Lesson 4: Investment Appraisal

Lesson 4
Investment Appraisal
Prepared by Simson Loong 1

Investment appraisal - Revision
In this chapter, we will be examining the

appraisal of projects which involve the outlay
of capital. Capital expenditure differs from
day to day revenue expenditure for two
reasons:
 It involves a significant amount of capital
outlay
 The benefit from capital expenditure
involves a long period of time usually over
one year and often much longer.

Capital investment appraisal techniques we

will cover:
 Discounted payback method
 Accounting rate of return method
 DCF methods involving:
 NPV method
 IRR method
 Profitability index method

Discounted Payback method
 The payback method looks at how long it takes for a
project’s net cash inflows to equal the initial investment.
 This method is often used as a ‘first screening method’
ie only those projects that fall within the targeted
payback period time frame will be considered.
 In the event where projects are exposed to fluctuations
due to change of price levels (inflation), then the
discounted payback period will be used.
 Using the discounted payback method, the future cash
flow will first be discounted back to present value before
the duration of time required to match the total inflows
with the initial investment.

Example:
The following represent the cash flow of a project:
Initial outlay RM60,000
Profits before depreciation
Year 1 RM30,000
Year 2 RM20,000
Year 3 RM40,000
Year 4 RM30,000
If the company has a cost of capital of 10%, calculate the

discounted payback period for the project.

Solution
Year Cash Flow Discount Present Cumulative
Factor Value present
value
0 (60,000) 1.000
1 30,000 0.909
2 20,000 0.826
3 40,000 0.751
4 30,000 0.683

The internal rate of return method (IRR)
 The general rule: The IRR method of project appraisal is

to accept those projects which have an IRR (the rate at
which the NPV is zero) that exceeds a target rate of
return.
 The IRR is “The annual percentage return achieved by

a project, at which the sum of the discounted cash
flows over the life of the project is equal to the sum of
the discounted cash outflows”.

Basically, there are 2 methods to determine the IRR

of a particular project:
 Using the graphical approach (academic only
but much easier to establish it)
 Using the interpolation method (not that
accurate and more tedious but can be
acceptable for examination purpose).
Using the interpolation method, the IRR
interpolation formula applicable is:
 IRR = A + [P/(P + N) x (B-A)] %

Example:
The VV Group of Companies produces a variety of high-
quality garden furniture and associated items, mostly in wood
and wrought iron. Recently the directors identified that there
is an option to expand the business by expanding its
flourishing retail outlet to include all products. As the future is
highly unpredictable, it only considers 4 years of cash flow to
evaluate its investment.
Calculate the IRR of the option if the initial cost of the
investment is RM100,000 and expected year end cash inflow
is expected to be RM40,000 in year 1, RM50,000 in year 2
and 3 and RM60,000 in year 4.

Solution
Cash Discount Factor Discount
Year Flow (20%) PV Factor (50%) PV
0 -100000 1 -100000 1 -100000
1 40000 0.833 33333 0.6667 26666.67
2 50000 0.694 34722 0.4444 22222.22
3 60000 0.579 34722 0.2963 17777.78
4 60000 0.482 28935 0.1975 11851.85
NPV 31713 -21481.5
Therefore, IRR of the project =

When compared with the NPV method, the IRR

method has a number of disadvantages.
 It ignores the relative size of investments.
 There are problems with its use when a project

has non-conventional cash flows or when
deciding between mutually exclusive projects
 Discount rates which differ over the life of a
project cannot be incorporated into IRR
calculations.

 When a conflict arises in selecting mutually

exclusive projects between the IRR method
and the NPV method, then the selection will
be based on NPV method as this method is
the most consistent with the shareholders
wealth maximization objectives.

