Investment Appraisal Full Slides

ADVANCED MANAGEMENT
ACCOUNTING
INVESTMENT APPRAISAL
© 2023 Claremont Business School. All Rights Reserved.

The Basic Investment Appraisal process
 Basic investment appraisal focuses on performing

the following:
 What are we going to get out of it?
 How does it compare to what we are paying for

it?

INVESTMENT APPRAISAL TECHNIQUES
The key methods of project appraisal are:

 ROCE/Accounting Rate of Return (ARR)
 The payback period(PBP)
 Discounted payback period(DPBP)
 Net present value(NPV)
 Internal rate of return (IRR)
 Modified internal rate of return(MIRR)

CLASS QUESTION – MAIN TECHNIQUES
ABC Limited has the opportunity to invest in a project with the
following initial costs and returns:
$
Initial investment 100 000
Cashflows Year 1 50 000
Year 2 40 000
Year 3 30 000
Year 4 25 000
Year 5 20 000
Residual value Year 5 5 000
The cost of capital is 10%
Appraise this investment using different investment appraisal

techniques.

INVESTMENT APPRAISAL TECHNIQUES
The key methods of project appraisal are:

 ROCE/Accounting Rate of Return (ARR)
 The payback period(PBP)
 Discounted payback period(DPBP)
 Net present value(NPV)
 Internal rate of return (IRR)
 Modified internal rate of return(MIRR)

CLASS QUESTION - MIRR

Example - MIRR

Recap Class Question
Annuities
An annuity is a series of equal cash flows received over a specific

period.
Question
A project costing $2,000 has returns expected to be $1,000 each
year for 3 years at a discount rate of 10%.
Calculate NPV

Question
A project would involve a capital outlay of $50,000. Cash

infows would be $10,000 per year. The cost of capital is 10%.
Would the project be worthwhile if it will have:
(a) Five yearly inflows ,beginning in a year’s time?
(b) Seven yearly inflows, beginning in three years time?
(c) Six yearly inflows, beginning now?

Perpetuities
A form of annuity where an equal amount of money is going to

be received forever.
Present value of the perpetuity = Cash flow per annum

Interest rate
Question
A company expects to receive $10,000 each year in
perpetuity. The current discount rate is 9%.
Required:
1. What is the present value of the perpetuity?

2. What is the value if the perpetuity starts in 5 years?
3. What is the value if the perpetuity starts now?

Dealing with non annual periods
 In some instances we may have to deal with cash flows which are
not in annual terms – for example, costs might be paid in 6 monthly
blocks.
 In these case, we need to pro-rate the discount rate to match the

period of the cash flows.
 For example if the annual discount rate is 10% but cashflows are
received in non annual instalments;

A company expects sales for a new project to
be $225,000 in the first year growing at 5% pa.
The project is expected to last for 4 years.
Working capital equal to 10% of annual sales is
required and needs to be in place at the start
of each year.
Calculate the working capital flows for

incorporation into the NPV calculation.

A project costing $1 000 000 will
generate $500 000 per annum for the
next 3 years. The residual value of the
asset is $100 000. Tax is charges are
30% payable one year in arrears and
capital allowances are available at
25% on a reducing balance basis.
Required:
Calculate the NPV of the project
using a discount rate of 10%
A project costing $980 000 will
generate $400 000 per annum for the
next 3 years. The residual value of the
asset is $300 000. Tax is charges are
30% payable in the year to which it
relates and capital allowances are
available at 25% on a reducing
balance basis.
Required:
Calculate the NPV of the project
using a discount rate of 15%
An investment of $100,000 is to be done
today. The entity will be selling one product,
with a sales volume of 10,000 units, selling
price of $12.50 and variable costs per unit of
$10. Annual fixed cost of $10,000 will be
incurred for the next four years. The discount
rate is 10%. Corporation tax is levied at 30%.
At the end of the project, the asset will have
nil residual value.
Required:
Calculate the NPV of this investment.

There are two approaches to dealing with inflation:
Include Inflation Exclude Inflation
(Money Analysis) (Real Analysis)
Inflate cash flows by the inflation Leave cash flows in year 0 terms
rates given
Use a money rate of Use a real rate of

return return
Can use where a single inflation rate is

Must use where there is more than given for an easier computation
one inflation rate in the question
Question 1
r = 8% i = 5%
Required:
What is the money rate of interest?
Question 2
m = 10.6% i = 5%
Required:
What is the real rate of return?

Storm Co is evaluating Project X, which
requires an initial investment of $50,000.
Expected net cash flows are $20,000 per
annum for four years at today’s prices.
However these are expected to rise by
5.5% pa because of inflation. The firm’s
money cost of capital is 15%.
Find the NPV by:

(a)discounting money cash flows
(b) discounting real cash flows

Specific and general inflation rates
 In practice, inflation does not affect all costs to the

same extent.
 In some investment appraisal questions you may be

given information on more than one inflation rate.
 In these situations you will have information on both

specific inflation rates and general inflation rates.
 Under such circumstances, always use the money

method since the real method becomes complex
to apply.

