Chapter 11

Investment appraisal techniques

The investment decision-making process

• Origination of proposals.
• Project screening : This will involve a qualitative evaluation of the investment options.
• Analysis and acceptance : This will involve a financial analysis of the investment options, using
the organisation’s preferred investment appraisal techniques.
• Monitoring and review.

Methods of investment appraisal

The payback period

The payback period is the time required for the cash inflows from a capital investment project to equal the
initial cash outflows.

An organization may accept a capital project if its payback period is equal to or less than the target
payback period.

Payback is typically a first screening process, and may be combined with other project appraisal
techniques to arrive at investment decision.

Payback calculation is based on cash inflow which is calculated as profits before depreciation.

Advantages of Payback

• Payback period will indicate how long capital is being tied up, this indicating investment risk
• Focus on payback can enhance liquidity
• Shorter term forecasts may be more reliable
• Quick and simple to calculate
• An easily understood concept

Disadvantages of Payback

• Ignores timing of cash flows within the payback period

• Ignores cash flows after the payback period
• Ignores time value of money
• Cannot distinguish between projects with the same payback period
• Choice of cut-off period may be arbitrary
• Does not take into account variability of cash flows

The accounting rate of return

• The Accounting Rate of Return (ARR) expresses the average accounting profit as a percentage of
 the capital investment. ARR can use either of the following two formulae:

ARR = Average annual accounting profit X 100%

Initial investment

ARR = Average annual accounting profit X 100%

Average Investment

The average investment is calculated as (initial investment + scrap value)

2
ARR is the only appraisal method that uses accounting profits instead of cash flow.

Worked example: Page 266

The ARR method can be used to compare two or more projects which are mutually exclusive. The project
with the highest ARR may be selected (provided the expected ARR is higher than the company's target
ARR).

Interactive Question 1: Page 266

Advantages of ARR

• Quick and simple to calculate

• It involves a familiar concept of a percentage return
• Accounting profits can be easily calculated from financial statements
• ARR looks at the entire project life
• appraisal method which employs profit may be more easily understood
• It allows more than one project to be compared

Disadvantages of ARR

• It is based on accounting profits which is subject to a number of different accounting policies

• It takes no account of the size of the investment
• It does not account of length of the project
• It does not take account of the timing of the profits from a project
• it ignores the time value of money.

Terminal value

The terminal value is the value of an investment at a given point in future.

Formula for the future value or terminal value of an investment is V = X (1+r)n

Where,
V is the future value
X initial or `present’ value of investment
r is the rate of return
n is the number of time periods.
Worked example: Terminal Value- Page 268

Discounting

Discounting is the calculation of converting the future value of an investment to the present value, which
is the cash equivalent now of the future value.

Discounting formula X = V/(1+r)n

Tk. 1 earned after one year will always be worth more than Tk 1 earned after two years.

Discount factor

Discount factor is calculated as 1/(1+r)n

Interactive Question 2- Page 269

Net present value (NPV)

This measures the change in shareholder wealth now as a result of accepting a project.

NPV = present value of cash inflows less present value of cash outflows

• If the NPV is positive the project should be undertaken.

• If the NPV is negative, the project should not be undertaken as it will fail to generate the
organization’s required rate of return
• If the NPV is exactly zero, the project will have a neutral impact on shareholder wealth. In this
case also, the project should not be accepted undertaking due to inherent risk factors.

Worked example: NPV- Page 269

Timing of cash flows

• A cash flow to be incurred at the beginning of an investment project ('now') occurs in time 0. The
present value of Tk1 now, in time 0, is Tk1 regardless of the value of the discount rate r.
• A cash flow which occurs during the course of a time period is assumed to occur all at once at the
end of the time period (at the end of the year).
• A cash flow which occurs at the beginning of a time period is taken to occur at the end of the
previous time period. Therefore a cash outflow of Tk. 100 at the beginning of time period 2 is
taken to occur at the end of time period 1.

DCF calculations are always based on cash flows and not accounting profits.
Annuities
An annuity is a series of constant cash flows for a number of years.

Annuity factor formula= 1 ( 1- 1

r (1+r)n

Worked example- Annuity- Page 270

Net terminal value

Net terminal value (NTV) is the cash surplus remaining at the end of a project after taking account of
interest and capital repayments. The NTV discounted at the cost of capital will give the NPV of the
project.

