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Suad Bećirović

DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

Novi Pazar, 2006.

DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

CONTENTS 1. Investment and Finance......................................................................................................7 2. Acquisition Costs................................................................................................................7 3. Residual Value....................................................................................................................7 4. Useful Life..........................................................................................................................7 5. Cost of Capital....................................................................................................................8 1.1. Overview..........................................................................................................................9 1.2. Equivalent Annual Cost Method....................................................................................10

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.........17 Illustration 12: Example of Two Competing Investments.........8 Illustration 4: Factors for determining the cost of capital..................................................23 3 ....................................................................................................................DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL List of Illustrations Illustration 1: Overview of the several types of investment.8 Illustration 5: Methods for Investment Appraisal........13 Illustration 9: Example for an Accounting Rate of Return Method..5 Illustration 3: Different types of useful life......9 Illustration 7: Example for an Equivalent Annual Cost Method......................................................................................................19 Illustration 15: Example for Determining the Internal Rate of Return with the Approximation Method..........................19 Illustration 14: Example for Using the Net Present Value Method in Comparing Two Alternatives..................................18 Illustration 13: Example for a Net Present Value calculation...............4 Illustration 2: Steps in Project Appraisal..............................................................21 Illustration 16: Example for Calculating an Annuity........................................................................................................................................................................................................15 Illustration 11: Example for Non-Monetary Criteria in the Value Benefit Analysis..................................14 Illustration 10: Example for Simple Payback Method..........................................................................................12 Illustration 8: Example for a Profit Comparison Method.......................................9 Illustration 6: Operands and Characteristics of the Static Methods................................22 Illustration 17: Example for Dynamic Payback Method..................................................................................................................................................

. in order to have an advantage compared to their competitors. Script Investition und Finanzierung. the company expects a profit. Type of investment Examples: Diversification Investment − A company decides to produce its product in a foreign country for the foreign market Expansion Investment − Due to high demand. p. G. As compensation of this abandonment and the fact that the company cannot use this liquidity anymore for other purposes. innovation of modern production equipments and processes or changes in the markets of the manufactured products. 1 Wöhe. Figure 1 gives an overview of the several types of investment or reasons for an investment. 618 4 . the available capacity will be expanded Modernisation Investment − An existing IT-equipment will be replaced by a more powerful equipment Rationalisation Investment − A machine falls regularly out. in order to minimize the production costs Maintenance investment First or Construction Investment − A machine will not be replaced.. For this purpose. p.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL Introduction Organisations operate in a dynamic environment. so the company will produce the part on its own − Start-up of a company − Construction of a branch Finance Investment − A company wants to buy shares of a supplier for a strategic partnership − Temporary investment of excess liquidity in stocks and shares Security Investment Personnel Investment − Increase of safety stock of raw materials − Expenditures for education of personnel Illustration 1: Overview of the several types of investment Source: Schulte. rationalisation investments are intended to change the production process. a company has to invest large sums of money. Therefore they have to meet the challenges that the dynamic nature of the environment brings. the decision for an investment means to give up liquidity. which can be seen in illustration 2. To meet these challenges. so it has to be decided whether it should be replaced by a better machine ⇒ Contrary to a modernisation investment. the decision for an investment takes place in several steps.”1 As every investment contains risks. but repaired − A supplier announces to increase its prices. an investment can be defined as “spending of money now in the hope of higher returns in future. All these causes require new investments. The need for investments is a daily occurrence in a company: obsolescence and excess of age of machines. means of transportation and buildings. increasing expenses for maintenance and servicing. Einführung in die Allgemeine Betriebswirtschaftslehre. in order to have more liquidity in future. S. 8 For a company.

