Chapter 14
Capital Investment Appraisal
Capital investment appraisal
Capital investment involves the sacrifice of current
funds in order to obtain the benefit of future wealth.
It involves investing now in the hope of generating
future cash flows which will exceed the initial
investment.
Investment in capital projects involves large initial
financial outlays, with long waiting periods before
these funds are repaid from future cash flows or
profits.
Features of capital investments
Capital investment involves the use of significant
levels of finance to acquire assets for long-term
use in an organisation with the desire to
increase future revenues and profits.
Capital investment decisions
The decision to charter or purchase an aircraft.
The decision to lease or buy property to open a retail outlet, restaurant,
leisure centre or other such business.
The decision to install an energy saving control system within a
property.
The decision to extend or refurbish a hotel, pub, restaurant or retail
outlet.
The decision to develop leisure or conference facilities within a hotel.
The decision to invest in a central reservations computer system in a
hotel.
The decision to employ a computerised point of sales stock control
system in a retail chain.
The decision to purchase new fun activities equipment within a leisure
park.
The decision by a catering firm to purchase more equipment in order to
tender for a school meals contract.
Features of capital investment
decisions
The sums involved are relatively large.
The timescale over which the benefits will be received is
relatively long, with greater risks and uncertainty in forecasting
future revenues and costs.
The nature of a business, its direction and rate of growth is
ultimately governed by its overall investment programme.
The irreversibility of some projects due to the specialised nature
of certain assets for example, some plant and machinery bought
with a specific project in mind could have little or no scrap value.
In order to complete projects on time and within budget,
adequate continuous control information is required.
Capital investment is long-term and the recoupment of
investment may involve a significant period of time.
Factors to consider in assessing
capital projects
The size of the investment.
The phasing of the investment expenditure.
The period between the initial investment and the
asset actually generating revenues and profits for the
business.
The economic life of the project.
The level of certainty regarding the projected cash
flows.
The working capital required.
The degree of risk involved in the project.
Capital appraisal methods
As capital investment decisions usually involve
significant amounts of finance, it is important to
fully evaluate each decision using sound
appraisal techniques. The main methods used
to evaluate investment in capital projects are:
Accounting rate of return.
Payback method.
Net present value.
Internal rate of return.
Capital appraisal methods
Accounting Rate of Return (ARR)
Profits
Payback
Cash flows
Net Present Value (NPV)
Cash flows
Internal Rate of Return (IRR)
Cash flows
Capital appraisal methods
The accounting rate of return is based on the use of operating
profit. The operating profit of a project is the difference
between revenues earned by the project, less all the operating
costs associated with the project, including depreciation.
All other appraisal methods use net cash flows as the basis for
appraising capital projects. This is due to the nature of
assessing capital investment projects where one must spend
cash now and reap the cash rewards later.
The calculation of accounting profit is not concerned with the
timing of cash flows. This is due to its adherence to the
accruals concept whereby profits are calculated by deducting
expenses charged from revenues earned.
Net cash flow
Net cash flow =
operating cash flows + / - capital cash flows
Net profit and net cash flow
Net profit
Net cash flow
Related revenue earned
less
Related cash inflows (operating +
capital)
less
All related costs
(including depreciation)
equals
Related cash outflows (operating
+ capital)
(NOT including depreciation)
equals
Profit
Net cash flow
Accounting rate of return (ARR)
The accounting rate of return method calculates the
estimated overall profit or loss on an investment project
and relates that profit to the amount of capital invested
and to the period for which it is required.
A business will have a required minimum rate of return for
any investment. This is related to the cost of capital of the
business.
If an investment yields a return greater than the cost of
capital, then the investment would be considered suitable
and profitable.
The accounting rate of return is an average rate of return
calculated by expressing average annual profit as a
percentage of the average value of the investment.
Accounting rate of return (ARR)
ARR = Average annual profit
Average investment
Average annual profit
Average investment
Total
project
profit
after
depreciation and before interest,
tax and dividends, divided by the
estimated life of the project.
