Session Goals

At the end of the session, you should be able to understand:

 Payback period
 Net Present Value
 Equal lifespan
 Unequal lifespan
 IRR

A. Afful-Dadzie 1
 Capital Investment Appraisal
Often times, since money is limited and there may be a number of competing
investment/project alternatives, one is compelled to select the projects whose capital outlay
is within budget and also offer the best return. This lecture presents techniques for analyzing
and selecting business projects/investments.

Capital Investment is a project which (for this course) consists of;

1. An initial outlay of capital (C0)
2. A set of estimated cash inflows and outflows over the life of the project
3. Optionally, a resettlement figure, which might be caused by resale of a plant or a cash
settlement to clear any liabilities incurred.
Often times, since money is limited and there may be a number of competing
investment/project alternatives, one is compelled to select the projects whose capital outlay
is within budget and also offer the best return. This lecture presents techniques for analyzing
and selecting business projects/investments.
2
A. Afful-Dadzie
 Capital Investment Appraisal
Techniques of Investment Appraisal
1. Payback Period
 Non discounted, 𝑖 = 0% (No time value of money)
 Discounted, 𝑖 > 0% (Time value of money)
 Annuity ( Equal Periodic Payments)
2. NPV (Net Present Value)
 Equal Lifespan
 Non-equal Lifespan
 Annuity Worth
 LCM
3. IRR (Internal Rate of Return)
A. Afful-Dadzie 3
 Capital Investment Appraisal
Payback Period
Given 𝐶𝑘 as the cash flow in period 𝑘,
When interest rate is zero, Payback period (𝑛) = 𝐶0 − σ𝑛𝑘=1 𝐶𝑘 ≤ 0
𝑛 𝐶𝑘
When 𝑖 > 0%, Payback period (𝑛) = 𝐶0 − σ𝑘=1 ≤0
1+𝑖 𝑘
The Payback Period for the case of 𝑖 = 0% can be easily calculated using the formula below:
𝐵
𝑇𝑝 = 𝐴 +
𝐶
where 𝑇𝑝 is the payback period, A is the last period with the negative cumulative cash flow.
B is the absolute value of the cumulative cash flow at the end of the period A.
C is the total cash flow during the period immediately after A.
Note: Unlike when 𝑖 = 0% (i.e. non discounting), when 𝑖 > 0%, cash flows should be discounted to their
present values before the formula above is applied.

A. Afful-Dadzie 4
 Capital Investment Appraisal
Example
Find the Payback period for the investment with the following cash
flow assuming

a. 𝑖 = 0%; Year Cash flow

b. b. 𝑖 = 10% 0 -50000
Assuming 360 days in a year. 1 20000
2 20000
3 17000
4 14000

A. Afful-Dadzie 5
 Capital Investment Appraisal
Solution
a. First find the cumulative cash flow for
each year
Year Cash Flow Cumulative
𝑖 = 0%
Cash flow
𝐵
𝑇𝑝 = 𝐴 + 0 -50000 -50000
𝐶
1 20000 -30000
10000 2 20000 -10000
𝑇𝑝 = 2 + × 360 𝑑𝑎𝑦𝑠
17000 3 17000 70000
𝑇𝑝 = 2 + 211.7 𝑑𝑎𝑦𝑠 4 14000 21000

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 2 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 211.7 𝑑𝑎𝑦𝑠.

A. Afful-Dadzie 6
 Capital Investment Appraisal
b. First find the cumulative Present Value of each period
𝑖 = 10% Year Cash flow Present Value Cumulative
𝐵 PV
𝑇𝑝 = 𝐴 +
𝐶 0 -50000 -50000 -50000
1 20000 20000 -31818.18
2516.9 = 18181.82
𝑇𝑝 = 3 + × 360 𝑑𝑎𝑦𝑠 1.1
9562.19
2 20000 20000 -15289.25
𝑇𝑝 = 3 + 94.7 𝑑𝑎𝑦𝑠 = 16528.93
1.12
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 3 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 94.7 𝑑𝑎𝑦𝑠.
3 17000 17000 -2516.9
3
= 12772.35
1.1
4 14000 14000 7045.29
4
= 9562.19
1.1
A. Afful-Dadzie 7
 Capital Investment Appraisal
Example
A company has to choose either Machine A or Machine B. The following are the
cash flows for both machines. Which of the two machines should be chosen based
on discounted payback period if interest is a. 0%, and b. 15%? Assume 360 days in a
year.
Year Machine A Machine B
0 -50,000 -45,000
1 25,500 12,500
2 24,500 15,500
3 17,000 21,000
4 14,000 38,000

