Investment Appraisal

Investment Decision
• Making a cash outlay with the aim of
receiving, in return, future cash inflows
• A common method of appraisal is
required, which can be applied to all
investment decisions
• Will a particular investment help the
company in maximising shareholder
wealth ( by share price maximisation)?
 Objectives of
Investment appraisal
• Understand the drawbacks and attractions of the
techniques available to appraise capital investment
projects.
• Appreciate why discounted cash flow methods are
preferred to pay-back and accounting rate of return.
• Understand why net present value is preferred to
internal rate of return from an academic point of view.
• Have an awareness of the empirical evidence of the
techniques used in practice.
• Understand the concept of capital rationing and the
use of the profitability index.
 Capital budgeting process
• Identification
• Estimating cash flows
• Evaluation
• Selection
• Post-audit
 Factors to consider
• Magnitude & timing of cash flows
• How to deal with mutually – exclusive
projects
• Time Value of Money
• Cost of Capital
• Easy-to-use calculations etc
 Discounted cash flow (DCF)
• Takes into account the time value of money and
the cash flows over the entire life of the project.
• All cash flows are put in present value terms
using the following formula
PV = FV (1 + r) -n
where PV is the present value, FV is the future
value, r is the rate of return and n is the number
of years or time periods.
 Method 1: Payback Method
• The most widely – used project appraisal
technique
• Used as a screening method; ie projects
which pass this “hurdle rate” can be
investigated further
• Ignores magnitude and timing of cash
flows within payback period
• Ignores all cash flows after payback period
• Mutually – exclusive projects: Payback
selects the less – risky project
 Payback Method
Strengths Weaknesses
• It is easy to • Does not take into
calculate, account the time
understand and value of money
communicate
• Cash inflow
• Used widely beyond pay-back
• Discounted pay- period is ignored
back addresses the • Pay-back duration
time value of money is an arbitrary
problem decision
 Example of Payback period
• Years to recover initial investment
Year Project A Project B
0 (450) (450)
1 100 0
2 200 0
3 100 400
4 100 100
5 80 80
Payback 3.5 years 3.5 years
 Example of Payback period
How many Years to recover initial investment?
Year Project A Project A Project B Project B
Cumulative Cumulative

0 (450) (450)

1 100 0

2 200 0

3 100 400

4 100 100

5 80 80

Payback 3.5 years 3.5 years

 Example of Payback period
How many Years to recover initial investment?
Year Project A Project A Project B Project B
Cumulative Cumulative

0 (450) (450) (450) (450)

1 100 (350) 0 (450)

2 200 (150) 0 (450)

3 100 (50) 400 (50)

4 100 50 100 50

5 80 130 80 130

Payback 3.5 years 3.5 years

 Example of Payback period
• Years to recover initial investment
Year Project A Project B
0 (450) (450)
1 100 0
2 200 0
3 100 400
4 100 100
5 80 80
6 40 200
7 40 200
Payback 3.5 years 3.5 years
 Payback period
Advantages of payback period:
• Simple concept to understand
• Easy to calculate (provided future cash flows
have been calculated)
• Uses cash, not accounting profit
• Takes risk into account (in the sense that
earlier cash flows are more certain)
 Payback period
Disadvantages:
• Considers cash flows within the payback
period only: says nothing about project as
a whole
• Ignores size and timing of cash flows
• Ignores time value of money (although
discounted payback can be used)
• It does not really take account of risk
 Method 2: Accounting Rate of Return
• ARR = (Average Profits minus Depreciation)
divided by Average Investment
• Note: if given Profits before Depreciation,
use the above formula
• Note: if given Profits after Depreciation has
already been charged, there is no need to
deduct the Depreciation a second time!
 Method 2: Accounting Rate of Return
• ARR also known as Return on Capital
Employed (ROCE) and Return on
Investment (ROI)
• Usually compared with Cost of Capital
invested in project
• Allows for differences in useful project lives
• Based on accounting profits, not cash flow
• Ignores power of compound interest
• Biased by depreciation method used
 ARR (Continued)
• Mutually – exclusive projects: highest ARR
is selected
• Ignores time value of money
• Ignores magnitude of the project
• Too many variations in formula
• Management are judged by the firm’s
ROCE, so with ARR, individual projects
can also be judged on that basis
Accounting rate of return (ARR)
Strengths Weaknesses
• Easy to • Different definitions
calculate. exist.
• Fails to take account
• Managers are
of timing of cash
familiar with a flows.
profitability
• The cut-off or hurdle
measure.
rate is an arbitrary
• It looks at the decision.
full life of the • Uses accounting
investment. profit, not cash flow.
Slide 6.20