Initial investment, plus value of
investment at project-end, divided
by two.
Example 14.1: Accounting rate of
return
Example 14.1: Accounting rate of
return
Accept or reject criteria for ARR
method
Accept the project
Reject the project
Project ARR greater
than the minimum
required return.
Project ARR less than
the minimum required
return.
Advantages of ARR
It takes account of the overall profitability of the
project.
It is simple to understand and easy to use.
Its end result is expressed as a percentage, allowing
projects of differing sizes to be compared.
Disadvantages of ARR
It is based on accounting profits rather than cash
flows.
The ARR does not take into account the timing of
cash flows.
The ARR does not take into account the time value of
money. It does not take into account the cost of
waiting to recoup the investment.
The ARR takes no account of the size of the initial
investment.
The payback method
This method of investment appraisal simply asks
the question ‘how long before I get my money
back?’
How quickly will the cash flows arising from the
project exactly equal the amount of the
investment.
It is a simple method, widely used in industry and
is based on management’s concern to be
reimbursed on the initial outlay as soon as
possible.
It is not concerned with overall profitability or the
level of profitability.
Example 14.2: Payback
Example 14.2: Payback
Accept or reject criteria for
payback method
Accept the project
Reject the project
Payback period is less than
that required by investors.
Payback period is greater
than that required by
investors.
Advantages of payback
It is simple to understand and apply.
It promotes a policy of caution in investment.
Disadvantages of payback
It takes no account of the timing of cash flows (€100
received today is worth more than €100 received in
12 months time).
It is only concerned with how quickly the initial
investment is recovered and thus it ignores the overall
profitability and return on capital for the whole project.
Time value of money
The time value of money concept plays an important
role in appraising capital projects because the time
lag between the initial investment and payback can
be quite long.
€1 earned or spent sooner, is worth more than €1
earned or spent later.
To evaluate any project taking into account the time
value of money, the cash flows received in the future
must be reduced or discounted to a present value, so
that all relevant cash flows are denominated in todays
value (present value).
The cost of capital
All investment projects require funding. Generally,
funding can be classified into:
Equity funding, where investors buy an equity or ownership
share in a project. This is done through the issue of shares or
by retaining profits in the business.
Debt, where the company can borrow or issue its own
debentures.
Each source of finance has a cost. The cost of debt is
the interest rate that applies to the debt. The costs of
equity finance are the dividends and increases in share
price expected by shareholders.
This cost of capital becomes the benchmark or
minimum required return on a project.
A project is only truly profitable when its actual return
on assets is greater than the company’s cost of capital.
Example 14.3: Cost of capital
Weighed average cost of capital
If a project is funded by more than one method of
financing, the weighted average cost of capital (WACC)
should be calculated.
•Loan finance €100,000 at 9%.
•Equity finance €50,000 at 12%.
Debt
Equity
€100,000 x 9% =
€9,000
€50,000 x 12% = €6,000
€150,000
€15,000
Thus the WACC is 10% (15,000  150,000 x 100).
Discounted cash flow (DCF)
DCF is the investment appraisal technique that takes
account of the time value of money.
DCF looks at the cash flows of a project, not the
accounting profits. It is concerned with liquidity not
profitability.
The timing of cash flows is taken into account by
discounting all future cash flows to present value.
The effect of discounting is to give a bigger value per
euro for cash flows that occur earlier.
The discount factor to use is the cost of capital to the
business.
Net present value (NPV)
Present value can be defined as the cash equivalent
now of a sum of money to be received or paid at a
stated future date, discounted at a specified cost of
capital.
The net present value is the value obtained by
discounting all the cash outflows and inflows of a
capital investment project, at a chosen target rate of
return or cost of capital.
The present value of the cash inflows, minus the
present value of the cash outflows, is the net present
value.
Net present value (NPV)
If the NPV is positive, it means that the cash inflows
from the investment will yield a return in excess of the
cost of capital and thus the project should be
undertaken, as long as there are no other projects
offering a higher NPV.
