CHAPTER 17

INVESTMENT APPRAISAL
1. Investment appraisals
So everyday, we as people have to make decisions: decisions about what to eat, what
to drink, what job to take, where to live, who to be friends with, what book to read,
what programme to watch etc.

Now obviously we all have to make work-related decisions as well, but in the realm of
work, directors and investors probably have some of the more difficult decisions to
make, such as: where the company should invest its money, should the new machine
that might increase production be purchased, should we start producing the new
concept products yet, or have more testing done. And the list goes on!

However, this is precisely where investment appraisals come in, to assess the
attractiveness and risks involved with different proposals before coming to a logical
conclusion.

A successful business must make profitable long term decisions if they wish to
continue being successful. After all, being successful and profitable is in effect what
business is all about, and likewise, providing relevant and useful information that
allows these types of decision to be made is in effect what management accountancy
is all about!

2. Net present value (NPV)

Imagine that it is 2005 and you are the finance manager at Apple Inc. Your research
and development team come to you with two ideas, one is a hand-held device with a
touch screen that makes phone calls, sends emails and plays music and the other is
new phone modelled on an existing phone on the market with a unique design.
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The first is of course far more costly than the second, and obviously more risky too,
since it will be a novel idea. The second option would be safer and more likely to
bring a guaranteed return.

But, you are the financial manager, and you need to approach this more analytically
and with numbers. But where do you start with a project like this? Is there a way to
input some data and have a simple 'yes' or 'no' output?

Well, while we don't have anything quite that simple yet, we do have NPV.

Net Present Value (NPV) is a project appraisal technique which uses relevant net
cash flows generated by a project over its total lifetime to calculate a project’s net
contribution to an organisation. Basically, NPV tells us whether it's worth doing a
project or not!

So, NPV calculates an organisation’s change in wealth if it undertakes a particular

project. A positive NPV is an increase in the total value of the company from
doing the project, while a negative NPV is a decrease in total value of the
company from doing the project. Clearly then, any project with a positive NPV
should be undertaken.

Discounting and the time value of money

If you put £100 in a bank for one year, you would expect to get more money back in
one year's time than you put in. Why? Because of the interest you would expect to
earn from it. So, if the interest rate was 5% for example, then, in simple terms, you
would expect to get £105 back in one year, because £100 x 1.05 = £105.

Let's look at it the other way round now – if my friend is going to give me £105 in
one year's time, what is that really worth in today's terms? Given the choice of £105
now or £105 in one year's time, what would I choose? Obviously, I'd choose £105
today, because then I could invest it and earn interest. So, £105 in one year's time
must be worth less than £105 today. This effect is called the time value of money.

How do I work out how much the £105 in one year’s time is worth today, using
our 5% interest example? Well, I look at the £105 I will receive (also called the
future cash flow) and divide it by 1 + 5% interest rate i.e. 1.05. Therefore, £105
to be received in one year’s time is worth £100 today. This process of taking future
values and adjusting them to reflect their present value (value today) is called
discounting.

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A discount factor provides us with a quick way of calculating our present value. So, a
discount factor for a sum received in one year's time at an effective interest rate of
5% is 1 ÷ 1.05 = 0.952.

NPV takes account of the time value of money by ‘discounting’ future cash flows to
recognise that the further away cash flows are, the less value they have today.

Given that the company needs to achieve a percentage return equivalent to the cost
of capital to satisfy investors, the rate used is the cost of capital. Taking account of
the time value of money and all relevant cash flows (both incoming and outgoing)
means NPV is considered a superior project appraisal technique to others such as,
payback periods and IRR (see later).

The timing of cash flows

When completing NPV calculations, it is vital therefore that the timing of cash flows
is clearly recorded, as amounts received at later times need to have a greater
discounting factor applied to them. It is vital therefore that a standardised approach
is used in these calculations including a standard NPV proforma.

