Investment Appraisal 1

Process and Methods

Objectives
 Describe the nature of capital investment
appraisal
 Discuss the investment process
 Apply the main appraisal techniques
 Examine the limitations of the main investment
appraisal techniques
Investment: scope and types
Scope of Capital Investment
 Sacrifice immediate/certain for greater expected future consumption

 Acquisition of fixed assets or adding value to existing ones

 Significant impact; large resources; often lengthy periods; difficult to

reverse decisions; strategic consequences

Types
 Replacement investment: assets that are exhausted or have high
replacement costs
 Cost reduction: e.g. substitution for labour by machines

 Expansion projects: to raise capacity and output

 Strategic projects: e.g. new areas – training, distribution

 Diversification: e.g. possibly linked to strategic risk reduction

Investment Appraisal Process
 Recognition of investment
1. Investment Idea opportunity/need
 Examine demand, alternatives
 Is concept technically feasible?
2. Planning  Fit with corporate objectives?
 Are resources available?
3. Financial and  Scoping of project
Strategic Analysis  Is project economically feasible?
 Cash flow estimates
 Does it meet decision criteria?
4. Decision  Implementation within costs and
Implementation deadlines
 Corporate learning
 Assessment of economic,
5. Monitor and control technical and qualitative aspects
Appraisal techniques
 Payback
 Discounted payback
 Accounting Rate of Return (ARR)
 Discounted Cash Flow (DCF) methods
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
Payback
 Lecture example
 LBS uses the payback period as its sole investment appraisal
method. LBS invests £30000 to replace its computers and this
returns £9000 annually for the five years. From the information
above calculate the investment using payback. Assume the £9000
accrues evenly throughout the year.
Year Yearly cash flows £ Cumulative NCF(£)
0 (30000) (30000)
1 9000 (21000)
2 9000 (12000)
3 9000 (3000)
4 9000 6000
5 9000 15000

So 3 years = 3x9000 = 27000 plus 3000/9000 x12 = 4 so 3 years 4 months

Payback and Discounted Payback
 Lecture example 2
 You are faced with two investment opportunities which each cost
£30000 and which have net cash inflows:
Year Project A CF (£) Project B CF (£)
1 7500 5000
2 7500 5000
3 7500 6000
4 7500 6000
5 5000 8000
6 0 15000
7 0 15000
Required
a) Use payback to choose between the two projects
Answer A = 4 years B = 5 years so A

b) Using a discount rate of 12% which has the faster payback?

Payback and Discounted Payback
Discounted payback cash flows

Year 12%DF Project A CF Project A DCF Project B CF (£) Project B DCF

1 0.8926 7500 6696 5000 4464
2 0.7970 7500 5979 5000 3986
3 0.7118 7500 5338 6000 4271
4 0.6355 7500 4766 6000 3813
5 0.5674 5000 2837 8000 4539
6 0.5066 0 0 15000 7539
7 0.4524 0 0 15000 6785

Total DCF for A = £25616 i.e. < £30000 initial cost so A does not payback on a
DCF basis

Total DCF for B = £28612 after 6 years; £35397 after 7 years so discounted
payback period is between these i.e. 6.2 years (assume even spread of CF over
year – so B has quicker payback on a discounted payback basis
Payback: Pros and Cons
Pros
 Popular, ease of understanding, calculation and use
 Ranks higher projects that return cash sooner which is useful during
capital rationing
 Based on cash flows not profit

Cons
 No account of time value of money and cash received after payback
period
 Arbitrary cut-off discriminates against projects with longer lead times
 Measure of risk not profitability (lower the payback period, lower the
risk)
 Short-termist and may conflict with longer-term goals of firm
Accounting Rate of Return (ARR)

 Accounting rate of return = Av annual profit

Av capital investment
 where Average annual profit = total profit/years
 where Average capital investment = (initial capital investment +
scrap value)/2
 Lecture example 3 - Using the data below, calculate the ARR

Project C
Year 0 1 2 3 4
Cash flows (45000) 11000 12250 12250 32000
Depreciation (11250) (11250)(11250) (11250)
Accounting profit (250) 1000 1000 20750
Accounting profit (-250+1000+1000+20750)/4 = 5625
Average investment = 45000/2 = 22500
ARR = 5625/22500 = 25%
Accounting Rate of Return
Pros
 Easy to understand and communicate – managers relate
to profit; expressed as a %
 Takes account of profits over the whole project life

Cons
 No account of time value of money
 No agreed, clear method of calculating capital employed
or profits
 Assumes profit maximisation goal
 No account of risk or liquidity
Profit vs Cash Flow

Company X invests in plant and machinery costing £100,000 and

depreciates this over 4 years - £25,000 pa.

