INVESTM EN T

APPRA IS A L

CHAPTER 525
• Managers use investment appraisal techniques to assess whether the likely
future returns on projects will be greater than costs and by how much.
• Different techniques of investment appraisal are used before new investment
projects are given the go-ahead or abandoned.

What information is required to understand the profitability of a project?

• Initial cost of the investment
• Estimated life expectancy- over how many years returns can be expected
• Residual value of the investment- value of asset at the end of their useful lives
• Forecasted net cash flows (forecast cash inflows- forecast cash outflows) from
the project
FIVE MAIN METHODS TO INVESTMENT APPRAISAL

• Payback period
• Average rate of return
• Discounted payback
• Net present value
• Internal rate of return
PAYBACK PERIOD
Payback Period = 3 + ( 75,000/150,000)
= 3 + 0.5
= 3.5 years

According to payback method, the project that promises a quick recovery of initial
investment is considered desirable.
If Project A’s PBP = 3 years
If Project B’s PBP = 2.5 years
Advisable to choose project B, because Project B promises to recover the initial
TIPS- PAYBACK PERIOD
While calculating Payback Period:
Information given:
• Year
• Annual net cash flow

Need to compute:
• Cumulative cash flow
• Calculate payback with the formula
BENEFITS OF USING PAYBACK METHOD
LIMITATIONS OF USING PAYBACK METHOD
ACCOUNTING RATE OF RETURN/
AVERAGE RATE OF RETURN (ARR)

It measures the annual profitability of an

investment as a percentage of the initial investment

ARR (%) = Annual profit (Net cash flow) x 100

Initial capital cost
CALCULATING ARR

On average over the lifespan of the

investment, it can expect an annual
return of 20% in its investment
BENEFITS & LIMITATIONS OF ARR
DISCOUNTING FUTURE CASH FLOWS

Hence, the third method considers both size of the cash flow and
the timing of them. It does this by discounting the cash flows.
DISCOUNTED PAYBACK

Given a situation, would you want $100 now or $100 after 2 years? – This is
based on the concept of time value of money.

Value of the discounted

factor will be provided
to you in the
examination, you do not
need to calculate it.

Discount factor- is an estimate

of how much less something is
worth if it is received in the
future.
CALCULATING DISCOUNTED PAYBACK
Year Net Cash Discount Discounted cash Cumulative
Flow ($) Factor flow ($M) discounted
cash flow
($M)
0 (5) 1
1 2 0.91
2 2 0.83
3 2 0.75
4 3 0.68

Calculate the Discount

Payback Period
CALCULATING DISCOUNTED PAYBACK
Year Net Cash Discount Discounted cash Cumulative
Flow ($) Factor flow ($M) discounted
cash flow
($M)
0 (5) 1 (5)*1 = (5) (5)
1 2 0.91 (2)*.091= 1.82 (3.18)
2 2 0.83 1.66 (1.52)
3 2 0.75 1.50 (0.02)
4 3 0.68 2.04 2.02

Calculate the Discount

Payback Period
NET PRESENT VALUE (NPV)
CALCULATING NPV
W
This means ?
TIPS- NPV
While calculating NPV:
Information given:
• Year
• Annual net cash flow
• Discounted factor

Need to compute:
• Discounted cash flow
• Calculate NPV by adding all values
 2017- PAPER 32

Calculate the
Net Present
Value
INTERNAL RATE OF RETURN (IRR)
 FACTORS TO CONSIDER BEFORE CHOOSING A PROJECT
THROUGH INVESTMENT APPRAISAL
The key issues to consider are:
Risks and uncertainties
All business investments involve risk – the probability that the hoped-for outcome will not happen.
An investment needs to earn a return that compensates for the risk.
The risk of a capital investment will vary according to factors such as:
Length of the project
The longer the project, the greater the risk that estimated revenues, costs and cash flows prove
unrealistic
Source of the data
Are estimated project profits and cash flows based on detailed research, gut feel, or a little of both?
The size of the investment
An investment that uses a substantial proportion of the available business funds is, by definition,
more risky than a smaller project. Risk is also about the consequences to the business if something
goes wrong!
• The economic and market environment
• A major issue for most large investments
• Most projects will make assumptions about demand, costs, pricing etc which can become wildly
inaccurate through changing market and economic conditions
• The experience of the management team
• A project in a market in which the management team has strong experience is a lower-risk proposition
than one in which the business is taking a step into the unknown!
• Qualitative influences on investment appraisal
• An investment decision is not just about the numbers. A spread sheet calculation for NPV or ARR might
suggest a particular decision, but management also need to take account of qualitative issues such as:
• The impact on employees
• Product quality and customer service
• Consistency of the investment decision with corporate objectives
• The business' brand and image, including reputation
• Implications for production and operations, including any disruption or change to the existing set-up
• A business' responsibilities to society and other external stakeholders
• Quantitative influences on investment appraisal
• The investment appraisal comes up with a result, but how is a decision made?
• Many firms set what are known as "investment criteria" against which they judge investment
projects.
• A problem with the three main investment appraisal methods is that they can generate
seemingly contradictory results. For example, an investment might have a long payback period
because the returns only occur several years into the project (possibly too long to be
acceptable). However, if those returns are significant to the original investment, it is likely that
the NPV or ARR would suggest going ahead.
The use of investment criteria is intended to help guide
management through these decisions and address the
potential conflicts.

So possible criteria might suggest only accepting investment

proposals which meet at least two of the following:

•A payback within four years.

•ARR of at least 20%, with no profits taken into account
beyond Year 5.
•NPV of at least 25% of the initial investment.