24/02/20201LO 2: Investment AppraisalMethodsDr Fidelis AkangaLearning outcomesBy the end of this unit Explain capital investment decision andInvestment appraisal methods Apply the main investment appraisalmethods Understand and discuss the strengths andweaknesses of these methods24/02/20202Principal Assumptions Cash inflows and outflows are known with certainty Sufficient funds available to enable acceptance of allprojects with positive NPV Firms operate in environments with no taxes and noinflation Cost of capital is risk freeCapital Investment AppraisalDefinition of Capital Investment appraisal Capital Investment appraisal is an application of a setof quantitative methods used by managers to makedecisions on how to best invest funds in the long term(Weetman, 2010:261)24/02/20203Types of capital investment Replacement of obsolete assets Cost reduction e.g. IT system Expansion e.g. new building & equipment Strategic proposal: improve delivery service, stafftraining. Diversification for risk reduction Research and DevelopmentNeed for Investment Appraisal Large amount of resources are involved and wrongdecisions could be costly Difficult and expensive to reverse Investment decisions can have a direct impact on theability of the organisation to meet its objectives24/02/20204Investment Appraisal ProcessStages: Identify objectives. What is it? Within the corporateobjectives? Identify alternatives. Collect and analyse data. Examine the technical andeconomic feasibility of the project, cash flows etc. Decide which one to undertake Authorisation and implementation Review and monitor: learn from its experience andtry to improve future decision – making.Investment Appraisal MethodsProposedCapitalProject2.AccountingRate ofReturn1. Payback4. InternalRate ofReturn3. Net PresentValue5.ProfitabilityIndex24/02/20205Investment Appraisal Methods1. Payback period This is the length of time it takes to repay the costof initial investment In case where there are competing projects, theone with the shorter payback period should beacceptedPayback period We can approach payback in two ways; Equation method (for uniform cash flows) Cumulative method (uniform & non uniformcash flows)24/02/20206Payback period In the case of uniform cash flows, paybackperiod can be calculated as:Net initial investmentUniform increase in annual cash flows Then multiply the remainder (decimal) by 12to get number of monthsPayback periodExample 1LBS Ltd uses the payback period as its soleinvestment appraisal method. LBS invests£30,000 to replace its computers and thisinvestment returns £9,000 annually for thefive years. From the information aboveevaluate the investment using the payback.Assume that £9,000 accrues evenlythroughout the year.24/02/20207Payback periodSolution:= 30,0009,000= 3.33330.333x x12 = 3.996 approx 4= 3 years, 4 monthsPayback period Example 2: Cumulative method ABC invests in an investment of £6.2m. Cashflows is as follows: YearCash flow (£)11,200,00022,200,00032,500,00041,700,000 24/02/20208Example 2 SolutionAfter year 3, we stillhave a balance of£300,000 tocomplete payment.So we divide thisbalance by year 4cash flow andmultiply by 12.= 300,0001,700,000= 0.176 x 12 = 2 YearCash flow (£)Cumulativecash flow (£)0(6,200,000)11,200,0001,200,00022,200,0003,400,00032,500,0005,900,00041,700,0007,600,000 Payback period = 3 years, 2 monthsAdvantages of payback• Simple to calculate and understand• Focuses on project’s cash flows rather than accountingprofits. Hence more objectively based• Favours projects with short/quick payback periods. Thistends to minimise risk and may also produce fastergrowth for the company Once the relevant cash flows are calculated, payback iseasy to apply and to explain to management Capital rationing: -it ensures the recycling of cash intonew projects with the least delay.24/02/20209Disadvantages of payback periodmethod Method ignores time value of money Ignores cash flows after the payback periodInvestment Appraisal Methods2. Accounting Rate of Return (ARR) This method takes the average accounting profit whichthe investment will generate and expresses it as apercentage of the original investment or the average ofinitial investment in the project as a measure of aproject’s profitability (or viability). ARR = Average Annual Profit * 100%Original Investment in Project Where there is a scrap value at the end of the useful lifeof the project,24/02/202010Accounting Rate of Return (ARR)Accounting Rate of Return (ARR) In assessing individual project, it is normal forcompanies to have a minimum ARR below whichinvestment will not be undertaken. The minimum could be a rate which previousinvestments have achieved, or it could be anindustry average. Where there are competing projects, the one withthe higher or highest ARR would be accepted.24/02/202011Accounting Rate of Return (ARR)Accounting Rate of Return (ARR)Solution to Example 3.Average Accounting Profit =(- 250 +1000 + 1000 + 20,750) / 4 = 5625Original investment = 45,000ARR = (5625/45000) * 100 = 12.5%24/02/202012Accounting Rate of Return (ARR)Advantages of ARR It is quick and simple to calculateIt involves a familiar concept of a percentage return Accounting profits can be easily calculated from financialstatementsDisadvantages of ARRBased accounting profits rather than cash flows, whichare subject to a number of different accounting policies.It