Sales revenue is £200,000. Operating costs are £150,000

Year Profit Cash Flow

0 - (100,000)
1 25,000 50,000
2 25,000 50,000
3 25,000 50,000
4 25,000 50,000
+ 100,000 + 100,000

NB Totals are the same BUT timing differs

------------------------------------------------------------------------------
Measuring value – Present Values

 To create wealth the present value of all future cash

inflows must exceed the present value of anticipated cash
outflows
 Future cash flows converted back into estimates of current
values by discounting
 Value maximising implies maximising these discounted cash flows
 Takes account of time value of money – a Sh now is worth more
than a Sh in one year’s time
 Time value of money depends on
 Opportunity cost – ability to reinvest cash flows in alternative
projects
 Inflation – inflation erodes the value of money
 Risk – a pound now is certain; not a pound receivable in a year
Measuring value – Present Values
 Compounding FV= PV(1+r)n
 The future value of the present value of £1

 £100 invested now at 10% compound interest:

 after 1 year £100 grows to 100(1+0.10)1 = £110

 after 2 years £100 grows to 100(1+0.10)2 = £121

 after 3 years £100 grows to 100(1+0.10)3 = £133.1

 After 4 years £100 grows to 100(1+0.10)4 = £146.41

 Discounting PV= FV / (1+r)n

 The present value of £1 in the future

 To earn a future sum of £1331 in 3 year’s time how much to invest

now at 10%?
 i.e. 1331 / (1 + 0.10)3 = £1000

 where r=10% represents the discount rate (or cost of capital or

required return or opportunity cost)
DCF methods- Net Present Value (NPV)

 NPV = difference between the present values of the cash inflows

and outflows of an investment when discounted at the cost of capital
or opportunity cost
 Projects are viable, ceteris paribus, when PV benefits > PV costs
i.e. +ve NPV
 A +ve NPV adds value to the firm and shareholders’ wealth
 Discounted Cash Flow appraisal infers finding the present value of
future cash flows
NPV = CF0 + CF1 + CF2 + CF3 ……. + CFn
(1+r)1 (1+r)2 (1+r)3 (1+r)n

NPV = ∑ CFt - CF0

t=1 (1+r)
 NPV – example
A company can purchase a machine for £2200. The machine has a
productive life of 3 years and net additions to cash inflows at the end of
each of the 3 years are £770, £968 and £1331. The company can buy
the machine without having to borrow and the best alternative is
investment elsewhere at an interest rate of 10%. Evaluate the project
using a) NPV and b) IRR

NPV = -2200 + 770/(1.10) + 968/(1.10)2 + 1331/(1.10)3 = 300 or…

Year Cash Flow Discount Factor (10%) PV

0 (2200) 1.000 (2200)
1 770 0.9091 700
2 968 0.8264 800
3 1331 0.7513 1000
300
NPV – Pros and Cons
Pros
 Leads to shareholder wealth maximisation

 Takes account of time value of money

 Takes into account whole life of project

 Absolute gain/loss shown

Cons
 May not be easily understood by managers (vs %)

 Does not take account of risk and liquidity issues

 Issue of choice of discount rate

DCF methods – Internal Rate of Return (IRR)
 IRR = the interest rate that equates the present value of the
expected cash flows or receipts to the initial outlay
 IRR = the discount factor that gives a zero NPV
n
0= ∑ CFt - CF0
t=1 (1+r)
 IRR compared to the target rate of return
 if IRR>target then undertake project
 Calculation?
 Trial and error – compute PVs of cash flows from 2 discount factors.
 If PV > cost then try higher DF & vice versa until PV of cash flows=cost
 Interpolation
IRR = L + NL x (H-L)
N L- N H
where L = lower interest rate; H= higher interest rate; NL = NPV at lower
interest rate; NH = NPV at higher interest rate
IRR – example
Year Cash Flow DF (16%) PV
0 (2200) 1 (2200)
1 770 0.8621 663.83
2 968 0.7432 719.42
3 1331 0.6407 852.77
+36.01

Year Cash Flow DF (17%) PV

0 (2200) 1 (2200)
1 770 0.8475 652.58
2 968 0.7305 711.48
3 1331 0.6244 831.08
-4.86
IRR – example
 IRR = L + NL x (H-L)
N L- N H

 Interpolation L= 16%; N = 17%; NL= 36.01; NH = -4.86

 [16 + 36.01 x (17-16)] % = 16 + 36.01 = 16.88%

36.01-(-4.86) 40.87
IRR – Pros and Cons
Pros
 Yield or IRR widely understood as a % return
 A discount rate does not need to be set to calculate IRR
 Takes into account the whole life of the project
 Takes into account the time value of money
Cons
 Potential confusion between DCF IRR or Yield and ARR
 Ignores relative size of projects
 More difficult to calculate than NPV
 Assumes reinvestment of cashflows at the prevailing IRR
 Multiple rates of return – if large cash outflows at end of project
life
 Multiple Rates of Return
 Initial investment then cash inflows followed by a cash outflow
 e.g. extraction industry – mining
 Year 0 buy land; years 1-10 income from mining; year 11 reinstate
land

-ve +ve -ve

NPV=0
DF
IRR 1 IRR 2

How overcome? - modified IRR by netting out +ve and –ve cash flows at end
e.g. Year 1 (500) becomes (500)
Year 2 800 600
Year 3 (200) -