You will need to become familiar with the following approximate proforma for NPV
calculations:

Year 0 Year 1 Year 2 Year 3 Year 4

Sales receipts Xi Xi Xi
Costs (X) (X) (X)
Sales less costs Xi Xi Xi
Taxation (X) (X) (X) (X)
Capital expenditure (X)
Scrap Value Xi
Working capital (X) Xi
Tax benefit of tax
depreciation Xi Xi Xi Xi
Net Cash Flow (X) Xi Xi Xi (X)
Discount factors @ post tax
cost of capital Xi Xi Xi Xi Xi
Present value (X) Xi Xi Xi (X)

This is a lot to take in visually, but will really help you in the exam! The good news is
that you should have seen plenty of NPVs by then. There are also some key points
that it's worth noticing about the presentation of an NPV:

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• Cash outflows that occur at the beginning of a project occur now (Year 0),
meaning that these outflows are already at their nominal value.

• Cash outflows or inflows that occur during any particular year are all
treated as if they occurred at the end of that financial year. For instance
revenue will be earned over a full 12-month period, but for the purpose of
NPV calculations we treat revenue as if it occurred all in month 12. This
assumption is used to keep calculations straightforward.

If you are specifically told that a cash outflow or inflow occurs at the start of a
year, include it as the end of the previous year. For instance a cash flow received
at that start of Year 2 is deemed to have occurred at the end of Year 1 and should be
included in Year 1 cash flows in your calculation.

Again this is an understood assumption that ensures consistent treatment of inflows/

outflows across different NPV calculations.

Example – basic NPV

Buzzing Batteries are looking to expand operations by opening up three retail shops
selling their batteries directly to the public. They have decided upon a company
policy of acquiring all of their store locations. The following cash flows are forecast:

Year 0 Year 1 Year 2 Year 3 Year 4

£000 £000 £000 £000 £000
Land and Buildings (4,225)
Fittings & Equipment (910)
Gross Revenue 2,340 3,250 3,640 3,900

Calculate the NPV of this project where cost of capital is 12%

Solution
We start by completing a table over a number of years (which will look like the one
above), and also find the net cash flow for each year:

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Year 0 Year 1 Year 2 Year 3 Year 4

£000 £000 £000 £000 £000
Land and Buildings (4,225)
Fittings & Equipment (910)
Gross Revenue 2,340 3,250 3,640 3,900
Net Cash Flow (5,135) 2,340 3,250 3,640 3,900

Next use discount tables to look up the relevant discount factors to use. In this case
we add a row for a discount rate of 12%:

Year 0 Year 1 Year 2 Year 3 Year 4

£000 £000 £000 £000 £000
Land and Buildings (4,225)
Fittings & Equipment (910)
Gross Revenue 2,340 3,250 3,640 3,900
Net Cash Flow (5,135) 2,340 3,250 3,640 3,900
Discount Factor 1.00 0.893 0.797 0.712 0.636

Next up is the calculation of the present value of each year.

Finally, add up all years of present values to find the Net Present Value. To do this, we
total the costs or revenues (= net cash flow) for each year and multiply this by the
discount factor for that year.

Here’s what this should then look like:

Year 0 Year 1 Year 2 Year 3 Year 4

£000 £000 £000 £000 £000
Land and Buildings (4,225)
Fittings & Equipment (910)
Gross Revenue 2,340 3,250 3,640 3,900
(5,135) 2,340 3,250 3,640 3,900
Discount Factor 1.00 0.893 0.797 0.712 0.636
Present Value (5,135) 2,090 2,590 2,592 2,480

Now we simply add up all of these present values to create the Net Present Value:

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-5,135 + 2089.62 + 2590.25 + 2,591.68 + 2,480.4 = 4,616.95

As such, the new retail shops will generate Buzzing Batteries £4,616,950 over the four
years.

The NPV of the project is positive. This means it gives investors a return above the
12% cost of capital, and so the opening of the new shops should be undertaken.

It’s also worth noting that effectively this is saying that doing this project increases
the total value of the company by £4,616,950. If the stock market was efficient, as
soon as the announcement of the project was made to the market, BB share prices
would increase!

Example – NPV including relevant costs and scrap

value.
Using the same BB example we can add in additional factors to demonstrate other
concepts you will need to be familiar with when completing NPV calculations. The
following question introduces a range of other costs (some of which are relevant and
some which are not) and scrap value.