 NPV (Net present value method)

- NPV is the difference between the sum of all inflows and
the sum of all outflows expressed at present value.
- The general rule using NPV method is projects that give
generates positive NPV will be accepted and reject those
having negative NPV.
- The future cash flows are normally discounted to the
present value using a discount rate – normally the WACC
of the company

Discount Factor
One of the key elements in computing an accurate NPV to
assess the viability of an investment is the assumptions used
in deriving the discount factor used in the analysis.
As most companies are financed by a combination of equity
and debt, the discount factor that may be used represents
the weighted average cost of capital (WACC).
WACC can be defined as the required return on
investments by the firm that have the same risk as its
existing operations.
WACC can be computed by using the following formula:

WACC = E/V*Re + D/V*Rd*(1-Tc)

Where Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’ debt
V=E+D
Tc = Corporate tax rate

Example:
A company currently finances it’s long term investment using
a combination of 40% debt and the balance using equity.
Assuming that after tax cost of new debt is 6% and the
required rate of return on equity capital is 14%, compute the
overall WACC of the company.
Solution

Sensitivity analysis
 The margin of error approach to sensitivity analysis
assess how responsive the project’s NPV is to changes in
the variables used to calculate that NPV.
 The basic approach involves calculating the project’s
NPV under alternative assumptions to determine how
sensitive is to changing conditions, thereby indicating
those variables to which the NPV is most sensitive
(critical variables) and the extent to which those
variables may change before the investment decision
would change (ie a positive NPV becoming a negative
NPV)

The sensitivity of an NPV computation to changes in

a variable that affects the cashflows is:
NPV of project X 100%
PV of cash flow affected
Example:
Measure the sensitivity of a project to changes in
variables for KEE, which has a cost of capital of 8%
and has the following ‘most likely cash flows
associated with the project:

Year 0 (RM’000) 1 (RM’000) 2 (RM’000)

Initial (7,000)
Investment
Variable cost (2,000) (2,000)
Cash inflows 6,500 6,500
(65,000 units
at RM10 per
unit)
Net Cash (7,000) 4,500 6,500
Flows

Solution:
Step 1 - to calculate the NPV of the project:
Year DF (8%) I. Investment Variable Cost Cash inflows PV of Investment PV of Variable Cost PV of Cash Inflow Total PV
0 1 -7000 -7000 -7000
1 0.9259 -2000 6500 -1852 6019 4167
2 0.8573 -2000 6500 -1715 5573 3858
-7000 -3567 11591 1025
Based on the above computation, as the NPV of the project is

positive, the project is viable hence should be undertaken.
Step 2 – to calculate the percentage of changes that is

required to affect the viability of the investment.

Solution
 The initial investment can increase by ______% before the project
becomes not viable.
NPV of project X 100% = 1,025/7,000 X 100% = 14.64%
PV of cash flow affected


Capital rationing
If an organization is in a capital rationing situation it will not be
able to enter into all projects with positive NPV because there is
not enough capital for all investments. In this case, the selection
of projects for investment will be based on which projects that
gives the highest NPV per RM invested that is using the PI
method of investment appraisal.
Example:
BRIT House is experiencing capital rationing in year 0, when
only RM60,000 of investment finance will be available. No
capital rationing is expected in future periods, but none of the
three projects under consideration can be postponed. The
expected cash flows of the three projects are as follows:

Project Year 0 Year 1 Year 2 Year 3 Year 4

A (50,000) (20,000) 20,000 40,000 40,000
B (28,000) (50,000) 40,000 40,000 20,000
C (30,000) (30,000) 30,000 40,000 10,000
The cost of capital is 10%.
Required:
Determine the optimal investment plan for BRIT Sdn Bhd
assuming the projects are divisible.

Solution
Project A Project B Project C

Year Discount Factor (10%) Cash Flow DCF Cash Flow DCF Cash Flow DCF
0 1 -50000 -50000 -28000 -28000 -30000 -30000
1 0.909090909 -20000 -18182 -50000 -45454.5 -30000 -27272.7
2 0.826446281 20000 16529 40000 33057.85 30000 24793.39
3 0.751314801 40000 30053 40000 30052.59 40000 30052.59
4 0.683013455 40000 27321 20000 13660.27 10000 6830.135
NPV 5720.238 3316.167 4403.388
PV of cash flows 55720 31316.17 34403.39
PI = PV of future cash flows / Initial Investment 1.114405 1.118435 1.14678
Ranking 3 2 1

Advanced Investment Appraisal
Now that we have discussed the basic aspect of the capital
expenditure appraisal technique, we will look into the more
advanced level of investment appraisal involving taxation and
inflation. We will also cover the many capital investment
decisions.
We will be looking into the following:
 Mutually exclusive projects with unequal lives (the use of
annualised equivalents and the lowest common multiple
(LCM))
 Asset replacement
 Project abandonment
 Probability analysis and long term decisions
 Incorporating inflation and taxation effects on project appraisal
 Sensitivity analysis involving taxation and inflation

Mutually exclusive projects with unequal lives

 All of the discounted cash flow examples we have
come across so far have involved a choice with
projects with equal lives. However, if managers are
deciding between projects with different time span, a
direct comparison between each project’s NPV
would not be valid. Instead, an annualised
equivalent or lowest common multiple is to be
used to enable a comparison to be made between
projects with different durations.

