LECTURE-6

INVESTMENT APPRAISAL TECHNIQUES

Accounting Rate of Return (ARR)

This method does not use time value of money in evaluating projects.

The accounting rate of return (ARR) approach calculates the return generated from net
income of the proposed capital investment.

Average Net Income

ARR 
Average Investment

The average investment is based on the book value of the project. The beginning book value
and the ending book value are averaged to obtain the denominator.

Beginning book value is the book value at the beginning of year 1 and ending book value is
the value at the end of useful life of the proposed investment.

beginning BV  Ending BV
Average Investment 
2

Interpretation of ARR
The ARR is a percentage return, such as 12%. If the ARR is equal to or greater than the
required rate of return, the project is acceptable. If it is less than the desired rate it should be
rejected. When comparing investments, the higher the ARR, the more attractive the
investment.

Illustration-1
An initial investment of ksh132,500,000 is expected to generate annual cash inflow of
ksh32,000,000 for 6 years. Depreciation is allowed on the straight-line basis. It is estimated
that the project will generate scrap value of ksh12,500,000 at end of the 6th year.

Required:
Calculate its accounting rate of return (ARR) assuming that there are no other expenses on
the project.

Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years

Annual Depreciation = (ksh132,500,000 − ksh12,500,000) ÷ 6 ≈ ksh 20,000,000 p.a

Converting cash flows into profits;

Profit = CF -Depreciation

Page 1 of 14
Average Accounting Income = ksh32,000,000 – ksh 20,000,000 = ksh12,000,000 p.a

beginning BV  Ending BV 132,500  12,500

Average Investment    ksh72,500
2 2

Average Net Income 12, 000

ARR    16.6%
Average Investment 72,500

Example-1
An asset with an initial cost of ksh 450 million is expected to generate cash inflows of ksh 90
million pa over 8 years of its usage. At the end of the eight-year period, the asset is expected
to have a salvage value of ksh 50 million. Depreciation is uniform for all the 8 years of the
asset’s life.

Required:
Calculate the ARR

Solution:

Average investment = (Beg. BV + End. BV)÷2 = (450+50)/2 = 250 million

Cash flow pa = 90 million

Depreciation pa = (BV beginning – Scrap Value)÷useful life of asset
Depreciation pa = (450-50)÷8 = 50 million pa
Net income = cashflow -depreciation
Net income = 90-50 = ksh 40 million pa

ARR = Average net income ÷ Average asset

ARR = 40÷ 250 = 16%

Example-2
An asset with an initial cost of ksh 700 million is expected to generate cash inflows of ksh
130 million pa over 9 years of its usage. At the end of the nine-year period, the asset is
expected to have a salvage value of ksh 70 million. Depreciation is uniform for all the 9 years
of the asset’s life.

Required:
Calculate the ARR

Payback Period Method

The payback period method (PB) calculates the time it takes to recover the initial cost of
project.

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 i) Equal Annual Cash Inflows
Payback period = Initial investment_____
Annual Cash Flow Amount

Illustration-2

The Delta company is planning to purchase a machine known as machine X. Machine X

would cost ksh 25,000,000 and would have a useful life of 10 years with zero salvage value.
The expected annual cash inflow of the machine is ksh8,000,000.

Required:
Compute payback period of machine X and conclude whether or not the machine would be
purchased if the maximum desired payback period of Delta company is 3 years.

Solution
Payback = initial cost ÷ cash flow
Payback = 25,000,000÷8,000,000 = 3.125 years
Since the company only accepts investments that pay back within 3 years, this investment is
NOT acceptable.

Example-1
The Jubilee company is planning to purchase a machine known as machine Q. Machine Q
would cost ksh 72,000,000 and would have a useful life of 6 years with zero salvage value.
The expected annual cash inflow of the machine is ksh28,000,000.

Required:
Compute payback period of machine Q and conclude whether or not the machine would be
purchased if the maximum desired payback period of Jubilee company is 4 years.

ii) Unequal Annual Cash Inflows

Under this method, one computes the cumulative cash flow until a value of zero is obtained.
If the zero cumulative cashflow does not exactly fit in this schedule, an interpolation method
is used to estimate the period that would coincide with zero cash flow

Illustration-3
A project costs ksh. 20,000,000 and has the following cash lows:

Period Cashflow
0 (20,000,000)
1 4,500,000
2 6,000,000
3 5,000,000
4 4,500,000
5 3,500,000
6 2,500,000

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 7 1,500,000

Required:
Determine the payback period.

