Financial Reporting to Management

BSc Business Management

Capital Budgeting: Investment Appraisal Techniques

Student’s name: Nguyễn Thế Tân

Student’s ID: 2233027
Email: [email protected]
Marking tutor: Miss Huỳnh Thị Ngọc Anh
Date of submission: 15/01/2022

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Contents
I. Introduction....................................................................................................3
II. Discussion of the need for investment appraisal.....................................4
III. Critical evaluation of the methods of investment appraisal...................5
A) Accounting rate of return.....................................................................5
B) Payback Period.....................................................................................6
C) Net present value..................................................................................7
D) Internal rate of return............................................................................8
IV. Conclusion..................................................................................................9
V. Bibliography.................................................................................................10
VI. Appendix......................................................................................................12

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I. Introduction
According to Lisa Borga, all investments include some level of risk, and when a specific

investment necessitates a substantial number of inputs, an investment assessment should

take into account both quantitative and qualitative components of the venture. With this

paper, will cover about the need of capital investment appraisal and critically evaluate all

the method.

The utilization of proper methods of assessment and investment appraisal, which is the

method of determining whether or not a certain investment is viable. In practice, four

primary methodologies are utilized by firms throughout the world to analyze investment

prospects, with ARR and ROCE following the same method (K. H. Erickson,2003):

a) Accounting rate of return (ARR)

b) Payback period (PP);

c) Net present value (NPV);

d) Internal rate of return (IRR).

With this, the paper will contain 4 parts which will explain about the investment appraisal

and discuss about the method of investment appraisal. And also every methods will have

an example do help more understanding and talk about it problem when using the method.

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II. Discussion of the need for investment appraisal

One of the most typical goal in investment evaluation is to maximize shareholder value

because the majority of choices are made by corporations, whose directors are obligated to

follow the best interests of their investors. According to Kaplan Financial, the following

elements must be considered when developing judgment measures that maximize

shareholder value: Cash is preferable and exceeding the cost of the capital, must be high

enough to compensate for both the cost of equity as well as the cost of debt. In a Harvard

Corporation Review article, Peter Drucker stated: "A business functions at a loss until it

delivers a profit that is more than its cost of capital. It doesn't matter that it pays taxes as

though it had a real profit. Up to that point, the firm does not produce wealth; rather, it

destroys it, returning less to the economy than it consumes in resources”.

By gathering information from books and articles made by Gerald L. Salamon(1985),

Katrina Sutherland(2020) and Robert Schmidt(2022) and compose them together, finally

the table at appendix A will compare them to each other.

III. Critical evaluation of the methods of investment appraisal.

a) Accounting rate of return (ARR)

A capital budgeting indicator that can be used to quickly determine a project's

profitability is the accounting rate of return. Most of the time, businesses apply ARR to

evaluate various projects, to figure out the expected RoR on each one or to help them

make a decision on an investment or purchase. ARR takes into account all of the project's

potential annual expenses, including depreciation. Spreading out a fixed asset's cost over

its useful life, or depreciation, is a useful accounting technique. Even in its first year of

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operation, the corporation can profit immediately from the asset because of this

(Murphy,2022).

True Tamplin stated that the accounting rate of return is one of the most commonly utilized

measures for determining the profitability of an investment.

- The formula for calculation: ARR = (Average annual profit / Initial investment) * 100

ARR estimates the return provided by the planned capital investment's net income. The

ARR is a percentage rate of return. If the ARR is greater than or equal to the required rate

of return, the project is approved. If it is less then it should be rejected. When comparing

investments, the more appealing an investment is, the higher the ARR. More than half of

large corporations use ARR to value projects (Arnold,2007).

One advantage of ARR is that it is typically simple to compute and comprehend. It takes

into account the savings or gains that the project generates over its entire economic life.

Now for the down side of it, after showing the result it really confusing when the outcomes

change depending on whether ROI or ARR is calculated.

With an example at appendix B, the accounting rate of return of the investment project
could currently be determined in one of two ways (for more detail look at appendix B):

- ARR = ($8,000 / $45,000) x 100% = 17.78%

- ARR = ($8,000 / $27,500) * 100% = 29.09%

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Now there are some problem that appear. First of how is the target set ? Could it be

17.78% or 29.09% ? And which calculation way should be used? (appendix B)

b) Payback period (PP)

Payback helps figure out how long it takes to pay back an investment's initial costs.

Payback is thought to emphasize management's concern for adaptability and the necessity

of quickly recovering the initial investment to reduce risk. The payback technique (PP) is

frequently used to evaluate capital investments in businesses despite its shortcomings.

