Chapter 4

Investment appraisal
methods
 Learning Objectives
• The net present value approach and why it is consistent with shareholder goals
• The three discounted cash flow approaches – net present value, internal rate of return
and profitability index.
• The underlying strengths and limitations of the above methods.
• How net present value and internal rate of return methods can be reconciled when
they conflict.
• Non-discounting methods.
• Analysing investments when capital availability is an important constraint.
 Cash Flow Analysis
• Cash flow matters more than Profit
• Timing of Cash Flows
• Incremental CF analysis

Project CF = CF for firm with project - CF for firm without project.

 Net Present Value
A project’s net present value (NPV) is determined by summing the net annual cash
flows, discounted at a rate that reflects the cost of an investment of equivalent risk on
the capital market, and deducting the initial outlay.

• Project acceptability depends upon cash flows and risk.

• The higher the risk of a given set of expected cash flows (and the higher the
discount rate), the lower will be its present value. In other words, the value of a
given expected cash flow decreases as its risk increases.
Net Present Value
 Internal Rate of Return
The rate of return that equates the present value of future cash
flows with the initial investment outlay
 Profitability Index
The profitability index is the ratio of the present value of project benefits to
the present value of initial costs. The decision rule is that projects with a PI
greater than 1.0 are acceptable

PI = PV of benefits/ PV of outlay
 Payback Period
The payback period (PB) is the period of time taken for the future
net cash inflows to match the initial cash outlay.
RANKING MUTUALLY EXCLUSIVE
PROJECTS
 Capital Rationing
• Capital rationing may arise either because a firm cannot
obtain funds at market rates of return, or because of
internally-imposed financial constraints by management.
• Externally-imposed constraints are referred to as hard
rationing
• Internally imposed constraints as soft rationing
End of chapter