Solution:
Period Cashflow Cumulative cashflow
0 (20,000,000) (20,000,000)
1 4,500,000 (15,500,000)
2 6,000,000 (9,500,000)
3 5,000,000 (4,500,000)
4 6,500,000 2,000,000
5 3,500,000
6 2,500,000
7 1,500,000

Hence the pay-back period lies between year 3 and year 4.

Using linear interpolation technique;

 45, 000 
Payback  3 yrs    x12 Months  3 yrs  8 months
 65, 000 

Example-1

A project costs ksh. 120,000,000 and has the following cash lows:

Period Cashflow
0 (120,000,000)
1 35,000,000
2 46,000,000
3 25,000,000
4 53,000,000
5 15,000,000
6 12,500,000
7 10,500,000

Required:
Determine the payback period and advise on the acceptability of the project if the company
only accepts projects that can pay back in 4 years or less.

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Solution:

Period Cashflow Cumulative cash flow

0 (120,000,000) (120,000,000)
1 35,000,000 (85,000,000)
2 46,000,000 (39,000,000)
3 25,000,000 (14,000,000)
4 53,000,000 39,000,000
5 15,000,000
6 12,500,000
7 10,500,000

Payback period = 3 years + 3 months. Thus the project is acceptable

Decision rule:
 For independent projects, the projects will only be accepted if its payback period is
shorter than a benchmark e.g. only projects with payback periods of 3 years and
below are accepted as a company policy.

 For mutually exclusive projects, the project with the shortest payback is accepted as
long as it is within the benchmark.

Discounted payback method

This method discounts the cash flows to be used in determining the payback period.

Year Cashflows PVIF PV Cumulative

Cash flow

Net Present Value (NPV) Method

This is a technique that compares the present values of the future cash inflows generated by
an investment to the present value of the cash outflows. Generally, NPV is determined as
follows:

NPV= PV of cash inflows – initial investments

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 n
CFt
NPV=   CF0
(1 r)
t
t 1

NPV = ∑(CFi x PVIFi) – I

Decision rule:

1. For independent projects accept the projects having positive NPVs

2. For mutually exclusive projects accept the project that has the highest positive NPV

Illustration 4:

Project X costs ksh 25,000,000 and is expected to generate year-end cash inflows of ksh
9,000,000, ksh 8,000,000, ksh7,000,000, ksh 6,000,000, and ksh 5,000,000 in years 1 through
5. The opportunity cost of capital (rate of return) for the company is 10%.

Required:

Calculate the net present value for the project and advise on the suitability of the project

Solution:

PVIF = (1+r)-n = 1.1-n

Year Cash flows PVIF PV

(Ksh)
0 (25,000,000) 1.000 (25,000,000)
1 9,000,000 0.909 8,181,000
2 8,000,000 0.826 6,608,000
3 7,000,000 0.751 5,257,000
4 6,000,000 0.683 4,098,000
5 5,000,000 0.621 3,105,000
NPV 2,249,000
The project has a positive NPV hence suitable

Alternative format:

Year Cash flows PVIFr=10% PV

(Ksh)
1 9,000,000 0.909 8,181,000
2 8,000,000 0.826 6,608,000
3 7,000,000 0.751 5,257,000
4 6,000,000 0.683 4,098,000
5 5,000,000 0.621 3,105,000
Total present value-PV 27,249,000
Less: Initial Investment (25,000,000)

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 NPV 2,249,000

Since the NPV is positive, the project is acceptable

Example-1
Consider an investment with an initial outlay of ksh 48 million with the following stream of
ash inflows:
Year Cash inflow
1 14,000,000
2 16,000,000
3 8,000,000
4 22,000,000
5 0
6 4,000,000

The company has a 14% required rate of return.

Required:
Calculate the NPV and advise on the acceptability of the project.