According to Segelod(1995), although payback period utilization as a single criterion has

decreased over time, its utilization as a supplementary metric has increased. The

employment of the payback technique as the only or primary approach appears to be

increasingly widespread in small and medium-sized businesses (Longmore,1989).

- The formula for calculation: PP = (Cost of Investment / Average annual cash flow)

The advantages of the payback period include the fact that it is a method for calculating the

required time that is relatively simple and does not require a great deal of complexity.

However, when projects are evaluated using a basic payback method, according to Pike

(1985), the error caused by not taking into account the time value of money in the payback

calculations partially offsets the error caused by neglecting the post-payback cash flows.

The second difficulty is that it does not correctly estimate the temporal worth of money, in

other words, it overlooks the timing of the returns ( Julia Kagan,2022).

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Appendix C.1 will show why is ignoring the value of money over time when calculating PP is

problematic and C.2 will demonstrate why is it a problem to ignore the cash flows after the

payback period.

c) Net present value (NPV)

The total of the present values of receiving (benefits) and losing (costs) cash flows

over a period of time is known as the Net Present Value (NPV) or Net Present Worth

(NPW) (Lin and Nagalingam,2000). A cash flow nowadays is more valuable than a future

cash flow equivalent, as opposed to a future flow, which cannot be invested immediately

and earn rewards (Berk et al.2015). NPV is frequently utilized in accounting, finance, and

economics due to its importance during discounted cash flow (DCF) analysis (Balen et

al.1988;Naim et al.2007).

-The formula for calculation: NPV = Cash flow / (1 + r)^t – initial investment

In this case, r is discount rate and t is number of time periods.

The fact that NPV is based on the idea that money held in a bank today is worth less than

money acquired in the future is its strength. The NPV method generates a monetary value

that reflects the value the project will bring to the business, and future cash flow is

discounted back to the present to determine its value. In addition, the primary drawback of

employing the NPV is that it requires accurate guesswork regarding an organization's cost

of capital and future cash flows. The NPV method is not suitable for comparing projects with

different investment levels.

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The example at appendix D will demonstrate the problem and help understanding the depth

of using NPV in real life. After all the calculation, the net present value for Golden Owl

($30,113) and B`owl ($21,315), which lead to the problem what project will the CEO and the

CFO select ? (appendix D).

d) Internal rate of return (IRR)

The internal rate of return is a statistic used in financial statement analysis to

calculate the profitability of possible investments (IRR). An examination of discounted cash

flows shows that the IRR is a discount rate that sets the net present value (NPV) of all cash

flows at zero ( Jason Fernando,2022). Investors and managers of businesses can use the

IRR, which is expressed as a percentage, to compare the profitability of various

investments or capital expenditures. If everything else is the same, an investment with a

higher IRR is better than one with a lower IRR (Mark Henricks,2022).

The pros of using the IRR is that it can find the value of money which is it can be

determined by the rate of interest at which the quantity of capital required and the present

value of future revenues equal each other, as well as the absence of the hurdle rate.

However, when comparing projects, the IRR method does not take into account project

size, which is a drawback. Moreover, the IRR method only considers the anticipated cash

flows brought about by a capital injection and disregards any potential costs that may arise

in the future that could have an impact on profit (Philippe Lanctot,2019).

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- The formula for calculation: IRR = [ Cash flow / (1+r)^t ] - Initial investment

Where cash flow is the cash flow in the time period, r is discount rate and t is the time

period.

Let look at the example at appendix E. When NPV is not at zero we have to rise discount

rate, thus NPV at the rate of 13% = ($24) as calculated in excel below (appendix E).

Following the example, studies show that one of the most common capital budgeting

methods is the internal rate of return, despite the fact that ideally, net present value, which

is a measurement of the absolute amount contributed by a project, is a superior predictor of

a project's viability. This is due to the sporadic occurrence of unusual cash flows (Irfanullah

Jan,2019).

IV. Conclusion

Through applying them to our case, this report has determined the significance of

investment appraisal methods in financial management decision-making, particularly in the

capital budgeting process. When calculating an investment evaluation ARR, PP, NPV, and

IRR are all very important. Each of them has a unique characteristic and is suitable for

anyone interested in investing.

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 Bibliography

- Arnold, G. (2007). Essentials of corporate financial management. London: Pearson

Education, Ltd. Available from:
https://www.sciencedirect.com/science/article/abs/pii/S0305048305001209?via%3Dihub

- Balen RM, Mens H-Z, Economides MJ (1988) Applications of the Net Present Value (NPV)
in the optimization of hydraulic fractures. Society of Petroleum Engineers, Charleston.
Available from:
https://onepetro.org/SPEERM/proceedings-abstract/88ERM/All-88ERM/SPE-18541-MS/
187586

- Berk J, DeMarzo P, Stangeland D (2015) Corporate finance, 3rd edn. Pearson Canada,
Toronto.