When inflation is not a factor, AE can be used.
Example:
DEEP Rest Sdn Bhd has the opportunity to invest in either project D or
project R. The forecasted cash flows from the projects are as follows:
Project D (RM’000) Project R (RM’000)

Capital Cost (200) (143)
Cash inflows:
Year 1 90 100
Year 2 120 80
Year 3 50 -
The company’s cost of capital is 12%.

Required:
Determine which project should be invested?
Solution

DEEP
Rest Sdn.
Bhd
Project P Project R
DF Cash DF
Year Cash Flow (12%) PV Flow (12%) PV
0 -200 1 -200 -143 1 -143
1 90 0.893 80.37 100 0.893 89.3
2 120 0.797 95.64 80 0.797 63.76
3 50 0.712 35.6
11.61 10.06

However, when asset replacement includes inflation, we will

not be able to use annualised equivalent costs to determine
which option is suitable. Instead, the lowest common multiple
(LCM) will be used.
The key points when using the lowest common multiple
method are:
Calculate cash flows including inflated values for both
alternatives
Use a lowest common multiple to establish a common time
period and base asset lives on that

Example:
FIONA is considering the replacement of a caravan he lets
out for hire. He is planning to retire in six years’ time and is
therefore only concerned with that period of time, but cannot
decide whether it is better to replace the caravan every two
years or every three years.
The following data have been estimated (all values at today’s
price levels):
Purchase cost and trade-in values
RM
Cost of a new caravan 20,000
Trade-in value of caravan: after two years 10,000
after three years 5,000

Annual costs and revenues

Per year (RM)
Caravan running cost 10,000
Lettings charged to customers;
that is revenue for Fiona 20,000
Caravan servicing and repair costs

Caravan servicing and repair costs depend on the age of the
caravan. In the following table, year 1 represents the cost in
the first year of the caravan ownership; year 2 represents the
cost in the second year of ownership, and so on:

RM
Year 1 500
Year 2 2,500
Year 3 4,000
Inflation
New caravan costs and trade-in-values are expected to
increase by 5% per year. Caravan running costs and lettings
are expected to increase by 7% per year. Caravan servicing
and repair costs are expected to increase by 10% per year.

Required:
Advise Fiona on the optimum replacement cycle for his
caravan and state the net present value of the opportunity
cost of making the wrong decision. Use a discount rate of
12% per year. All workings and assumptions should be
shown. Ignore taxation.

Solution
When caravan is replaced
every 2 years
Description 0 1 2 3 4 5 6NPV
Caravan Cost (5%)
Trade in Value (5%)

Annual cost and
revenue (7%)
Caravan Service
and Repair (10%)
Net Cash Flow -20000 10150 -2601 11585 -2707 13220 23979
Discount Factor
(12%) 1 0.893 0.797 0.712 0.636 0.567 0.507
Present Value -20000 9064 -2073 8248 -1722 7496 12158 13171
When caravan is replaced
every 3 years
Description 0 1 2 3 4 5 6NPV
Caravan Cost (5%)
Trade in Value (5%)

Annual cost and
revenue (7%)
Caravan Service and
Repair (10%)
Net Cash Flow -20000 10150 8424 -10438 12376 9999 14622
Discount Factor (12%) 1 0.893 0.797 0.712 0.636 0.567 0.507
Present Value -20000 9064 6714 -7432 7871 5670 7413 9300
Asset replacement
As well as assisting with decisions between particular assets,
the DCF techniques combined with annualised equivalents
can be used to assess when and how frequently an asset
should be replaced. When an asset is being replaced with an
identical asset, the equivalent annual cost method can be
used.
Example: Replacement of an identical asset

Farnshi operates a machine which costs RM25,000 to buy
and has the following costs and resale values over its four
year life:

Year 1 Year 2 Year 3 Year 4

(RM) (RM) (RM) (RM)
Running costs (cash 7,500 10,000 12,500 15,000
expenses)
Resale Value (end of the 15,000 10,000 7,500 2,500
year)
The organization’s cost of capital is 10%.

