Capital Investment Decisions: NPV, IRR & Payback Period

CAPITAL/BUDGETING INVESTMENT
DECISIONS
Capital Investment/ Capital Budgeting
Decisions
Investment is a key part of building a business.
New assets such as machinery can boost
productivity, cut costs and give a competitive
edge. Investments in product development,
research and development, expertise and new
markets can open up exciting growth
opportunities
CAPITAL INVESTMENT DECISIONS
• Deciding where to focus your investment is an
essential part of making the most of your
potential. Even a project that is not designed
to generate a profit should be subjected to
investment appraisal to identify the best way
to achieve its aims.
Purpose
The purpose of the capital investment
decisions includes allocation of the firm' s
capital funds most effectively in order to
ensure the best return possible.
The major goal of capital investment decision
is to increase the value of firm by undertaking
right project at right time.
• it is the process of determining whether or
not an investment is worthwhile.
• Often companies will have several
opportunities and must measure each one's
potential in order to make a comparison and
choose just one or a few.
• Evaluating the projects and allocating capital
depending on the requirements of the projects
are the most important aspects of capital
investment decisions.
• For example: a company might be trying to
determine whether to buy new equipment to
expand production capacity on an existing
product, or to invest in research and
development for a new product.
• There may be various criteria for selecting the
right and appropriate decision for capital
investment.
For example: a firm may emphasize on the
projects that promise for the immediate
return while some other firms may insist on
the projects that ensure long term growth.
• The firm needs to decide which of the given
investments will ensure the most value to the
business.
• The decision of project ranking plays significant
role in the decisions of capital investment. The
ranking of projects depends on how much a
project will return and which project will be
able to add maximum value to the business.
Investment appraisal
Investment Appraisal is the activity which is an
integral part of capital budgeting and is
responsible for carrying out a Cost Benefit
Analysis which is used to justify Capital
Expenditure for a new or old services.
• Investment appraisal
• Investment appraisal involves assessing the
viability of a particular project and justifying
the expenditure of capital allocated for a
particular project
• A planning process is used to determine
whether an organisation's long term
investments such as new machinery, new
plants, new products, and research
development projects are worth pursuing.
• Investment appraisal is important because it
involves the commitment of a large amount of
company resources that necessitate careful
evaluation to be undertaken before a decision
is reached.
• Different appraisal techniques let you assess
the effects an investment will have on your
cashflow. You can compare the expected
return to the cost of funding and to the
returns offered by other potential
investments.
• Your assessment should consider all the
financial consequences of an investment.
For example: buying more expensive
machinery might be worthwhile if it is more
efficient and uses cheaper supplies.
• Effective investment appraisal does not
consider an investment in isolation. Instead,
you should consider how the investment could
contribute to your overall strategic objectives.
Some investments can offer strategic benefits
for your business.
• For example: you might invest in extending
your product range so that you can supply
more of the products that your key customers
want. An investment like this could help
strengthen your brand and your relationship
with your customers.
A useful test for a possible investment is to think
about your alternatives. For example, instead of
buying new machinery you could:
• do nothing
• do the minimum necessary to maintain your
existing machinery
• achieve a similar outcome a different way: e.g.
by outsourcing production to a supplier
• invest in an alternative project instead
In order to determine the value of a particular
project, three most famous methods used are:
• PAYBACK period
• Net Present Value
• IRR methods
These methods are applied while taking
decisions on capital investment
PAYBACK PERIOD
• The payback period is the time a project will take
to pay back the money spent on it. It is based on
expected cash flows and provides a measure of
liquidity.
• Very simply, the payback period tells you how long
it will take to recover your investment in a project.
• measures the length of time that it takes to
recover the initial investment.
• The CIMA defines payback as 'the time it
takes the cash inflows from a capital
investment project to equal the cash
outflows, usually expressed in years'.
• When deciding between two or more
competing projects, the usual decision is to
accept the one with the shortest payback.
• Payback is often used as a "first screening
method". By this, we mean that when a
capital investment project is being considered,
the first question to ask is: 'How long will it
take to pay back its cost?' The company might
have a target payback and so it would reject a
capital project unless its payback period were
less than a certain number of years.
• The method takes no account of the time value
of money and neither does it take account of
the earnings after the initial investment is
recouped.
For example: a project requires a $3 million
investment and:
• Option 1 returns $2 million in the first year and
• Option 2 returns $3 million for the same year.
• On this basis Option 2 is the preferred option
as the payback period is shorter
• BUT if the cashflows changed in subsequent
years and Option 1 returned $2 million
annually while Option 2 only earned $1 million
annually:
• the chosen option would have been incorrect.
GROUP EXERCISE (worked example)
Work out how long it takes to repay the
initial investment:
• Investment A. costs $100
• Annual return of $25
• Length 5 years
YEAR NET CASH FLOW CUMULATIVE CASH FLOW
0 -100 -100
1 25 -75
2 25 -50
3 25 -25
4 25 0
5 25 25
Payback is 4 years.
ADVANTAGES
• Easy to calculate
• Easy to understand
• Most relevant to businesses with cashflow
problems
• Emphasises speed of return – good in rapidly
changing markets
DISADVANTAGES
• Ignores money received after payback
• Can be difficult to establish a target payback
period
• Doesn’t consider the future value of money
• Short term approach
NET PRESENT VALUE (NPV) OR
DISCOUNTED CASH FLOW
This takes into account the time value of money.
It is based on the principle that money is worth
more than it is in the future. The principle exists
for two reasons:
• Risk – money in the future is uncertain
• Opportunity cost – Money could be in an interest
account earning interest.
Net Present Value (NPV) OR
DISCOUNTED CASH FLOW
Net Present Value combines two concepts of
value.
• First, it determines how much cash will flow
in as a result of the investment and compares
that against the cash that will flow out in order
to make the investment
• Since these flows take place over time and
often the investment will pay off much later,
we also take into account the present and
future value of money.
Because of inflation, money earned in the
future is worth less in today's dollars than
the same amount would be today.
Therefore, NPV calculates all of those inflows
and outflows over time, takes inflation and
foreign exchange rates into account, and
expresses the final benefit to the company in
terms of today's dollars.
NPV: Discounting
• This is the process of adjusting the value of money
from its present value to its value in the future. The
key to discounting is the rate of interest.
• The business chooses the most appropriate rate for
the life of the project. It then identifies the discounting
factor. The amount of money is then multiplied by the
discounting factors to convert it to its net present
value.
e.g. Project A $100: $25 return 5 years
YEAR NET DISCOUNT NET PRESENT
RETURN FACTOR VALUE
0-100 0 -100
125 0.952 23.8
225 0.907 22.675
325 0.864 21.6
425 0.823 20.575
525 0.784 19.6
= $108.25

