INVESTMENT APPRAISAL

Before capital expenditure projects are undertaken, they should be assessed and
evaluated. As a general rule, projects should not be undertaken unless:
 they are expected to provide a suitable financial return, and
 the investment risk is acceptable.

Investment appraisal is the evaluation of proposed investment projects involving

capital expenditure. The purpose of investment appraisal is to make a decision about whether
the capital expenditure is worthwhile and whether the investment project should be
undertaken

CAPITAL BUDGETING

Capital budgeting is the process that a business uses to determine which proposed fixed
asset purchases it should accept, and which should be declined.

Two techniques are used:

 Non-Discounted Cashflows
 Discounted Cashflows (DCF)

Methods of investment appraisal

There are four methods of evaluating a proposed capital expenditure project. Any or all of the
methods can be used, but some methods are preferable to others, because they provide a more
accurate and meaningful assessment.

The four methods of appraisal are:

Non-Discounted cash flow (DCF) methods:

 Accounting rate of return (ARR) method
 Payback method

Discounted cash flow (DCF) methods:

 Net present value (NPV) method
 Internal rate of return (IRR) method

Each method of appraisal considers a different financial aspect of the proposed

capital investment

The basis for making an investment decision

When deciding whether or not to make a capital investment, management must

decide on a basis for decision-making. The decision to invest or not invest will be
made for financial reasons in most cases, although non-financial considerations
could be important as well.

There are different financial reasons that might be used to make a capital
investment decision. Management could consider:
  the effect the investment will have on the accounting return on capital
employed, as measured by financial accounting methods. If so, they might use
accounting rate of return (ARR) /return on investment (ROI) as the basis for
making the decision
 the time it will take to recover the cash invested in the project. If so, they might
use the payback period as the basis for the investment decision
the expected investment returns from the project. If so, they should use
discounted cash flow (DCF) as a basis for their decision. DCF considers both the
size of expected future returns and the length of time before they are earned.

There are two different ways of using DCF as a basis for making an investment decision:
 Net present value (NPV) approach. With this approach, a present value is given
to the expected costs of the project and the expected benefits. The value of the
project is measured as the net present value (the present value of income or
benefits minus the present value of costs). The project should be undertaken if it
adds value. It adds value if the net present value is positive (greater than 0).
 Internal rate of return (IRR) approach. With this approach, the expected return
on investment over the life of the project is calculated, and compared with the
minimum required investment return. The project should be undertaken if its
expected return (as an average percentage annual amount) exceeds the required
return

Payback period Method

This method number of years it takes for a project to recoup the original investment in cash
terms.
If the payback is sooner than the target period then the project is accepted. It excludes
depreciation in its computation.

Accounting rate of return (ARR)

This approach is an accounts-based measure and considers the expected profitability of an
investment. It includes depreciation in its computation.

The Accounting Rate of Return (ARR) is calculated as:

the average profits p.a. from an investment

the average book value of the investment ×100%

The ARR is compared with a target rate of return to decide whether or not the investment is
worthwhile. The project/investment is accepted if the ARR is more than the target rate of
return.
These methods do not take into consideration TVM
Example

Mandevu Ltd is considering investing in a new machine with the following financial
information:

Description Year 0 Year 1 Year 2 Year 3 Year 4

K’m K’m K’m K’m K’m
Profit (Loss) - 28 (5) 15 10
Initial investment (100) - - - -
Scrap value - - - - 12

It is the policy of Mandevu Ltd to evaluate new investment costing below K105
million using the accounting rate of return and payback period. The company has a
target accounting rate of return of 30% and a payback period of two (2) years. The
company depreciation policy requires that straight-line method is used for plant and
machinery.

Required:
Calculate the Accounting rate of Return and the payback period and advise on the
acceptability of the investment.

Solution
a) Average Profits= 28+(-5) +15+10/4 = 12
Average investment = 100+12/2 = 56

ARR = 12/56 x 100% = 21.42%

The project should not be undertaken because it gives an ARR which is below the target rate
of 30% as per company policy.

Payback period
Depreciation = 100-12/4 = 22

Year 1 2 3 4
K’m K’m K’m K’m
Profit (Loss) 28 (5) 15 10
Add: Depreciation 22 22 22 22
Cash flow 50 17 37 32

Year Cash flow (K’m) Balance

0 (100) (100)
1 50 (50)
2 17 (33)
3 37 4
Payback period = 2.89 years ( 2 years + 33/37 = 2 +0.89 = 2.89 years)
The project should not be undertaken because it gives a payback period of 2.89years which is
higher than the company policy of 2 years.

