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Investment Appraisal
What do you understand by the term
Investment Appraisal?
Investment appraisal involves a series of
techniques, which enable a business to
financially appraise investment projects.
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Investment Appraisal
It is a techniques use to determine if a particular
investment is worthwhile.
It can be used to compare different projects to determine
which is more favourable.
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Types of Investment Appraisal
Techniques?
Pay Back Period (PBP)
Accounting Rate of Return (ARR)
Net Present Value (NPV)
Internal Rate of Return (IRR
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Accounting Rate of Return (ARR)
Accounting Rate of Return (ARR) expresses the
average accounting profit as a percentage of the
capital outlay.
The decision rule is that projects with an ARR
above a defined minimum are acceptable; the
greater the ARR, the more desirable the project.
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Calculating the accounting rate of return
The average investment is calculated as :
(Initial investment + final or scrap value)
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Equipment item Equipment item
X
Y
Capital Cost
Rs 80,000
Rs. 150,000
Life
5 years
5 years
Profits before depreciation
Year 1
50,000
50,000
Year 2
50,000
50,000
Year 3
30,000
60,000
Year 4
20,000
60,000
Year 5
10,000
60,000
Disposal value
0
0
ARR is measured as the average annual profit after depreciation,
divided
by the average net book value of the assets. Which item of the
equipment
should be selected, if any , if the company’s target ARR is 30 % ?
Solution
Eqpmnt X
Total profit over life
Before depreciation
After depreciation
Average annual profit
After depreciation
EqpmntY
160,000 280,000
80,000 130,000
16,000
26,000
(Capital Cost +disposal Value) /2 40,000
75,000
ARR
40%
34.7%
Both projects would earn a return in excess of 30%, but
since equipment X would earn a bigger ARR, it would be
preferred to equipment Y, even though the profits from
Y
would be higher by an average of Rs. 10,000 a year.
Practice Questions
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Advantages
0 It is quick and simple to calculate.
0 It involves a familiar concept of a percentage return.
0 Accounting profits can be easily calculated from financial
statements.
0 It looks at the entire project life
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Disadvantages
0 It is based on accounting profits rather than cash flows,
which are subject to a number of different accounting
policies.
0 It is a relative measure rather than an absolute measure and
hence takes no account of the size of the investment.
0 It takes no account of the length of the project.
0 Like the payback method, it ignores the time value of money
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Pay Back Period
This is defined by CIMA as 'The time required for the
cash inflows from a capital investment project to
equal the initial cash outflow(s)
It simply means the time it takes an investment to pay
back the amount invested.
The decision rule is that projects with the minimum
pay back time are acceptable.
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Example 1
YEAR
CASHFLOW (£)
CUMULATIVE CASH
FLOW (£)
0
1
2
3
4
5
(10,000)
2,000
3,000
4,000
1,000
2,000
(10,000)
(8,000)
(5,000)
(1,000)
0
2,000
PAYBACK PERIOD (when the cost of investment has been
paid off)
4 YEARS
Clevedon Community School
EXAMPLE 2
YEAR
MACHINE A
MACHINE B
0
(10000)
(10000)
1
3000
1000
2
5000
3000
3
3000
5000
4
2000
4000
5
3000
6000
Clevedon Community School
PAYBACK PERIOD IS
BETWEEN 2 AND 3 YEARS
YEAR
MACHINE CUMULATIVE
A
CASH FLOW (£)
0
(10000)
(10000)
1
3000
(7000)
2
5000
3
3000
4
2000
5
3000
THEREFORE THE FOLLOWING
CALCULATION IS USED.
INCOME REQUIRED
NET CASH FLOW FROM NEXT YEAR
X12
(2000)
1000
3000
6000
INCOME REQUIRED =£2000
NET CASH FLOW FROM NEXT YEAR = 3000
MONTH OF PAYBACK =8 MONTHS
(2000/3000) X12
PAYBACK PERIOD =2 YEARS 8 MONTHS
Clevedon Community School
Now it’s your turn! Calculate the payback period for machine
B
YEAR
0
MACHINE CUMULATIVE
B
CASH FLOW (£)
(10000)
1
1000
2
3000
3
5000
4
4000
(10000)
= INCOME REQUIRED
X12
NET CASH FLOW FROM NEXT YEAR
(9000)
(6000) INCOME REQUIRED =£1000
NET CASH FLOW FROM NEXT YEAR =4000
MONTH OF PAYBACK =3 MONTHS
(1000) (1000/4000) X 12
3000
5
6000
PAYBACK PERIOD =3 YEARS 3 MONTHS
9000
Clevedon Community School
The payback period for machine A is 2 years 8
months
The payback period for machine B is 3 years 3
months
Therefore the business would select machine A
However machine B generates £6000 as opposed
to £3000 by machine A. This is one of the
disadvantages of this method. The advantages
and disadvantages will now be examined.
Clevedon Community School
A Short Payback Period Can Be Useful When:When technology is changing rapidly. A business does not
want to purchase an expensive piece of equipment and find
that it is obsolete before it has been paid for. In certain
circumstances innovations can carry with them cost and
efficiency advantages that can give them the opportunity to
increase their sales and market share.
Products can go out of favour with customers before they
have brought in sufficient revenue to repay the costs of the
investment. This is particularly true of high fashion products
whose life may only be a few months before another product
takes its place. It can also be true of technical products when
innovation is moving rapidly.
Clevedon Community School
Advantages Payback
1. Simple to calculate.
2. Quick screening tool for analysis.
3. It places stress on early return, forecasts of which are likely
to be more accurate.
4. An early return is especially important when liquidity is more
important than profitability.
Disadvantages Payback
1. It disregards all cash flows beyond the payback period so fails
to measure overall profitability.
2. It ignores the time value of money.
3. It discriminates against projects which involve a long payback
period.
4. It fails to recognise that revenue generated early in the payback
period is more valuable than money received later.
Cost of capital
 The cost of capital is the rate of return that the
suppliers of capital—bondholders and owners—require as
compensation for their contributions of capital.
 This cost reflects the opportunity costs of the suppliers of
capital.
 The cost of capital is the cost of using the funds of
creditors and owners.
 Cost of capital refers to the opportunity cost of making a
specific investment. It is the rate of return that could have
been earned by putting the same money into a different
investment with equal risk
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Copyright © 2013 CFA Institute
Net Present Value (NPV)
This takes into account the time value of
money. It is based on the principle that
money is worth more than it is in the future.
The principle exists for two reasons:

Risk – money in the future is uncertain.

Opportunity cost –could be in an interest
account earning interest.
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Discounted Net Cash Flow
 The ARR method of project valuation
ignores the
timing of cash flows and the opportunity
cost of
capital tied up. Pay back considers the time
it takes to recover the original investment
cost, but ignores total profits over a
project’s life.
 Discounted cash flow, or DCF for short, is
an investment appraisal technique which
takes into account both the time value of
money and also the profitability over a
project’s life. DCF is therefore superior to
both ARR and pay back as method of
investment appraisal.
Important points about
DCF
 DCF looks at the cash flows of a project, not the
accounting profits. Like the pay back technique,
DCF is concerned with liquidity, not profitability.
Cash flows are considered because they show the
cost and benefits of a project when they occur.
For example, the capital cost of a project will be
original cash outlay, and not the depreciation
charge which is used to spread the capital cost
over the asset’s life in the financial accounts.
 The timing of the cash flows is taken into account
by discounting them. The effect of discounting is
to give a bigger value per $ for cash flows that
occur earlier, for example $1 earned after 1 year
will be worth more than $1 earned after 2 years,
which in turn be worth more that Rs 1 earned
after 3 years or so on.
Net Present Value (NPV)
NPV = present value of cash inflows minus
present value of cash outflows.
NPV=PVCI-PVCO

If the NPV is positive, it means that the cash inflows from a
project will yield a return in excess of the cost of capital, and
so the project should be undertaken.

If the NPV is negative, it means that the cash inflows from
a project will 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 a project
24will yield a return which is exactly the same as the cost of
capital.