Calculate the NPV of this project where cost of capital is 12%, according to the
information given:

Year 0i Year 1i Year 2i Year 3i Year 4i

£000i £000i £000i £000i £000i
Land and Buildings (4,225)
Fittings & Equipment (910)
Gross Revenue 2,340i 3,250i 3,640i 3,900i
Direct Costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Office Overheads (165) (165) (165) (165)

• The cost of land and buildings includes £100,000 which has been spent on
legal fees!

• 55% of the office overhead is a charge made for head office services.

• BB anticipate selling the new stores at the end of year four for £4 million
which includes £75,000 for fixtures and fittings.

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Solution
To answer this question we need to be able to recognise which costs are relevant!

The legal fees are a sunk cost because they have already happened whether the
project happens or not, as such, these will not actually be incurred as part of the
project. We therefore reduce land and buildings fees by £100,000: 4,225 – 100 =
4,125. Remember that this is a cost and must therefore be (4,125)!

The (55%) allocated overhead charge is also irrelevant to this project for the same
reason, the head office will be maintained whether this project happens or not! As
such, we can adjust the given cost of office overheads accordingly: 165 x 45% =
74.25

We are told that BB can sell the new stores at the end of year 4 and this additional
factor (£4 million) has also been included in the solution below as a gain.

Year 0 Year 1i Year 2i Year 3i Year 4i

£000 £000i £000i £000i £000i
Land & Buildings (4,125)
Fittings & Equipment (910)
Gross Revenue 2,340i 3,250i 3,640i 3,900i
Direct Costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Office Overheads (45%) (74) (74) (74) (74)
Resale Value 4,000i
Net Cash Flow (5,035) 1,071 1,421 1,356 5,486

We can then do exactly what we did in the previous example, which is apply the
discount factor based on a 12% cost of capital:

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Year 0i Year 1i Year 2i Year 3i Year 4i

£000i £000i £000i £000i £000i
Land & Buildings (4,125)
Fittings & Equipment (910)
Gross Revenue 2,340i 3,250i 3,640 3,900i
Direct Costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Office Overheads (45%) (74) (74) (74) (74)
Resale Value 4,000
Net Cash Flows (5,035) 1,070 1,421 1,356 5,486
Discount Factor 1.00 0.893 0.797 0.712 0.636
PV of future cash flows (5,035) 956 1,132 956 3,489
Net Present Value £1,507

We can see that the NPV is positive and so the project should be undertaken! A lot
of the work with NPV calculations is about being methodical, ensuring that you cover
all of the criteria and working through each factor carefully. While parts of an NPV
calculation can become quite involved there are also a lot of easy marks available!

3. Internal rate of return (IRR)

There is a competitor to NPV's undisputed crown for the best method of analysing
whether a project is worth undertaking! Just like Rocky Balboa and Apollo Creed,
NPV and IRR trade blows on a number of factors. Rather than becoming the
undisputed world heavyweight champion, however, NPV and IRR both have useful
and less useful characteristics. Before we get on to that, though, we'd best have an
idea of what IRR is and how we use it.

The Internal Rate of Return calculation provides the cost of capital at which the net
present value of all cash flows from a project is 0. Or, in other words, it tells us at
what level the cost of capital should be so that the project at leasts breaks even
(neither making a profit nor a loss). This is the break even cost of capital.

If the IRR is above the current cost of capital, then returns are higher than those
required by shareholders. For example, if a project has an IRR of 12% and a cost of

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capital of 10%, we are making 2% profit. This isn't huge, but is enough to recommend
that the project go ahead.

Calculating IRR
IRR is calculated using this formula:

Where:

A =The discount rate used to calculate NPVa

B= The discount rate used to calculate NPVb

If this looks complicated, it's because it is. Calculating IRR involves calculating
multiple NPVs and is therefore tricky. Don't panic though; we're going to go through
an example in very close detail!

First, however, let's get comfortable with the procedure for calculating an IRR:

1. Calculate an NPV for the project at a cost of capital that you choose (often
10% is a good starting point). This will give your A and NPVa values to use in
the equation.

