Investment Appraisal:

The Business Case

A document which justifies doing a project
after due consideration of the time, cost, risks
and benefits of the options.

Is it worth doing the project?

In Civil Engineering, something similar to a
Feasibility Study Report?

“Information necessary to enable approval,

authorisation and policy making bodies to
assess a project proposal and reach a
reasoned decision.”

BS6079:2002
 The Business Case

Key Information in the Business Case

•Why is the Project being done

•Business Benefits expected of the Project
•What different options considered
•Timescale and costs
•Risks identified
•Investment Appraisal involving Life cycle Costs

Focussing on the lucre – Investment Appraisal, this will

require::

Estimation Establish the cashflow

Calculation Economic merits established

Consider Sensitivity Analysis
 The Business Case

Economic merit comparisons are usually made by:

•Payback

•Net Present Value (NPV)

(Discounted Cashflow (DCF))

•Internal Rate of Return (IRR)

 The Business Case

Payback
 
+ Simple and Quick
-Does not look beyond Payback period
-No account of timing or Rate of Return

Initial appraisal
Highly speculative ventures
Main Equation:

Uneven annual cash flows:

Where cash flows are uneven, payback is calculated by
working out the cumulative cash flow over the life of the
project.
 The Business Case

Net Present Value (NPV)

The future value of money
How much is £10 in two years worth to you today?

Food and drink prices in the 1970s/Now

Bread Loaf: 9p/£1.10
Pint of beer 20p/£3.10
 The Business Case

Net Present Value (NPV)

The sum of future net cashflows discounted back to a

common base time, usually the present.

Takes into account the timing of cashflow

Takes into account Rate of Return

All schemes
 The Business Case

Net Present  Value (NPV)

Main Equation:

Ct = net cash inflow during the period t

Co = total initial investment costs
r = discount rate, and
t = number of time periods 
 The Business Case
Internal Rate of Return (IRR)

“The rate at which future cashflows, when discounted back,

equate to the initial investment.”

Or

“The net present value will be zero for an investment when

cashflows are discounted at the Internal Rate of Return”

All schemes

Commonly the NPV is calculated with an RoR in mind for

comparison (E.g. 5%, 10%, 15%).
(10% can allow for borrowing capital, inflation and still leave
room for an added return)
The IRR can be found using trial and error
 Example 1 – Project with 6 year life
Analyse the project using Payback
Analyse the project using NPV based on a Rate of return of 10%
Find the true IRR for the project
Discuss the differences between the analysis methods
TIME PROJECT A Cumlative cashflow:
 
Now -£500,000
 
-£500,000
 
YearPayback
1 for Project£50,000
300  
-£450,000
200  
Year 2 £50,000 -£400,000
Cumulative payback (£1000)

100  
 
0 Year 3 £200,000
0   2 4 6 -£200,000
8
-100
 
Year 4 £200,000
Point of payback
-200
 
£0 (4 years)
-300  
Year 5 £100,000
-400  
£100,000
-500  
Year 6 £100,000
-600  
£200,000
Time (Year)
 Example 1 – Project with 6 year life
Analyse the following using NPV based on a Rate of return of 10%

  𝐶𝑡
𝑁𝑃𝑉 =∑ 𝑡
−𝐶 𝑜
(1+𝑟 )
TIME PROJECT A Present worth:
 
Now -£500,000
 
 
Year 1 £50,000
 
= 50k / (1+0.1)1= £45,455
 
Year 2 £50,000 = 50k / (1+0.1)2 = £41,322
 
 
Year 3 £200,000 £150,263
 
 
Year 4 £200,000
 
£136,603
 
Year 5 £100,000
 
£62,092
 
Year 6 £100,000
 
£56,447

=£ 492,182
 
NPV = £492,182 - £500,000 = - £7818
 Example 1 – Project with 6 year life
Find the true IRR for the project Need to use trial and error. We know 10%
was not achieved. Therefore try 9% in the
  𝐶𝑡 calcs below.
𝑁𝑃𝑉 =∑ 𝑡
−𝐶 𝑜
(1+𝑟 ) Present worth
TIME PROJECT A 9%:
 
Now -£500,000
 
 
Year 1 £50,000 = 50k / (1+0.09)1 = £45,872
 
 
Year 2 £50,000 = 50k / (1+0.09)2 = £42,084
 
 
Year 3 £200,000 £154,437
 
 
Year 4 £200,000
 
£141,685
 
Year 5 £100,000
 
£64,993
 
Year 6 £100,000
 
£59,627

=£ 508,697
 
NPV = £508,697 - £500,000 = £8697
 Example 1 – Project with 6 year life
Find the true IRR for the project We know 10% was not achieved and 9%
was too low. Therefore try 9.5% in the
  𝐶𝑡 calcs below.
𝑁𝑃𝑉 =∑ 𝑡
−𝐶 𝑜
(1+𝑟 ) Present worth Present worth
TIME PROJECT A 9%: 9.5%
 
Now -£500,000
 
 
Year 1 £50,000 £45,872
 
£45,662
 
Year 2 £50,000
 
£42,084 £41,701
 
Year 3 £200,000 £154,437
 
£152,331
 
Year 4 £200,000
 
£141,685 £139,115
 
Year 5 £100,000
Almost zero  
£64,993 £63,523
(9.52)  
Year 6 £100,000
 
£59,627 £58,012

=£ 500,343
 
NPV = £500,343 - £500,000 = £343
Tip – Use present worth factors to help
speed of calculations!
(remember the time value of money)
Say you have an compound rate of return of 10% and you start with £1
You start with £1.00 in year 0
End Year 1 £1.10
2 £1.21
3 £1.33
4 £1.46
5 £1.61