p. there must be a reason or cause for an investment. After making this decision. Such a comparison is important for two reasons. the types of investment. G. On the one hand. several methods for investment appraisal have been developed. because this will lead to a misinvestment. Investment appraisals are aids to forecast and assess the future success of an investment. This person supervises that the project will be realised within the technical standards and the planned finance and time frame. On the other hand. 622 5 . 625 Ibid. p. By means of these methods a decision will be made. on the occasion of an accounting variance. On the other hand this assessment enables the investor to do a better forecast for future investments. A misinvestment occurs. At the stage of implementation of the investment proposal. To realise this goal. which project is the most efficient and allows the greatest possible profit. the investor has to check. shown in figure 1. a detailed investigation will take place in order to examine the projected cash flows of the project. whether the project is technically feasible and commercially viable. 4 Ibid. p.2 After realisation of the project. S. This involves assessing the risks and deciding whether the project is in line with the company's long-term strategic objectives. this also shows the danger. which will be discussed in detail in this paper. The main motivation for an investment is profit maximisation.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL Motivation for an Investment ⇓ Initial Investigation ⇓ Evaluation of the Investment ⇓ Decision for an Investment ⇓ Implementation of the investment ⇓ Investment Controlling Illustration 2: Steps in Project Appraisal Source: Schulte. the planned cash flows have to be compared with the actual cash flows. 13 Investment Appraisal Firstly. Script Investition und Finanzierung.. if an investment appraisal is not executed correctly.. Therefore. In order to make the correct decision.3 This short description of the steps in a project appraisal shows what importance investment appraisals have in the framework of this process. the investor has to implement retaliatory action. So these methods play an important role in the appraisal of a project.4 2 3 Wöhe. the investor has to check the economic efficiency of the project. responsibility for the project is assigned to a project manager or another responsible person.. Einführung in die Allgemeine Betriebswirtschaftslehre. can be used. After realisation of the necessity of an investment and what type of investment the company wants to conduct. when the actual cashflows are so much behind the original expectations that it would have been better for the investor not to undertake the investment.

which are mentioned in the literature for this purpose. So. in order to have a better understanding of the methods of investment appraisal. we will clarify essential fundamental terms of finance and investment. whether these methods are useful or not. At the beginning of the study. 2. Besides the method. Thus. the following steps will be carried out: 1. 6 . So. it will be possible to assess. the reader should be able to separate these terms. Goals of the Thesis Due to the great importance of the investment appraisals in project appraisal. Means of Research In order to fulfil the mentioned goals. we will investigate. After this.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL Methodology 1. 2. whether these methods are able to meet the required tasks. this study has the goal to investigate the standard methods. we will discuss the advantages and disadvantages of every single method. we will present the different methods of investment appraisal.

4. Examples for such additional costs. In this case it has to be calculated with the production costs. These terms have the following meaning: Finance: Provision of liquid funds. there are several types of useful life. advisory opinions etc. which are shown in the following table: 5 Gabler Wirtschaftslexikon. Launching costs for implementing. p. In practice. until the investment object can be used. Acquisition Costs Normally there is no problem to determine the costs for the acquisition of an investment object. usually longterm.5 2. Residual Value Besides the acquisition costs. The residual value has to be considered. Investment and Finance The terms investment and finance have to be differentiated. 3. orientation etc. because they describe contrasts. the value of the investment object at the end of the useful life has to be considered. in which the investment object is used according to its purpose. Useful Life The useful life is the period. because it effectively decreases the acquisition costs in the calculation of the investment appraisal. Fundamental Terms 1. test runs. Therefore it is important to add all costs. which occur. besides the acquisition price.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL I. capital lockup in order to receive future returns. can be: Costs for rebuilding due to changes and displacement of the available machines or other assets Installation costs for assembly. the object can be manufactured by the company itself. e.g. by taking a credit to finance a project Investment: An investment is the dedicated. The residual value is the expected sales revenue of an investment object at the end of the calculated useful life. Engineering costs for necessary investigations. 1636 7 . Besides the acquisition of the investment object from outside. installation etc. It has to be observed that all costs for the acquisition are recorded.

DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL Technical Useful Life Period. buildings) is technically able to fulfil its purpose. in which an asset (especially machines. Illustration 4 shows several methods for determining the cost of capital. Therefore the main disadvantage of this type is that this useful life is determined according to the taxation policy and not according to economic aspects. 5.. in order to limit the maximum possible depreciation of an object. when an old object should be replaced by a new one. which leads to the biggest possible profit of an investment object. the economic useful life is the most important. Script Investition und Finanzierung. Therefore the technical useful life is longer than the economic one. i. Legal Useful Life The legal useful life is in particular relevant for intangible assets like licences. property rights and furthermore for leasing contracts. Illustration 3: Different types of useful life Source: See Script Investition und Finanzierung & Gabler Wirtschaftslexikon For the investment appraisals. Important factors here are: • Technical wear out • Technical development • Economic development Average Useful Life Average useful life is usually determined by the tax authorities. This length is determined by the respective contracts.e. Methods for Determining the Cost of Capital Costs of Financing − Cost for loan capital − Cost for equity capital Opportunity Costs − Choice of the interest rate of the next best excluded alternative as internal rate of return. S. Therefore. the main problem in determining the economic useful life is the calculation of the optimal replacement time. Economic Useful Life Useful life. p. 9 of 8 . Cost of Capital Cost of capital represents the minimum interest rate demanded by the investor. Determination is made according to statistical investigations or experience figures. It is possible to extend this period substantially by preventive maintenance and repair. Therefore those costs are included into the calculation. − Determination internal rate method via the of return Other Methods − Rate of return of the company − Rate of return similar companies Bank interest modified by: − expected inflation rate − tax rate − risk surcharge Illustration 4: Factors for determining the cost of capital Source: Schulte.

p. Static Methods In the static methods. they usually calculate only with one period. which consider the time value of money in their appraisals.. They do not consider the time factor.und Börsenwesens. i. Bank. we will present and discuss these methods. 6 Knapps Enzyklopädisches Lexikon des Geld-. Overview With regard to the used operands and number of planning periods. Overview over the Different Methods for Investment Appraisal Methods for Investment Appraisal Static Methods Equivalent Annual Cost Method Profit Comparison Method Accounting Rate of Return Static Payback Method Illustration 5: Methods for Investment Appraisal Source: Own Picture Dynamic Methods Net Present Value Method Annuity Method Dynamic Payback Method The methods for investment appraisal are divided into static and dynamic methods.1. the following methods can be differentiated: Operands Equivalent Annual Cost Method Profit Comparison Method Accounting Rate of Return Static Payback Method costs costs and revenues costs and revenues cash flows Number of the considered periods one one one several Illustration 6: Operands and Characteristics of the Static Methods Source: Wöhe.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL II. Therefore.6 1. 1027 9 . Einführung in die Allgemeine Betriebswirtschaftslehre. profits and rate on returns are compared. p. 629 In the following.e. Therefore static methods are more and more ousted by the dynamic methods. The main difference between these types is that static methods usually consider only one period and particularly do not consider the interest on capital (especially compound interest). costs. the results are only useful for relatively short periods. G. revenues. 1.

Furthermore. According to this method. it has to be considered that this money could also be invested in interest-bearing investments.2. The cost accounting depreciation can be calculated with the following formula: Cd = C − RV UL Cd = cost accounting depreciation C = acquisition costs RV = residual value UL = useful life 10 . However. This method can be used in comparing. the interest on this loan has to be paid. if a residual value exists. 1. if the project is financed by equity capital. the alternative with the minimal costs has to be chosen. Determination of the Single Types of Costs 1. In investment appraisals.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL 1. which should be included into this calculation. The average capital employed bases on a simple calculation of the average.1. it can be used in comparing several comparable replacement investments. linear depreciation is usually used. so the investment causes opportunity costs.1. this has to be considered at calculating the average.2. we will present the single types of costs. Therefore. The interest charges are calculated on the basis of the average capital employed. On the other hand. On the one hand.2. Character The equivalent annual cost method compares the costs of several investment alternatives. Determination of the Cost of Capital The cost of capital is calculated in order to consider the costs for the acquisition of the loan or equity capital. the depreciation of the investment object is considered.2. if a credit is taken from a bank.2. all occurring costs should be included into this calculation.2. In the following section.2. So we can conclude the following formula for this calculation: Cc = C + RV *i 2 Cc = cost of capital C = acquisition costs RV = residual value i = interest rate 1. whether a replacement investment is favourable (comparison: old asset/new asset). Equivalent Annual Cost Method 1. Determination of the Cost Accounting Depreciation With the cost accounting depreciation.2.2.

1. in order to get the real depreciation of the investment object. it has to be subtracted from the acquisition costs.2. Determination of the Operating Costs The operating costs consist especially of the following types of costs: Personnel costs: - Wages Salaries Fringe benefits Raw materials Auxiliary material Operating supplies Repair costs Inspection costs Service costs Material costs: - Maintenance costs: - Occupancy costs Energy costs Tooling charges 11 .3.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL If there is a residual value at the end of the period.2.