2. Calculate a second NPV value using a different cost of capital. If the first
NPV calculated was positive use a higher discount rate (e.g. 15%), if negative use
a lower rate (e.g. 5%). This will give your B and NPVb values to use in the
equation.

3. Complete the calculation using the formula

Let's take a look at an example:

Example
Cats R Us are a pet shop based in the UK. They are considering expanding their
business by procuring a second shop in a neighbouring town. Dogorama will cost

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£525,000 to purchase and a further £75,000 for refurbishment and new equipment.
Revenue projections for this project show the following profits over 5 years:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£000 £000 £000 £000 £000 £000

Net Cash Flow 105 117 120 150 180

Dogarama's fixtures and equipment are expected to have a low re-sale value by the
end of year 5, but it is forecast that the whole business could be sold for £525,000.

The current estimated cost of capital for the project is 12%.

Calculate both an NPV and IRR for this scenario.

Solution
Step 1

We've been given our initial investment (£600,000 = £525,000+£75,000), as well as an

estimate resale value (£525,000). We can therefore add these to our proforma:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£000 £000 £000 £000 £000 £000
Capital Expenditure (600)
Net Cash Flow 105 117 120 150 180
Sale of Business 525

We now need to calculate our NPV for this project (NPVa), which will be done at the
12% discount factor specified in the question.

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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£000 £000 £000 £000 £000 £000
Capital Expenditure (600)
Revenue 105 117 120 150 180
Sale of Business 525
Net Cash Flow (600) 105 117 120 150 705
Discount Factor (12%) 1.000 0.893 0.797 0.712 0.636 0.567
Present Value (600.00) 93.77 93.25 85.44 95.40 399.74
Net Present Value 167.60

Step 2 Repeat using a different percentage cost of capital. As the NPV on the first
NPV was positive, we should now choose a second cost of capital that is higher than
12%. Let's choose 20%.

Year 0i Year 1 Year 2 Year 3 Year 4 Year 5

£000i £000 £000 £000 £000 £000
Capital Expenditure (600)
Revenue 105 117 120 150 180
Sale of Business 525
Net Cash Flow (600) 105 117 120 150 705
Discount Factor (20%) 1.00 0.83 0.69 0.58 0.48 0.40
Present Value (600) 87.47 81.20 69.48 72.30 283.41
Net Present Value (6.15)

The second NPV calculation at the higher cost of capital has given a marginally
negative NPV value. That’s ideal as the formula works best when this is the case.

Step 3: Now we simply input these results into the IRR calculation:

A = 12%

NPVa = 167.6

B = 20%

NPVb = -6.15

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NPVa
IRR = A + x (B – A)
NPVa – NPVb

167.60
IRR = 0.12 + x (0.20 – 0.12)
167.60 + 6.14

167.60
IRR = 0.12 + x 0.08
173.74

IRR = 0.12 + 0.96 × 0.08

IRR = 0.12 + 0.0768

IRR = 0.1968

We can therefore see that the IRR for Cats R Us' project is 0.1968 or 19.68%.

Advantages of the IRR

• The IRR calculation does take account of the time value of money.

• The IRR also considers all cash flows.

• It gives a percentage measure that is easily understandable to both

financial and non-financial managers

• There is no need to know an exact cost of capital (which can be very hard to
calculate in practise).

Disadvantages of the IRR

As it is a % measure, doesn’t give the whole picture when choosing between
projects of different sizes. The IRR doesn’t give an absolute figure for the returns
an investment is expected to generate.

e.g. Project A has an IRR of 10%. It is a large project

Project B has an IRR of 15%. It is a small project

Project A although it has the smaller IRR, as it’s a large project may actually be more
beneficial to the company as it’s a larger project. As an analogy, consider that 1% of
£10,000 = £100 while 15% of £50 is just £7.50.

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In other unusual circumstances the IRR can conflict with the NPV decision and when
this occurs, the NPV is considered the superior tool for project assessment.

4. Payback period
Cast your minds back to being in school in the days of regular homework
assignments. You have two classes in particular that are very strict about setting
homework, but they do it in totally different ways. In biology, you are given one
large, 20-page assignment to be completed by the end of the year, whereas in Maths
you have weekly tasks of around a page each.