Practise-Expected Values
Dralin Co is considering an investment of $460,000 in a noncurrent

asset expected to generate substantial cash inflows over the next
five years. Unfortunately the annual cash flows from this
investment are uncertain, but the following probability distribution
has been established:
Annual cash flow ($) Probability

50,000 0.3
100,000 0.5
150,000 0.2
At the end of its five year life, the asset is expected to sell for
$40,000.The cost of capital is 5%.
Should the investment be undertaken?

Risk neutral decision, i.e. ignores investor’s attitude to risk!

The lower the sensitivity margin, the more sensitive the
decision to the particular parameter being considered,
i.e. small changes in the estimate could change the
project decision from accept to reject.

An investment of $40,000 today is expected to give rise to annual
contribution of $25,000. This is based on selling one product, with
a sales volume of 10,000 units, selling price of $12.50 and variable
costs per unit of $10. Annual fixed cost of $10,000 will be incurred
for the next four years; the discount rate is 10%.
Required:
(a) Calculate the NPV of this investment.
(b) Calculate the sensitivity of your calculation to the following:

(i) initial investment
(ii) selling price per unit
(iii) variable cost per unit
(iv) sales volume
(v) fixed costs
(vi) discount rate

Time Narrative Cash flow DF PV (ii) Sensitivity to selling price per unit
$ 10% $
0 Investment (40,000) 1.000 (40,000) PV of revenue = $12.50 × 10,000 × 3.170
1–4 Contribution 25,000 3.170 79,250 = 396,250
1–4 Fixed costs (10,000) 3.170 (31,700)
–––––– 7,550
NPV = 7,550 Sensitivity margin = –––––– × 100 = 1.9%
–––––– 396,250
Therefore the decision should be to accept the investment. (iii) Sensitivity to variable cost per unit
PV of total variable cost = $10 × 10,000 ×
(b) 3.170 = 317,000
(i) Sensitivity to initial investment = 7,550 7,550
–––––– × 100 = 18.9% Sensitivity margin = –––––– × 100 = 2.4%
40,000 317,000
(iv) Sensitivity to sales volume (vi) Sensitivity to the discount rate

PV of contribution = ($12.50 – $10.00) × 10,000 × Time Cash flow DF PV
3.170 =79,250 $ % $
Sensitivity margin = (7550/79250)× 100 = 9.5% 0 (40,000) 1.000 (40,000)
1–4 15,000 2.667 (W1) 40,000
(v) Sensitivity to fixed cost ––––––
Sensitivity margin = (7550/31700)× 100 = 23.8% NPV = 0
––––––

An investment of $500,000 is about to be made. Sales of 50,000
units per year are anticipated at a selling price of $15 per unit
and variable costs per unit are expected to be $10. Annual fixed
cost of $40,000 will be incurred per year. The project is expected
to last for five years and the discount rate is 10%.
Required:
(a) Calculate the NPV of this investment.
(b) Calculate the sensitivity of your calculation to the following:

(i) initial investment
(ii) selling price per unit
(iii) variable cost per unit
(iv) sales volume
(v) fixed costs
(vi) discount rate

How do we best use the funds to get the
maximum possible net present value?

The profitability index (PI) and divisible projects
 The aim when managing capital rationing is to maximise the NPV

earned per $1 invested in projects.
 Where the projects:
 are divisible (i.e. can be done in part)

 earn corresponding returns to scale
it is achieved by:
1) calculating a PI for each project
2) ranking the projects according to their PI
3) allocating funds according to the projects’ rankings until they
are used up.

Discounted Payback Profitability Index (DPBI)
 Alternatively, the index may be shown as a 'discounted payback

index' (DPBI)
 This is a measure of the number of times a project recovers the

initial funds invested, something that is particularly important if
funds are scarce.
 The higher the figure, the greater the returns. A DPBI of less than 1
indicates a negative NPV, i.e. that the present value of the net
cash inflows is less than the initial cash outlay

Indivisible projects – trial and error
 If a project is indivisible it must be done in its

entirety or not at all.
 Where projects cannot be done in part, the

optimal combination can only be found by
trial and error.

Mutually exclusive projects
 Sometimes the taking on of projects will preclude

the taking on of another, e.g. they may both require
use of the same asset.
 In these circumstances, each combination of

investments is tried to identify which earns the higher
level of returns.