Required:
Assess how frequently the asset should be replaced.

Solution
Keep for 1 year Keep for 2 year Keep for 3 year Keep for 4 year
DF Cash Cash Cash Cash
Year (10%) Flow PV Flow PV Flow PV Flow PV
0 1.000 -25000 -25000 -25000 -25000 -25000 -25000
1 0.909 7500 6817.5 -7500 -6817.5 -7500 -6817.5
2 0.826 0 0 -10000 -8260
3 0.751 -5000 -3755
4 0.683
NPV (18183) (31818) (43833) (58003)

Cummulative
(10%) 0.909 1.735 2.486 3.169
AEC (20003) (18339) (17632) (18303)

Allowing for inflation
 Inflation refers to the general increase in price of goods and
services ie a dollar today can buy more goods than a dollar in
the future.
 As the inflation rate increases so will the minimum required
return required by an investors. For example, one may be
contended to earn a 5 % return in an inflation free world but if
inflation is running at 15 % pa, one would consider a higher
yield before an investment is undertaken to account for
inflation.
For example,
Suppose to say that one is to invest RM1,000 today and the
required return for this investor is 20% and inflation is running
at 10%, how would one need to address the inflation problem
of the investors?

 Money rate measures the return in terms of

RM which of course falling in value over time.
 Real rate measures the return in constant
price level terms.
The two rates of return and the inflation rate are
linked by an equation called the Fisher’s equation:
(1 + money rate of return) = (1 + real rate of
return) X (1 + rate of inflation)

The general rule to account for inflation:
If money cash flows are given in the questions, then it should be
discounted at a money discount rate.
If real cash flows (ie adjusted for inflation) given, then it should be
discounted using a real discount rate.
Example:
An organization is considering investing in a project with the following
cash flows.
Time Projected cash flows (RM)
0 (15,000)
1 13,000 2
25,000

The organization requires a minimum return of 20% under the

present and anticipated conditions. Inflation is currently running at
10% pa and this rate of inflation is expected to continue
indefinitely. Should the company undertake the project?
Solution 1– Using money cash flow approach
Method 1 (Discount Money Cash Flow with Money Discount Rate)
Year Cash Flow Discount Factor (20%) Present Value
0 -15000 1 -15000
1 13000 0.8333 10833
2 25000 0.6944 17361
13194

Solution 2– Using real cash flow approach

Method 2 (Discount Real Cash Flow with Real Discount Rate)
Year Real Cash Flow
Real Discount Factor (9.091%) Present Value
0 -15000 1 -15000
1 11818 0.9167 10833
2 20661 0.8403 17361
13194
Real Discount Factor = (1 + money rate of return) -1

(1 + rate of inflation)
= 0.09091

As you can see that both will arrive at the same NPV of
RM13,194. Which method to be used will much depends
on the question itself. However, if all costs and revenues
are subjected to different rises in price levels, then we
will need to apply the money rate to inflated values to
determine a project’s NPV.

Allowing for taxation in capital projects
Tax will have an impact of capital projects appraisal by
considering:
 Payment for corporate taxation – a cash outflow. (net cash
flows from a project should be considered as the taxable
profit arising from the project)
 Capital allowances/writing down allowances (WDA) – a
method of reducing chargeable profit hence tax payable.
 Balancing allowances and balancing charges – depending
on the difference between the selling price of the asset
and the reducing balance amount.
A balancing allowance reduces the amount of tax payable.
A balancing charge increases the amount of tax payable.

Example:
CCN Sdn. Bhd. plans to buy a new machine to meet expected
demand for a new product, ST. This machine will cost
RM250,000 and last for four years, when it will be sold for
RM5,000. The company expects demand for ST to be as follows:
Year 1 2 3 4
Demand 35,000 40,000 50,000 45,000
(units)

The selling price for ST is expected to be RM12.00 per unit and

the variable production cost is expected to be RM7.80 per unit.
Incremental annual fixed costs of RM25,000 per year will be
incurred.
Selling price and costs are all in current price terms. Selling price
and all costs of Product ST are expected to increase as follows:
Increase
Selling price: 3% per year
Variable production costs: 4% per year
Fixed costs: 6% per year

Other information:
CCN Sdn. Bhd. has a real cost of capital of 4.7% and pays
tax at an annual rate of 25% one year in arrears. It can claim
capital allowances on a 25% reducing balance basis.
General inflation is expected to be 6% per year. Working
capital representing 10% of sales for the year is required and
will be adjusted accordingly.
CCN Sdn. Bhd. has a target return on capital employed of
35%. Depreciation is calculated on a straight-line basis over
the life of an asset.

