Capital investment appraisal 2 DCF and decision making

1
Capital investment appraisal 2DCF and decision
making
2
Capital investment appraisal 2

• Different types of decision using NPV
• Is a project worthwhile?
• Choosing between two options
• Continuing with a project
• Prioritising projects when capital is limited
• Other discounted cash flow methods
• Internal rate of return
• Discounted payback
• Non-financial considerations
• Reading Management Accounting for Business
  chapter 6

3
Is a project worthwhile?

• Simple decision
• Go ahead or not?
• Will the project increase wealth?
• Go ahead if NPVgt0
• Return greater than opportunity cost of capital

4
Choosing between two projects

• Focus on relevant cash flows
• Choose project with higher NPV
• Can use differential cash flows instead
• Applies when projects are of equal length
• Otherwise have to consider annual equivalents

5
Continuing with a project

• Decision whether to abandon a project which is
  already started
• Relevant incremental cash flows
• Expenses so far are sunk costs
• Make decision based on future cash flows from
  today
• May be other significant non-financial factors

6
Prioritising projects when capital is limited

• Maximise return per invested
• Rank according to profitability index
• PV of future inflows / PV of future outflows
• Applies when projects are divisible (can be done
  in part)
• If not, need to calculate NPV for all possible
  combinations up to available capital

7
Internal rate of return

• Method which takes account of time value of money
• Represents interest rate earned by investment
  over its life
• Advantage gives measure managers can relate to
• Rate at which present values of outflows
  present value of inflows
• Rate at which NPV 0

8
Estimating and using IRR

• Calculate NPV at different discount rates
• Then can use alternative methods to find point at
  which NPV 0
• Using a graph
• Interpolation (calculate based on two points)
• Trial and error
• Project is profitable if IRR gt opportunity cost
  of capital
• With choice of projects choose higher IRR

9
Estimating the IRR (2)
10
IRR the main issues

• Does consider time value of money but
• Ignores the scale of the project
• Assumes interim cash flows reinvested at same
  return as the project ie at the IRR
• Problematic with unconventional cash flows such
  as net outflows in later years
• can lead to more than one possible IRR

NPV
Cost of capital
11
Discounted payback method

• Calculate payback period after discounting cash
  flows
• Gives better indication than simple payback
  period
• Shares other disadvantages with simple payback
  period
• Does not take account of cash flows after payback
  period ends

12
Non-financial considerations

• How does this project fit with the organisations
  strategy
• Is it mandatory?
• What non-financial resources are required?
• How risky is it?
• Possible alternatives?
• Will it lead to other opportunities?
• Ethical issues
• Other impacts?
• On employees
• On the community
• On the environment