does not take into account of the length of the projectIt ignores the time value of money Investment Appraisal MethodsDiscounted Cash flow (DCF) methods Net Present Value (NPV) Internal Rate of Return Both use cash flow (rather than accountingprofits) Cash-flows covering the whole life of the projectare taken into account; Both take into account time value of money24/02/202013Discounted Cash flow (DCF)methods DCF methods operate on the principle that moneyreceived or paid at different times cannot be compareddirectly.Rather they need to discounted (or reduced) to equivalentpresent values before any comparison can be made.Note: time value of money concept still applies even if there is no inflation (i.e. inflation rate 0%). The presence of inflation simply increases thediscrepancy in values of monies received or paid atdifferent times.Discounted Cash flow (DCF)methods DCF methods operate on the principle that moneyreceived or paid at different times cannot be compareddirectly.Rather they need to discounted (or reduced) to equivalentpresent values before any comparison can be made.Note: time value of money concept still applies even if there is no inflation (i.e. inflation rate 0%). The presence of inflation simply increases thediscrepancy in values of monies received or paid atdifferent times.24/02/202014Discounted Cash flow (DCF)methods1. Net Present Value (NPV) Present value:- the amount of money you must invest orlend at the present time so as to end up with aparticular amount of money in the future. Discounting: -finding the present value of a future cashflow Net Present Value (NPV) – the difference between thepresent values of cash inflows and outflows of aninvestment Opportunity cost of undertaking the investment is thealternative of earning interest rate in the financialmarket.Net Present Value (NPV) Net Present Value of an Investment is the presentvalue of all its present and future cash flows,discounted at the opportunity cost of those cashflows. In case of competing projects, the project withHighest NPV is accepted NPV calculations can be approached in two ways; Summation method Columnar method24/02/202015Net Present Value (NPV)Net Present Value (NPV)Example 4 A company can purchase a machine at the price of£2200. The machine has a productive life of threeyears and the net additions to cash inflows at theend of each of the three years are £770, £968 and£1331. The company can buy the machine withouthaving to borrow and the best alternative isinvestment elsewhere at an interest rate of 10%.Evaluate the project using the NPV method24/02/202016Net Present Value (NPV)Discounted Cash flow (DCF)methods2. Internal rate of Return (IRR) Internal Rate of Return – is the discount ratethat equates the present values of aninvestment’s cash inflows and outflows. Internal Rate of Return (IRR) – is the discountrate that causes/brings an investment’s NPVto be zero24/02/202017Internal Rate of Return (IRR)Internal Rate of Return (IRR)Example 5 A company can purchase a machine at the price of£2200. The machine has a productive life of threeyears and the net additions to cash inflows at theend of each of the three years are £770, £968 and£1331. The company can buy the machine withouthaving to borrow and the best alternative isinvestment elsewhere at an interest rate of 10%.Evaluate the project using the IRR method24/02/202018Internal Rate of Return (IRR)Solution to Example 5IRR Try 15% YearCash flowDiscountDiscountedPVFactor (15%)Cash flow 0 (2200) 1.000 (2200)1 770 0.8696 669.592 968 0.7561 731.903 1331 0.6575 875.13NPV 76.62Internal Rate of Return (IRR)• Year Cash flow DC (16%) PV• 0 (2200) 1.000 (2200)• 1 770 0.8621 663.83• 2 968 0.7432 719.42• 3 1331 0.6407 852.77• NPV 36.0124/02/202019Internal Rate of Return (IRR)• Year Cash flow DCF (17%) PV• 0 (2200) 1.000 (2200)• 1 770 0.8475 652.58• 2 968 0.7305 711.48• 3 1331 0.6244 831.08• NPV (4.86)Internal Rate of Return (IRR)Using the formula above the IRR canbe computed as follows.15+(76.62/76.62- – 4.86)x(17-15)15+(76.62/81.48)x(2)15+(0.940353461)x2= 16.88%24/02/202020Investment Appraisal Method3. Profitability Index The Profitability Index (PI) is based on thecomparison of the net present value of the cashflow with the amount of the original investment. It is, therefore, a measure of the increase in thecapital sum that the net present valuerepresents. Projects are thus ranked in order of profitability.Profitability Index The profitability index is calculated in the followingmanner: Present value of cash flows = profitability indexOriginal amount invested (PI)The index shows the return (in Present Value terms)per each of £1 of original investment.24/02/202021Profitability IndexThus, the higher the profitability index, thehigher the return earned on the project. The lower the profitability index, the lessprofitable the project; And if the index falls below 1, this means thatthe project has failed to meet the requiredrate of return.Profitability IndexExample 6.We have 3 Projects : ABCCostPV of [email protected] 10%100,00050,000200,000110,99363,444214,450NPVProfitability Index(110,993/100,000)10,9931.11013,4441.26914,4501.072 Thus, although all 3 projects have positive NPVs, project B provides abetter return for each £ invested.24/02/202022Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 13.
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