000 € 10.3.500 € 11.000 10. which leads to inaccuracies − At comparing alternatives. 1.500 € 13.000 € 15. it is often difficult to separate the costs in variable and fixed − The extent of capital expenditure is not considered adequately 1.500 € 7. Useful Life (years) 5 5 3. Total Fixed Costs 24.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL 1.000 € 12.500 € 2. Machine 1 Machine 2 1.000 5.500 € 13. Total Variable Costs 7.000 € 10.000 € 6.2.70 € 1.000 € 700 € 8.3. according to this method. Depreciation (€/year) 18. machine 2 has to be chosen as an investment. Profit Comparison Method 12 . because only the costs of one period are taken into account − Future differences in quality and capacity are not considered − In practice. Utilisation (units/year) 10. Therefore. Variable costs per unit 0.000 € 0 4. Acquisition Costs 100.55 € 13.4.500 € 1. Cost of Capital (interest rate of 10%) 5. Total Costs 31. Material Costs (€/year) 1. Other Fixed Costs 1. Labour Costs 4. different useful lives are not considered.000 € 2.700 € 12.000 € 50. Residual Value 10.700 € Illustration 7: Example for an Equivalent Annual Cost Method Source: Own Illustration We can see that machine 2 has smaller total costs. Assessment Advantages: − Simple application − Relatively easy data collection Disadvantages: − Possible accrual of costs at different times is not considered − Only period is assessed.2. Energy and other costs 800 € 2.200 € 9. Example The following table shows two investment alternatives with their respective costs.500 € 28.

static method − Different extent of profits in the single periods are not considered − Assignment of the revenues to the single investment objects is usually very difficult 7 8 Schulte.000 € 28. 22 Boegelspacher. besides the costs. If the possible revenues of the alternatives are different.500 € Machine 2 35.3. So we receive the following results: Machine 1 Revenues Costs Profit 40.. so investment objects with different revenues can be compared − Simple application − Relatively easy data collection Disadvantages: − Short-term. Script Investition & Finanzierung.300 € Illustration 8: Example for a Profit Comparison Method Source: Own Illustration In this case.1. the revenues are taken into account. so it could be possible that the output quantity is the same. K. p. S. the revenues are also included into the calculation. Here.50 € per unit. 1. but the products of one alternative are qualitatively superior and could be sold at a higher price However. For example the products of machine 1 can be sold at 4 € per unit and the products of machine 2 for 3. a comparison of the rate of return should be executed. Script Finanzierung und Investition.500 € 8.8 1. Example We will use the same example.2. in which different revenues occur.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL 1.700 € 6. some authors are of the opinion that the profit comparison method should not be used.3. Assessment Advantages: − Besides the costs. 26 13 . machine 1 is more favourable than machine 2. because in all cases.3. the profit comparison method has to be carried out. Reasons for different profits could be:7 a) The investment alternatives have different performance features (e.g. Character The profit comparison method is an extension of the equivalent annual cost method.3. maximum output) b) The investment alternatives have different qualitative characteristics. as in the previous section. p.. because the equivalent annual cost method would lead to wrong conclusions.000 € 31.

1. 631 For the calculation of the average capital employed see section 1.1 14 .9 Ac u tin con g Rte a o Rtun f e r = C r e te or c d Ae a e vr g Cp l a ita Poit rf E p yd mlo e *1 0 0 According to this method. 1. has much a greater average capital employed. Assessment 9 10 Wöhe..500 € 5. in relative terms. machine 2 is more favourable.2.5 % Machine 2 35. the costs of capital. Example Machine 1 Revenues Costs Profit Cost of Capital Corrected Profit Average Capital Employed10 Accounting Rate of Return 40.2. besides the actual profits. an investment is advantageous. G.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL − Already realised profits are compared with future possible ones − This method only compares absolute profits.500 € 8.500 € 8.4. 1.2 % Illustration 9: Example for an Accounting Rate of Return Method Source: Own Illustration It is interesting that according to this method. Therefore the accounting rate of return determines the relative advantage of an investment.000 € 35. The reason for this is that machine 1. but does not compare the rates of return 1. For the calculation of the rate of return.000 € 31. Character One of the essential disadvantages of the equivalent annual cost method and profit comparison method is that they assess investment opportunities without consideration of the necessary employment of capital. while the profit comparison method proposed machine 1. when the rate of return is greater than the minimum rate of return or the investment with the greatest rate of return is the most favourable.700 € 6.800 € 25. Here the corrected profit of a period is related to capital employed on average. The corrected profit contains.4. Therefore. machine 2 is more favourable. despite its greater absolute profits. Einführung in die Allgemeine Betriebswirtschaftslehre.500 € 14.4.000 € 55. this method uses the results of the annual cost and profit comparison method. p.3.4.300 € 2.2.000 € 25. In that way this method wants to consider greater differences in the acquisition costs.000 € 28. Accounting Rate of Return 1.

