISAL
METHODS

Bruno creates £2,126 additional wealth and hence is preferred.

EXAMPLE OF MUTUALLY
EXCLUSIVE PROJECTS
X = higher IRR, Y = higher NPV The two project intersecting at 17%
CASH FLOW PROFILES
There are 3 basic cash flow profiles:

For a reverse cash flow pattern, such as a loan where cash is received
and interest paid in subsequent periods, the IRR can be usefully
applied. But in interpreting the result, remember that the lower the
rate of return the better, so the decision rule is to accept the loan
proposal if the IRR is below the required rate of return
UNCONVENTIONAL CASH
FLOWS
Create particular difficulty for the IRR approach.

NPV= 0 = IRR =10%

However at a rate of 20% and 30%, NPV is still ZERO! (multiple IRR)
While conventional projects have ONLY ONE IRR, unconventional may have
many IRRs as there are changes in the CF signs
THE ‘SCIENCE’ AND THE
‘ART’ OF INVESTMENT
APPRAISAL
In generating and evaluating major investments the firm has to take
into account the following:
• Strategy – proposed project and the strategic direction of the firm
• Social context – enthusiasm and commitment of individuals is
important
• Expense – sophisticated project evaluation cost a considerable amount
of money.
• Stifling the entrepreneurial spirit – excessive emphasis on formal
evaluator systems – demotivating those who thrive on fast decision
making and action
• Intangible benefits – difficult to measure with $$ (customers
satisfaction.
END OF LECTURE 4