A. Afful-Dadzie 8
 Capital Investment Appraisal

a
Cum Cash Cum Cash
Year Machine A flow for A Machine B flow for A
0 -50,000 -50,000 -45,000 -45,000
1 25,500 -24,500 12,500 -32,500
2 24,500 0 15,500 -17,000
3 17,000 17,000 21,000 4,000
4 14,000 31,000 38,000 42,000

For 𝑖 = 0%, Payback period for Machine A is end of year 2.

Payback period for Machine B is 2+4/21000*360 days = 2 years and 291 days
Thus, pick Machine A since it has the shortest payback period

A. Afful-Dadzie 9
 Capital Investment Appraisal

b.
Cum Cash Cum Cash
Year Machine A flow for A Machine B flow for A
0 -50,000 -50,000 -45,000 -45,000
1 25,500 -27,826 12,500 -34,130
2 24,500 -9,301 15,500 -22,410
3 17,000 1,877 21,000 -8,602
4 14,000 9,882 38,000 13,124

For 𝑖 = 15%, payback period for Machine A is: 2+9301/1700*360 days = 2 years and
197 days.
Payback period for Machine B is: 3 + 8602/3800 *360 days = 3 years and 81 days. So,
decision is to go for Machine A.

A. Afful-Dadzie 10
 Capital Investment Appraisal

Payback Period for Equal Periodic Payment

𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶0
 When 𝑖 = 0%, 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = =
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝐴

 When 𝑖 > 0%, 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑎𝑟𝑙𝑖𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ

𝐴 1+𝑖 𝑛−1
𝐶𝑜 − 𝑛
≤0
𝑖 1+𝑖
where 𝐶0 is initial the capital outlay.

A. Afful-Dadzie 11
 Capital Investment Appraisal
Example
A company is evaluating the following mutually exclusive projects at an interest rate
of a) 0% and b) 10% per annum
Project 1 Project 2
GHS GHS
Initial Cost 150000 80000
Annual Benefits 20000 15000
Project life (years) 20 13

i. What is the payback period for project 1 and project 2 at 0% interest rate?
ii. What is the discounted payback period for both projects at 10%?
iii.Which project should be selected based on i) and ii) above?
A. Afful-Dadzie 12
 Capital Investment Appraisal
Solution
i. when 𝑖 = 0%

𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶0
𝑇𝑝 = =
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝐴
150000
For Project 1: 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = = 7.5 𝑦𝑒𝑎𝑟𝑠
20000
80000
For Project 2: 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = = 5.3 𝑦𝑒𝑎𝑟𝑠
15000

ii. when 𝑖 = 10%

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑎𝑟𝑙𝑖𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ
𝐴 1+𝑖 𝑛−1
𝐶𝑜 − ≤0
𝑖 1+𝑖 𝑛
For Project 1;
20000 1.1 14 −1
at 𝑛 = 14; 150000 − = 2666.25 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠 𝑛𝑜𝑡 ≤ 0
0.1 1.114
20000 1.1 15 −1
at 𝑛 = 15; 150000 − = −2121.59 < 0
0.1 1.115
Therefore the payback period is year 15 13
A. Afful-Dadzie
 Capital Investment Appraisal

For Project 2;
15000 1.1 7 −1
at 𝑛 = 7; 80000 − = 6973.71 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠 𝑛𝑜𝑡 ≤ 0
0.1 1.17

1.1 8 −1
at 𝑛 = 8; 80000 − = −23.89 < 0
1.18

Therefore the payback period is year 8

iii. Based on the solutions above, Project 2 should be selected since in both
situations, it has the shorter payback period.

A. Afful-Dadzie 14
 Capital Investment Appraisal

NB: The payback period has some disadvantages.

- It ignores cash flow after the payback period.
- The default approach of i=0% ignores time value of money.
An advantage of the payback period technique could be that;
- it helps reduce risk due to shorter time to recover initial outlay.