So.300 €) 16. Assessment 11 Knapps Enzyklopädisches Lexikon des Geld-. The depreciation is subtracted from the revenues at calculation of the profit. machine 2 has to be chosen.5.000 €) 15.000 € 5 26. Example Machine 1 Acquisition Costs Useful Life (years) Cash Flow Year 1 (cumulative) Cash Flow Year 2 Cash Flow Year 3 Cash Flow Year 4 Payback Period 100. p.000 €) 12. In this method it is assumed that the whole cash flow is used exclusively for the payback of the investment. This method calculates the period.000 € (100. However. Furthermore.300 € (16. The payback period is the period in which the acquisition costs of the investment are “paid back”.e.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL The greatest advantage of the accounting rate of return method is that it determines the relative advantage of an investment. Bank.000 €) 4 years Machine 2 50. this assumption is not very realistic. The methods. practically at every interest rate). So the approximate cash flow can be determined. 1. This method has the same disadvantages as the profit comparison method.5. 1028 15 .000 €) 25.11 However. this method does not take into account the time value of money in determining the rate of return. the profits have to be corrected by the depreciation.5.000 € (48.700 € (33. Character The static payback method is the only static method. but the depreciation is not affecting payment.17 years Illustration 10: Example for Simple Payback Method Source: Own Illustration According to this method.500 €) 27. which is necessary to compensate the acquisition costs by the annual cash flows of the investment. which uses data of several periods. i. it supposes that the differences in the acquisition costs can be invested at the respective accounting rate of return (i. An investment is advantageous when it has a short payback period. this method has the same advantages as the profit comparison and equivalent annual cost method. use costs and revenues.e. 1.3.000 € 5 16.000 € (60. Furthermore.000 €) 3.500 € (54.1. discussed so far. returned to the company.2. Simple (Static) Payback Method 1.5.500 € (26.und Börsenwesens. 1. so it has to be added to the profits.000 €) 21. in order to calculate the cash flow.000 € (79.

The single criteria are weighted and every investment alternative receives certain points according to its fulfilment of the criteria. e.g. It is a method to assess alternatives according to non-monetary criteria. 16 . 1. technical. Therefore this method should complete every investment appraisal.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL Advantages: − Simple application − Shows how fast the acquisition costs return to the company − Relatively easy data collection Disadvantages: − Simple payback does not take into account the time value of money − It ignores cash flows received after the end of the payback period − It does not take into account the overall profitability of the project. psychological or social criteria. The alternative with the most points is chosen. Value Benefit Analysis The value benefit analysis is not a classical method for investment appraisal.6. Illustration 11 shows some examples for such criteria.

K. 29/30 17 .. p.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL Market Criteria • • • • Market Share Saturation of the Market Product Range Market Strategy Availability of Qualified Labour Availability of Raw Material Service Delivery Time Accident Prevention Dust. Script Investition & Finanzierung.and Procurement Criteria • • • • Labour Physiological Criteria • • • • • Infrastructure Criteria • • • • Technical Criteria • • • • • Environmental Criteria • • • • Illustration 11: Example for Non-Monetary Criteria in the Value Benefit Analysis Source: Bögelspacher.and Post-Capacity Waste Disposal Universal Availability Capacity Reserves Degree of Automation Maturity of Construction Disturbances during Installation Accordance with Magisterial Planning Environmental Impact due to Emissions Image Improvement in the market Meeting Socio-Political Needs Labour. Noise and Other Annoyances Intellectual Capability Manual Capability Handling Internal and external transport possibilities Energy Supply Pre.