- Chris B. Murphy, (2022) Accounting Rate of Return (ARR): Definition, How to Calculate,
and Example. Investopedia. Available: https://www.investopedia.com/terms/a/arr.asp

- K. H. Erickson, (2003) Investment Appraisal: A Simple Introduction

- Irfanullah Jan, (2019). Internal Rate of Return (IRR). XPLAIND. Available from:
https://xplaind.com/484996/irr

- Jason Fernando (2022). Internal Rate of Return (IRR) Rule: Definition and Example.
Investopedia. Available from: https://www.investopedia.com/terms/i/irr.asp#:~:text=What
%20Is%20Internal%20Rate%20of,a%20discounted%20cash%20flow%20analysis./

- Julia Kagan (2022). Payback Period Explained, With the Formula and How to Calculate It.
Investopedia. Available from:
https://www.Investopedia.com/terms/p/paybackperiod.asp#:~:text=The%20payback
%20period%20disregards%20the,to%20recover%20the%20funds%20invested./

- Kaplan Financial Knowledge Bank (nd), Investment Appraisal. Available from:

shorturl.at/cpIS6

- Lin GCI, Nagalingam SV (2000) CIM justification and optimisation. Taylor & Francis,
London.

- Lisa Borga (2022), Investment Appraisal: Explained & Defined with Examples and
Formulas. Available from:https://fundsnetservices.com/investment-appraisal/

- Longmore, D. (1989). The persistence of the payback method: a time-adjusted decision rule
perspective.

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- Mark Henricks (2022). What Is Internal Rate of Return (IRR)?. smartasset. Available from:
https://smartasset.com/investing/what-is-irr

- Naim MM, Wikner J, Grubbström RW (2007) A Net Present Value assessment of make-to-
order and make-to-stock manufacturing systems. Omega 35(5):524–532.

- Peter F. Drucker, (1995) The Information Executives Truly Need. Harvard Business
Review. Available from: https://hbr.org/1995/01/the-information-executives-truly-need/

- Philippe Lanctot (2019). The Advantages and Disadvantages of the Internal Rate of Return
Method. Chron. Available from: https://smallbusiness.chron.com/advantages-disadvantages-
internal-rate-return-method-60935.html

- Pike, R.H. (1985). Disenchantment with DCF promotes IRR. Certified Accountant.

- Robert Schmidt, (2022) Understanding the Difference Between NPV vs IRR. Available
from: https://propertymetrics.com/blog/npv-vs-irr/

- Salamon, G. L. (1985). Accounting rates of return. The American Economic

Review, 75(3), 495-504.

- Segelod E. (1995), Resource Allocation in Divisionalized Groups, Ashgate, Avebury.

- Sutherland, K. (2020) Investment Appraisal-Payback Period and Accounting Rate of

Return.

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 Appendix

Appendix A

Accounting
Points of Net present Internal Rate Payback
Rate of Return
difference value (NPV) of Return (IRR) Period(PP)
(ARR)
IRR is
NPV in the form expressed in
Expressed as PB in the form ARR in the form
of currency the form of
of a time period. of a percentage.
returns. percentage
returns.

IRR is
NPV focuses on
concerned with
determining Payback is
calculating the ARR is
whether the concerned with
break even rate, specialized to
investment is establishing the
which is the calculating the
Focus generating time span over
point at which percentage
surplus returns which the initial
the present returns on an
than the investment may
value of future investment
expected be returned.
cash flows
returns.
equals zero.

The
employment IRR does not ARR does not
of a discount have this Payback does face the
rate, which problem not employ problem of
Discount rate
might be difficult because it discount rates determining a
to determine, 'calculates' the either. suitable
is required for rate of return. discount rate.
NPV.

The present The same goes

The present
The present value of future to ARR. ARR
Calculation of value of future
value of future cash flows does not
Present Value cash flows is
cash flows is is likewise measured the
calculated
ignored by IRR. ignored by the present value of
using NPV.
PB technique. cash flows

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Appendix B

A corporation is thinking about investing in a project that would require a $45,000 initial
investment in a machine. Net cash inflows of $7,000 will be created in the first two years,
$13,000 in the third and fourth years, and $40,000 in the fifth year, following which the
machine will be sold for $5,000.

