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Capital Investment Appraisal

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CAPITAL INVESTMENT

APPRAISAL

1

Investment Appraisal

A means of assessing whether an investment project is

worthwhile or not

Investment project could be the purchase of a new PC for a

small firm, a new piece of equipment in a manufacturing

plant, a whole new factory, etc

Used in both public and private sector

As investments involve large resources, wrong investment

decisions are very expensive to correct

Managers are responsible for comparing and evaluating

alternative projects so as to allocate limited resources and

2

maximize the firms wealth

money concept

Internal rate of return

money concept

Payback period

Accounting rate of return

Payback period

Payback period

Payback period is the period of time it takes

for a company to recover its initial

investment in a project

The method measures the time required for

a projects cash flow to equalize the initial

investment

Acceptance criterion

< predetermined cutoff period Accept the project

> Predetermined cutoff period Reject the project

Example

Investments in the production facilities for the new products with

an Estimated useful life of four years. The cash inflow and

outflows are Listed as follows:

Project A

$

900000

Project B

$

1000000

Initial investment

Cash inflow at the end of year

Year 1

700000

600000

Year 2

100000

400000

Year 3

100000

400000

Year 4

1300000

400000

Project A : 3 years

Project B: 2 years

Project B takes only two years to recover its initial investment. With

The shortest payback period, the company will accept project B

Easy to adopt

Facilities further evaluation

the project will be evaluated by other financial

capital budgeting techniques

Ignore the cash flows after payback period

Adopt an arbitrary standard for the payback

period

Ignores the timing of cash flow

10

The payback period method is criticized for

ignoring the timing of cash flows, therefore

discounted cash flows are used to calculate

the discounted payback period

11

Example

12

investments in the production facilities for the new products with an

estimated useful life of four years. The cash inflow and outflows are

listed as follows:

Project A

Project B

900000

1000000

Year 1

700000

600000

Year 2

100000

400000

Year 3

100000

400000

Year 4

1300000

400000

Initial investment

Cash inflow at the end of year

13

Project A

$

900000

Project B

$

1000000

Initial investment

Discounted cash flow

Year 1

700000 = 583333

400000 = 500000

1.21

1.21

Year 2

100000 = 69444

400000 = 277778

1.22

1.22

Year 3

100000 = 57870

400000

= 231481

3

3

1.2

1.2

Year 4

100000 = 626929 400000 = 192901

1.24

1.24

Discount payback period

Project A

3+ 900000-710647 = 3.3 years

626929

Project B

231481

14

15

The accounting rate of return compares the

average accounting profit with the average

investment cost of project

The accounting profit can be expressed

either before tax or after tax

16

Calculation procedures

Average net profit per year (over the life of the project)

ARR =

Average investment cost

Total profit

Average net profit per year = No. of life of the project

Initial investment

Average investment cost =

2

17

Acceptance criterion

In evaluating an investment project, the ARR of the project is

compared with a predetermined minimum acceptable accounting

Rate of return:

ARRs

< minimum acceptable rate

= minimum acceptable rate

> minimum acceptable rate

Highest

Comments

Reject project

Accept project

Accept project

Choose highest ARR

18

Example

19

For a new production line. The purchase price of machinery is

$400000 and its estimated useful life is four years. There is no scrap

Value after four years

The project income statements:

Year1

Year 2

Year 3

Year 4

$

$

$

$

Revenue

310000

280000

280000

310000

Depreciation 10000

100000

100000

100000

Other expenses150000

100000

110000120000

Profit before tax 60000

80000

70000

90000

Taxation (15%) 9000

12000

10500

13500

51000

68000

59500

76500

Should the company buy the new machinery if the minimum acceptable

Rate of return is 20%?

20

51000+68000+59500+76500 = $63750

Average net income =

4

400000+0

= $200000

Average investment =

2

The cost of machinery is $400000 at the beginning

The cost of machinery is $0 at the end as depreciation is provided

On straight line method and there is no scrap value

$63750

ARR = $200000 = 31.875%

Since the ARR is 31.875%, which is higher than the minimum

Acceptable rate of 20%, the company should invest in the new

machinery.

21

Advantages of ARR

It is easy to understand and compute

It avoids using gross figures. Therefore, it

enables comparisons to be made between

projects with different useful lives

22

Disadvantages of ARR

It ignores the time value of money

ARR method seems to be less reliable than

the NPV method. It adopts the accounting

profit instead of cash flows calculation. The

change of depreciation method may also

alter the accounting profit

23

24

Net present value (NPV) method is a process that

uses the discounted cash flow of a project to

determine whether the rate of return on that

project is equal to, higher than, or lower than the

desired rate of return

With the NPV method, we can compare the return

on investment in capital projects with the return on

an alternative equal risk investment in securities

traded in financial market

25

Calculation procedures

Determining the discount rate

2. Calculating the NPV:

1.

