Topic 9

Investment Appraisal
Techniques (1)

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 An Introduction

Accounting Rate of
Return (ROCE)
Traditional
Methods
Payback period

Net Present Value

DCF
Methods
Internal Rate of Return
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 Accounting Rate of Return

average annual accounting profit x 100

ARR = average investment (AI)

AI = initial investment + scrap value

2

• Also known as ROCE (return on capital employed)

• Individual projects: accept project if ARR is equal to or greater
than target value i.e. current ROCE
• Mutually exclusive projects: accept project with highest ARR
(as long as it is equal to or greater than target value ARR)
 Accounting Rate of Return
Example:
TC plc could buy a machine for £10,000. It will run for 5
years, then be sold as scrap for £2,000. Cash inflows
would be £3,000 per year. Ignore tax. What is the
machine's ARR?

Solution:
• Depreciation = (10,000 - 2,000)/5 = £1,600
• Average Annual profit = 3,000 - 1,600 = £1,400
• Average investment = (10,000 + 2,000)/2 = £6,000
• ARR = (1,400/6,000) x 100 = 23%

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 Accounting Rate of Return

Advantages of ARR:
• Many managers prefer to use accounting profits and they
understand ARR.
• ARR looks at the entire life of a project.
Disadvantages of ARR:
• It uses accounting profits, not cash flows, and it may not be
appropriate for investment decisions.
• ARR is a relative measure, it ignores the actual size of the
projects.
• It does not take into account the timing of the profits as it
ignores the time value of money.
• Ambiguities arise due to the many ways of calculating capital
employed.
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 Payback Period
• Number of years needed to recover the original
investment from project cash flows
• Example – Calculate payback period of Project A
and Project B
Year Project A Project B
0 (1,000) (1,000)
1 400 600
2 400 400
3 400 200
4 400 nil
Payback 2.5 years 2 years
Which project should be selected? 6
 Payback Period
Advantages:
• Payback is simple to understand
• Payback is easy to calculate (provided that you
have information about future cash flows)
• It uses cash rather than accounting profit
• It can be seen as taking risk into account ( in the
sense that earlier cash flows are more certain)
• It provides information about investment cash
flow
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 Payback Period
Disadvantages:
• Payback only considers cash flows within the
payback period: it has nothing to say about the
investment project as a whole
• It ignores both the size and timing of profits
• It ignores the time value of money
• It does not really take account of risk

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 Discounted Cash-flow Techniques
• £1 now is worth more than £1 in the future due
to uncertainty, inflation and pleasure.
• Money has time ‘productivity’.
• Cash flows arising at different times cannot be
directly compared.
• They must be converted to equivalent values at
a common time, e.g. present.

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 Net Present Value
Introduction:
• Takes account of the time value of money and
the amount and timing of all relevant cash flows
over the project life
• Difference between the present value of future
benefits and the present value of capital invested,
discounted at a company’s cost of capital.
• Non-mutually exclusive projects: accept all
projects with a positive net present value.
• Mutually exclusive projects: accept project with
highest NPV.
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 Net Present Value
NPV is given by:

C1 C2 C3 Cn
– I0 + ------ + ------ + ------- + ..... ------
(1+r) (1+r)2 (1+r)3 (1+r)n

Where:
• I0 is the initial investment
• C1, C2, . . Cn are the project cash flows occurring
in years 1, 2, . . n
• r is the cost of capital or required rate of return
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 Restrictions on using WACC as a
discount rate
Thinking about investment appraisal:
• The cost of capital (discount rate) must take account
of the risk of an investment project
• WACC can be used if the financial risk and business
risk of the investing company remain about the same
• No significant change in capital structure
• Investment project is like existing operations
• Investment is small compared to investing company

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 Net Present Value
Example:
Project costing £1,000 is expected to yield £500
per year for 2 years. What is the NPV?
Year Cash flow 10% PVF PV
0 (1,000) 1.000 (1,000)
1 500 0.909 455
2 500 0.826 413
NPV = (132)
Would you accept the project? No
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 Net Present Value
Advantages:
– Fully accommodates the three variables that affect SHW
(time, cash, risk)
– Allows for conventional and non-conventional cash
flows
– Allows for changes in discount rate during project life
– Gives an absolute (not relative) measure of project
value.
Difficulties:
– Estimating cash in-flows/out-flows over project life
– Cost of capital for may be difficult to determine
– Cost of capital may change over project life
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