Return on capital employed

• ARR or ROCE can be defined as:
average annual accounting profit × 100
average investment
• Where average investment is:
(initial investment + scrap value)/2
ROCE can also be defined as:
average annual accounting profit × 100
initial investment
• ROCE is also known as accounting rate of return
(ARR) and return on investment (ROI)
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 6.21

Return on capital employed

• Average annual accounting profit can be
calculated from project cash flows by taking off
depreciation.
• Depreciation is NOT a cash item
• Accounting profit is not cash flow.
• Simple decision rule: accept project if ARR or
ROCE is equal to or greater than target value, i.e.
current company or division ROCE.
• If projects are mutually exclusive, select project
with highest ROCE.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
 Depreciation Formula
• (Cost of Asset minus Scrap Value) divided by
the number of years is formula for StraightLine
• Straight-line Depreciation! Unless specifically
required in a Question, always use Straight
Line rather than Reducing Balance method.
• If given Cash Flows: we need Accounting
Profits to calculate ARR %
• Accounting Profit for any year = Cash Flow for
year minus Depreciation charge for that year
• Cash Flow for any year = Accounting Profit
plus Depreciation charge added back
 Return on capital employed
Example:
– A machine costs €10,000
– Useful economic life is 5 years
– After 5 years, scrap value of €2,000
– Net cash inflows from the machine would be
€3,000 per year
– Ignore taxation
REQUIRED:
Average annual accounting profits: convert cash
flow to profit
Average investment €6,000 see calculation
Annual Depreciation charge €1,600 see calculation
 Return on capital employed
Example:
• Depreciation:
(Cost 10,000 – Scrap value 2,000) / 5 years =
€1,600
• Average annual profit:
Annual cash flow 3,000 – Depreciation 1,600 =
€1,400
• Average investment:
(Cost 10,000 + Scrap value 2,000) / 2 = €6,000
• ARR: Note: €1,400 calculated above is after deducting
Depreciation
(1,400/6,000) × 100 = 23.33% or 23%
Slide 6.25

Return on capital employed

Advantages of return on capital employed:
• Gives value in familiar percentage terms
• Can be compared with primary accounting
ratio (ROCE) for the business as a whole
• Relatively simple concept compared to DCF
methods, such as NPV and IRR
• Can compare mutually exclusive projects
• Considers whole of project, unlike payback

Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 6.26

Return on capital employed

Disadvantages of return on capital employed:
• Uses accounting profit rather than cash
• Profit not directly linked to primary financial
objective of shareholder wealth maximisation
• Uses average profits and hence ignores
timing of profits
• Ignores time value of money
• Relative measure and so ignores size of
initial investment
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
 Return on Capital Employed
• In Investment Appraisal: the appraisal or
evaluation of an individual asset or project;
ROCE and ARR mean the same thing
• In another section of the module, doing
Ratio Analysis, we calculate ROCE for the
business as a whole
 Method 3: Net Present Value
• Similar to IRR except Discount Factor is
given
• All cash flows are discounted to present value
using required rate of return (i.e the Cost of
Capital). You will be told what Discount % to
use, by using the Present Value tables
• Reflects magnitude of projects
• Assumes reinvestment of cash flows at Cost
of Capital
• Cost of Capital is the usual discount factor,
but what is a company’s Cost of capital?
 NPV (Continued)
• NPV method gives an answer in € or money
• Mutually – exclusive projects: project with
highest NPV should be chosen
• Consistent with goal of shareholders’ wealth
maximisation
• A positive NPV adds to shareholder wealth
and a negative NPV reduces shareholder
wealth
• Does not provide a relative measure of
profitability
 NPV (Continued)
• The rule is: Positive NPV means project gives
return in excess of Cost of Capital & leads to
increase in shareholder wealth and we accept
any project with a Positive NPV i.e. any €
value greater than zero
• Also we reject any proposal with a negative
NPV. If NPV = 0: we are indifferent about it!
• If we do not have enough money to undertake
all projects that have a positive NPV: we
should sell the option for that project to
someone else!
 Net present value
Strengths Weaknesses
• The NPV takes into • Not as easily
account the time value understood as
of money. pay-back or
• It is expressed in ARR.
today’s money terms.
• The discount
• Uses cash flow rather factor that is
than accounting profits
appropriate can
over entire project life.
be a complex
• It is the academically decision.
preferred method.
 Net present value
• Difference between PV of future benefits and
present value of capital invested, discounted at
company’s cost of capital
• NPV decision rule is to accept all projects with a
positive NPV
• With mutually exclusive projects, select project
with highest NPV
• Regarded as the best investment appraisal
method by academics
 Net present value
Example of calculating a NPV:
• Project costing €1,000 is expected to yield €500
of cashflow per year for 2 years and interest rate
is 10%.
Year Cash flow 10% PVF PV
0 (1,000) 1.000 (1,000)
1 500 0.909 455
2 500 0.826 413
NPV = (132)
Question: Would you accept the project?
Answer: No, because it has a negative NPV. This
means that the wealth or value of the business
will decline if this project is carried out
 Net present value
Advantages:
• Takes account of time value of money
• Uses cash flow, not accounting profit
• Takes account of all relevant cash flows over life
of project, unlike for example the Payback method
• Can take account of conventional and non-
conventional cash flows, as well as changes in
discount rate during project
• Non-conventional cashflow: say a negative cash
flow in Year 0 and again a negative cash flow in
Year 5
• Gives absolute measure of project value
 Net present value
Disadvantages:
• Project cash flows may be difficult to
estimate (but applies to all methods).
Supposing you have a large project with a
20 year life….how certain are the later year
cash flows?
• Accepting all projects with positive NPV only
possible in a perfect capital market.
• Cost of capital may be difficult to find.
• Cost of capital may change over project life,
rather than being constant.
Method 4: Internal Rate of Return
• Rate of discount which, when applied to a
project’s cash flows, produces a zero NPV
• Pick a discount rate and calculate project’s NPV.
If answer is positive, keep picking a higher rate
until NPV becomes negative
• IRR is found by interpolation
• Uses Time Value of Money (equivalent to risk-
free rate of interest)
• Assumes cash flows can be reinvested at IRR,
which is seldom the same as cost of capital
 IRR (Continued)
• Problems with mutually – exclusive projects.
(Get the IRR of the incremental cash flows)
• Ignores magnitude of the project
• IRR is rate of return which equates PV of cash
outflows with PV of cash inflows
• Problems with “unconventional” cash flows
• Only projects with IRR > predetermined “cut-off”
rate should be selected
 Internal rate of return
Strengths Weaknesses
• It considers both • It ignores the relative size or
the magnitude and scale of investments.
the timing of the • More than one IRR may result if
project’s cash flows cash flows from projects are ‘not
conventional’.
over the entire life
• IRR should not be used to
of the project.
assess mutually exclusive
• IRR is measured projects.
as a percentage, • When projects are mutually
which is easy to exclusive, NPV is a better
understand. criterion for making decisions.
• IRR assumes cash flows related
to a project can be re-invested
elsewhere at the IRR.
 Internal rate of return
• Decision rule is to accept all projects with
an IRR greater than company's cost of
capital or target rate of return.
• Linear interpolation or extrapolation gives
an approximate value of IRR.
 IRR versus NPV
• If IRR used to compare mutually exclusive
projects, wrong project may be selected:
NPV always gives correct selection advice
+

NPV Area of conflict

0 Discount rate

IRR of incremental project

Cost of capital

- Project B Project A
 IRR versus NPV
• A problem of applying IRR to projects with
non-conventional cash flows is that multiple
IRRs may be found: again, NPV gives
correct selection advice.
• NPV can accommodate changes in
discount rate during project, but IRR ignores
them.
• NPV method assumes that cash flows can
be reinvested at a rate equal to the cost of
capital: IRR method assumes that cash
flows can be reinvested at a rate equal to
IRR.
 Empirical evidence
• The pay-back is the most popular technique
• IRR is the most commonly used DCF method
• Companies prefer to use a combination of pay-
back and DCF
• Qualitative judgment is important
• ARR is very popular despite its limitations
• The most common method of risk assessment
used is sensitivity analysis, followed by risk-
adjusted discount rate and adjusted pay-back
 Conclusion
• NPV is academically preferred as an
investment appraisal method – it has no
major defects and is consistent with
Shareholder Wealth Maximisation.
• IRR comes a close second and can prove
to be a useful alternative.
• ARR and payback are flawed as investment
appraisal methods, but payback is often
used as an initial screening method.
 Capital rationing
• Insufficient funds available for investment in all
projects with positive NPVs
• Hard capital rationing: when limitations are
externally imposed.
• Soft capital rationing: when limitations are
internally imposed. This type is more common.
• Appropriate technique to adopt is the Profitability
Index (PI), showing NPV per €1 of scarce capital
• Profitability = Present value of future cash flow
Index (PI) Value of initial investment