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CAPITAL INVESTMENT APPRAISAL

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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1. Meaning of relevant cash flows


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.

2. Examples of relevant cash flows:

Future sales revenue


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

3. Items which are not relevant cash flows

Changed future depreciation


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.

4. Capital outlays are treated as occurring in Year 0 unless otherwise indicated.


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

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5. Cash flow layout


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

Net cash flows

(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

6. Explain what is meant by:

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.

Net present value


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.

7. Calculating discount factors


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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8. Interpolating between two discount rates in order to arrive at the IRR


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.

10. Advantages and disadvantages of NPV and IRR.


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.

Ranking mutually exclusive projects


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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is a reasonable assumption. (In contrast IRR makes the


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%

Reinvestment assumptions / Doesnt account for size


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

11. Advantages and disadvantages of the Accounting rate of return


ACCOUNTING RATE OF RETURN (ARR)
Advantages

Disadvantages

Simple to understand and calculate


The formula is:
Average accounting profit over the life of
the project / Average capital employed

Uses accounting profits


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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12. The advantages and disadvantages of Payback


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

It is a useful way of measuring the degree of 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.

It is for this reason that Payback should never be


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

Target period can be set


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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