Example-Mutually Exclusive Projects
A company has $100,000 available for investment and has identified

the following 5 investments(divisible projects) in which to invest. All
investments must be started now (Yr 0).Project C and E are mutually
exclusive.
Project Initial investment(Yr 0) $000 NPV$000 PI NPV/$

C 40 20 0.5
D 100 35 0.35
E 50 24 0.48
F 60 18 0.3
G 50 (10) not worth while
Required:
Determine the optimal project selection.

A firm has decided to acquire a new machine to neutralise the
toxic waste produced by its refining plant. The machine would
cost $6.4 million and would have an economic life of five years.
Tax allowable depreciation of 25% pa on a reducing balance
basis is available for the investment.
Taxation of 30% is payable on operating cash flows, one year in
arrears. The firm intends to finance the new plant by means of a
five year fixed interest loan at a pre tax cost of 11.4% pa, principal
repayable in five years’ time.
As an alternative, a leasing company has proposed a finance

lease over five years at $1.42 million pa payable in advance.
Scrap value of the machine under each financing alternative will

be zero.
Evaluate the two options for acquiring the machine and advise
the company on the best alternative.

An asset costs $30 000 to purchase and
has the following running costs and net
realizable value:
Year 1 Year 2
$ $
Running Costs 5 000 8 000
Residual Value 15 000 12 000
The cost of capital is 10%. Determine the

optimum replacement cycle between 1
year and 2 years.
Limitations of replacement analysis
The replacement analysis model assumes that the firm replaces like
with like each time it needs to replace an existing asset. However this
assumption ignores:
 changing technology – machines fast become obsolete and can

only be replaced with a more up-to-date model which will be
more efficient and perhaps perform different functions
 inflation – the increase in price over time increases the cost

structure of the different assets, meaning that the optimal
replacement cycle can vary over time
 change in production plans – firms cannot predict with accuracy

the market environment they will be facing in the future and
whether they will even need to make use of the asset at that time.


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ADVANCED MANAGEMENT

© 2023 Claremont Business School. All Rights Reserved.

 Basic investment appraisal focuses on performing

 What are we going to get out of it?

 How does it compare to what we are paying for

© 2023 Claremont Business School. All Rights Reserved.

The key methods of project appraisal are:

 Modified internal rate of return(MIRR)

© 20223 Claremont Business School. All Rights Reserved.

The cost of capital is 10%

Appraise this investment using different investment appraisal

© 2023 Claremont Business School. All Rights Reserved.

The key methods of project appraisal are:

 Modified internal rate of return(MIRR)

© 2023 Claremont Business School. All Rights Reserved.

© 2023 Claremont Business School. All Rights Reserved.

© 2023 Claremont Business School. All Rights Reserved.

An annuity is a series of equal cash flows received over a specific

© 2023 Claremont Business School. All Rights Reserved.

A project would involve a capital outlay of $50,000. Cash

Would the project be worthwhile if it will have:

(a) Five yearly inflows ,beginning in a year’s time?

(b) Seven yearly inflows, beginning in three years time?

(c) Six yearly inflows, beginning now?

© 2023 Claremont Business School. All Rights Reserved.

A form of annuity where an equal amount of money is going to

Present value of the perpetuity = Cash flow per annum

1. What is the present value of the perpetuity?

© 2023 Claremont Business School. All Rights Reserved.

 In these case, we need to pro-rate the discount rate to match the

© 2023 Claremont Business School. All Rights Reserved.

Calculate the working capital flows for

© 2023 Claremont Business School. All Rights Reserved.

© 2023 Claremont Business School. All Rights Reserved.

Use a money rate of Use a real rate of

Can use where a single inflation rate is

What is the money rate of interest?

What is the real rate of return?

© 2023 Claremont Business School. All Rights Reserved.

Find the NPV by:

© 2023 Claremont Business School. All Rights Reserved.

 In practice, inflation does not affect all costs to the

 In some investment appraisal questions you may be

 In these situations you will have information on both

 Under such circumstances, always use the money

© 2023 Claremont Business School. All Rights Reserved.

Dralin Co is considering an investment of $460,000 in a noncurrent

Annual cash flow ($) Probability

Should the investment be undertaken?

© 2023 Claremont Business School. All Rights Reserved.

© 2023 Claremont Business School. All Rights Reserved.

© 2023 Claremont Business School. All Rights Reserved.

(a) Calculate the NPV of this investment.

(b) Calculate the sensitivity of your calculation to the following:

© 2023 Claremont Business School. All Rights Reserved.

(iv) Sensitivity to sales volume (vi) Sensitivity to the discount rate

© 2023 Claremont Business School. All Rights Reserved.

(a) Calculate the NPV of this investment.

(b) Calculate the sensitivity of your calculation to the following:

© 2023 Claremont Business School. All Rights Reserved.

© 2023 Claremont Business School. All Rights Reserved.

 The aim when managing capital rationing is to maximise the NPV

 are divisible (i.e. can be done in part)