SFM-SECTION C-11(A)

INVESTMENT APPRAISAL
ARSLAN ARIF
0315-5231092

2019

ARSLANARIF@LIVE.COM
 Investment Appraisal

1. Capital Expenditure is spending on non-current assets, such as buildings and equipment or investing in
a new business. In contrast revenue expenditure refers to expenditure refers to expenditure that does
not create long term assets and is either written off in the income statement or creates a current asset.

2. Before capital expenditures projects are undertaken, they should be assessed and evaluated. As a
general rule projects should not be undertaken unless:

o They are expected to provide suitable financial returns

o The investment risk is acceptable.

3. Methods of Investment Appraisal:-

Capital Expenditure

Making An Investment
that will provide Financial Accounting
Cah Flow Reasons
adequate return over Reasons
time (DCF)

NPV(creating ARR
IRR(making a good
additional value in the Payback Period
return)
business)

 Accounting Rate of Return (ARR)

 Payback method
 Net Present Value(NPV)
 Internal Rate of Return (IRR)

4. Accounting Rate of Return (ARR):-

If accounting rate of return is used to decide whether or not to make
a capital investment we calculate the expected annual accounting return over the life of the project. If
the ARR of the project exceeds a target accounting return, the project would be undertaken.
Unfortunately, a standard definition of ARR does not exist. There are two main definitions:-
  Average annual profit as a percentage of the average investment in the project
 Average annual profit as a percentage of the initial investment

You would normally be told which definition to apply .If in doubt assumes that capital employed is the
average amount of capital employed over the project life.

Capital Employed = (Initial cost of equipment + Residual Value) + Working Capital

2

Average Accounting Profit = Total Accounting Profit – Depreciation

No of Years

ARR = Average Annual Accounting Profit X 100%

Capital Employed

Example No 1. :- A company is considering a project which requires an investment of $120,000 in

machinery. The machinery will last four years after which it will have scrap value of $20,000. The
investment in additional working capital will be $15,000. The expected annual profits before
depreciation are:-

Year $
1 45,000
2 45,000
3 40,000
4 25,000

The company requires a minimum accounting rate of return of 15% from projects of this type.ARR is
measured as average annual profits as a percentage of the average investment.

Should the project be undertaken?

Example 2. A capital project would involve the purchase of an item of equipment costing $240,000.The
equipment will have a useful life of six years and would generate cash flows of $66,000 each years for
the first three years and $42,000 each year for the final three year.

The scrap value of the equipment is expected to be $24,000 after six years. An additional investment of
$40,000 in working capital would be required.

The business currently achieves a return on capital employed as measured from the data in its financial
statements of 10%.
Required:-

(a)Calculate ARR using the initial cost of the equipment to calculate capital employed.
(b)Calculate ARR using the average cost of equipment.
4. Advantages of using ARR:-

 Fairly easy to understand.

 Easy to calculate.

5. Disadvantages of ARR:-

 It is based on accounting profits and not cash flows.

 Accounting profits are a unreliable measure.
 ARR ignores the timings of the accounting profit.
 ARR is a percentage return not an absolute return.
 When using the ARR method for investment appraisal a decision has to be made about what the
minimum target ARR should be. There is no rational economic basis for setting a minimum
target for ARR.
6. Payback Period Method: -
Payback is measured by cash flows and not profits.
It is the length of time before the cash invested in a project will be recognized from the net cash returns
from the investment project.
Using the payback method a maximum acceptable payback period is decided as a matter of policy. The
expected payback period for the project is calculated.

 If the expected payback is within the maximum acceptable time limit, the project is acceptable
 If the expected payback does not happen until after the maximum acceptable time limit, the
project is not acceptable.

Example 3. A company requires all investment projects to pay back their initial investment within three
years. It is considering a new project requiring a capital outlay of $140,000 on plant and equipment and
an investment if $20,000 in working capital. The project is expected to earn the following net cash
receipts:

Year $
1 40,000
2 50,000
3 90,000
4 25,000

Should the investment be undertaken?

Advantages of Payback Period:

 Simplicity
 The method analyses cash flows not profits.
 Often used with DCF method particularly by companies having liquidity problems.

Disadvantages:-

 Ignores cash flows after the payback period.

 Ignores the timing of cash flows.