A. Afful-Dadzie 15
 Capital Investment Appraisal
Net Present Value (NPV)
Net Present value (NPV) is a technique that finds the sum of the present values of all cash
flows for each competing alternatives. As long as the NPV ≥ 0, the investment is
worthwhile.
𝐶𝑘
𝑁𝑃𝑉 = σ𝑛𝑘=1 − 𝐶0 When;
(1+𝑖)𝑘
NPV ˃ 0, project or investment is profitable
NPV = 0, breakeven (return on investment or project is the same as return from the bank
or risk free investments)
NPV = 0 implies that your required return has been met exactly. So for example if you
wanted a return of 20% on your investment, you have achieved it if NPV=0
NPV ˂ 0 project or investment is not profitable. For a firm, it means the investment adds
no value to the firm.

A. Afful-Dadzie 16
 Capital Investment Appraisal
Example 1
A company has to choose either Machine A or Machine B. The following
are the cash flows for both machines.

Year Machine A Machine B

0 -50,000 -45,000
1 25,500 12,500
2 24,500 15,500
3 17,000 21,000
4 14,000 38,000

Assume Machine A has a scrap value of GH¢5,000 and Machine B, a scrap

value of GH¢4,000. Which of the two machines would be chosen based on NPV
if interest rate is 20% per annum?
A. Afful-Dadzie 17
 Capital Investment Appraisal

Solution
𝑛
𝐶𝑘
𝑁𝑃𝑉 = ෍ 𝑘
− 𝐶0
(1 + 𝑖)
𝑘=1
25,500 24,500 17,000 14,000 + 5,000
𝑁𝑃𝑉𝐴 = + 2
+ 3
+ 4
− 50,000 = 𝐺𝐻¢7264.66
1.2 1. 2 1. 2 1. 2
12,500 15,500 21,000 (38,000 + 4,000)
𝑁𝑃𝑉𝐵 = + 2
+ 3
+ 4
− 45,000 = 𝐺𝐻¢8587.962
1.2 1. 2 1. 2 1. 2

Based on NPV, Machine B would be chosen.

A. Afful-Dadzie 18
 Capital Investment Appraisal
NPV and unequal life projects/investments
Example
A company is evaluating the following mutually exclusive projects.

Project 1 Project 2
GH¢ GH¢
Initial Cost 200,000 100,000
Annual Benefits 26,000 21,000
Project Life (years) 16 10

Which project should be selected based on NPV at 6% per year?

A. Afful-Dadzie 19
 Capital Investment Appraisal

Solution
𝐴 (1+𝑖)𝑛 −1
𝑁𝑃𝑉 = − 𝐶0 For Project 1;
𝑖 (1+𝑖)𝑛
26,000 (1.06)16 −1
𝑁𝑃𝑉1 = − 200,000 = 𝐺𝐻¢62,753.28
0.06 (1.0616

For Project 2;
21,000 (1.06)10 −1
𝑁𝑃𝑉2 = − 100,000 = 𝐺𝐻¢54,561.83
0.06 (1.0610
Based purely on NPV, Project 1 should be selected.

A. Afful-Dadzie 20
 Capital Investment Appraisal
Note: When evaluating two or more projects or investments, choose the project or
investment with the highest NPV in terms of revenue and choose the project or
investment with the least NPV in terms of cost.

Example
Your company is evaluating two projects with the following information:
Project 1 requires an investment of GHS 500,000, an annual revenue of GHS 80,000
starting in year 2 and increasing by GHS 2,000 per year till the end of the project.
Project 2 requires an investment of GHS 300,000, an annual revenue of GHS 50,000
starting in year 3 and increasing by 8% per year till the end of the project.
Calculate the NPV for both projects if the lifespan for both project is 14 years and the
interest is 10% per year.
A. Afful-Dadzie 21
 Capital Investment Appraisal
Solution
For Project 1
𝑁𝑃𝑉 = 𝑃𝐴 + 𝑃𝐾 − 𝐶0

where 𝑃𝐴 is the present value of the annual revenue (80,000)

𝑃𝐾 is the present value of the increase (2,000)

