CE309

CAPITAL INVESTMENT AND

APPRAISAL METHODS

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CAPITAL BUDGETING /
INVESTMENT APPRAISAL
 Detailed analysis which entail the planning process
to ensure that projects pursued are viable
 Budget for major investment / expenditure such as:
 New machinery
 Replacement of machinery
 Launch of new products
 Research development projects

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CAPITAL BUDGETING OBJECTIVE
 Assist managers to make informed decisions on
acquiring & disposing of assets

 Detailed analysis examples: new machinery, new

vehicles & land

 Capital investment decisions have direct effect on:

- future profitability
- increase in efficiency and
- reduction in costs

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Capital investment basis
Capital investment involves the sacrifice
of current funds in order to obtain the
benefit of future wealth.

Itinvolves investing now in the hope of

generating future cash flows which will
exceed the initial investment.
Features of capital investments

Capital investment involves:

 the use of significant levels of finance to
acquire assets for long-term use in an
organisation with the desire to increase
future revenues and profits.
Factors to consider in
assessing capital projects
 The size of the investment.
 The phasing of the investment expenditure.
 The period between the initial investment and the asset
actually generating revenues and profits for the
business.
 The economic life of the project.
 The level of certainty regarding the projected cash flows.
 The working capital required.
 The degree of risk involved in the project.
Capital appraisal methods
 As capital investment decisions usually involve significant
amounts of finance, it is important to fully evaluate each
decision using sound appraisal techniques.
 The main methods used to evaluate investment in capital
projects are:

 Payback method
 Net present value (NPV)
 Internal rate of return (IRR)
Capital appraisal methods
Accounting Rate of Return (ARR) Profits

Payback Cash flows

Net Present Value (NPV) Cash flows

Internal Rate of Return (IRR) Cash flows

 PAY BACK METHOD (1)
 The payback is defined as the time it takes
the cash inflow from a capital investment
project to equal the initial cash outflows, usually
expressed in years.
 When deciding between 2 or more competing
projects, the usual decision is to accept the
one with the shortest payback.
 How long does it take for incoming returns to cover
costs or break even?
 Project should be rejected if its payback period is
more than the company’s target payback period.
 Example
Project P Project Q

Capital expenditure $ 60,000 $ 60,000

Cash Inflows
Year 1 20,000 50,000
Year 2 30,000 20,000
Year 3 40,000 5,000
Year 4 50,000 5,000
Year 5 60,000 5,000
 Solution

Project P
Year 0 ( 60,000)
Year 1 20,000
Year 2 30,000
Year 3 40,000 only 10,000 more
required in 3rd year
Therefore Project P’s pay back period is about
one quarter of the way through year 3 i.e,
( 2.25 years).
 Project Q
Year 0 ( 60,000)
Year 1 50,000
Year 2 20,000 only 10,000 more
required in 2nd year
Therefore Project Q’s pay back period is
about half way through year 2 i.e,
( 1.5 years).
Using pay back period alone to judge the Capital
investment projects, project Q would be
preferred. But the returns from project P over its
life are much higher than the returns from
project Q
Conclusion
 The pay back period has provided a rough
measure of liquidity and not profitability.
 Project P will earn total profits after
depreciation of $140,000, on an investment
of $60,000.
 Project Q will earn total profits after
depreciation of only $25,000, on an
investment of $60,000.
 Pay back can be important and long payback
periods mean capital tied up and also high
investment risk, but total project return ought
to be taken into consideration as well.
Accept or reject criteria for payback
method

Accept the project Reject the project

Payback period is less than Payback period is greater

that required by investors. than that required by
investors.
 Payback period formula
 Payback period = Y + ( A / B)

where Y = number of years before final

payback year
A = total remaining to be paid at the start
of payback year
B = total (net) paid back in the entire
payback year
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Advantages of payback
 It is simple to understand and apply.
 It promotes a policy of caution in investment.
Disadvantages of payback
 It takes no account of the timing of cash flows
($100 received today is worth more than $100
received in 12 months time).
 It is only concerned with how quickly the initial
investment is recovered and thus it ignores
the overall profitability and return on capital
for the whole project.
 It ignores the time value of money
Question???