Example 4: A company must choose between two investments Project A and Project B.It cannot
undertake both investments. The expected cash flows for each project are:

Year Project A Project B

0 (80,000) (80,000)
1 20,000 60,000
2 36,000 24,000
3 36,000 2,000
4 17,000
  The company has a policy that:
 The max permissible payback period for an investment is three years.

If a choice has to be made between two projects, the project with the earlier payback will be chosen.

Required:

Calculate the payback period for each project:

(A) Assuming that cash flow occur at that year end

(b) Assuming that cash flows after Year 0 occur at a constant rate throughout each year.

Are the projects acceptable, according to the company’s payback rule?

Which project should be selected?

Do you agree that this is the most appropriate investment decision?

1. Relevant Costs:-
Relevant costs and benefits are future cash flows arising as a direct consequence of the
decision under consideration.

 Relevant costs are cash flows. Any items of cost that are not cash flows must be ignored for the
purpose of decision .For example depreciation must always be ignored.
 Relevant costs are future cash flows. Cash flows which have already been incurred are not
relevant to a decision that is being made now. Such costs are called sunk costs.
 Relevant coasts are costs that will arise as a direct consequence of the decision.
 Relevant costs are the opportunity costs or the benefits forgone by using assets or resources for
one purpose, instead of using them in most profitable alternative way.
 DCF TECHNIQUES

1. Time Value of Money:-

Money received today is worth more than the same sum received in the future
i.e. it has a time value. This occurs for three reasons:-

 Potential for earning interest:- If a capital investment is to be justified it needs to earn at

least a minimum amount of profit so that the return compensates the investor for both the
amount invested and also for the length of time before the profits are made.
 Impact of inflation(loss of purchasing power)
 Risk
2. Compounding:-
A sum invested today will earn interest . Compounding calculates the future or terminal
value of a given sum invested today for a number of years.

FV = P (1 + r)n

Example 1:- You have $5,000 to invest now for six years at an interest rate of 5 % pa.

What will be the value of the investment after six years?

3. Discounting:-

In a potential investment project, cash flows will arise at many different points in time.
To make a useful comparison of the different flows, they must all be converted to a common point in
time, usually the present day so for this purpose future cash flows need to be converted to present
values to make a logical and sound decision.

PV = FV = FV x (1 + r)-n
(1 + r)n

Example 2:- What is the PV of $115,000 receivable in nine years’ time if r = 6%?

4. The Net Present Value (NPV):-

The most common and reliable method of appraising a capital investment project is NPV . To appraise
the overall impact of a project using DCF techniques involves discounting all the relevant cash flows
associated with the project back to their PV.
If we treat outflows of the project as negative and inflows as positive, the NPV of the project is the sum
of the PVs of all flows that arise as a result of doing the project.
NPV is the value obtained by discounting all cash outflows and inflows of a capital investment project by
a chosen target rate of return or cost of capital.

The cost of capital used to discount the cash flows not only reflects the cost of funds that a company
raises and uses but also shows the minimum return that a company should make from its own
investments.

The Decision Rule :-

 If the NPV is positive –the project is financially viable

 If the NPV is zero- the project breaks even.
 If the NPV is negative – the project is not financially viable
 If the company has two or more mutually exclusive projects under consideration it should
choose the one with highest NPV.
The NPV gives the impact of the project on shareholder wealth.

Assumptions Used in Discounting:-

 All cash flows occur at the start or end of a year.

 Initial investments occur at To.
 Other cash flows start one year after that (T1).

Example 3:- The cash flows for a project have been estimated as follows:

Year $

0 (25,000)

1 6,000

2 10,000

3 8,000

4 7,000
The cost of capital is 6%. Calculate the NPV of the project to assess whether it should be undertaken.

Example 4:- An organization is considering a capital investment in new equipment. The estimated cash
flows are as follows.

Year $

0 (240,000)

1 80,000

2 120,000

3 70,000

4 40,000

5 20,000

The company’s cost of capital is 9%. Calculate the NPV of the project to assess whether it should be
undertaken.

Discounting Annuities:-
An annuity is a constant annual cash flows for a number of years. The PV of an
annuity can be quickly calculated using the formula:

PV = Annual cash flow x AF

AF = 1-(1+ r)

r
Example 5:- A payment of $1,000 is to be made every year for 3 years, the first payment occurring in
one year’s time. He interest rate is 10%. What is the PV of the annuity?

