1. 2BUS0197 – Financial Management
Investment Appraisal

2. Learning outcomes
By the end of this session students should appreciate:
The main investment appraisal methods
The reasons why discounted cash flow methods are preferred
Why net present value is regarded as superior to internal rate of return
Capital rationing and investment appraisal
The role of taxation, inflation, risk and uncertainty on investment decisions
The application of sensitivity analysis to investment projects

3. The net present value method
Uses discounted cash flows to evaluate capital investment projects
A cost of capital or target rate of return is used to discount all cash inflows to their present values
The present value of all cash inflows is then compared to the present value of all cash outflows
A positive net present value indicates that an investment project is expected to give a return in excess of the cost of capital and will therefore increase shareholder wealth

4. The net present value method
where:
I0 is the initial investment
C1, C2, …, Cn are the project cash flows occurring in years 1, 2, …, n
r is the cost of capital or required rate of return
N.B. Cash flows occurring during a time period are assumed to occur at the end of that period
Decision rule: accept all independent projects with a positive net present value
With mutually exclusive projects, select project with highest NPV

5. Example
A project costing £1,000 is expected to yield £500 per year for 2 years. Calculate its NPV
Year Cash flow % PVF PV
0 (1,000) (1,000)
NPV = (132)
Question: Would you accept the project?

6. Pros and cons of NPV method
Advantages:
Accounts for the time value of money
Uses cash flows, not accounting profit
Takes into account timing and amount of project cash flows
Takes account of all relevant cash flows over the life of a project
Disadvantages:
Accepting all projects with positive NPV only possible in a perfect capital market
Cost of capital may be difficult to find
Cost of capital may change over project life, rather than being constant

7. The internal rate of return (IRR) method
IRR of an investment project is the cost of capital or required rate of return which, when used to discount the cash flows from a project, produces a net present value of zero
where:
I0 is the initial investment
C1, C2, …, Cn are the project cash flows occurring in years 1, 2, …, n
r* is the internal rate of return

8. The internal rate of return (IRR) method
The IRR method involves calculating the IRR of a project by linear interpolation and then comparing it with a target rate of return (or hurdle rate)
Decision rule: accept all independent investment projects with an IRR greater than the company’s cost of capital or target rate of return

9. Internal rate of return
NPV
£9,500
10%
18%
IRR
Discount rate
£3,000
Investment project _

10. Estimating the IRR of a project
In the previous example, the NPV for r = 18% is negative, while the NPV for r = 10% is positive
Hence, the IRR giving a zero NPV falls between 10 and 18%.
Using linear interpolation it is possible to estimate the IRR by applying the following formula:

11. Comparing NPV and IRR methods
Mutually exclusive projects: If IRR is used, the wrong project may be selected. NPV always gives the correct selection advice +
NPV
Area of conflict
Discount rate
IRR of incremental project
Cost of capital _
Project B
Project A

12. Comparing NPV and IRR methods
Non-conventional cash flows: If an investment project has cash flows of different signs in successive periods (i.e. non-conventional cash flows), it may have more than one IRR
Applying the IRR method to projects with non-conventional may result in incorrect decisions being taken
The NPV method can accommodate non-conventional cash flow, hence it gives the correct selection advice
The basic cash flow profiles

13. IRR and NPV with non-conventional cash flows+
NPV
Cost of capital = RA
Project accepted by IRR method since IRR1> RA and IRR2> RA
Project rejected by NPV method because NPV<0 for RA
Cost of capital = RB
NPV>0, so accept project
IRR does not offer clear advice since
IRR1 < RB < IRR2 RA RB
Discount rate
IRR1
IRR2 _

14. Comparing NPV and IRR methods
Changes in the discount rate: NPV can accommodate changes in the discount rate over the life of an investment project, while IRR ignores them
Reinvestment assumptions: NPV method assumes that cash flows from project can be reinvested at a rate equal to the cost of capital. IRR method assumes that cash flows can be reinvested at a rate equal to IRR. NPV reinvestment assumption is realistic

15. The payback method
The payback period is the number of years it is expected to take to recover the original investment from the net cash flows resulting from a capital investment project
Decision rule: accept a project if its payback period is equal or less than a predetermined target value

16. Example: a simple investment project
The above cash flows refer to an investment project that requires a cash investment at the start of the project, followed by a series of cash inflows over the life of the project (conventional project)
Question: What is the payback period for the above project?