• $108.25 MINUS INITIAL COST ($100) = $8.25
• Profit = $8.25
• ADVANTAGES
• Considers the time value of money
• Reducing discounting rate reduces future monies more
heavily
• Only one method that gives a definitive answer
• Positive return – it is worth doing
• DISADVANTAGES
• Time consuming
• More difficult to understand
• Based on an arbitrary choice of interest rate
Summary
In the NPV method, the revenues and costs of a
project are estimated and then are discounted
and compared with the initial investment. The
preferred option is that with the highest
positive net present value. Projects with
negative NPV values should be rejected because
the present value of the stream of benefits is
insufficient to recover the cost of the project.
Summary
Compared to other investment appraisal
techniques such as the IRR and the discounted
payback period, the NPV is viewed as the most
reliable technique to support investment
appraisal decisions.
• The NPV method should be always be used
where money values over time need to be
appraised. Nevertheless, the other techniques
also yield useful additional information and
may be worth using.
Decision rule:
• If NPV is positive (+): accept the project
If NPV is negative(-): reject the project
• Mathematical proof: for a project to be
acceptable, the NPV must be positive,
GROUP Exercise : Net present value
• A firm intends to invest $1,000 in a project
that generated net receipts of $800, $900 and
$600 in the first, second and third years
respectively. Should the firm go ahead with
the project?
• Attempt the calculation using net present
value tables: using 10% discount rate
Internal Rate of Return - IRR
The IRR is the discount rate at which the NPV
for a project equals zero. This rate means that
the present value of the cash inflows for the
project would equal the present value of its
outflows.
• The IRR is the break-even discount rate.
• The IRR is found by trial and error.
• The preferred option is that with the IRR
greatest in excess of a specified rate of return.
• An IRR of 10% means that with a discount rate
of 10%, the project breaks even.
• The IRR approach is usually associated with a
hurdle cost of capital/discount rate, against
which the IRR is compared.
IRR
There are disadvantages associated with the
IRR as a performance indicator. It is not
suitable for the ranking of competing projects.
It is possible for two projects to have the same
IRR but have different NPV values due to
differences in the timing of costs and benefits.
• The key advantage of NPV and IRR is that they
take into account the time value of money –
the fact that money you expect sooner is
worth more to you than money you expect
further in the future.
QUALITATIVE FACTORS
• Investment appraisal techniques consider the
financial results but there are other factors to
be considered. These will be different for
every organisation.
• The aims of the business
• The reliability of the date
• The economy
• Image
• SWOT (strengths, weakness, opportunities,
threats) analysis
• PEST analysis
• HRM issues
• Stakeholder analysis
• Anything else that needs to be considered
END

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