𝐴 1+𝑖 𝑛−1 80000 1.1 13 − 1

𝑃𝐴 = 𝑛
= 13
= 568268.50
𝑖 1+𝑖 0.1 1.1

𝐾 1+𝑖 𝑛 −𝑛𝑖−1 2000 1.1 13 − 13 0.1 −1

Also, 𝑃𝐾 = = = 66754.39
𝑖2 1+𝑖 𝑛 0.12 1.1 13

∴ 𝑃𝐴 + 𝑃𝐾 = 568268.50 + 66754.29 = 635022.89

A. Afful-Dadzie 22
 Capital Investment Appraisal

But 𝑃𝐴 + 𝑃𝐾 is the present value at year 1 so find the present value at year 0
635022.89
Present value at year 0 = = 577293.54
1.1
Therefore 𝑁𝑃𝑉 = 577293.54 − 500000 = 77293.54

For Project 2
𝑁𝑃𝑉 = 𝑃𝑇 − 𝐶0
1+𝑔 𝑛 1.08 12
1− 1+𝑖 1−
𝑃𝑇 = 𝐴 = 50000 1.1 = 494083.49
𝑖−𝑔 0.1 − 0.08
But 𝑃𝑇 is the present value at year 2 so find the present value at year 0
494083.49
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑦𝑒𝑎𝑟 0 = 2
= 408333.46
1.1
𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒 𝑁𝑃𝑉 = 408333.46 − 300000 = 108333.36.
A. Afful-Dadzie 23
 Capital Investment Appraisal
Example
A company has to choose either Machine A or Machine B. The following
are the cash flows of both machine.

Year Machine A Machine B

0 -50000 -45000
1 25500 12500
2 24500 15000
3 17000 21000
4 14000 38000

Which of the two machines would be chosen based on NPV if interest rate
is 10% per annum? A. Afful-Dadzie 24
 Capital Investment Appraisal
Solution

𝑛
𝐶𝑡
𝑁𝑃𝑉 = ෍ 𝑡
− 𝐶0
1+𝑖
𝑡=1

For Machine A;

25500 24500 17000 14000

𝑁𝑃𝑉 = + 2
+ 3
+ 4
− 50000 = 15764.29
1.1 1.1 1.1 1.1
For Machine B;

12500 15500 21000 38000

𝑁𝑃𝑉 = + 2
+ 3
+ 4
− 45000 = 20905.68
1.1 1.1 1.1 1.1
A. Afful-Dadzie 25
 Capital Investment Appraisal
Annual worth Approach
The Annual worth Approach of the Net Present Value is usually used when the lifespan
of the projects or investment are different. When this is the case, using the NPV
approach will introduce biasness in the selection process.
In calculating for the Annual worth of each project or investment, first find the NPV of
the project or investment and use it to find for the annual worth of the project or
investment.
𝐴 1+𝑖 𝑛 −1
That is, if 𝑃 =
𝑖 1+𝑖 𝑛

𝑃𝑖 1 + 𝑖 𝑛
⇒𝐴=
1+𝑖 𝑛−1

A. Afful-Dadzie 26
 Capital Investment Appraisal

Example
A company is evaluating the following mutually exclusive projects.

Project 1 Project 2
GH¢ GH¢
Initial Cost 200,000 100,000
Annual Benefits 26,000 21,000
Project Life (years) 16 10

Which project should be selected based on NPV at 6% per year?

A. Afful-Dadzie 27
 Capital Investment Appraisal

Solution
𝐴 (1+𝑖)𝑛 −1
𝑁𝑃𝑉 = − 𝐶0 For Project 1;
𝑖 (1+𝑖)𝑛
26,000 (1.06)16 −1
𝑁𝑃𝑉1 = − 200,000 = 𝐺𝐻¢62,753.28
0.06 (1.0616

For Project 2;
21,000 (1.06)10 −1
𝑁𝑃𝑉2 = − 100,000 = 𝐺𝐻¢54,561.83
0.06 (1.0610
Based purely on NPV, Project 1 should be selected.

A. Afful-Dadzie 28
 Capital Investment Appraisal
Annual worth approach
𝐴 (1+𝑖)𝑛 −1 𝑃∗𝑖∗ 1+𝑖 𝑛
𝑃= ⇒ 𝐴=
𝑖 (1+𝑖)𝑛 (1+𝑖)𝑛 −1

For Project 1; P=62753.28, n=16

62753.28∗0.06
𝐴= (1.06)16 −1
= 𝐺𝐻¢6209.57
1.0616

For Project 2; P=54,561.83, n=10

54,561.83∗0.06
𝐴= (1.06)10 −1
= 𝐺𝐻¢7413.20
1.0610

Based on the annual worth approach, Project 2 should be selected.