- Cash inflow in year 1 and 2 ($7,000 x 2) $14,000

- Cash inflow in year 3 and 4 ($13,000 x 2) $26,000

- Cash inflow in year 5 $40,000

- Depreciation ($45,000 - $ 5,000) (40,000)

- Total profit of the project $40,000

Next, we must turn this profit of the project into an average value, which is $8,000
($40,000/5).

Now that we've determined the numerator, we must investigate the denominator, which is
the initial investment and the average investment. So in this case:

- The initial investment is $45,000

- The average investment is ($45,000 + $10,000) /2 = $27,500

- ARR = ($8,000 / $45,000) x 100% = 17.78%

- ARR = ($8,000 / $27,500) * 100% = 29.09%

If the target in the example is 20% then one calculation would be denied but other is

accepted, indicating that changing the calculation method might vary the conclusion

concerning whether the project should be approved or rejected. Other problems about

accounting rate of return, the timing of the financial flows is neglected, as is the time value

of money.

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Appendix C.1

Assume you had two $10,000 investments to pick from. The initial investment yields $6,000
in cash in year one, $4,000 in year two, and $1,000 in year three. The second investment
brings in $6,000 in year one, $4,000 in year two, and $1,000 in year three. The following is
a summary of the two investments:

Investment 1 Investment 2
Year 0 $(10,000) $(10,000)
Year 1 $6,000 $4,000
Year 2 $4,000 $6,000
Year 3 $1,000 $1,000

Both have a payback period is 2 year but they don’t have the same value. Because in year
one, the first investment generates significantly more cash than the second. In fact,
calculating the IRR to compare these two investments would be preferable. The IRR on the
first investment is 6.42%, while the IRR on the second investment is 5.71%.

The comparison of these two projects highlights the benefits and drawbacks of employing
the net present value approach. Although it does provide some initial insights into the
financial viability of various projects, there are frequently additional qualitative factors that
must be taken into consideration.

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Appendix C.2

Assume $50,000 can be invested in 2 separated project as such:

Investment 1 Investment 2
Year 0 $(60,000) $(60,000)
Year 1 $30,000 $5,000
Year 2 $30,000 $5,000
Year 3 $5,000 $50,000
Year 4 $0 $25,000

The first investment has a two-year payback time, while the second investment has a three-
year payback period. If the manager requires a payback period less or equal to 2 years
then the first investment would be an answer. However, during its payback time, the first
investment yields just $5,000 in cash, but the second investment provides $25,000 in cash.
Despite the fact that the second investment creates considerable cash inflows after year
three, the repayment approach ignores both of these amounts. Hence, calculating the IRR
to compare both of these investments would be ideal. The IRR on the first investment is
5.11%, while the IRR on the second investment is 11.96%.

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Appendix D

The Vanoss Corporation has had an extremely successful year selling its winning gaming
mouse, the Golden Owl. However, the director believes that the business should be more
dispersed since it is overly dependent on one product. Vanoss' CFO is currently debating
whether to invest $180,000 in a brand-new manufacturing facility to develop the
groundbreaking B'owl gaming mouse or spend $80,000 expanding Golden Owl's current
production facilities.

With the Golden Owl, the firm has a long history of sales. It consistently ranks among the
best sellers and is quite successful. The sales team is unsure of how many of the B'owl
gaming mouse's sleek designs they can sell, on the other hand. They believe it will be a
popular item, but they are unable to make any certain sales predictions.

These are the figures for the plant expansion and new plant projection:

Expand Production for

New Plant For B`owl
Golden Owl
Cost $80,000 $180,000
Time period 5 years 5 years
Rate 10% 10%
Year 1 cash flow $23,000 $40,000
Year 2 cash flow $25,000 $46,000
Year 3 cash flow $29,000 $53,000
Year 4 cash flow $33,000 $63,000
Year 5 cash flow $39,000 $71,000

All the calculation below is calculated in excel

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The CFO would choose to increase production of Golden Owl because it has the highest

net present value —$30,113 versus $21,315— if the decision were solely based on which

project has the highest net present value. However, this indicates that Hasty Rabbit's

product line will continue to rely solely on the Golden Owl.

Appendix E

An investment has a $220,000 cash outflow at first. The first, second, third, and fourth years

are anticipated to see cash inflows of $66,200, $93,000, $76,100, and $58,400,

respectively. Let's say the rate is 10 percent.

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Since NPV is greater than zero we have to increase discount rate, thus NPV at 13%

discount rate = $($24) as calculated in excel below.

Since NPV is close to zero at 13% value of r, therefore IRR = 13%

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