Worked example- Net Terminal Value- Page 271

Advantages of NPV

• Directly calculates in cash terms of maximising shareholder wealth.

• It considers the time value of money
• It considers all relevant cash flows, so that it is unaffected by the accounting policies (unlike
ARR).
• Risk can be incorporated into decision making by adjusting the company’s discount rate.
• Gives clear, decisions (positive- accept, negative- reject)

Disadvantages of NPV

• Selecting an appropriate discount rate may be critical.

• Does not factor in the opportunity cost of investment

Interactive Question 3: Page 272

Time value of money

Why a present Tk 1 is worth more than a future Tk 1

• Due to risk factors, management can never be certain that the money will be received until it has
actually been received.
• Inflation may devalue value of money in future.
• An individual attaches more weight to current pleasures than to future ones.
A comparison of the ROI and NPV methods

In many case, investments be rejected if the ROI measure were to be used, despite the fact that the
investment's NPV may be positive, meaning the project will be earning more than the target rate of return
(Example of sub-optimal decision making)

See section 4.12- Page 273

Discounted Payback

The discounted payback period is the time it takes for a projects cumulative NPV to turn from negative to
positive.

Worked example: Page 274

Advantages of discounted payback period

• Easy to understand and calculate,

• Provides a focus on liquidity
• Takes into account the time value of money
• it produces a longer payback period than the payback period (safer approach)
• It takes into account more of the project's cash flows
• Provides clear accept-or-reject criterion

Disadvantages of discounted payback period

• Ignores cash flows after the payback period.

The discount rate

• Selection of discount rate is critical in investment decision making.

• Cost of capital (therefore required rate of return) can fluctuate widely over fairly short periods of
time,
• Management may therefore wish to use different discount rates at different points over the life of
a project. This is possible if NPV and discounted payback methods of appraisal are being used,
but IRR and ARR methods are based on a single rate.

Delayed annuities- Cash flow starts at end of year 2 or later

Annuities in advance- Cash flow starts at end of year 0

Worked example- page 275

Perpetuity
An annuity that lasts forever
Perpetuity = CUa (Cash flow per annum divided by discount rate)
r

Worked example- Perpetuity- page 275

Changing discount rates

In NPV calculation, management may wish to change discount rates across period.

Year 0 Year 1 Year 2

NPV = outflow + inflow/(1+r1) + inflow/(1+r1)(1+r2)

Worked example- Page 276

The Internal rate of return (IRR)

IRR is the discount rate at which the NPV is zero.

If the IRR exceeds a target rate of return, a project can accepted.

Graphical approach- worked example- page 277

IRR formula= a + ___NPVa___ (b-a)

NPVa-NPVb

Where, a is the first discount rate giving NPVa

b is the second discount rate giving NPVb

Worked Example- Page 278

Interactive Question 4- Page 280

Advantages of IRR

• Easily understood
• A discount rate does not have to be specified before the IRR can be calculated.
• Based on cash flows.
Disadvantages of IRR
• Ignores the relative size of investments
• IRR cannot incorporate it when discount rates are expected to differ over the life of the project.
• IRR method is not the most useful when project has non-conventional cash flows or when
deciding between mutually exclusive projects.

Non-conventional cash flows

- If the sign of the net cash flow changes in successive periods (inflow to outflow or vice versa), it is
possible for the calculations to produce up to as many IRRs as there are sign changes.
- In such cases, management may often reject the project due to lack of knowledge of multiple IRR (See
section 5.5- Page 281).
- The use of the IRR is therefore not recommended in circumstances in which there are non- conventional
cash flow patterns. The NPV method, on the other hand, gives clear results whatever the cash flow
pattern.

Mutually exclusive projects

The IRR and NPV methods can give conflicting rankings when assessing which project should be given
priority.
Typically under such circumstances, the NPV method provides the more accurate investment decision.

See example in section 5.6- Page 282

Interactive question 5- Page 283

Reinvestment assumption

NPV method assumes that net cash inflows generated will be reinvested elsewhere at the cost of capital.
The IRR assumes these cash flows can be reinvested elsewhere to earn a return equal to the IRR of the
original project.
This may not be practical as in reality, organizations will generally accept projects earning the cost of
capital.