Investment Appraisal Techniques

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.

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.

Types of Investment Appraisal Techniques? Pay Back Period (PBP) Accounting Rate of Return (ARR) Net Present Value (NPV) Internal Rate of Return (IRR

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.

Calculating the accounting rate of return The average investment is calculated as : (Initial investment + final or scrap value) 2

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 EqpmntY Total profit over life Before depreciation 160,000 280,000 After depreciation 80,000 130,000 Average annual profit After depreciation 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

Advantages It is quick and simple to calculate. It involves a familiar concept of a percentage return. Accounting profits can be easily calculated from financial statements. It looks at the entire project life

Disadvantages It is based on accounting profits rather than cash flows, which are subject to a number of different accounting policies. It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. It takes no account of the length of the project. Like the payback method, it ignores the time value of money

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.

Example 1 YEAR CASHFLOW (£) CUMULATIVE CASH FLOW (£) (10,000) 1 2,000 (8,000) 2 3,000 (5,000) 3 4,000 (1,000) 4 1,000 5 PAYBACK PERIOD (when the cost of investment has been paid off) 4 YEARS Clevedon Community School

EXAMPLE 2 YEAR MACHINE A MACHINE B (10000) 1 3000 1000 2 5000 3 4 2000 (10000) 1 3000 1000 2 5000 3 4 2000 4000 5 6000 Clevedon Community School

PAYBACK PERIOD IS BETWEEN 2 AND 3 YEARS YEAR MACHINE A (10000) 1 3000 2 5000 3 4 2000 5 CUMULATIVE CASH FLOW (£) THEREFORE THE FOLLOWING CALCULATION IS USED. (10000) (7000) INCOME REQUIRED X12 NET CASH FLOW FROM NEXT YEAR (2000) INCOME REQUIRED =£2000 NET CASH FLOW FROM NEXT YEAR = 3000 MONTH OF PAYBACK =8 MONTHS (2000/3000) X12 1000 3000 6000 PAYBACK PERIOD =2 YEARS 8 MONTHS Clevedon Community School

PAYBACK PERIOD =3 YEARS 3 MONTHS Now it’s your turn! Calculate the payback period for machine B YEAR MACHINEB (10000) 1 1000 2 3000 3 5000 4 4000 5 6000 CUMULATIVE CASH FLOW (£) (10000) = INCOME REQUIRED X12 NET CASH FLOW FROM NEXT YEAR (9000) INCOME REQUIRED =£1000 NET CASH FLOW FROM NEXT YEAR =4000 MONTH OF PAYBACK =3 MONTHS (1000/4000) X 12 (6000) (1000) 3000 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

Disadvantages Payback Simple to calculate. Quick screening tool for analysis. It places stress on early return, forecasts of which are likely to be more accurate. An early return is especially important when liquidity is more important than profitability. Disadvantages Payback It disregards all cash flows beyond the payback period so fails to measure overall profitability. It ignores the time value of money. It discriminates against projects which involve a long payback period. 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 LOS: Calculate and interpret the weighted average cost of capital (WACC) of a company. Pages 128–129 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 contribution of capital. The cost of capital is a marginal cost because it is the cost associated with making an investment, so everything is at the margin (that is, incremental). Discussion question: What is the reason for the cost of capital to reflect the marginal cost of capital instead of the average or embedded cost of capital? 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.

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 will yield a return which is exactly the same as the cost of capital.