If the NPV is negative, it means that the cash inflows
from the investment yield a return below the cost of
capital and so the project should not be undertaken.
If the NPV is exactly zero, the cash inflows from the
investment will yield a return which is exactly the
same as the cost of capital and thus the project may
or may not be worth undertaking depending on other
investment opportunities available.
Example 14.4: Net present value
Example 14.4: Net present value
Accept or reject criteria for NPV
method
Accept the project
NPV is positive.
In choosing between
mutually exclusive projects,
accept the project with the
highest NPV.
Reject the project
NPV is negative.
Advantages of NPV
It takes into account the time value of money.
Profit and the difficulties of profit measurement are
excluded.
Using cash flows emphasises the importance of
liquidity.
It is easy to compare the NPV of different projects.
Disadvantages of NPV
It is not as easily understood as the payback and
accounting rate of return.
It requires knowledge of the company’s cost of
capital, which is difficult to calculate.
The internal rate of return (IRR)
The IRR method calculates the exact rate of
return which the project is expected to achieve,
based on the projected cash flows. It is the
discount rate which, when applied to the
projected cash flows, ensures they are equal to
the initial capital outlay. The IRR is the discount
factor which will give a NPV of zero. It is the
actual return from the project, taking into
account the time value of money.
The internal rate of return (IRR)
The internal rate of return (IRR)
Example 14.5: Internal rate of return
Example 14.5: Internal rate of return
Accept or reject criteria for IRR
method
Accept the project
Reject the project
IRR greater than the
cost of capital.
IRR less than the
cost of capital.
Advantages of IRR
The main advantage of the IRR is that the information it
provides is more easily understood by managers,
especially non-financial managers.
Disadvantages of IRR
The trial and error process of calculating the IRR can be time
consuming, however this disadvantage can easily be overcome
with the use of computer software.
It is possible to calculate more than two different IRR’s for a
project. This occurs where the cash flows over the life of the
project are a combination of positive and negative values. Under
these circumstances it is not easy to identify the real IRR and the
method should be avoided.
In certain circumstances the IRR and the NPV can give
conflicting results. This occurs because the IRR ignores the
relative size of investments as it is based on a percentage return
rather than the cash value of the return.
Appraisal methods
Accounting Rate of Return (ARR)
Non time based
Profits
Payback
Cash flows
Net Present Value (NPV)
Cash flows
Internal Rate of Return (IRR)
Cash flows
Time based (DCF)
Appraisal methods
Of the four appraisal methods presented, it is clear
that the discounted cash flow methods (NPV and
IRR) have a distinct advantage over the payback and
accounting rate of return methods because they are
cash based and they take the time value of money
into account.
The NPV approach is considered superior to the IRR
because of the disadvantages associated with the
IRR method.
However it is clear that there is a place for all four
methods, which inform judgement, not replace it.
Appraisal methods
Newport Leisure Park Ltd investment appraisal summary
Comparing mutually exclusive
projects with unequal lives
When comparing mutually exclusive projects, the
appraisal method to use is the net present value
approach.
However businesses often have to decide on two or
more competing projects that have unequal or different
life spans. To simply compare the net present values of
each project without looking at the unequal lifespan
would not be comparing like with like.
The net present value of both projects needs to be
expressed in equal terms.
The ‘equivalent annual annuity method’ to compare the
net present values on an annualised basis.
Comparing mutually exclusive
projects with unequal lives
1. Calculate the NPV of each project.
2. Divide the NPV of each project by the annuity
factor for the period of the project. This
calculates what is called the ‘equivalent annual
annuity’ or EAA.
3. Compare the EAA of each project, accepting the
project with the highest equivalent annual
annuity.
Example 14.6: Project appraisal
with unequal lives
Example 14.6: Project appraisal
with unequal lives
The calculation of cash flows
Operating cash flows represent sales revenues, less
variable cost attributed to the project or investment.