If the result gives a positive net present value. whether the combination of profits of project B are probably more favourable than of project A.12 The following example will show the differences between the dynamic and static methods: Project 1 A B 10 27 Profits in the years 2 20 20 3 30 10 20 19 Average Illustration 12: Example of Two Competing Investments Source: Knapps Enzyklopädisches Lexikon des Geld-.1. because they take into account the time value of money. but greater profits at the beginning of the period. but has small profits at the beginning of its use. 1.Ot qt NPV I O t n = net present value = cash inflows in the years1 to n = cash outflows in the years1 to n = period (t = 0. the dynamic methods try to consider all periods. the net present value is saying that one should compare like with like. project B has a smaller average profit. Because today’s one Euro can be invested and receive income from it. The dynamic methods give an answer to this question.. The present values of these future cash flows can then be compared with what we are spending now on the project. Character This method compares the present values of cash outflows and inflows. then the project is favourable. 1027 In this case. the greater the net present value is. 2. However. p. n) = useful life of the investment object 12 O Idowu. as we will see in the following sections. . one is not being realistic and fair. S..1. Net Present Value Method 2. 2. project A will be chosen. By setting the future cash inflows from the project without discounting them against the initial capital cost.und Börsenwesens. if we want to conduct an investment appraisal according to the static methods. An investment is more advantageous. which of course is a fair statement.part 1 18 . Dynamic Methods The dynamic methods are said to be more superior to the static methods.1. Because the static methods only use one period and calculate with average values.. Capital investment appraisal . The net present value is calculated according to this formula: NPV = -A 0 + ∑ i =1 n It . Therefore it has to be investigated. we will choose Project A. Bank. We can see that project A has on the one hand a greater average profit.. Contrary to this.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL 2. the dynamic methods stress that future cash flows should be expressed in terms of what they are worth now when cash is expended on the project. In other words. These methods assume that one Euro today is worth more than one Euro this time next year. Therefore. in which the investment object is used.

000 € in period 5. This is especially important. in order to make the cash flows of different years comparable 19 .209 5.653 1. the investment only produces the minimum rate of return.000 12. The net present value method can also be used in comparing two competing investments.000 6.000 15.270 4 18. which was used in the calculation.000 18.000 18.000 10.653 Illustration 13: Example for a Net Present Value calculation Source: Own Illustration We can see that the investment has a net present value of 4.294 5 38.2.000 25.000 1 55.830 5 10.793 15.397 3 25.364 20.000 12. we will calculate the net present value of an investment.182 2 30.000 36.000 24.000 24.1. It has to be mentioned that the residual value at the end of the period is treated as a cash inflow and therefore has to be discounted.653 €.000 0 10.000 -100. Therefore the internal rate of the investment is higher than the interest rate of 10 %.000 -100.000 40.000 20.000 11. In this case the cash flow can only cover the acquisition costs and the cost of capital for the capital employed.294 10.000 28.000 20.000 6. Furthermore we will calculate with an interest rate of 10% and with the following cash inflows and outflows: Year Cash Inflows Cash Outflows Difference Present Value 0 100.783 15.000 -50. Example In the following example. the inflation rate can be used. with acquisition costs of 100.209 Net Present Value 4.000 18.209 Residual Value 10. 13 Instead of the interest rate.000 22.000 3.000 1 40.000 30.000 -100.000 -50.783 Illustration 14: Example for Using the Net Present Value Method in Comparing Two Alternatives Source: Own Illustration This example shows that machine 1 is more favourable than machine 2. So the net present value shows the profit of the investment.000 6.000 6. This shows the following example: Year Machine 1 Machine 2 0 -100.105 Residual Value 10.209 0 0 Net Present Value 4. If the net present value is zero.793 3 45. when the investment is financed with loan capital.000 € and a residual value of 10.783 4 40.000 18.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL q A0 = interest rate13 = Acquisition Costs in period 0 A positive net present value can be interpreted as follows: The internal interest rate of the investment is higher than the interest rate.000 12.364 2 50.000 6.000 36. 2.