A. Afful-Dadzie 29
 Capital Investment Appraisal

The IRR is the true interest rate earned on an investment over the course of its
economic life.
𝑛 𝐶𝑘
IRR is that rate 𝑖∗ at which 𝑁𝑃𝑉 = σ𝑘=1 − 𝐶0 = 0
(1+𝑖 ∗ )𝑘
𝐶𝑘
That is, σ𝑛𝑘=1 = 𝐶0
1+𝑖 ∗ 𝑘

That is, taking time value of money into account, the IRR is the maximum rate of
return that an investment is able to recover the initial capital outlay of 𝐶0 .
Most organizations have an established minimum returns that any investment must
meet. This is usually termed, the Minimum Acceptable Rate of Return (MARR).
For such organizations, it is only when the IRR>=MARR, would the potential
investment merit consideration.
A. Afful-Dadzie 30
 Capital Investment Appraisal

Thus the following rules apply when using the IRR:

When IRR ˃ MARR, investment is profitable
When IRR = MARR, investment add no value to the investor and so investor is
indifferent.
When IRR<MARR, investment is not worthwhile

When comparing two or more projects, the first condition for any project to merit
consideration is for it to have IRR >=MARR. For those projects meeting this
criterion, select the project with the maximum IRR.
That is, suppose project 1 and project 2 have IRR1 > MARR and IRR2 > MARR
respectively, and are mutually exclusive. If IRR2 > IRR1 then select project 2.
A. Afful-Dadzie 31
 Capital Investment Appraisal
Calculating Internal Rate of Return using Interpolation

1. Graphic Approach
The graphical approach requires that one first select an interest rate 𝑖1 and calculate
its corresponding net present value 𝑁𝑃𝑉1 for the point (𝑖1 , 𝑁𝑃𝑉1 ), and again 𝑖2 and
its associated 𝑁𝑃𝑉2 , for the point (𝑖2 , 𝑁𝑃𝑉2 ). The point at which the line passing
through these two points touches the x-axis is the IRR.

A. Afful-Dadzie 32
 Capital Investment Appraisal
Algebraic Approach
The algebraic approach makes use of interpolation and can be understood through the graph
above when finding the slope.
For any line with two points (𝑥1 , 𝑦1 ) and (𝑥2 , 𝑦2 ), the slope 𝑚 is given as:
𝑦1 −𝑦2
𝑚=
𝑥1 −𝑥2
It can be observed that the slope of the line above that the slope of the line is:
𝑁1 −𝑁2 𝑁1 −0
𝑚= or 𝑚 = . Thus,
𝑖1 −𝑖2 𝑖1 −𝐼𝑅𝑅
𝑁1 −𝑁2 𝑁1 −0
=
𝑖1 −𝑖2 𝑖1 −𝐼𝑅𝑅
Rearranging, we get:
𝑁1 − 𝑁2 𝑖1 − 𝐼𝑅𝑅 = 𝑁1 (𝑖1 − 𝑖2 ) ⇒ 𝑁1 𝑖1 − 𝑁1 𝐼𝑅𝑅 − 𝑁2 𝑖1 + 𝑁2 𝐼𝑅𝑅 = 𝑁1 𝑖1 − 𝑁1 𝑖2
𝑁2 − 𝑁1 𝐼𝑅𝑅 = 𝑁2 𝑖1 − 𝑁1 𝑖2
𝑁2 𝑖1 − 𝑁1 𝑖2 𝑁1 𝑖2 − 𝑁2 𝑖1
𝐼𝑅𝑅 = =
𝑁2 − 𝑁1 𝑁1 − 𝑁2
Note: The accuracy of IRR is high when one of the 𝑁1 and 𝑁2 is positive and the other negative.
A. Afful-Dadzie 33
 Capital Investment Appraisal

Example
A company has to choose either Project 1 or Project 2. The following are the cash
flows for both machines.
Year Project 1 Project 2
0 -50,000 -45,000
1 25,500 12,500
2 24,500 15,500
3 17,000 21,000
4 14,000 38,000

Find the Internal Rate of Return of both projects.