Fixed costs are also included but only if they relate to
the new investment and are incremental.
All costs that would occur irrespective of the
investment decision should be ignored.
The cash flows that are to be considered are those
that would not arise without the investment.
The calculation of cash flows
Sunk costs are past costs that have already been paid and should be
ignored.
Incremental costs that relate to the decision should be taken into
account.
Opportunity gains or costs should be taken into account.
Replacement costs of using that resource or asset should be used, not
its original cost.
Loan interest and dividend payments should not be taken into account in
calculating the operating cash flows (for DCF) as the discount factor
already takes into account the cost of financing.
Incremental working capital should be treated as part of the initial
expenditure or capital investment. At the end of the project's life, the total
investment in working capital is assumed to be liquidated (turned into
cash) at original cost and is treated as a cash inflow in the final year of
the life of the project.
Depreciation: is a non-cash item and must be ignored in calculating
operating cash flows.
Year-end assumption: in calculating the cash flows of a project, it is
assumed that they arise at the end of the relevant year.
Taxation: will usually be an important consideration as investors are
interested in the after tax returns generated from the business
Example 14.7: Calculation of cash
flows
Example 14.7: Calculation of cash
flows
Example 14.7: Calculation of cash
flows
Project appraisal and risk
All future projects are subject to some element of uncertainty and risk.
Operating risk: This occurs where a business has a high fixed
operating cost structure and hence it must ensure it generates
sufficient revenues and contribution to cover fixed costs. In
general, the hospitality and tourism sectors suffer from a high
level of operating risk.
Financial risk: This arises from the methods chosen to finance an
operation. High financial risk implies that a business is highly
financed through borrowings and hence must ensure operating
profit and cash flows are sufficient to meet the interest costs of
these financial instruments.
Business risk: This occurs as a result of changes to the
economic and business environment that can be caused by a
range of factors such as hurricanes, terrorism, tsunamis,
technological advances, consumer confidence, inflation and
fluctuations in national and global economies. All businesses are
subject to this type of risk and it is this type of risk that is
associated with investment appraisal.
Discounted payback
One of the weaknesses of the payback period is
that it does not take into account the cost of
waiting. The discounted payback method
overcomes this by simply discounting the cash
flows of a project with the cost of capital for the
business and calculating the payback period
based on the present value of the cash flows.
Discounted payback
Newport Leisure Park Ltd. – discounted payback
Sensitivity analysis
Sensitivity analysis assesses how sensitive the
NPV of a project is to changes in the various
inputs to the NPV model. Inputs include:
The value of the initial investment.
The estimated life of the project.
The sales volume forecast.
The forecast price used.
The forecast sales mix used.
The cost forecasts.
The disposal value of the investment assets.
The discount rate used.
Illustration 14.1: Sensitivity
analysis
Illustration 14.1: Sensitivity
analysis
Illustration 14.1: Sensitivity
analysis
Scenario analysis and the use of
probabilities
The use of probabilities in investment appraisal allows a range of
outcomes or alternatives to be considered, with probabilities
assigned to show how likely it is that these outcomes could
actually occur.
In its simplest form, these alternatives would include optimistic,
most likely and pessimistic scenarios.
Once probabilities have been assigned to these scenarios,
statistical measures of expected value (return) and standard
deviation (risk) can be used to measure the expected NPV and
the probability of a negative NPV for a project.
This information can be presented graphically in the form of a
decision tree showing all the possible outcomes that may result
from a particular project and their probabilities of occurrence.
Illustration 14.2: Calculation of
expected values
Non-financial considerations
Health and safety issues for both employees and
customers.
Environmental objectives.
Relations with the other stakeholders in the business.
Ethical values.
Technological developments.
Other considerations
The effect of an investment on the competitive
environment.
The effect of the investment on the risk profile of the
business.
The location of the investment.
Future trends in the industry.
The effects of the investment on the internal
organisation and company stakeholders.