17. Pros and cons of payback method
Advantages:
Simple and easy to apply
Should not be open to manipulation as it uses cash flows, not accounting profit
Accounts for risk as it implicitly assumes that a shorter payback period is superior
Disadvantages:
Ignores time value of money
Does not consider the project as a whole since cash flows outside the payback period are taken into account only out of managerial judgement

18. The return on capital employed method
ROCE can be defined as:
average annual accounting profit × average investment
Where average investment is:
(initial investment + scrap value)/2
ROCE can also be defined as:
average annual accounting profit × initial investment
ROCE is also known as accounting rate of return (ARR) and return on investment (ROI)

19. The return on capital employed method
Average annual accounting profit can be calculated from project cash flows by taking off depreciation
Accounting profit is not cash flow since depreciation does not correspond to a cash movement
Decision rule: accept project if ROCE is equal to or greater than target (or hurdle) rate of return (i.e. current company or division ROCE)
If projects are mutually exclusive, the project with the highest ROCE should be selected

20. Example Depreciation: (10,000 – 2,000)/5 = £1,600
A machine costs £10,000 and its useful economic life is 5 years. After 5 years, the machine’s scrap value is £2,000. The net cash inflows from the machine would be £3,000 per year. Ignore taxation
Depreciation: (10,000 – 2,000)/5 = £1,600
Average annual profit: 3,000 – 1,600 = £1,400
Average investment: (10, ,000)/2 = £6,000
ROCE: (1,400/6,000) × 100 = 23%

21. Pros and cons of ROCE method
Advantages:
Measured in %, so comparable with company’s ROCE
Fairly simple to apply
Can be used to compare mutually exclusive projects
Considers all cash flows arising during a project’s life, unlike payback method
Disadvantages:
Uses accounting profit rather than cash
Profit not directly linked to primary financial objective of shareholder wealth maximisation
Uses average profits and hence ignores timing of profits
Ignores time value of money
Relative measure and so ignores size of initial investment

22. Recap on investment appraisal methods
NPV is academically preferred as an investment appraisal method – it has no major defects and is consistent with shareholder wealth maximisation
IRR comes a close second and can prove to be a useful alternative
ROCE and payback methods are flawed as investment appraisal methods but payback is often used as an initial screening method

23. Capital rationing
Arises if a firm has insufficient funds to invest in all projects with positive NPV
Hard capital rationing: limitations are externally imposed
Capital markets may be depressed
Investors may consider the company to be too risky to invest in
Issue costs may make a small issue of finance expensive
Soft capital rationing: limitations are internally imposed. Arises if managers
Want to avoid dilution of control
Want to avoid dilution of EPS
Wish to avoid fixed interest payments (debt)
Wish to follow policy of steady growth
Believe restricting available funds will encourage better investment projects

24. Single period rationing
Firm must choose combination of projects to maximise total NPV
Ranking divisible projects by NPV will not lead to correct decision
Divisible projects must be ranked using the profitability index (PI):
PI = PV of future cash flows Initial investment

25. Single period rationing
For indivisible projects, selection must be made by looking at total NPVs of possible combinations of projects
The combination with highest NPV, which does not exceed capital rationing limit will be optimal investment schedule
The investment of surplus funds is not relevant to the investment decision

26. Multi-period period rationing
Profitability index and NPV evaluation of project combinations do not help
Linear programming must be used to determine the optimum combination
Simple problems can be solved by hand, complex problems by computer

