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N.B.

These notes are based on the capital investment appraisal questions set in many other Exams.

They are not therefore necessarily comprehensive different topics could be set in the Exams.

CONTENTS

1. MEANING OF RELEVANT CASH FLOWS

2. EXAMPLES OF RELEVANT CASH FLOWS

3. ITEMS WHICH ARE NOT RELEVANT CASH FLOWS

4. CAPITAL OUTLAYS AND CASH INFLOWS

5. CASH FLOW LAYOUT

6. THE MEANING OF: PAYBACK / NET PRESENT VALUE / IRR

7. CALCULATING DISCOUNT FACTORS

8. INTERPOLATING BETWEEN TWO DISCOUNT RATES

9. NPV v IRR

10. ADVANTAGES AND DISADVANTAGES OF NPV AND IRR

11. ADVANTAGES AND DISADVANTAGES OF THE ACCOUNTING RATE OF RETURN

12. ADVANTAGES AND DISADVANTAGES OF PAYBACK

13. SENSITIVITY ANALYSIS

GEOFF PAYNE

MARCH 2008

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A relevant cash flow is

one which will change as a direct result of a decision about an investment

one which will occur in the future a cash flow incurred in the past is irrelevant; it is a sunk cost

the difference between the cash flows

1. With the investment and

2. Without the investment

Only future, incremental cash flows are relevant

Why is it important to distinguish between relevant and irrelevant costs in project evaluation?

It is important to distinguish between relevant and irrelevant costs in decision making because only relevant costs

should be included and all irrelevant costs should be excluded. If one fails to accurately distinguish between the two

ones decision will be based on the wrong data.

Future production costs

Initial outlay

Future scrap / salvage value

Working capital outlays or reductions

Future taxes

Opportunity costs (lost inflows caused by the project) e.g. if a decision to build on piece of land would result

in the inability to realise an appreciation in the value of the land involved

Depreciation is not a cash flow it is the accounting amortisation of an initial capital cost

Depreciation is the result of accounting entries (journal entries) rather than a flow of cash

Reallocated existing overhead costs ie the overhead costs dont change; they are merely reallocated

Cost of unused idle capacity

Costs incurred in the past or already committed they are sunk costs

Finance flows not directly caused by the project although they may be caused by finance raised for the project

e.g.

Interest paid on debt

Loan repayments

Dividends paid on equity

NB The process of discounting future cash flows enables a decision to be made as to whether the

project finance costs would be sustainable to include those finance costs in the discount

calculations would distort the calculations. Discounting takes the cost of financing into account

automatically.

Cash inflows are treated as occurring at the end of a year.

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Set the cash flows out in a Table

This table should read across, in End of Years, starting at Year 0 (now) and ending at the projects last year

The cash flow table should read down in cash flow elements

Example (using 10% discount factors)

Year 0

1

2

3

4

5

New machinery

Old machinery - residual value

Working capital

Cash savings

(700)

50

160

(490)

Discount factors

Present Value

Net Present Value (NPV)

100

160

160

160

160

160

160

160

160

160

260

1.0

0.909

0.826

0.751

0.683

0.621

(490)

178.6

145.4

132.2

120.2

109.3

161.46

Payback

Payback is a commonly used method of appraising capital investment projects. It is seen as a useful

way of measuring the degree of risk involved in recovering the funds invested. The payback period

is the time that must elapse before the net cash flows from a project result in the initial outlay result

in the initial outlay being recovered in cash terms. It is argued that the shorter the payback period the

more attractive the project. It is a valid indicator for capital investment appraisal although it ignores

inflation. It also, perhaps more crucially, gives no indication of the overall cash flow benefits since it

ignores all cash flows after payback has been achieved, even when the later cash flows result in the

project never being paid back. It is for this reason that it should never be used in isolation.

A project that has a net present value (NPV) of 5000 means that if the organisation

undertakes the project it will be better off by 5000

IRR.

IRR is a means of appraising a project in financial terms. It takes into account the time value of

money i.e 1000 received today is worth more than 1000 received in a year's time. IRR refers to

the discount rate which, when applied to the project's cash flows, causes the cash inflows to equal

the cash outflows, with the result that the net present value of the project is equal to zero. If a project

has an IRR of,say, 15% this means that a project will be profitable if it can be financed at a rate less

than 15%. The IRR criterion is that a proposal with a return greater than the cost of capital (discount

rate) can be accepted. If there is more than one option, the option with the highest IRR should be

accepted.

Formula is 1 / (1+r)n where r is the discount rate and n = no of years

So, the 10% discount rate sum is:

1 / (1 + .1)1 (= 1.1) for year 1 = 0.909

1 / (1 + .1)2 (= 1.210) for year 2 = 0.826

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Ensure that one discount rate has a positive NPV and the other has a negative NPV. Example:

8% discount rate has produced a NPV of 8427

14% discount rate has produced a NPV of -2387

Deduct 8% from 14% = 6%

Calculate (8427 / (8427+2387 ) = 8427 / 10,814 =.77927

Multiply 6% by 0.77927 = 4.68%

8% + 4.68% = 12.68% = the IRR

9.

NPV V IRR

NPV is considered the superior method since in relation to mutually exclusive projects:

NPVs provision of financial returns (e.g. NPVs of say 1.6M and 1.0M) tells you how

much richer you would be in absolute terms and thus facilitates the choice of project to

pursue - assuming profit maximisation is your goal. IRR tells you only in relative terms

(e.g. 18% and 12%) which does not tell you how much richer you would be and is therefore

less useful to decision makers. In the example, the 18% IRR project could generate a very

modest NPV whilst the 12% IRR project could generate a very substantial NPV

NPVs are easier to base a decision upon (by choosing the project which gives the higher

NPV) in situations where IRR generates multiple yields that straddle the hurdle rate.