Required:
(a) Calculate the net present value of buying the new
machine and comment on your findings (work to the
nearest RM1,000).
(b) Compute the maximum amount that the company should
pay to acquire the machinery.

Present Value Table

Year 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.812 0.731 0.659 0.593
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497

a) CNN
Working 1
Year 1 2 3 4
Demand (units) 35,000 40,000 50,000 45,000
Selling price (RM/unit)
Sales (RM/year) 432,600 509,232 655,636 607,775
Working capital requirement (10% of
sales) 43,260 50,923 65,564 60,777
Working 2
Variable Cost (RM/unit)
Total Variable Cost (RM) 283,920 337,459 438,697 410,620
Working 3
Year Capital Allowances
1
2
3
**4 100,469
Solution
Working 4 (working capital calculation) 43,260 50,923 65,564 60,777
Working capital injection/(recovered) 43,260 7,663 14,640 (4,786)
** Balancing Charge = 250,000 - 5,000 - total allowance claimed to date
Year 0 1 2 3 4
Sales (W1) 432,600 509,232 655,636 607,775
Variable Cost (W2) (283,920) (337,459) (438,697) (410,620)
Contribution 148,680 171,773 216,939 197,154
Less: Fixed Cost (26,500.00) (28,090.00) (29,775.40) (31,561.92)
Cash Profit 122,180 143,683 187,164 165,592
Less: Capital Allowance 62,500.00 46,875.00 35,156.25 100,468.75
Taxable proft 59,680.00 96,807.80 152,007.59 65,123.73
Tax payable (25%) 14,920.00 24,201.95 38,001.90 16,280.93

0 1 2 3 4 5
Net Cash Profit 122,180 143,683 187,164 165,592
Tax Payable (14,920) (24,202) (38,002) (16,281)
Working Capital (W4) (43,260) (7,663) (14,640) 4,786 6,077
Investment
(250,000) 5,000
After Tax Net Cash
Flow (293,260) 114,517 114,122 167,748 138,668 (16,276)
Discount Factor (11%) 1 0.901 0.812 0.731 0.659 0.593
Present Values (293,260) 103,168 92,624 122,656 91,345 (9,659) 106,874

The maximum amount that the company should pay

to acquire the machinery is
________________________________

Lesson 4: Investment Appraisal

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Lesson 4

Prepared by Simson Loong 1

In this chapter, we will be examining the

Prepared by Simson Loong 2

Capital investment appraisal techniques we

Prepared by Simson Loong 3

Prepared by Simson Loong 4

If the company has a cost of capital of 10%, calculate the

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The internal rate of return method (IRR)

 The general rule: The IRR method of project appraisal is

 The IRR is “The annual percentage return achieved by

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Basically, there are 2 methods to determine the IRR

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Therefore, IRR of the project =

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When compared with the NPV method, the IRR

 There are problems with its use when a project

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 When a conflict arises in selecting mutually

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 NPV (Net present value method)

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WACC = E/V*Re + D/V*Rd*(1-Tc)

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The sensitivity of an NPV computation to changes in

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Year 0 (RM’000) 1 (RM’000) 2 (RM’000)

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Based on the above computation, as the NPV of the project is

Step 2 – to calculate the percentage of changes that is

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Project Year 0 Year 1 Year 2 Year 3 Year 4

B (28,000) (50,000) 40,000 40,000 20,000

C (30,000) (30,000) 30,000 40,000 10,000

The cost of capital is 10%.

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Project A Project B Project C

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Mutually exclusive projects with unequal lives

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Project D (RM’000) Project R (RM’000)

The company’s cost of capital is 12%.

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However, when asset replacement includes inflation, we will

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Annual costs and revenues

Caravan servicing and repair costs

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WACC = E/VRe + D/VRd*(1-Tc)