Discounted Cashflows (DCF)

Two methods are considered here

1. Net Present Value (NPV)

The NPV is the difference between the present value of cash inflows and the present value of
cash outflows over a period of time.
Accept the project where there is a positive NPV. That is if there is a cash surplus over the
initial investment of the project.

2. Internal Rate of Return (IRR)

The IRR is the discount rate that makes the net present value (NPV) of a project zero. That is,
it is the breakeven discount rate. It is calculated using the following formula:

Accept the project when the cost of capital is less than the IRR

These methods take into consideration TVM.

Example.

A machine will cost K80,000.

It has an expected life of 4 years with an anticipated scrap value of K10,000.
Expected net operating cash inflows each year are as follows:

Year NCF
1 20,000
2 30,000
3 40,000
4 10,000

The cost of capital is 10% p.a..

Calculate the Net Present Value (NPV) and the Internal rate of Return (IRR)of the
investment and determine whether or not it should be accepted.
Solution.

a) NPV
Year CF df @ 10% P.V.
0 (80,000) 1 (80,000)
1 20,000 0.909 18,180
2 30,000 0.826 24,780
3 40,000 0.751 30,040
4 20,000 0.683 13,660
N.P.V + 6,660
+ ‘ve – Accept

b) IRR
Year CF df @ 15% P.V.
0 (80,000) 1 (80,000)
1 20,000 0.870 17,400
2 30,000 0.756 22,680
3 40,000 0.658 26,320
4 20,000 0.572 11,440
N.P.V (2,160)

IRR=10% + 6,660
(6,660+2,160) ×5%=13.78%

As the IRR is above the required rate of Return (10%) then Accept.

Working Capital (1)

It is very common in questions to be told that in addition to the cash needed to buy a
machine, cash is also needed immediately to finance working capital requirements.

The working capital requirements relate to such things as the carrying of inventory of raw
materials and the financing of receivables resulting from the sales.

Unless told differently, we always assume that the working capital results in a cash outflow at
the time it is needed, that the requirement remains for the life of the investment, but that it is
released (and therefore results in a cash inflow) at the end of the project.

Note that in several recent exam questions the examiner has stated within the question that
the machine in question will be replaced at the end of its life. This implies that the product
will still continue to be made and that therefore the working capital will still be needed. In
this case you should not recover the working capital at the end of the project.
Relevant/irrelevant cash flows
You should remember the ‘Golden Rule’ which states that to be included in a cash flow table
an item must be a future, incremental cash flow. Irrelevant items to look out for are sunk
costs such as amounts already spent on research and apportioned or allocated fixed costs.
Equally all financing costs should be ignored as the cost of financing is accounted for in the
discount rate used.

Example

The Roger Federer Company has obtained a license to introduce a new product for 6 years.
The product would be purchased from manufacturing company for $10 per unit and sold to
customers for $20 per unit. The estimated annual cash expenses to sell the new product would
be $18,000. Other information associated with the new product is given below:

 Cost of equipment needed: $30,000

 Working capital needed: $40,000
 Repairs and maintenance of equipment end of year 5: $2500
 Residual value of equipment end of year 6: $5,000

The working capital would be released at the end of 6-year period. The expected annual sales
are 5,000 units of product. The discount rate of the company is 16%.

Required:

1. Compute Net Present Value (NPV) of the new product. (Ignore income tax).
2. Would you recommend the addition of new product?

Suggested Solution
Conclusion:

Yes, the addition of new product is recommended because its net present value (NPV) is
positive.

Annuities

The discount factor for an annuity may be calculated using the following formula:

Annuity discount factor = 1−(1+r)−n

r
Where:
r = discount rate

n = number of periods

Perpetuities
The discount factor for a perpetuity is:
1
r

Where r = rate of interest

Example

A machine costs K100,000 and is expected to generate K12,000 p.a. in perpetuity.

The cost of capital is 10% p.a.

What is the NPV of the project?

Yr CF df P.V.
0 (100,000) 1 (100,000)
1– ∞ 12,000 1/0.10 120,000
N.P.V 20,000