So £1 now is worth £1.61 in 5 years with your expected interest

 Tip – Use present worth factors to help
speed of calculations!
(remember the time value of money)
Turn this around:
How much would you need today in order to have £1 next year with interest of 10%

Before for year 1 the calculation was:

  1x(1+0.1)=1.10

So

Or

 E.g. If you wanted to have £1 after one year, then

(Present worth factor for 1 year)

 Tip – Use present worth factors to help
speed of calculations!
(remember the time value of money)
If you wanted to have £1 in 2 years with interest of 10%, what would you need today

 Go back another year

(Present worth factor for 2 years)

Or
 

So £0.83 today would be worth £1 in two years with an expected

interested rate 10%
 Tip – Use present worth factors to help
speed of calculations!
(remember the time value of money)
You can list these by year(time period)

Time period PWF These can be used for PW calculations from Ex 1

1 0.909 £50k x 0.909 = £45,455
2 0.826 £50k x 0.826 = £41,322
3 0.751 etc
4 0.683
5 0.621
6 0.564
7 0.513
8 0.467
9 0.424
10 0.386
etc etc

  𝐶𝑡 Can create lists for

𝑁𝑃𝑉 =∑ −𝐶 𝑜 = ∑ (𝐶 ¿¿ 𝑡 × 𝑃𝑊𝐹 )−𝐶 𝑜 ¿
(1+𝑟 )𝑡 different IRR
 Discussion of methods?
Payback NPV IRR
Simple/Quick Good indication of return value Time consuming, but
compared to a benchmark RoR gives precise
Time not considered. No (above or below +’ve or –’ve) information about rates
measured account of
of return of a particular
return on investment
beyond payback period
Easily understood project.

Good for early stage Good for projects that appear Can be compared to
appraisal quite different in terms of return benchmark value

If quick return on capital Considers time value of money Good for use with
is considered vital, then projects that appear
should be considered
Calculation fairly complicated quite different in terms
with greater importance
of return
Minimises risk
Considers time value
of money
 Example 2 – Three choices – now B and C!!!
Analyse the following using NPV based on a Rate of return of 10%
Discuss which project is preferred for implementation
Find the IRR for the preferred project (note we have done Project A!!!)
TIME PROJECT A PROJECT B PROJECT C
 
Now -£500,000 -£500,000 -£500,000
 
 
Year 1 £50,000 £300,000 £250,000
 
 
Year 2 £50,000 £100,000 £250,000
 
 
Year 3 £200,000 £50,000 £50,000
 
 
Year 4 £200,000 £50,000 £50,000
 
 
Year 5 £100,000 £50,000 £50,000
 
 
Year 6 £100,000 £50,000 £0
 
 Example 2 – Ans Project B
Analyse the following using NPV based on a Rate of return of 10%
Discuss which project is preferred for implementation
Find the IRR for the preferred project
TIME PROJECT B PWF (10%) PW
 
Now
 
 
-£500,000 1.0000 -£500,000
∑ =£ 486,358
 

Year 1 £300,000 0.9091 £272,727

 
 
Year 2 £100,000 0.8264 £82,645
 
 
Year 3 £50,000 0.7513 £37,566
 
 
Year 4 £50,000 0.6830 £34,151
 
 
Year 5 £50,000 0.6209 £31,046
 
 
Year 6 £50,000 0.5645 £28,224
 

NPV = £486,358 - £500,000 = -£13,642

 Example 2 – Ans Project C
Analyse the following using NPV based on a rate of return of 10%
Discuss which project is preferred for implementation
Find the IRR for the preferred project
TIME PROJECT C PWF (10%) PW
 
Now
 
 
-£500,000 1.0000 -£500,000
∑ =£ 536,647
 

Year 1 £250,000 0.9091 £227,273

  Project C has
 
Year 2 £250,000 0.8264 £206,612 highest NPV and is
  selected.
  Consider checking
Year 3 £50,000 0.7513 £37,566
  payback.
 
Year 4 £50,000 0.6830 £34,151
 
IRR = 14.1%
 
Year 5 £50,000 0.6209 £31,046 NPV
  Guess 15%, -£7250
 
Year 6 £0 0.5645 £0
Guess 14%, £986
  Guess 14.1% £151
NPV = £536,647 - £500,000 = £36,647
 Tutorial Question
Rank these three Projects using:
a. Payback
b. Net Present Value using a Rate of Return of 10%
c. Only one Project can proceed. Based on your ranking, identify a
preferred Project giving the reason why this is preferred.

Project A
Year Project B Project C
 

0 -1000000 -2000000 -1500000

1 150000 300000 400000
2 300000 500000 400000
3 300000 750000 400000
4 300000 750000 400000
5 300000 750000 300000
 Tutorial Question
a. Only one Project can proceed. Based on your ranking, identify a
preferred Project giving the reason why this is preferred.

Choose Project B as it gives the highest NPV (£227k) and IRR (13.8%)

Note: negative of B is the initial capital is highest at £2million

Payback is best for project B also at 3.6 years

Project A
Year Project B Project C
 

0 -1000000 -2000000 -1500000

1 150000 300000 400000
2 300000 500000 400000
3 300000 750000 400000
4 300000 750000 400000
5 300000 750000 300000