3. First.g.NPV1 * q 2 . 1030 Bögelspacher. Bank.1.2. In the approximation method two net present values (NPV 1 and NPV2) for two arbitrarily determined interest rates. Disadvantages: − It assumes that there is no difference between the interest rate for equity capital and for loan capital. Script Investition & Finanzierung. but in practice this is over simplistic − It is assumed that the cash flows can be assigned directly to the investment object − It is difficult to compare alternatives with different useful lives with this method 2. MS Excel) can be used to calculate the internal rate of return or an approximation method can be used.1.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL 2..und Börsenwesens. the equation for determining the net present value has to be solved for qt. This is a very complicated mathematic operation. Therefore there are two possibilities to solve this problem. 14 15 Knapps Enzyklopädisches Lexikon des Geld-. which are less subjective than profits. while the second one must be positive (NPV2). p. when the project is financed by loan capital. Character This method allows determining the real rate of return of an investment. However. So in such a case the net present value of an investment would be zero. In order to calculate the internal rate of return. K. The first net present value has to be negative (NPV1).q1 NPV2 . when the internal rate of return is not below the expected minimum interest rate. Assessment Advantages: − Considers the time value of money − Shareholder wealth is maximised − It is based on cash flows. This is especially an important question.2. − It assumes that money can be invested on the same interest rate during the whole period14 − it can be difficult to identify an appropriate discount rate − Cash flows are usually assumed to occur at the end of a year. 32 20 .NPV1 The investment is advantageous. software (e. Internal Rate of Return Method 2. The internal rate of return therefore is the maximum rate of discount that will be used to finance a project without making a loss from it. So the investor knows what the maximum possible interest rate of the loan could be. p. these interest rates should not be too far from another (< 5 %).15 The calculated values are inserted into the formula below: q int = q1 .

which results in a negative net present value.1 .000 18.1 %.886 Illustration 15: Example for Determining the Internal Rate of Return with the Approximation Method Source: Own Illustration When we insert the data into the formula.040 5 10.000 24. which IRR of this example is the correct one.000 5. Example For this example. For example.793 30.1 45 6 3 .1 .000 11. which is a good basis for decision-making − Results are expressed as a simple percentage and therefore are more easily understood than some other methods − It indicates how sensitive decisions are to a change in interest rates.000 6.3.(1 8 ) .2. Such results make no 2 2 2 3 3 3 sense. CF1 = 6.294 18.000 -100.000 12. this project has two 1 1 1 (!) further IRRs.428 Net Present Value 4.398 2 30. we will use an interest rate of 13%.428 Residual Value 10. However. mentioned above. especially when we calculate the maximum possible interest rate for loans and moreover the question.209 10.000 -100. qint = 100 % and qint = 200 %.000 23.494 3 25. is not answered.000 36. Disadvantages: − Projects with unconventional cash flows can have either negative or multiple IRRs. we would refuse this investment. p.und Börsenwesens.783 25.000 35. a project has the following cash flows: A0 = 1. If we use the simple payback method. 1031 21 . because the payback period is at the end of the useful life. If we use the internal rate of return method. As second interest rate.16 16 Knapps Enzyklopädisches Lexikon des Geld-.000 6. Because − 1 + 1 − 2 + 3 = 0 .2. Assessment Advantages: − It takes into account the time value of money. Bank.( 1 8 ) 1 3 . we receive the following result: q int = .DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL 2. Year i = 10% i = 13 % 0 -100. because the equations 6 11 6 6 11 6 − 1 + 1 − 2 + 3 = 0 and − 1 + 1 − 2 + 3 = 0 are also solved.326 4 18.000 17. CF2 = -11 und CF3 = 6.2.000 1 40. we will use the same data as in the example of the previous section. we would 6 11 6 also receive an IRR of 0 %.000 5.209 10.86 = .86 * 1 0 -1 3 .364 40. 2.000 -100.1 1 1 2 So machine 1 has an internal rate of return of 12.653 -1.