Now, the fatal error made by your biology teacher here is having too long of a period
in which to complete the task. Whilst the year-long homework assignment has the
potential to be highly researched and of exceptional quality, it also comes with the
risk that most students will not start it until a few days before the deadline!

This brings us on to the payback period. This is the length of time it will take for
an investment to be paid back. The longer the payback period the greater the risk,
as a greater period of time is being allowed for problems to arise. Payback technique
is a basic technique for appraising investments, but it's still something you need to
be aware about for the exam:

For example, if a project costs £500k and net cash flows are forecast to be £100k
annually, the payback period will be:

500
= 5 years
100

There are two immediate problems with using the payback period to analyse a
project:

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The discounted payback method

We can overcome the value for money issue by using the discounted payback
method. This means that we do an NPV calculation using a discount factor and
then complete the payback calculation. Let's have another look at this using our
friends at Cats R Us:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£000 £000 £000 £000 £000 £000
Capital Expenditure (600)
Revenue 105 117 120 150 180
Sale of Business 525
Net Cash Flow (600) 105 117 120 150 705
Discount Factor (12%) 1.00 0.893 0.797 0.712 0.636 0.567
Present Value (600) 93.77 93.25 85.44 95.40 399.74
Net Present Value 167.6

If we look at the NPV of the project (taking over Dogarama) which we calculated
before, we can do a simple payback calculation using the capital expenditure info the
net cash flow:

Step 1 – Work out the outstanding balance at the end of each of the four years that
the new shop will be operating.

Year 0 Year 1i Year 2i Year 3i Year 4i Year 5

£000 £000i £000i £000i £000i £000
Capital Expenditure (600)

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Revenue 105i 117i 120i 150i 180

Sale of Business 525
Net Cash Flow (600) 105i 117i 120i 150i 705
Balance Outstanding (495) (378) (258) (108)

So if the new shop is open for four years, the payback for this project is:

108
4 years + = 4.15
180 + 525

This is because if the shop is open for four years, this must be added to the payback
period which will be calculated from year 5 figures.

This particular scenario does not account for the time value of cash flows.

To do this we would complete the same calculation using the discounted cash
inflows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£000 £000 £000 £000 £000 £000
Capital Expenditure (600)
Revenue 105 117 120 150 180
Sale of Business 525
Net Cash Flow (600) 105 117 120 150 705
Discount Factor (12%) 1.00 0.893 0.797 0.712 0.636 0.567
Present Value (600) 93.77 93.25 85.44 95.40 399.74
Balance Outstanding (506.24) (412.99) (327.55) (232.15)

The payback for this project is:

232.15 (as this is the debt at the start of year 5)

4 years + = 4.58
399.74 (the annual cash flow for year 5)

Adjusted payback
Generally speaking, it is much better to have a short payback period, since the
investor's initial outlay is at risk for a shorter period of time. As such, companies

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should try and keep their payback period as short as possible in order to minimise
risk!

5. Intangible and non-financial factors

in decision making
We must remember that in the real world it’s not just the financial results that are
important – there are other considerations in decision making too. A key product
could be sold at below the ‘minimum price’ us accountant’s have calculated, using
our relevant costing models, in order to gain a foothold in a new market, or to help
fight off competition.

These factors may include but are not limited to:

Intangible and non-financial factors

Yes, taking that order for additional units above capacity may
be financially rewarding for the company, but how are your
Employees employees going to react to the additional work? Will you
have to bring in more employees or offer more incentives to
your current workforce?
How will your competitors react to anything you do? If their
Competitors reaction will be as strong as to steal more market share than
your new plan gains, will it really be worthwhile?
Will government regulations both present and future have an
impact on your business and operations? These need not be
financial (tax or tariffs etc.). For example in the UK, there is talk
of government bodies setting new guidelines on the amount
Government of sugar that should be consumed in any one day. Now if your
product contains a large amount of sugar this may have a
huge impact on demand for your product, hence despite not
being a directly financial factor it may affect your revenue in
the long run.
A business will have a long term plan for its competitiveness.
Business strategy This might, for example, include making losses in the short
term for long term gain.

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