Investment Appraisal

• A means of assessing whether an

investment project is worthwhile or not
• Investment project could be the purchase of a
new PC for a small firm, a new piece of
equipment in a manufacturing plant, a whole
new factory, etc
• Used in both public and private sector
Investment Appraisal
• Types of investment
appraisal:
– Payback Period
– Accounting Rate of
Return (ARR)
– Internal Rate of
Return (IRR)
– Profitability Index
– Net Present Value
(discounted cash
flow)
Payback Period
• The length of time taken to repay the initial
capital cost
• Requires information on the returns the
investment generates
• e.g. A machine costs Rs600,000
• It produces items that generate a profit of Rs5
each on a production run of 60,000 units per
year
• Payback period will be 2 years
Payback method

• Payback could occur during a year

Days/Weeks/Months x Initial Investment
Payback = ------------------------------------------
Total Cash Received
Payback Period
Simple to use
Useful for short term decision
Useful if the returns are accurate
Income streams not time related
Investment Appraisal
• To make a more informed decision, more sophisticated
techniques need to be used.
• Importance of time-value of money
 Time Value of Money
The value today of a rupee tomorrow: how much you have to put into your
account today, so that in one year the balance is W at a rate of r %

Rs110 in a year = Rs100 deposit in a bank at

10% interest
Rs 110 = Future Value(FV)

Rs 100 = Present Value(PV)

PV  100  110
(1 0.10 )
Discounting

 the future value must be discounted to obtain PV

Computational Finance 8/36

Net Present Value

• Takes into account the fact that money values change

with time
• How much would you need to invest today to earn x
amount in n years time?
• Value of money is affected by interest rates
• NPV helps to take these factors into consideration
 00 11 22 33 …
… nn

CF
CF1 1 CF
CF2 2 CF
CF3 3 …
… CF
CFn n
CF
CF0 0

Where CFt = estimated future cash flow

at time t
CF0 = the initial cash outlay
 Firm’s Cost of Capital( k)

• The firm’s cost of capital determines the minimum rate

of return that would be acceptable for a capital
project.
NPV = the sum of the present value of all benefits
minus the present value of costs
n
Cash Flow Benefitsi
NPV    Initial Cost
i 1 ( 1  k)i

If benefits > cost, NPV will be positive and the

project is acceptable.

If benefits < cost, NPV will be negative and the

project is unacceptable because it destroys
firm value.
 NPV Example 1
Problem:
• Initial outlay = Rs12,000
• cash flow benefits: CF1 CF2 CFn
NPV    ....  CF0
– Year 1 = Rs5,000 (1  k ) (1  k )
1 2
(1  k ) n

– Year 2 = Rs5,000
5,000 5,000 8,000
– Year 3 = Rs8,000     12,000
(1.15)1 (1.15) 2 (1.15) 3
• Discount rate (k) = 15%
 4,348  3,781 6,260  12,000
 Rs1,389
NPV Example 2

Initial cost = 100000.00

annual cash flow benefits = 60000.00
Useful life(years) = 6.00
Cost of Capital = 0.05

Year Cashflow CF PV Factor Present Value

0 Initial cost -100000.00 1.00 -100000.00
1 Annual operating benefit 60000.00 0.95 57142.86
2 Annual operating benefit 60000.00 0.91 54421.77
3 Annual operating benefit 60000.00 0.86 51830.26
4 Annual operating benefit 60000.00 0.82 49362.15
5 Annual operating benefit 60000.00 0.78 47011.57
6 Annual operating benefit 60000.00 0.75 44772.92
NPV = 204541.52
Increasing the discount rate to 10%, the NPV of
the project falls from $204,542 (at 5%) to
$161,316.
Initial cost = 100000.00
annual cash flow benefits = 60000.00
Useful life(years) = 6.00
Cost of Capital = 0.10

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -100000.00 1.00 -100000.00
1 Annual operating benefit 60000.00 0.91 54545.45
2 Annual operating benefit 60000.00 0.83 49586.78
3 Annual operating benefit 60000.00 0.75 45078.89
4 Annual operating benefit 60000.00 0.68 40980.81
5 Annual operating benefit 60000.00 0.62 37255.28
6 Annual operating benefit 60000.00 0.56 33868.44
NPV = 161315.64
Increasing the discount rate to 20%, the NPV of
the project falls to $99,531.