Solution:
Year Cash inflow PVIFr=14% PV
1 14,000,000 0.8772 12,280,800
2 16,000,000 0.7695 12,312,000
3 8,000,000 0.6750 5,400,000
4 22,000,000 0.5921 13,026,200
5 0
6 4,000,000 0.4556 1,822,400
Total PV 44,841,400
LESS: Initial Investment 48,000,000
NPV (3,158,600)

Since NPV is negative, the project is NOT worthwhile.

4. Profitability Index/Benefit Cost Ratio

This is the ratio of the present value of cash inflows to the initial investment.

In NPV technique, we get PV and less Initial Investment. In Profitability Index, we get PV
and divide it by the Initial Investment.
n

 CF 1  r 
t
t
PI  t 1
CF0

Decision rule:

 Accept independent projects if the PI is greater than 1

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  For mutually exclusive projects, accept the project that has the highest PI that is
greater than 1

Illustration-5

Use the facts in illustration-4 above and calculate the profitability index for the project.

Refer to 4:

Project X costs ksh 25,000,000 and is expected to generate year-end cash inflows of ksh
9,000,000, ksh 8,000,000, ksh7,000,000, ksh 6,000,000, and ksh 5,000,000 in years 1 through
5. The opportunity cost of capital (rate of return) for the company is 10%.

Required:

Calculate the PI for the project and advise on the suitability of the project

Solution

Year Cash flows PVIFr=10% PV

(Ksh)
1 9,000,000 0.909 8,181,000
2 8,000,000 0.826 6,608,000
3 7,000,000 0.751 5,257,000
4 6,000,000 0.683 4,098,000
5 5,000,000 0.621 3,105,000
Total present value 27,249,000

PI = PV÷I = 27,249,000÷25,000,000 = 1.08996

Since the PI is greater than 1, the project should be accepted.

Trivia-1

A project with an initial cost of ksh 6,000,000 has a PI of 1.125. calculate the project’s NPV.

Trivia-2

A project has an initial cost of ksh X and a profitability index of 1.375. The NPV for the
project is ksh 187,500. Calculate the value of X.

NPV of 187,500 = 0.375 of X

IF 0.375x = 187,500

X= 187,500/0.375 = 500,000

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Trivia-3

A project has an initial cost of ksh 4,500,000 and a profitability index (PI) of 0.875. Calculate
the NPV

PV÷I = PI

PV/4,500,000 =0.875

PV=0.875x4,500,000= 3,937,500

NPV = PV-I

NPV =3,937,500-4,500,000 = (562,500)

Internal Rate of Return (IRR)

Internal rate of return refers to the discount rate that equates the present value of cash inflows
to the Initial Investment.

Mathematically the IRR is determined as follows:

n
CFt
0=   CF0
(1 IRR)
t
t 1

n
CFt
Thus; CF0= 
(1 IRR)
t
t 1

NPV = PV -I

NPV = ∑(CFt x PVIFt) – I

0 = ∑(CFt x PVIFt) – I

NB;

The higher the r- the lower the PV and vice versa.

Example:

Year Cash flows PVIFr=10% PV

(Ksh)
1 9,000,000 0.909 8,181,000
2 8,000,000 0.826 6,608,000
3 7,000,000 0.751 5,257,000

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 4 6,000,000 0.683 4,098,000
5 5,000,000 0.621 3,105,000
Total present value-PV 27,249,000
Less: Initial Investment (25,000,000)
NPV 2,249,000

The PV of 27,249,000 is higher than initial investment of ksh 25,000,000. Therefore, the r-
should be increased to a level above 10% so that the PV reduces from the 27,249,000.

Try r =12%

PVIF = (1+r)-n

Year Cash flows PVIFr=12% PVIFr=14 PVr=12% PVr=14%

(Ksh)
1 9,000,000 0.8929 0.8772
2 8,000,000 0.7972 0.7695
3 7,000,000 0.7118
4 6,000,000 0.6355
5 5,000,000 0.5674
Total present value-PV 26,046,300 ?
Less: Initial Investment (25,000,000) (25,000,000)
NPV 1,046,300 (74,600)
r=14% r=?% r=12%

NPV=0 +1046300
-74600
Y X
1120900

14% - 3/8X2%
12%+5/8X2

IRR=12% + 1046300 x (14%-12%)= 13.87%

(74,600+1046300)