A project yields the following cash flows over its

five year life. Calculate the payback period.
YEAR CASH FLOW
0 - 1000
1 500
2 400
3 200
4 200
5 100

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Net Present Value (NPV) – (2)
 Takes into account the fact that money values change
with time (time value of money)
 How much would you need to invest today to earn x
amount in x years time?
 Value of money is affected by interest rates
 NPV helps to take these factors into consideration
 Shows you what your investment would have earned in
an alternative investment regime
Net Present Value
 The principle:
 How much would you have to invest now to
earn $100 in one year’s time if the interest
rate was 5%?
 Allows comparison of an investment by
valuing cash payments on the project and
cash receipts expected to be earned over the
lifetime of the investment at the same point
in time, i.e. the present.
Net Present Value
Future Value
PV = -----------------
(1 + i)n
Where i = interest rate
n = number of years
 The PV of $1 @ 10% in 1 years time is 0.9090
 If you invested 0.9090c today and the interest rate was
10% you would have $1 in a year’s time
 Process referred to as:
‘Discounting Cash Flow’
Net Present Value
 Cash flow x discount factor = present value
 e.g. PV of $500 in 10 years time at a rate of
interest of 4.25% = 500 x .6595373 = $329.77
 $329.77 is what you would have to invest today
at a rate of interest of 4.25% to earn $500 in 10
years time
 PVs can be found through valuation tables
(e.g. Parry’s Valuation Tables)
Discounted Cash Flow
 An example:
 A firm is deciding on investing in an energy
efficiency system. Two possible systems are
under investigation
 One yields quicker results in terms of energy
savings than the other but the second may be
more efficient later
 Which should the firm invest in?
Discounted Cash Flow – System A

Year Cash Flow (£) Discount Factor Present Value

(4.75%) (£)
(CF x DF)
0 - 600,000 1.00 -600,000

1 +75,000 0.9546539 71,599.04

2 +100,000 0.9113641 91,136.41

3 +150,000 0.8700374 130,505.61

4 +200,000 0.8305846 166,116.92

5 +210,000 0.7929209 166,513.39

6 +150,000 0.7569650 113,544.75

Total 285,000 NPV =139,416

Discounted Cash Flow – System B

Year Cash Flow (£) Discount Factor Present Value (£)

(4.75%) (CF x DF)
0 - 600,000 1.00 -600,000
1 +25,000 0.9546539 23,866.35
2 +75,000 0.9113641 68,352.31
3 +85,000 0.8700374 73,953.18
4 +100,000 0.8305846 83,058.46
5 +150,000 0.7929209 118,938.10
6 +450,000 0.7569650 340,634.30
Total 285,000 NPV =108,802.70
Discounted Cash Flow
 System A represents the better investment
 System B yields the same return after six years
but the returns of System A occur faster and
are worth more to the firm than returns occurring
in future years even though those returns are
greater
 Internal Rate of Return (3)
 Allows the risk associated with an investment project to be
assessed
 The IRR is the rate of interest (or discount rate) that makes the
net present value equal to zero
 Helps measure the worth of an investment
 Allows the firm to assess whether an investment in the machine,
etc. would yield a better return based on internal standards of
return
 Allows comparison of projects with different initial outlays
 Set the cash flows to different discount rates
 Software or simple graphing allows the IRR to be found
IRR
 IRR is the rate of return on an investment
 IRR is the discount rate that gives NPV of zero
 Decision to accept or reject the purchase depends on
whether IRR is higher or lower than the discount rate
 Start with a guess at IRR, r.
 NPV is calculated using discount rate r.
 When NPV is close to zero then r is the IRR.
 When NPV is positive r is increased
 When NPV is negative r is decreased

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The internal rate of return (IRR)
Accept or reject criteria for IRR method

Accept the project Reject the project

IRR greater than the IRR less than the

cost of capital. cost of capital.
Appraisal methods
Accounting Rate of Return (ARR) Profits
Non time based
Payback Cash flows

Net Present Value (NPV) Cash flows

Time based (DCF)
Internal Rate of Return (IRR) Cash flows
 Conclusion on Capital budgeting methods

 Companies normally employ more than capital budgeting

method as each method will provide somewhat different piece
of information to the decision maker.
 Pay back and discounted pay back provide indication of
both risk and liquidity of the project.
 NPV method gives a direct measure of the dollar benefit of
the project to the share holders. Therefore it is regarded as
the best single measure of profitability.
 IRR is also a measure of profitability but it also contains a
projects safety margin
Questions???
Investment in capital projects involves large initial
financial outlays. Briefly explain three appraisal
methods used in capital investment projects
and the importance of doing so. (25 marks)

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END!!!!!

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