Investment Appraisal

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Investment Appraisal

• ECO506C1 (Financial Management)

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Objectives

• The Importance of the investment decision
• The Payback Rule (PB)
• The Accounting Rate of Return (ARR)
• The Net Present Value Rule (NPV)
• The Internal Rate of Return (IRR)
• What methods are used?

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The Investment Decision

• Large amounts
• Irreversible?
• Deferrable?
• Risky?

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The Payback Rule (PB)

• How long?
• Easy to use - clear results

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Accounting Rate of Return (ARR)

• Profit increase
• Predetermined rate -
• Easy to compare

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The Net Present Value Rule (NPV)

• Money - A constant value?
• Time value of money
• Present Value (PV)
• PV Cn / (1 i)n
• C Cash flow
• n years and i Risk free rate

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(Net) Present Value

• Why?
• Acknowledging the time value of money
• Shows equivalent purchasing power
• Comparability
• Net?
• Criterion - Positive NPV!

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Example of Net Present Value (NPV)

• Year 0 (20 000)/(10.12)0 (20 000)
• Year 1 6 000 /(10.12)1 3 572
• Year 2 6 000 /(10.12)2 4 783
• Year 3 6 000 /(10.12)3 4 271
• Year 4 7 000 /(10.12)4 4 449
• Year 5 6 000 /(10.12)5 3 404
• NPV 479.00

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NPV - Points to Note

• Discounting -Converting cash flows to PVs
• Tables
• Attributes-
• Maximisation of shareholders wealth
• Timing
• Portmanteau
• Easy to use
• Unambiguous

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The Internal Rate of Return

• i?
• NPV 0!
• IRR gt set hurdle rate
• Simple two period project
• Multiple periods linear interpolation

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IRR NPV?

• Maximisation of shareholder wealth
• Mutually exclusive project, differing scales of
  investment
• Problems with the assumptions underlying IRR

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The Problem with the IRR

• Opportunity cost of capital
• Assumption that IRR opportunity cost of capital
• NPV assumes opportunity cost is the borrowing
  lending rate
• Differing projects have differing IRRs
• Illogical, why should the opportunity cost
  fluctuate?

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The IRR Approach in General

• Accounts for all information
• Opportunity cost of capital
• Unwieldy
• Ambiguity
• Multiple IRRs

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Multiple and No IRR

• Unconventional cash flows
• NPV superior
• NPV and other techniques?

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Comparison of Payback and NPV

• Liquidity - not wealth maximisation
• Timing of cash flows
• Portmanteau?
• Unambiguous

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Comparison of ARR and NPV

• Maximisation of return not shareholders wealth
• Timing ignored
• Portmanteau
• Simple

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Investment Appraisal in Practise

• Pike (1982), Pike Wolf (1988) and Hutchinson et
  al (1998)
• Two periods, 1975 and 1986 (Pike, 1988)
• Payback most popular
• NPV rapidly growing in use

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Pike Wolfs (1988) Results
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Summary

• Investment decision irreversibility etc
• Payback rule (PB)
• Accounting Rate of Return (ARR)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Comparison
• Empirical research