FV1

FV2

+

NPV = (1+r)1

(1+r)2

FV3

(1+r)3

FVn

(1+r)n - I0

n = no. of years

r = Rate of return available on an equivalent risk

security in the financial market

I 0= initial investment

26

NPVs Comments

Reasons

<0

small than the rate of return from an

equivalent risk investment

=0

Indifferent to accept

or reject the project

equal to the rate of return from an

equivalent risk investment

>0

greater than the rate of return from an

equivalent risk investment

project with highest positive NPV

should be chosen

27

Example

28

Production facilities for the new products with an estimated useful

Life of four years. The cash inflows and outflows are listed as follows:

Project

A

B

C

D

$

$

$

$

Initial investment

900000

1000000

303730 1500000

Cash inflow

Year 1

120000

400000

100000 10000

Year 2

250000

400000

100000 10000

Year 3

400000

400000

100000 1000000

Year 4

1300000

400000

100000 1000000

The appropriate discount rate of these investment is 12%

29

Required:

(a) Calculate the NPV of each investment and determine whether

to accept it or not (assuming the company has unlimited

resources)

(b) If the company has limited resources, determine which

investment should be accepted by referring to the highest NPV

30

(a)

Project A

120000

250000

400000

1300000

+

+

+

NPV = 1.12

2

3

1.12

1.12

1.124 - 900000

= $517327 (accepting)

Project B

40000

NPV = 1.12

400000

+

1.122

400000

400000

+

+

3

1.12

1.124 - 1000000

= $214920(accepting)

31

(a)

Project C

100000

100000

100000

100000

+

+

+

NPV = 1.12

2

3

1.12

1.12

1.124 - 303730

= $0 (indifferent to accept or reject)

Project D

10000

NPV = 1.12

10000

+

1.122

1000000

1000000

+

+

3

1.12

1.124 - 1500000

= -$135801(rejecting)

(b) With limited resources, the company should only accept project A

because it generates the highest NPV

32

Advantages of NPV

Consistency with the time value of money

concept

Consideration of all cash flows

Adoption of cash flows instead of

accounting profit

33

34

The internal rate of return is the annual percentage

return achieved by a project, of which the sum of

discounted cash inflow over the life of the project

is equal to the sum of discounted cash outflows

If the IRR is used to determine the NPV of a

project, the NPV will be zero.

The company will accept this project only if the

IRR is equal to or higher than the minimum rate of

return or the cost of capital

35

Calculation procedures

1.

will give a zero NPV

FV1

FV2

FV3

NPV = (1+r)1 + (1+r)2 + (1+r)3 +

where FV = future value of an investment

n = no. of years

r = internal rate of return

I 0= initial investment

2.

FVn

(1+r)n - I0 = 0

order to give a negative NPV and vice versa

36

3.

negative NPV, use interpolation to find

out the rate giving zero NPV

P

IRR = L +

(H L)

PN

Where L = Discount rate of the low trial

H = Discount rate of the high trial

P = NPV of cash flows of the low trial

N = NPV of cash flows of the high trial

37

4.

IRR is compared with the managements

predetermined rate

IRRs

Comments Reasons

NPV<0

NPV=0

Accept

NPV>0

Highest

Accept

considered, the

highest IRR should

be chosen

38

Example

39

the end of each of the next three years. Calculate the IRR. If the

minimum rate of return is 15 %, suggest with reason whether you

Should accept the project or not.

$200

$200

NPV = (1+r)1 + (1+r)2

$200

+

(1+r)3

$200

$200

$200

+

+

NPV = 1.22

1.222

1.223

Assuming the discount rate is 24%

$200

$200

$200

NPV = 1.24 + 1.242 + 1.243

- $400 = 0

- $400 = 8.4

- $400 = -3.8

40

P

IRR = L +

(H L)

PN

Where L = Discount rate of the low trial

H = Discount rate of the high trial

P = NPV of cash flows of the low trial

N = NPV of cash flows of the high trial

IRR = 22% +

8.4

(24 22)%

8.4 (-3.8)

= 23.38%

Since the IRR (23.38%) is higher than the minimum rate of return (15%),

The project should be accepted

41

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