NET PRESENT VALUE (NPV)

Advantages

Easy to interpret / Accounts for investment size

The result of an investment appraisal using NPV is

easy to interpret. If a project generates a positive NPV

(say 10,000) this means that the business will be

better off by 10,000 if it accepts the project.

NPV ensures that cash flows are adjusted by the cost of

capital and thus ensures that it accounts for the size of

investments in its recommendations

Disadvantages

Sensititivity to discount rate

The results are very sensitive to the rate of

discount chosen and in capital rationing, where

NPVs as % returns on investment are being

compared, a change in discount rates can

change the rankings of projects since the

impact of different rates can vary materially

from project to project according to the timing

of the cash flows.

The result is expressed in financial terms making the

comparison with other mutually exclusive projects

easier to achieve e.g a project that has a NPV of 1.6M

is preferable to (a mutually exclusive) one that has a

NPV of 1.0M.

Ranking ability in capital rationing situations

If the capital available for investment is limited the

projects can be ranked by calculating each of their

NPVs relative to the capital they require enabling a

choice to be made that produces the greatest returns

relative to the limited funds available

Realistic reinvestment assumptions

NPVs assume that cash f lows can be reinvested

immediately at the discount rate (cost of capital) which

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less reasonable assumption that cash flows can be

reinvested immediately to earn a return equal to IRR)

INTERNAL RATE OF RETURN (IRR)

Advantages

Disadvantages

Easy to interpret

A decision as to whether or not to invest can be

straightforward. If the IRR is higher than the

hurdle rate (the minimum rate acceptable to the

investor or the cost of capital) then the project can

be accepted

Target setting

Businesses can set target IRRs for project

appraisals these take the timing of earnings into

account, unlike say a target accounting rate of

return.

Perpetual cash flows

Where cash flows can be regarded as a perpetuity

the IRR is simple to work out. One simply divides

the annual cash flow (say 4,000) by the initial

outlay (say20,000) to give the IRR of 20%

IRR assumes that all investment proceeds can be

reinvested to earn a return equal to the projects

IRR. This is a potentially fatal flaw in IRR,

particularly re: projects that earn higher than normal

returns

IRR does not account for investment size; a 50K

project may have a slightly higher IRR than a

500K project but the 500K project will

probably offer a much higher absolute return.

Mutually exclusive investments

IRR is not of great use in distinguishing between

mutually exclusive projects. e.g. Project As IRR

may be greater than Project Bs but Project A may

have a substantially higher NPV than Project B.

Thus, in general you should use NPV to distinguish

between projects.

Multiple yields

IRR is capable of generating multiple yields from the

same cash flows e.g. when the sequence of flows is

Initial investment outflow

Inflow

Outflow

The different IRRs generated could fall either side of

the hurdle rate, complicating the investment decision

ACCOUNTING RATE OF RETURN (ARR)

Advantages

Disadvantages

The formula is:

Average accounting profit over the life of

the project / Average capital employed

It uses accounting profits rather than cash flows -as

a result it incorporates non cash costs such as

depreciation

Ignores time value of money

Unlike NPV and IRR, ARR (in common with Payback)

ignores the time value of money and thus, for example,

accounting profits earned in later years are given equal

weight to those earned in earlier years

Cant compare with cost of capital

Because ARR is such a limited method of appraisal

it is not meaningful to compare it with the cost of

capital, the minimum acceptable return on capital

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PAYBACK

Advantages

Simple to understand and to calculate

The concept that This investment pays us back in 3

years is easy to understand.

It is also easy to calculate simply requiring a quick

review of the cash flows to find the period in which ,

in total, they amount to the initial outlay.

Useful way of measuring risk

involved in recovering the funds invested since,

arguably, the shorter the payback period the more

attractive the project

Disadvantages

Ignores cash flows after payback

Payback ignores all cash flows after payback has

been achieved and hence gives no indication of the

overall cash flow benefits, even when the later cash

flows result in the project never being paid back.

used in isolation

Ignores the pattern of cash receipts / time value of

money

Payback does not take into account the pattern of

cash receipts within the payback period; e.g they

could be front loaded - weighted towards the start

of the payback period - (attractive) or back

loaded- weighted towards the end of the payback

period (less attractive)

In other words Payback ignores the time value of

money

As with the accounting rate of return a target

payback period can be set if the payback period

is shorter than this target the project is acceptable

13. Sensitivity analysis

Sensitivity analysis refers to establishing how sensitive the result (e.g the NPV or IRR) is to changes in the

assumptions made about the project.

Sensitivity is measured by establishing how far an assumption (e.g. sales, cost levels, the discount rate etc)

can change before the NPV falls to zero.

If, for example, the NPV of a project is 30,000 and the NPV of the anticipated sales income is 90,000 this

means that the sales income could fall by one third (30,000 / 90,000) before the project NPV becomes zero.

Sensitivity is an essential part of capital investment appraisal since, without it, the organization would have no

information about the risk associated with an investment. Where there is a wide margin of safety the

organisation can be fairly confident. If the margin of safety is narrow more investigation may be needed and if

the project still looks risky it could be rejected even though it shows a positive NPV.

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