LESSON 3

INVESTMENT APPRAISAL TECHNIQUES

CONT….
ICE BREAKER
 LESSON 3-LEARNING OUTCOMES

At the end of this lesson you should be able to:

• evaluate project proposals using the techniques of
investment appraisal.
• compare and contrast the alternative techniques of
investment appraisal
 QUICK QUIZ

• What are the different capital appraisal methods you are

familiar with?
 NET PRESENT VALUE (NPV)

• Present value can be defined as the cash equivalent now of a sum

of money to be received or paid at a stated future date,
discounted at a specified cost of capital.
• The net present value is the value obtained by discounting all the
cash outflows and inflows of a capital investment project, at a
chosen target rate of return or cost of capital.
• The present value of the cash inflows, minus the present value of
the cash outflows, is the net present value.
 NET PRESENT VALUE (NPV)
• If the NPV is positive, it means that the cash inflows from the
investment will yield a return in excess of the cost of capital and
thus the project should be undertaken, as long as there are no
other projects offering a higher NPV.
• If the NPV is negative, it means that the cash inflows from the
investment yield a return below the cost of capital and so the
project should not be undertaken.
• If the NPV is exactly zero, the cash inflows from the investment
will yield a return which is exactly the same as the cost of capital
and thus the project may or may not be worth undertaking
depending on other investment opportunities available.
ACCEPT OR REJECT CRITERIA FOR NPV
METHOD
EXAMPLE: NET PRESENT VALUE (NPV)
EXAMPLE FEEDBACK
 EXERCISE: NET PRESENT VALUE (NPV)
• Mackey Ltd is considering two mutually-exclusive projects with the following details;
EXERCISE: FEEDBACK
 ADVANTAGES AND DISADVANTAGES OF NPV

Advantages
• It takes into account the time value of money.
• Profit and the difficulties of profit measurement are excluded.
• Using cash flows emphasises the importance of liquidity.
• It is easy to compare the NPV of different projects.
Disadvantages
• It is not as easily understood as the payback and accounting rate of return.
• It requires knowledge of the company’s cost of capital, which is difficult to
calculate.
 INTERNAL RATE OF RETURN (IRR)

• IRR method calculates the exact rate of return which the project
is expected to achieve, based on the projected cash flows.
• It is the discount rate which, when applied to the projected cash
flows, ensures they are equal to the initial capital outlay.
• IRR is the discount factor which will give a NPV of zero.
• It is the actual return from the project, taking into account the
time value of money.
INTERNAL RATE OF RETURN (IRR)
IRR FORMULA
ACCEPT OR REJECT CRITERIA FOR IRR
METHOD
EXAMPLE: INTERNAL RATE OF RETURN
EXAMPLE FEEDBACK
 ADVANTAGES AND DISADVANTAGES OF IRR
Advantages
• The main advantage of the IRR is that the information it provides is more easily understood by
managers, especially non-financial managers.
Disadvantages
• The trial and error process of calculating the IRR can be time consuming, however this
disadvantage can easily be overcome with the use of computer software.
• It is possible to calculate more than two different IRR’s for a project. This occurs where the cash
flows over the life of the project are a combination of positive and negative values. Under these
circumstances it is not easy to identify the real IRR and the method should be avoided.
• In certain circumstances the IRR and the NPV can give conflicting results. This occurs because
the IRR ignores the relative size of investments as it is based on a percentage return rather than
the cash value of the return.
 CONFLICT BETWEEN NPV AND IRR
• The conflict between NPV and IRR occurs under the following
circumstances:
 In case of non- conventional cash flow
 In case of the disparity in sizes of the mutually exclusive project
 In case of disparity in the timing of the cash flows of the mutually
exclusive projects
 In case of disparity in the economic life of mutually exclusive
projects.
COMPARING MUTUALLY EXCLUSIVE PROJECTS
WITH UNEQUAL LIVES

• When comparing mutually exclusive projects, the appraisal method to use is the net
present value approach.
• However businesses often have to decide on two or more competing projects that
have unequal or different life spans.
• To simply compare the net present values of each project without looking at the
unequal lifespan would not be comparing like with like.
• The net present value of both projects needs to be expressed in equal terms.
• The ‘equivalent annual annuity method’ is used to compare the net present values on
an annualised basis.
COMPARING MUTUALLY EXCLUSIVE PROJECTS
WITH UNEQUAL LIVES

• Calculate the NPV of each project.

• Divide the NPV of each project by the annuity factor
for the period of the project. This calculates the
‘Equivalent Annual Annuity’ (EAA).
• Compare the EAA of each project, accepting the
project with the highest equivalent annual annuity.
EXAMPLE: PROJECT APPRAISAL WITH UNEQUAL
LIVES
EXAMPLE: FEEDBACK