Initial cost = 100000.00

Annual cash flow benefits = 60000.00
Useful life(years) = 6.00
Cost of Capital = 0.20

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -100000.00 1.00 -100000.00
1 Annual operating benefit 60000.00 0.83 50000.00
2 Annual operating benefit 60000.00 0.69 41666.67
3 Annual operating benefit 60000.00 0.58 34722.22
4 Annual operating benefit 60000.00 0.48 28935.19
5 Annual operating benefit 60000.00 0.40 24112.65
6 Annual operating benefit 60000.00 0.33 20093.88
NPV = 99530.61
 Project NPV Profile
NPV
Rs
Rs260,000

0 0% 5% 10% 20% 40% 50% 60%

IRR = 55.8%

Discount Rate (%)

 Project NPV Profile
NPV
Rs
Rs260,000

IF the appropriate
discount rate (k) is
Rs146,684 12%, then the
NPV is forecast to
be positive.
0 0% 5% 10% 20% 40% 50% 60%

IRR = 55.8%

Discount Rate (%)

The Net Present Value Method:
Summary
 Internal Rate of Return
IRR
• The internal rate of return (IRR) is that discount
rate that causes the NPV of the project to equal
zero.
• If IRR > cost of capital(discount rate), then the
project is acceptable because it will return a rate
of return on invested capital that is likely to be
greater than the cost of funds used to invest in
the project.
 Internal Rate of Return (IRR)

CF CF CF CF
1
 2
 3
... n
 
CF
0 0
(
1IRR1
) (
1IRR2
) (
1IRR3
) ( 1IRR
)n

n
[ 13-2]

CF t
or
, 
i1
CF
0
(
1IRR
) t
IRR Example
Problem:
• Initial outlay = Rs12,000
• cash flow benefits:
– Year 1 = Rs5,000
– Year 2 = Rs5,000
– Year 3 = Rs8,000
• Cost of Capital = 15%
 IRR Example

CF1 CF2 CF3

CF0    - CF0  0
(1  IRR ) (1  IRR ) (1  IRR ) 3
1 2

5,000 5,000 8,000

  - 12000  0
(1  IRR ) (1  IRR ) (1  IRR ) 3
1 2

The only way you can use the formula is to use the iterative approach to solving for IRR. That is, substitute different values
for IRR until the mathematical expression becomes an equality.

Let IRR  20%

5,000 5,000 8,000
   12000  Rs 268.52
(1.2)1 (1.2) 2 (1.2) 3
Let IRR  25%
5,000 5,000 8,000
   12000  704
(1.25)1 (1.25) 2 (1.25) 3

we know the IRRis between 20% and 25%.

You can continue to substitute different values into the equation to iteratively
find the IRR, or you can use linear interpolation to ESTIMATE the approximate value of the IRR.
 IRR Example
Summarizing our results:
IRR is Discount Rate NPV
between 20% 268.52
20% and
25% 25% -704

By interpolation, IRR = 21.38%

The Internal Rate of Return
Method: Summary
 IRR versus NPV
• Both methods use the same basic decision inputs.
• The only difference is the assumed discount rate.
• The IRR assumes intermediate cashflows are reinvested at IRR…
NPV assumes they are reinvested at discount rate
– This difference, however, can produce conflicting decision
results under specific conditions
Investment Appraisal
• Key considerations for firms in
considering use:
– Ease of use/degree of simplicity required
– Degree of accuracy required
– Extent to which future cash flows can
be measured accurately
– Extent to which future interest rate
movements can be factored in and
predicted
– Necessity of factoring in effects of
inflation
 Question

• The construction cost of a shopping mall is estimated at Rs 1000 million.

The annual operation and maintenance cost will be Rs. 25 million per
year. The annual income (i.e. benefit) from the renting of floor spaces
will be Rs 125 million. Taking a time horizon of 20 years,

• (a) determine the NPV of the project., using a discount rate of 6 %. 
• (b) determine the IRR of the project.
• (c) advise the Client about the terms of a possible loan.