Professional Documents
Culture Documents
Investment
Appraisal
techniques
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
CHAPTER CONTENTS
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
We shall use the following example to illustrate how each method is calculated.
Cash flows Yr 1 50
Yr 2 40
Yr 3 30
Yr 4 25
Yr 5 20
Residual value Yr 5 5
The cost of capital is 10%.
Required:
Should the project be accepted?
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Payback
The length of time it takes for cash inflows from trading to pay back the initial
investment.
Example 1 contd
A
Initial
investment
Periodic Cumulative
Net cash
flows ($)
Yr 1
Yr 2
Yr 3
Yr 4
Required:
Alternate computation with equal cash flows each year.
Required:
Payback period.
Decision criteria
Accept the project in the event that the time period is within the acceptable time
period. What is an acceptable time period? It depends!!
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Advantages
1. It is simple to use (calculate) and easy to understand
2. It is a particularly useful approach for ranking projects where a company faces
liquidity constraints and requires a fast repayment of investment.
3. It is appropriate in situations where risky investments are made in uncertain
market that are subject to fast design and product changes or where future
cash flows are particularly difficult to predict.
4. The method is often used in conjunction with the NPV or IRR method and act
as the first screening device to identify projects which are worthy of further
investigation.
5. Unlike the other traditional methods payback uses cash flows, rather than
accounting profits, and so is less likely to produce an unduly optimistic figure
distorted by assorted accounting conventions.
Disadvantages
1. It does not give a measure of return, as such it can only be used in addition to
other investment appraisal methods.
2. It does not normally consider the impact of discounted cash flow although a
discounted payback may be calculated (see later).
3. It only considers cash flow up to the payback, any cash flows beyond that point
are ignored.
4. There is no objective measure of what is an acceptable payback period, any
target payback is necessarily subjective.
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
100
Estimated annual profit
ARR =
Average investment
Example 1 contd
A
Average annual profit
Total profit
Less depreciation
number of years
= average profit
Average investment
Initial investment
2
ARR
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Decision criteria
A profit measure that must be compared to a target profit. This profit is likely to be
related to the target performance measure already discussed
Advantages
1. It is easy to understand and easy to calculate.
2. The impact of the project on a company’s financial statement can also be
specified
3. ROCE is still the commonest way in which business unit performance is
measured and evaluated, and is certainly the most visible to shareholders
4. Managers may be happy in expressing project attractiveness in the same
terms in which their performance will be reported to shareholders, and
according to which they will be evaluated and rewarded.
5. The continuing use of the ARR method can be explained largely by its
utilisation of balance sheet and P&L account magnitudes familiar to managers,
namely profit and capital employed.
Disadvantages
1. It fails to take account of the project life or the timing of cash flows and time
value of money within that life
2. It uses accounting profit, hence subject to various accounting conventions.
3. There is no definite investment signal. The decision to invest or not remains
subjective in view of the lack of objectively set target ARR.
4. Like all rate of return measures, it is not a measurement of absolute gain in
wealth for the business owners.
5. The ARR can be expressed in a variety of ways and is therefore susceptible to
manipulation.
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Profit and loss account for the year ended 31 December 20X6
$m
Turnover 120
Cost of sales (100)
____
Operating profit 20
====
Required:
(a) Determine whether the proposed capital investment is attractive to
Armcliff, using the average rate of return on capital method, defined
as average profit to average capital employed, ignoring debtors and
creditors.
(b) Suggest three problems which arise with the use of the average
return method for appraising new investment.
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Year 0 Year 1
Reasons 1
Example 4
If we invest $100 now (Yr. 0) what will the value of that investment be in 1, 2, 3, 4
years at a compound rate of 10%?
1 $100
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Therefore we are able to express Present Values in terms of Future Values using the
following formula:
FV = PV (1 + r)n
Where PV - Present value.
FV - Future value.
r - Rate of interest or cost of capital.
n - Number of periods (years)
Discounting
The opposite of compounding, where we have the future value (eg an expected
cash inflow in a future year) and we wish to consider its value in present value
terms.
Illustration
COMPOUNDING
Year 0 Year 1
DISCOUNTING
PV = FV (1 + r)n = FV (1 + r)-n
Use tables to calculate the present values of example 4 on the previous page.
1 110
2 121
3 133.1
4 146.41
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Decision criteria
If the investment has a positive NPV then the project should be accepted (negative
rejected). A positive NPV means that the project will increase the wealth of the
company by the amount of the NPV at the current cost of capital.
Example 1 contd
($000s)
Year @
NPV
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Advantages
1. A project with a positive NPV increases the wealth of the company’s, thus
maximise the shareholders wealth.
2. Takes into account the time value of money and therefore the opportunity
cost of capital.
3. Discount rate can be adjusted to take account of different level of risk
inherent in different projects.
4. Unlike the payback period, the NPV takes into account events throughout the
life of the project.
5. Superior to the internal rate of return because it does not suffer the problem
of multiple rates of return.
6. Better than accounting rate of return because it focuses on cash flows rather
than profit.
7. NPV technique can be combined with sensitivity analysis to quantify the risk
of the project’s result.
8. It can be used to determine the optimum policy for asset replacement.
Disadvantages
1. NPV assumes that firms pursue an objective of maximising the wealth of their
shareholders.
2. Determination of the correct discount rate can be difficult.
3. Non-financial managers may have difficulty understanding the concept.
4. The speed of repayment of the original investment is not highlighted.
5. The cash flow figures are estimates and may turn out to be incorrect.
6. NPV assumes cash flows occur at the beginning or end of the year, and is not
a technique that is easily used when complicated, mid-period cash flows are
present.
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Decision criteria
If the IRR is greater than the cost of capital accept the project.
Required:
What will be the NPV at 10% and 20% discount rates?
Illustration
NPV
rate of
return
Linear interpolation
We must attempt to guess the IRR by linear interpolation. This uses the following
formula.
NL
L (H - L)
L H
Interpolated IRR =
N - N
Where:
L = Lower discount rate
H = Higher discount rate
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Advantages
1. Like the NPV method, IRR recognises the time value of money.
2. It is based on cash flows, not accounting profits.
3. More easily understood than NPV by non-accountant being a percentage
return on investment.
4. For accept/ reject decisions on individual projects, the IRR method will reach
the same decision as the NPV method.
Disadvantages
1. Does not indicate the size of the investment, thus the risk involve in the
investment.
2. Assumes that earnings throughout the period of the investment are re-
invested at the same rate of return.
3. It can give conflicting signals with mutually exclusive project.
4. If a project has irregular cash flows there is more than one IRR for that
project (multiple IRRs).
5. Is confused with accounting rate of return.
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CHAPTER 2 – INVESTMENT APPRAISAL TECHNIQUES
Annuities
An annuity is a series of equal cash flows.
Required:
(a) NPV using existing analysis.
(b) NPV using annuity tables
(c) Solely considering the annuity, what if the cash flows commenced in:
1. Year 4,
2. Year 6,
3. Year 0?
Perpetuities
A form of annuity that arises forever (in perpetuity). In this situation the
calculation of the present value of the future cash flows is very straightforward.
This is of particular importance when considering cost of capital later.
Cash flow per annum
Present value of the perpetuity =
Interest rate
Required:
1. What is the present value of the perpetuity?
2. What is the value if the perpetuity starts in 5 years?
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