Example 6:- A payment of $3,600 is to be made every year for seven years, the first payment occurring
in one years time. The interest rate is 8%. What is the PV of the annuity.

Discounting Perpetuities:-
A perpetuity is an annual cash flow that occurs for ever. The PV of a perpetuity
can be found using the formula.

PV = cash flow x 1
r

Advanced Annuities and Perpetuities :-

Some regular cash flows may start now(at To) rather than in one
year’s time (T1). They can be annuities as well as perpetuities.

Example 7:- Find the present values of the following cash flows:

(a) A fifteen year annuity of $300 starting at once. Interest rates are 6%.
(b) A seven year annuity of $450 starting immediately. Interest rates are 11%.
(c) A perpetuity of $33,000 commencing immediately. Interest rates are 22%.
(d) A perpetuity of 414,000 starting at once. Interest rates are 12.5%.

Delayed Annuities and Perpetuities :-

Some regular cash flows may start later than T1.

Example 8:- Find the present value of the following cash flows:

(a) A fifteen year annuity of $300 at T3. Interest rates are 6%.
(b) A seven year annuity of $450 starting in five years time. Interest rates are 11%.
(c) A perpetuity of $33,000 commencing at T2. Interest rates are 22%.
(d) A perpetuity of $14,000 starting in ten years time. Interest rates are 12.5%.
Advantages of NPV :-

 Considers the time value of money.

 Is an absolute measure of return.
 Is based on cash flows not profits.
 Considers the whole life of the project
 Leads to maximization of shareholder wealth.

Disadvantages:-

 Difficult to explain to managers.

 Requires understanding of ‘cost of capial’.
 Is relatively complex.

Internal Rate of Return (IRR)

1. The internal rate of return method is another method of investment appraisal using DCF.The
IRR is therefore the discount rate that will give a NPV of 0 .

2. Calculating IRR using Interpolation :-

Step 1 : Calculate two NPVs for the project at two different costs of capital.
Step 2 : Use the following formula to find IRR.
NL
IRR = L + [ × (H − L)]
NL − N H

Positive NPV IRR-Rate Given

Zero NPV

Discount Rate

10% 20%

Negative NPV
 3. The Decision Rule:
Projects should be accepted if their IRR is greater than the cost of capital.

Example 1. A potential project’s predicted cash flows give a NPV of $50,000 at a discount rate of 10%
and -$10,000 at a rate of 15%/ Calculate the IRR.

Example 2. A business requires a minimum expected rate of return of 12% on its investments. A
proposed capital investment has the following expected cash flows.

Year $
0 (80,000)
1 20,000
2 36,000
3 30,000
4 17,000

Calculate the IRR of the project .

Example 3. A business undertakes high-risk investments and requires a miimum expected rate of return
of 17% pa on its investments. A proposed capital investment has the following expected cash flows.

Year $
0 (50,000)
1 18,000
2 25,000
3 20,000
4 10,000

Estimate the IRR of the project and recommend on financial grounds whether this project should go
ahead.

4. Advantages of IRR:-

 As a DCF appraisal method it is based on cash flows , not accounting profits.

 Like the NPV method it recognizes the time value of money.
 It is easier to understand than NPV.
 For accept/reject decisions on individual projects the IRR method will reach the same decision as
the NPV method.

5.Disadvantages of IRR:-
  It is a relative measureand ignores the absolute size of the investment.
 If the investments are ,utually exclusive and only one of them can be undertaken the correct
answer is that it depends on the size of each of the investment.This means that IRR method of
appraisal can give an incorrect decision if it is used to make a choice between mutually exclusive
projects.
 Unlike the NPV method, the IRR method does not indicate by how much an investment project
should add to the value of the company.

Example:

Year Project 1 Project 2

$ $
(1,000) (10,000)
1,200 4,600
– 4,600
– 4,600
IRR 20% 18%
NPV at 15% +$43 +$503
Comparison of the four investment appraisal methods
ARR Payback Discounted Cash Flow
Disadvantages Advantages Advantages
Financial profits, not cash Cash flows, not accounting Based on investment cash flows,
flows values not accounting profit