Capital Investment Appraisal

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Capital Investment Appraisal

• February 20th 2007

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Learning Objectives

• To understand the nature and importance of
  investment decision-making in organisations
• To understand the concept of the time value of
  money and how to calculate discount factors
• To identify the four investment appraisal methods
  and how to evaluate investment proposals using
  these methods
• To summarise advantages and disadvantages of
  these methods both in theory and practice
• To make recommendations based on your analyses

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Recommended Readings

• Drury C (2001) Management Accounting for Business
  Decisions 2nd Edition. Thomson. (Chapter 9)
• Gowthorpe C (2003) Business Accounting and
  Finance for Non-Specialists. Thomson. (Chapter
  21)
• McLaney E and Atrill P (2002) Accounting An
  Introduction, 2nd edition. Prentice Hall
  Europe. (Chapter 14)
• Cashmore C (2002) Cut to the Chase, CIMA
  Insider, September.
• Dugdale D Jones C (1991) Discordant voices
  accountants views of investment appraisal
  Management Accounting, November.
• Dugdale D (1992) Is there a correct method of
  investment appraisal? Management Accounting,
  May.
• Scarlett B (2002) That Sinking Feeling, CIMA
  Insider, September.

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Nature Importance

• Nature
• Long-term rather than short-term
• Large investment rather than small investment
• More complicated from concerns of future cash
  flows and/or time value of money
• Importance
• Large amounts of resources are often involved
  business strategy, profitability, and survive
• Difficult to bail out, once an investment made
• Close relationship with shareholders wealth
  maximisation

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Methods of Investment Appraisal

• Payback period
• The length of time cash proceeds recover the
  initial capital expenditure
• Accounting Rate of Return (ARR)
• A return measurement by using average annual
  profits
• Net Present Value (NPV)
• The present value of the net cash inflows less
  the initial investment
• Internal Rate of Return (IRR)
• A return measurement takes into account the time
  value of money

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Example

• There are two optional projects for your
  company to choose. However, you can only choose
  one of them. The data for the initial investments
  are in the following table. You are required to
  calculate
• Payback period
• ARR
• NPV
• IRR, and
• Your recommendation

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Data for the Projects
Project A Project B
Initial investment 100,000 100,000
Cash inflows
Year 1 45,000 30,000
Year 2 40,000 30,000
Year 3 35,000 44,000
Year 4 30,000 46,000

• The depreciation is 20,000 per year.
• The residual value for both projects is the
  same, 20,000.

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Payback Period

• The Payback period the point in time at which
  cash flows turn from negative to positive

Project A Cash flows Cumulated cash flow
Year 0 -100,000 -100,000
Year 1 45,000 -55,000
Year 2 40,000 -15,000
Year 3 35,000 20,000
Year 4 50,000 70,000
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Payback Period

• Payback period (A) change in cash flow required
  to reach zero/total cash flow in year
• 15,000/35,000 0.43 2 years 2.43 years
• Payback period (B) 40,000/44,000 0.91 2
  years 2.91 years
• Which project is the better one based on payback
  period?

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Payback Period
Project B Cash flows Cumulated cash flow
Year 0 -100,000 -100,000
Year 1 30,000 -70,000
Year 2 30,000 -40,000
Year 3 44,000 4,000
Year 4 66,000 70,000
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ARR

• Step 1 calculate annual profit
• Annual profit net cash inflow - depreciation
• Step 2 calculate average profit
• Average profit total profits / number of years
• Step 3 calculate average capital invested
• Average capital invested (initial cost
  residual value) /2
• Step 4 calculate ARR
• ARR average profit/average capital invested x
  100

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ARR

• Project A
• Average profit (25,000 20,000 15,000
  10,000)/4 70,000/4 17,500
• Average capital invested (100,00020,000) /2
  60,000
• ARR 17,500/60,000 x 100 29
• Project B
• Average profit (10,000 10,000 24,000
  26,000)/4 17,500
• Average capital invested (100,000 20,000)/2
  60,000
• ARR 17,500/60,000 x 100 29
• Which project is the better one?

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The Time Value of Money

• What a difference between 1 now and 1 in a
  years time?
• Factors change the value of money
• Interest cost
• Inflation
• Other risks to materialise the money
• For example the annual interest rate is 10, I
  lend you 1 now and will get back after 1 year,
  how much worth of that 1 in a years time?
• ? x (110) 1
• ? 0.91
• 10 is called cost of capital ? is called
  the discount factor

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NPV

• Assume that your companys cost of capital is 10
• Discount factors at 10 are
• Year 1 0.909
• Year 2 0.826
• Year 3 0.751
• Year 4 0.683

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NPV
Project A Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 45,000 0.909 40,905
Year 2 40,000 0.826 33,040
Year 3 35,000 0.751 26,285
Year 4 50,000 0.683 34,150
NPV 34,380
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NPV
Project B Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 30,000 0.909 27,270
Year 2 30,000 0.826 24,780
Year 3 44,000 0.751 33,044
Year 4 66,000 0.683 45,078
NPV 30,172

• Which project is the better one based on NPV?

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IRR

• IRR the discount rate when the net present value
  is zero
• Project A
• NPV 34,380 when the discount rate is 10
• NPV ? When the discount rate is 25

Project A Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 45,000 0.800 36,000
Year 2 40,000 0.640 25,600
Year 3 35,000 0.512 17,920
Year 4 50,000 0.410 20,500
NPV 20
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IRR

• Project B
• NPV 30,172 when the discount rate is 10
• NPV ? When the discount rate is 25

Project B Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 30,000 0.800 24,000
Year 2 30,000 0.640 19,200
Year 3 44,000 0.512 22,258
Year 4 66,000 0.410 27,060
NPV -7,482
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IRR

• Project A IRR 25
• Project B
• Total change in NPV 30,172 7,482 37,654
• Total change in discount rate 25 - 10 15
• IRR 10 30,172/37,654 x15 22
• Which project is better?

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Project Selection
Methods Single project Choice of projects A or B?
Payback less than the target period Shortest payback period A
ARR Above the target rate With the highest ARR N/A
NPV A positive NPV With the highest NPV A
IRR Higher than the target rate (cost of capital) With the highest IRR A
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Advantages Disadvantages
Method Advantages Disadvantages
Payback simple and easy to understand and use objective using cash flows liquidity commercially realistic cautious risk averse ignores later cash flows ignores the time value of money ignores cash flows after the payback period
ARR simple and easy to understand and use aids internal and external comparisons looks at the whole life of the project A useful tool to measure divisional managerial performance subjective profit, not cash flows ignores the time value of money difficulty in use when with same ARR and various project sizes
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Advantages Disadvantages
Method Advantages Disadvantages
NPV takes account of the time value of money concerns of shareholder wealth takes account of risk looks at the whole life of the project difficult to be understood by managers adverse effects on accounting profits in the short run how to choose discount rate?
IRR takes account of the time value of money easy to be understood by managers difficult to use in choosing projects of varying sizes difficult to choose when have the same IRR
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Tips of Exam Question

• How to use four methods based on examples
• How to interpret and compare your calculations
• How to select the best choice
• How to distinguish advantages and disadvantages
  of four methods