IRR=14% - 74,600 x (14%-12%)= 13.87%

(74,600+1046300)

Decision Rule;
 If the IRR is greater than the cost of capital, accept the project
 If the IRR is less than the cost of capital, reject the project

IRR is calculated by means of an interpolation method as follows:

+𝑣𝑒𝑁𝑃𝑉
IRR = 𝑅𝐿 + (+𝑣𝑒𝑁𝑃𝑉+−𝑣𝑒𝑁𝑃𝑉) (𝑅𝐻 − 𝑅𝐿 )

NB- the absolute amount of the negative NPV is used in the above formula;

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Illustration 5:

Project X costs ksh 25,000,000 and is expected to generate year-end cash inflows of ksh
9,000,000, ksh 8,000,000, ksh7,000,000, ksh 6,000,000, and ksh 5,000,000 in years 1 through
5. The opportunity cost of capital for the company is 10%.

Required:
Calculate the IRR for the project.

Solution:
Try a rate of 13%:

YEAR CASH FLOWS PVIFr=13% PV

0 -25000000 1 -25000000
1 9000000 0.885 7965000
2 8000000 0.783 6264000
3 7000000 0.693 4851000
4 6000000 0.613 3678000
5 5000000 0.543 2715000
473000

Try another rate now a higher rate so as to obtain a negative NPV e.g. 15%

YEAR CASH FLOWS PVIF PV

0 -25000000 1 -25000000
1 9000000 0.87 7830000
2 8000000 0.756 6048000
3 7000000 0.658 4606000
4 6000000 0.572 3432000
5 5000000 0.497 2485000
-599000

 veNPV 
IRR = RL  
 veNPV  veNPV   RH  RL 
 

 
15%  13% 
47300
IRR= 13% + 
 47300  59900 

IRR= 13.88%

Alternatively;

 veNPV 
RH     RH  RL 
 veNPV  veNPV 

If, however the cash flows are uniform, then the calculation of the IRR is simplified as
follows;

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Since uniform cash flow mean annuity, then the present value of this uniform stream is
equated to the initial investment as follows:

CF0= A(PVIFr,n)

CF0
 PVIFA
A

By looking up the resulting value in the annuity tables for the period n gives the internal rate
of return.

Example-1

A project promises to generate the following streams of cash flows

Year Cash inflow

1 450,000

2 680,000

3 810,000

4 940,000

The initial cost is ksh 2,000,000 and the required rate of return for the project is 9%.

Required:

Calculate the project’s IRR using linear interpolation method.

Solution:

Year Cash inflow PVIFr=9% PVr=9% PVIFr=16% PVr=16%

1 450,000

2 680,000

3 810,000

4 940,000

PV 2,276,563 1,931,450

Less: Initial Investment (2,000,000) (2,000,000)

NPV +276,563 -68,550

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Sum of the NPV ratios = 276,563 +68,550 = 345,113

IRR = 16% - (68,550/345,113)x (16%-9%)

IRR = 16% - 1.39 = 14.6%

OR

IRR = 9% + (276,563/345,113) x (16%-9%)

IRR = 9% + 5.6% = 14.6%

In the case of uniform cash flows (Annuities),

The IRR formula becomes simple as follws:

NPV = PV -I

At IRR, NPV = 0

0 = PV-I

I=PV

But PV = CF x PVIFA

I = CF x PVIFA

But I and CF are known,

PVIFA = I÷CF

PVIFA = 8,000,000 ÷ 2,300,000 =3.4783

Check this 3.4783 out in the present value of annuity table as follows:

The IRR is 20%

Page 13 of 14
Illustartion-7

Sunlight company needs a machine for its manufacturing process. The cost of the new
machine is ksh. 12,500,000. The expected useful life of the machine is 8 years. At the end of
8-year period, the machine would have no salvage value. After installation, the machine
would increase cash inflows by ksh. 2,600,000 per year. Sunlight is interested to know the
internal rate of return (IRR) of the machine to accept or reject this investment. The minimum
required rate of return of the company is 14% on all capital investments.

Required:

1. Compute IRR of the machine.

2. Is it acceptable to purchase the machine?

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