INVESTMENT

APPRAISAL
TECHNIQUES
PREPARED BY: MS SHAZ
 What is Capital Budgeting?
• Capital budgeting is a decision that involves broad strategic aspects
of the company, in which managers analyze alternative long-term
investments.
• Examples of capital budgeting decisions:

Launch a new plant or plant expansion

Purchase new machinery
Equipment replacement
Equipment selection
 What is Capital Budgeting? (cont.)
• Nature of a capital budgeting decision:
(a) Outlays of large amounts of resources
(b) Non-reversible
(c) Strategic and risky
Capital Budgeting Evaluation Process
a) Identify potential capital investments
b) Forecast future net cash flow
c) Analyze potential investment
d) Choose among alternative investments
when the resources are not sufficient to
fund all profitable projects
e) Perform post-audits after making capital
investment
Capital Budgeting Evaluation Process
(cont.)
There are two main types of
capital budgeting decisions:

Screening Decisions Preference Decisions

Pertain to whether Attempt to rank

or not some acceptable
proposed alternatives from
investment is the most to least
acceptable; these appealing.
decisions come first.
 Capital Budgeting Decisions

a. Accounting b. Payback
rate of return period

Methods used to evaluate

capital expenditure decisions

c. Net present d. Internal rate

value of return
Capital Budgeting Decisions (cont.)
Mattel is evaluating a proposal to invest in a new children’s
MP3 product that would require an up-front investment of
$1,000,000. The product’s estimated life cycle is five years,
Mattel estimates the new product’s income over the next five
years as follows:
Sales Revenue $ 700,000
Less: Cash Operating Costs (320,000)
Depreciation (200,000)
Pre-Tax Income 180,000
Less: Taxes @ 30% (54,000)
Net Income $ 126,000

Should Mattel invest in this project?

 Accounting Rate of Return

Average Initial Accounting

Annual
Net Income
÷ Investment /
2
= Rate of
Return

$126,000 ÷ $1,000,000 /
2 = 25.2%

Average Annual
Net Income
Accounting Rate of Return (cont.)

Decision rule:
Accept the project if its ARR is greater than the
company’s target rate of return;
otherwise, reject it.
 Accounting Rate of Return (cont.)
Pros Cons
 Simple  The time value of money is
ignored.
 Intuitive
 The accounting rate of
return is based on net
income instead of cash
flow.
 Alternative accounting
methods may have an
impact on reported net
income.
Typical Cash Outflows
•The initial investment

•Additional amount of working capital

•Repairs and maintenance

•Additional operating costs

Typical Cash Inflows (cont.)
•Incremental revenues

•Reduction in costs

•Salvage value

•Release of working capital

 Time Value of Money

One ringgit received today is

worth more than one ringgit
received a year from now
because the dollar can be
invested to earn interest.

For example RM1,000 today,

invested at 10%, will be worth
RM1,100 in one year.
Discounted Cash Flow Methods

Now let’s look at capital budgeting methods

that consider the time value of cash flows:

Net Present Internal Rate

Value (NPV) of Return (IRR)
 Net Present Value (NPV)

Net present value analysis emphasizes on

discounted cash flows.

The reason is that accounting net income is

based on accruals that ignore the timing of
cash flows into and out of an organization.
 Net Present Value (NPV) (cont.)

 Choose a discount rate k – the

minimum required rate of return.

 Calculate the present

value of annual net cash flows CFt.

n
CF1 CF2 CFn CFt
NPV = CF0  
(1  k )1 (1  k ) 2
    
(1  k ) n t 0 (1  k )t
Net Present Value (NPV) (cont.)
Decision Rule under NPV
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return (discount rate).

Acceptable, since it promises a

Zero . . . return equal to the required rate of
return (discount rate).

Not acceptable, since it promises

Negative . . . a return less than the required rate
of return (discount rate).
Net Present Value (NPV) (cont.)
Let’s return to Mattel’s MP3 proposal. Recall that the up-front
investment is $1,000,000, and the product’s estimated life is
5 years. Mattel’s required rate of return, or hurdle rate,
is 12%. Mattel estimates the new product’s income
over the next five years as follows:

Sales Revenue $ 700,000

Less: Cash Operating Costs (320,000)
Depreciation (200,000)
Pre-Tax Income 180,000
Less: Taxes @ 30% (54,000)
Net Income $ 126,000
Net Present Value (NPV) (cont.)
Equal Annual Cash Flow
Year Cash Flow PV Factor Present Value
0 $ (1,000,000) $ (1,000,000)
1 326,000 × 0.893 = 291,085
2 326,000 × 0.797 = 259,887
3 326,000 × 0.712 = 232,047
4 326,000 × 0.636 = 207,173
5 326,000 × 0.567 = 184,972
Net Present Value = $ 175,165

Since the NPV is positive, we know the rate of return

is greater than the 12 percent discount rate.
 Net Present Value (NPV) (cont.)
Equal Annual Cash Flow

Year Cash Flow PV Factor Present Value

0 $ (1,000,000) $ (1,000,000)
1-5 326,000 × 3.6048 = 1,175,165
Net Present Value = $ 175,165

Year PV Factor
1 0.893
2 0.797
3 0.712 The present value of an annuity of $1
4 0.636 for 12%, 5 years is the sum of the present
5 0.567 value of $1 factors for 12%, 5 years.
Total 3.605
Internal Rate of Return (IRR)

The internal rate of return is the true economic

return earned by the asset over its life. It is computed by
finding the discount rate that makes…

NPV =
0 CF1 CF2 CFn
 CF0   
(1  IRR ) (1  IRR)
1 2
(1  IRR) n
n
CFt

t  0 (1  IRR )
t
Internal Rate of Return (IRR) (cont.)
Decision rule under IRR
Internal Required then Positive
Rate of > Rate of NPV
Return Return
Internal Required then Zero
Rate of = Rate of
NPV
Return Return

