Capital Investment Appraisal: Appraisal Process and

Methods

04/30/21 Bahiru Bewket, Ph.D.

 Why Do We Need an Investment Appraisal

Large amount of resources are involved and wrong decisions could

be costly;

Difficult and expensive to reverse;

Investment decisions can have a direct impact on the ability of the

organisation to meet its objectives;

04/30/21 Bahiru Bewket, Ph.D.

 Investment Appraisal Process
Stages:
Identify objectives. What is it? Within the agency’s objectives?

Identify alternatives.

Collect and analyse data. Examine the technical and economic feasibility of
the project, cash flows etc.

decide which one to undertake

authorization and implementation

review and monitor: learn from its experience and try to improve future
decision - making.

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
• Payback Method - length of time it takes to repay
the cost of initial investment

Example No. 1
The company uses the payback period as its sole investment
appraisal method. It invests 30,000 Birr to replace it and this
investment returns 9,000 Birr annually for the five years. From
the information above evaluate the investment using the
payback. Assume that 9,000 Birr accrues evenly throughout the
year.

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
• Payback Method
Solution No.1
Year Flow Yearly cash flow Cumulative Net Cash
Birrs Birrs

0 (-30,000) (-30,000)
1 +9,000 (-21,000)
2 +9,000 (-12,000)
3 +9,000 (-3,000)
4 +9,000 +6,000
5 +9,000 +15,000

Therefore 3 years = 27,000 then 3000/9000 x 12 = 4

Payback period = 3 years 4months

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
• Payback Method
Example No. 2
You are faced with two investment opportunities which each cost 30,000 Birrs
and which have the net inflows shown in the table below:
Year Project A Cash Flows Project B Cash Flows
(Birrs) (Birrs)
1 7,500 5,000
2 7,500 5,000
3 7,500 6,000
4 7,500 6,000
5 5,000 8,000
6 0 15,000
7 0 15,000
Required:
• Use the payback method to choose between the two projects.
• Using a discount rate of 12 %, which project has the faster payback?
04/30/21 Bahiru Bewket, Ph.D.
 Appraisal Methods
• Payback Method
Solution No. 2

b) Discounted Payback
Discounted Discounted
Year DF (12%) Cash Flows (A) Cash Flows (A) Cash Flows (B ) Cash Flows (B)
(Birrs) (Birrs)
• 0.89286 7,500 6,696. 5,000 4,464.30
• 0.79700 7,500 5,977.50 5,000 3,985.00
• 0.71178 7,500 5,338 .35 6,000 4,270.68
• 0.63552 7,500 4,766 .40 6,000 3,813.12
• 0.56743 5,000 2,837 .15 8,000 4,539.68
• 0.50663 0 0 15,000 7,599.45
• 0.45235 0 0 15,000 6,785.25
• ----------------- ----------------
25,616.85 35,457.48
For A, payback is outside the project’s life
For B payback is 6.25 years..
04/30/21 Bahiru Bewket, Ph.D.
 Appraisal Methods
• Payback Method
Reasons for payback’s popularity

Once the relevant cash flows are calculated, payback is easy to

apply and to explain to management;

Capital rationing: -it ensures the recycling of cash into new

projects with the least delay;

Convenient for risk averse because of short payback periods;

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
• Net Present Value (NPV)

the difference between the present values of cash inflows

and outflows of an investment;

Opportunity cost of undertaking the investment is the

alternative of earning interest rate in the financial market;.

04/30/21 Bahiru Bewket, Ph.D.

 Net Present Value (NPV)
• Net Present Value of an Investment is the present value of all its
present and future cash flows, discounted at the opportunity
cost of those cash flows. NPV is mathematically represented as:

• Where: CF0 = Cash flow at time zero (t0)

• CF1 = Cash flow at time one (t1), one year after time zero

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
• Net Present Value (NPV)

Present value:- the amount of money you must invest or

lend at the present time so as to end up with a particular
amount of money in the future.

Discounting: -finding the present value of a future cash flow

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
• Net Present Value (NPV)
Example No. 4
A company can purchase a machine at the price of 2,200 Birrs.
The machine has a productive life of three years and the net
additions to cash inflows at the end of each of the three years
are 770 Birrs, 968 Birrs and 1331 Birrs. The company can buy the
machine without having to borrow and the best alternative is
investment elsewhere at an interest rate of 10%.
Evaluate the project using the Net present value method.

04/30/21 Bahiru Bewket, Ph.D.