Because the internal rate of return method leads to inexpedient results.364 24.209 4.000 Present Value -100. The NPV method assumes that the cash flows can be invested on the calculated interest rate. G. − It may give conflicting recommendations to net present value The question arises.227 € and the investment has still an internal rate of return of 10%. Therefore. it can be called a version of the net present value method.. Einführung in die Allgemeine Betriebswirtschaftslehre. 2. Annuity Method 2.17 2. 644 22 . The annuity method leads to the same results. However.000 18. as the example mentioned above shows. an investment is advantageous. This assumption is very unrealistic.000 36. the IRR method assumes that funds are re-invested at a rate equivalent to the IRR itself.653 1.000 30. Character The annuity method distributes the net present value into commensurate annuities. when the annuity is not negative. p.227 Illustration 16: Example for Calculating an Annuity Source: Own Illustration This investment has an annuity of 1.1) q n −1 2.000 10.793 18. Therefore the investor is able to take annually 1.209 6. when the internal rate of return method and net present value method calculate different results? Then the net present value method should be used. which may be unrealistically high. Example Year 0 1 2 3 4 5 Residual Value Net Present Value Annuity Cash Flow -100.3.000 40.227 €. like the net present value method.000 25. Therefore.783 12.294 6. what to do. Dynamic Payback Method 17 Wöhe. especially for non-monetary investments.3.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL − IRR cannot accommodate changes in interest rates over the life of a project − It assumes funds are re-invested at a rate equivalent to the IRR itself. The annuity can be calculated with the following formula: a =N PV * q n (q .2.3.000 10.1.4.

2. 1645 18 23 . while a short interest rate leads to a short payback period.000 40. A high interest rate leads to a long payback period. Year Machine 1 Present Value 0 1 2 3 4 5 Residual Value Net Present Value -100. 2.793 18. Character The dynamic payback method determines in which period the capital employed plus the expected interest rate returned to the company.4.294 6. The payback period is in particular dependent on the interest rate.1.766 -1. Example We will calculate the payback period for machine 1. p.364 24. which is not very easy in practice Gabler Wirtschaftslexikon. Assessment Advantages: − Considers the time value of money − It is based on cash flows.000 25.000 10. which are less subjective than profits − Shows how fast the acquisition costs plus interest return to the company Disadvantages: − It ignores cash flows received after the end of the payback period − It does not take into account the overall profitability of the project.000 -100.000 10.000 30. 2.636 -38.000 36. the following conditions have to be fulfilled:18 For every investment object it must be possible to assign the cash inflows and outflows.653 Illustration 17: Example for Dynamic Payback Method Source: Own Illustration We can see that the payback period of this investment is about 4 years.000 -63.843 -20.653 Cumulative Value Present Value -100. Conditions for Using the Dynamic Methods For using the dynamic methods.000 18.2.4.557 +4.4.5.060 -7.209 4.783 12.209 6.3.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL 2.

what alternatives a company has. to assign cash inflows and outflows to the investment object Every investment contains risks. 654 24 . Einführung in die Allgemeine Betriebswirtschaftslehre. new methods have been developing for investment appraisals. However. G. Due to these constraints. Due to their disadvantages. i. these methods are based on some unrealistic assumptions:19 The cash flows can be invested on the same interest rate during the whole useful life of an investment object There is no difference between the interest rate for equity capital and for loan capital. no matter what kind of investment will be undertaken The company is able to sell its products at a predetermined price. 19 See also Wöhe. in unlimited quantity 3. sometimes impossible. These risks have to be considered in the investment appraisals All these assumptions are not very realistic.e. in order to determine the possible success of an investment. which try to compensate the disadvantages of the traditional methods. Conclusion We have shown in this study. especially because they use only one period and ignore the time value of money.DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL - The cash flows have to be reinvested immediately and they must be able to produce a yield at the calculated interest rate at minimum The liquidity of the company is assured in any case. methods of operations research and approaches for a simultaneous investment and finance planning. The most important advantage of the dynamic methods is that they consider the time value of money. the static methods are more and more ousted by the dynamic methods. Examples for these new methods are the DEAN-model.. p. The single methods have been investigated according to their advantages and disadvantages. but they are fundamental for the application of the dynamic methods. It is difficult.

Einführung in die Allgemeine Betriebswirtschaftslehre. Bögelspacher.. 5.accaglobal. article at http://www. 3. 25 .. 2000. S. 20th edition. O Idowu. article at http://www. Knapps Enzyklopädisches Lexikon des Geld-. Schulte. München.und Börsenwesens. Script: „Finanzierung und Investition“ 7. G. Capital investment appraisal. Bank. Frankfurt am Main. S.. 15th edition. A.com/publications/studentaccountant/1105038 4. Irons.accaglobal. Gabler Wirtschaftslexikon. 1999. 2000. 4th edition.part 1. Script: „Investition & Finanzierung“ 2..DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL Bibliography 1. Wöhe.com/publications/studentaccountant/39869 6. Capital investment appraisal .. K. Wiesbaden.

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