A. Afful-Dadzie 34
 Capital Investment Appraisal
Solution
Project 1
25,500 24,500 17,000 14,000
+ + + − 50,000
(1+𝑖)1 (1+𝑖)2 (1+𝑖)3 (1+𝑖)4

when 𝑖 is 10%
25,500 24,500 17,000 14,000
+ + + − 50,000 = 15764.29
(1.1)1 (1.1)2 (1.1)3 (1.1)4

when 𝑖 is 20%
25,500 24,500 17,000 14,000
+ + + − 50,000 = 4853.4
(1.2)1 (1.2)2 (1.2)3 (1.2)4
𝑖1 = 10%, 𝑁1 = 𝐺𝐻¢15764.29
𝑖2 = 20%, 𝑁2 = 𝐺𝐻¢4853.4
15764.29 0.2 −4853.4(0.1)
𝐼𝑅𝑅1 = = 0.244 = 24.4%
15764.29−4853.4
A. Afful-Dadzie 35
 Capital Investment Appraisal
Project 2
12,500 15,000 21,000 38,000
+ + + − 45,000
(1+𝑖)1 (1+𝑖)2 (1+𝑖)3 (1+𝑖)4

when 𝑖 is 10%
12,500 15,000 21,000 38,000
+ + + − 45,000 = 20,905.68
(1.1)1 (1.1)2 (1.1)3 (1.1)4

when 𝑖 is 20%
12,500 15,000 21,000 38,000
+ + + − 45,000 = 6658.95
(1.2)1 (1.2)2 (1.2)3 (1.2)4

𝑖1 = 10%, 𝑁1 = 𝐺𝐻¢20,905.68; 𝑖2 = 20%, 𝑁2 = 𝐺𝐻¢6658.95

20905.68 0.2 −6658.95(0.1)
𝐼𝑅𝑅2 = = 0.247 = 24.7%
20905.68−6658.95

A. Afful-Dadzie 36
 Capital Investment Appraisal
Capitalized Cost Investments
When the investment is for a very long period of time.
𝐴 1+𝑖 𝑛 −1
If 𝑃 =
𝑖 1+𝑖 𝑛
𝐴
When n is infinite (say n > 100 years) ⇒ 𝑃 =
𝑖

Example
Construction of a hydroelectric dam will take 12 years and will cost GHS 8m in each of
those years. Net revenue from selling electricity is expected to be GHS 8m starting in year
13 and continuing at the same amount in perpetuity (forever).
Calculate
i. The maximum rate of return needed to recover the project's investment (i.e IRR)
ii. The NPV for 𝑖 = 3%.
A. Afful-Dadzie 37
 Capital Investment Appraisal
Solution

i. For IRR, NPV = 0.

NPV is essentially revenue minus cost.
𝑁𝑃𝑉 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡
Let 𝑃𝐴𝑐 be the sum of the present values of all cost incurred, and𝑃𝐴𝑅 , the sum of the present
value of all revenue to be accrued. Then:
𝐴 1+𝑖 𝑛−1
𝐶𝑜𝑠𝑡: 𝑃𝐴𝑐 = 𝑤ℎ𝑒𝑟𝑒 𝑖 = 𝐼𝑅𝑅
𝑖 1+𝑖 𝑛
8 1+𝑖 12 −1
𝑃𝐴𝑐 =
𝑖 1+𝑖 12 A. Afful-Dadzie 38
 Capital Investment Appraisal
𝐴
Revenue: 𝑃𝐴𝑅 = 𝑤ℎ𝑒𝑟𝑒 𝑖 = 𝐼𝑅𝑅
𝑖
8
𝑃𝐴𝑅 𝑎𝑡 𝑦𝑒𝑎𝑟 12 = . This value in year 12 should be taken to the start of the project at zero.
𝑖
8 1
𝑃𝐴𝑅 𝑎𝑡 𝑦𝑒𝑎𝑟 0 = ×
𝑖 (1+𝑖)12
8 1 8 1+𝑖 12 −1
Therefore 𝑁𝑃𝑉 = × − =0
𝑖 (1+𝑖)12 𝑖 1+𝑖 12
8 1 8 1+𝑖 12 −1
⇒ × =
𝑖 (1+𝑖)12 𝑖 1+𝑖 12
1= 1+𝑖 12 −1 ⇒ 1+𝑖 12 =2
1 1
1 + 𝑖 = (2) 12 ⇒ 𝑖= 2 12 −1
𝑖 = 0.0594 = 5.94%
The rate of return for the investment is 5.94%

A. Afful-Dadzie 39