• Net Present Value (NPV)
Solution No. 4

• NPV = 770 + 968 + 1331 - 2,200 = 300

(1.1) (1.1)2 (1.1)3
OR
• Year Cash flow Discount Factor (10%) PV
• 0 (2,200) 1.000 (-2,200)
• 1 770 0.9091 +700
• 2 968 0.8264 +800
• 3 1,331 0.7513 +1,000
NPV 300
• Comments:
• The project is worthwhile and the machine should be bought.

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods

• Net Present Value (NPV)

Example No. 5

A firm invest 180,000 Birrs in a project that will give a net cash
inflow of 50,000 in real terms in each of the next six years. Its
real pre-tax cost of capital is 13%.

Required:

Calculate NPV

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods

• Net Present Value (NPV)

Solution No. 5

Year Cash Flow PV factor 13% Present value

0 (180,000) 1.00 (180,000)
1 50,000 0.885 44,250
2 50,000 0.783 39,150
3 50,000 0.693 34,650
4 50,000 0.613 30,650
5 50,000 0.543 27,150
6 50,000 0.480 24,000
• NPV 19,850
• Positive NPV indicates viability of the project.
• Negative NPV indicates non-viability of the project.

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods

Internal Rate of Return (IRR)

is the discount rate that equates the present

values of an investment’s cash inflows and outflows.

is the discount rate that causes an investment’s

NPV to be zero

04/30/21 Bahiru Bewket, Ph.D.

 Internal Rate of Return (IRR)

• Use interpolation method to calculate the IRR. The formula is as

follows:

Where:
• L = Lower rate of interest
• H = Higher rate of interest
• NL = NPV at lower rate of interest
• NH = NPV at higher rate of interest
•  

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
Internal Rate of Return (IRR)
Example No. 6
A company can purchase a machine at the price of 2,200
Birrs. The machine has a productive life of three years and the net
additions to cash inflows at the end of each of the three years are
770 Birrs, 968 Birrs and 1331 Birrs. The company can buy the
machine without having to borrow and the best alternative is
investment elsewhere at an interest rate of 10%.
Evaluate the project using the Internal Rate of Return (IRR)
method.

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
Internal Rate of Return (IRR)
Solution No. 6

IRR Try 15%

Year Cash flow Discount Factor (15%) PV

0 (2,200) 1.000 (2,200.00)
1 770 0.8696 669.59
2 968 0.7561 731.90
3 1,331 0.6575 875.13
NPV 76.62

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
Internal Rate of Return (IRR)
Solution No. 6

IRR Try 16%

Year Cash flow Discount Factor (16%) PV

0 (2,200) 1.000 (2,200.00)
1 770 0.8621 663.83
2 968 0.7432 719.42
3 1,331 0.6407 852.77
NPV 36.01

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
Internal Rate of Return (IRR)
Solution No. 6

IRR Try 17%

Year Cash flow Discount Factor (17%) PV

0 (2,200) 1.000 (2,200.00)
1 770 0.8475 652.58
2 968 0.7305 711.48
3 1,331 0.6244 831.08
NPV (4.86)

04/30/21 Bahiru Bewket, Ph.D.

 The appraisal method
Internal rate of return (IRR)
Interpolating

where
L=16
H=17
NL=36.01
Nh=4.86
IRR= 16+36.01*(17-16)/(36.01-(-4.86))
IRR=16.88%
04/30/21 Bahiru Bewket, Ph.D.
 Accounting Rate of Return (ARR)

• Accounting Rate of Return method relates average annual profit

to either the amount initially invested or the average
investment, as a percentage.
• Formulae
ARR = Average annual accounting profit x 100
Average investment
• Where:
– Average annual profit = Total profit/Number of years
– Average investment = (initial capital investment +
scrap value) / 2

04/30/21 Bahiru Bewket, Ph.D.

 Accounting Rate of Return (ARR)

Example No. 3

Using the data below, calculate the ARR.

Year 0 1 2 3 4

Cash flows (45,000) 11,000 12,250 12,250 32,000

 
Depreciation (11,250) (11,250) (11,250) (11,250)
 
Accounting profit (250) 1,000 1,000 20,750

04/30/21 Bahiru Bewket, Ph.D.

 Appraisal Methods
• Accounting Rate of Return (ARR)
Solution No. 3

Average Accounting Profit

(- 250 +1000 + 1000 + 20,750) / 4 = 5625

Average investment = 45,000 / 2 = 22500

ARR = (5625/22,500) x 100 = 25%

04/30/21 Bahiru Bewket, Ph.D.