Internal Required then Negative

Rate of < Rate of
NPV
Return Return
 Internal Rate of Return Method
Equal Annual Cash Flow
• Find the discount factor:
Investment required
= Present value factor
Net annual cash flows
$1,000,000
= 3.067
$326,000

The
The present
present value
value factor
factor (3.067)
(3.067) is
is located
located onon the
the table
table of
of
present
present value
value of
of annuity.
annuity. Scan
Scan the
the 5-year
5-year row
row and
and locate
locate
the
the value
value 3.067.
3.067. The
The internal
internal rate
rate of
of return
return isis
somewhere
somewhere between
between 18% 18% andand 20%.
20%.
Comparing the NPV and IRR Methods

Net Present Value Internal Rate of Return

 The required rate of return The required rate of return is

is used as the actual compared to the internal rate

of return on a project
discount rate
To be acceptable, a project’s
 Any project with a
rate of return must be greater
negative net present
than the cost of capital
value is rejected
Assumes that cash flows are
 Easier to adjust for risk
reinvested at the IRR
 Profitability Index

Project A Project B Project C

Present Value of
Future Cash Flows $ 600,000 $ 810,000 $ 1,200,000
Initial Investment 300,000 450,000 800,000
Net Present Value 300,000 360,000 400,000

Mattel is trying to decide how to prioritize their limited

research and development budget. They are
considering these three independent projects.

How should Mattel prioritize these three projects?

 Profitability Index (cont.)

The profitability index (PI) is an additional tool to

help managers compare investment projects with different sizes.

Profitability
Index =
Present Value of
Future Cash flows ÷ Initial
Investment

Decision rule:
The higher the PI, the more desirable the project.
 Ranking Investment Projects

Project A Project B Project C

Present Value of
Future Cash Flows $ 600,000 $ 810,000 $ 1,200,000
Initial Investment 300,000 450,000 800,000
Net Present Value 300,000 360,000 400,000
Profitability Index 2.0 1.8 1.5

Based on the profitability index, Project A

should be first, followed by Project B, then C.
 Additional Considerations
1. Intangible benefits:
• Increased quality
• Improved safety
• Greater employee loyalty
• More favorable social influence

2. Risk issues in capital budgeting

(a) Sensitivity analysis
(b) How to deal with risky projects
Post-audit of Investment Projects
• A post-audit is a follow-up evaluation after the project
has been approved to see how well a project’s actual
performance matches the original projections.
• A post-audit is important because:
a) Managers are more likely to submit reasonable and
accurate data when they make investment proposals.
b) The company can dynamically assess the projects and
determine whether to continuously support or terminate
existing projects.
c) Managers will improve future investment proposals and
implementation.
REVIEW QUESTION 1
• A company is considering the purchase of a copier that costs
$5,000. Assume a cost of capital of 10 percent and the following
cash flow schedule:

• Year 1: $3,000
• Year 2: $2,000
• Year 3: $2,000
• Determine the project's NPV and IRR.
ANSWER 1
• to determine the NPV, enter the following:
• PV of $3,000 in year 1 = $2,727, PV of $2,000 in year 2 = $1,653, PV
of $2,000 in year 3 = $1,503.
• NPV = ($2,727 + $1,653 + $1,503) − $5,000 = 883.
• You know the NPV is positive, so the IRR must be greater than 10%.
• [3000 ÷ (1 + 0.2)1 + 2000 ÷ (1 + 0.2)2 + 2000 ÷ (1 + 0.2)3] − 5000 = 46
This result is closer to zero (approximation) than the $436 result at
15%. Therefore, the approximate IRR is 20%
REVIEW QUESTION 2
•A firm is planning a $25 million expansion project. The project will
be financed with $10 million in debt and $15 million in equity stock
(equal to the company's current capital structure). The before-tax
required return on debt is 10% and 15% for equity. If the company
is in the 35% tax bracket, what cost of capital should the firm use
to determine the project's net present value (NPV)?
A. 12.5%
B. 9.6%
C. 11.6%
ANSWER 2
• WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)
• WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) =
0.09 + 0.026 = 0.116 or 11.6%
REVIEW QUESTION 3
• Nippon Post Corporation (NPC), a Japanese software development firm, has
a capital structure that is comprised of 60% common equity and 40% debt.
In order to finance several capital projects, NPC will raise USD1.6 million by
issuing common equity and debt in proportion to its current capital
structure.
• The debt will be issued at par with a 9% coupon and flotation costs on the
equity issue will be 3.5%. NPC’s common stock is currently selling for
USD21.40 per share, and its last dividend was USD1.80 and is expected to
grow at 7% forever. The company’s tax rate is 40%. NPC’s WACC based on
the cost of new capital is closest to:
• A) 11.8%.
• B) 9.6%.
• C) 13.1%
ANSWER 3
• kd
= 0.09(1 – 0.4) = 0.054 = 5.4%
• kce
= [(1.80 × 1.07) / 21.40] + 0.07 = 0.16 = 16.0%
• WACC = 0.6(16.0%) + 0.4(5.4%) = 11.76%
• Flotation costs, treated correctly, have no effect on the cost of equity component
of the WACC
REVIEW QUESTION 4
• Two projects being considered by a firm are mutually exclusive and have the
following projected cash flows:
• Project 1 Cash Flow Project 2 Cash Flow
• 0 −$4.0 ?
• 1 $3.0 $1.7
• 2 $5.0 $3.2
• 3 $2.0 $5.8
• The crossover rate of the two projects’ NPV profiles is 9%. What is the initial cash
flow for Project 2?
ANSWER 4
• A) −$4.22.
• B) −$4.51.
• C) −$5.70