27. Relevant project cash flows
Relevant cash flows are incremental cash flows arising from an investment decision, such as initial investment, cash from sales and direct costs
Usually exclude:
Sunk costs – incurred prior to the project start, hence not relevant to project appraisal (e.g. market research)
Apportioned fixed costs – excluded from project evaluation as are incurred regardless of whether a project is undertaken (e.g. rent)
Usually include:
Opportunity costs – if an asset is used for a project, relevant to know what benefit has been foregone
Incremental working capital – increase in working capital will be a cash outflow for the company relevant for the project appraisal

28. Optimising capital investment decisions
The investment appraisal process must account for:
The effects of taxation and inflation on project cash flows
The required rate of return
The risk and uncertainty to which future cash flows are subject

29. Taxation
Tax relief on capital expenditure is given through capital allowances
In the UK:
25% reducing balance capital allowances given on plant and machinery
100%, 50% and 40% first-year allowances have been offered for specific investments
In the last year of an investment project a balancing allowance is needed in addition to a capital allowance to ensure that the capital value consumed by the firm over the project’s life has been deducted in full in calculating taxable profits

30. Taxation Tax liability arises on taxable profits
Tax relief is available on allowable costs, such as materials, wages and maintenance
Interest payments are not relevant cash flows as these are included in the discount rate
After-tax cash flows must be discounted with a relevant after-tax cost of capital
Timing of tax liabilities and benefits should be considered

31. (1 + n) = (1 + r) × (1 + i) hence (1 + r) = (1 + n)
Inflation
Inflation can adversely affect capital investment decisions by reducing the real value of future cash flows and increasing their uncertainty
Future cash flows must be adjusted to take into account any expected inflation
The real cost of capital is found from the nominal (or money) cost of capital by making an adjustment for inflation:
(1 + n) = (1 + r) × (1 + i) hence (1 + r) = (1 + n)
(1 + i)

32. Risk and uncertainty
Risk refers to a set of unique circumstances, which can be assigned probabilities
Uncertainty implies probabilities cannot be assigned to different sets of circumstances
In practice, the terms ‘risk’ and ‘uncertainty’ are often used interchangeably
The business risk of an investment increases with the variability of returns
Uncertainty increases with project life

33. Sensitivity analysis
A method of evaluating project risk by examining how responsive the NPV of a project is to changes in the variables from which it has been calculated
Only one variable is changed at a time (i.e. variables assumed to be independent)
Two methods to measure sensitivity:
Change variables by a set amount then recalculating the NPV
Finding the change in a variable which gives a zero NPV
Both methods give indication of the key variables of an investment project, i.e. small changes in these variables can have a significant adverse effect on the project

34. Problems with sensitivity analysis
Only one variable at a time can be changed
No indication is given of the probability of changes in key project variables
Not really a method of analysing project risk, since probabilities are ignored

35. Summary Today we looked at: Investment appraisal methods
Comparison between NPV and IRR methods
Relevant project cash flows
Optimisation of capital investment decisions
Taxation
Inflation
Risk and uncertainty
Sensitivity analysis

36. Readings
Textbook
Watson D. and Head A., (2007), Corporate Finance Principles and Practice, 5th (4th) edition, FT Prentice Hall, Chapters 6 and 7
Research paper
Arnold, G. C., Hatzopoulos, P. D. (2000), The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom, Journal of Business Finance & Accounting, Vol. 27, 5, pp
Barwise, P., Marsh, P. R., Wensley, R. (1989), Must Finance and Strategy Clash?, Harvard Business Review, September- October, pp
Phelan, S. E. (1997), Exposing the illusion of confidence in financial analysis, Management Decision, Vol. 35, 2, pp

37. Your tutorial activities for next week
During the seminar you will be expected to work on:
Q2 p.187; Q1 p.220 (5th ed)
Q2 p.179; Q2 p.206 (4th ed)
To prepare for the seminar you should answer the following practice questions:
EQL - UFM4 
Textbook - Q4 p.183; Q5 p.185; Q3 p218 (5th ed)
Q4 p.176; Q5 p.178; Q4 p205 (4th ed)