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Capital investment:investment appraisal

Managing financial resources & decisions (H/601/0548)

Nurul Afza Binti Abd Rashid

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Investment Appraisal• A means of assessing whether an investment project is

worthwhile or not• Investment project could be the purchase of a new PC for a

small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc• Used in both public and private sector

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Investment Appraisal• Why do companies invest?• Importance of remembering investment as the purchase of

productive capacity NOT buying stocks and shares or investing in a bank!

• Buy equipment/machinery or build new plant to:• Increase capacity (amount that can be produced) which

means:• Demand can be met and this generates sales revenue• Increased efficiency and productivity

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METHODS OF CAPITAL INVESTMENT APPRAISAL

Proposed

Capital Project

Payback

Discounted payback

Accounting Rate

of Return

Internal Rate of Return

Net Present Value

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1. The PAYBACK method• The payback method is an attempt to estimate how long it

would take before a project begins to pay for itself.• Example : If a company was going to spend RM 300,000 on

purchasing some new plant, the accountant would calculate how many years it would take before RM 300,000 had been received back in cash.• The recovery of an investments in a project is usually measured

in terms of net cash flow.Net cash flow is the difference between cash received and cash

paid during a defined period of time.

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The PAYBACK method• The Newland City Council has investigated the possibility of

investing in a new project, and the following information has been obtained.

RM RMTotal cost project 500,000Expected net cash flows:Year 1 20,000 2 50,000 3 100,000 4 200,000 5 300,000 6 30,000 (700,000)Net Return 200,000

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The PAYBACK methodYear Net cash flow Cumulative net

cash flow

Year 0 (500,000) (500,000) 1 20,000 (480,000) 2 50,000 (430,000) 3 100,000 (330,000) 4 200,000 (130,000) 5 300,000 170,000 6 30,000 200,000

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The PAYBACK method

• By the year end of fifth year, the original investment of RM 500,000 will have been covered.

• However, the exact years that investments will be covered is 4 years and 5 months [(RM 130,00 / RM 300,000) x 12 months].

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2. The DISCOUNTED PAYBACK method

Year

(1)

Net Cash Flow

(2)

Discount factors

(3)

Present Value at 8 % [Column (2) x

Column (3)](4)

Cumulative present value

(5)0 (500,000) 1.0 (500,000) (500,000)

1 20,000 0.9259 18,518 (481,482)

2 50,000 0.8573 42,865 (438,617)

3 100,000 0.7938 79,380 (359,237)

4 200,000 0.7350 147,000 (212,237)

5 300,000 0.6806 204,180 (8,057)

6 30,000 0.6302 18,906 10,849

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The DISCOUNTED PAYBACK method

• By the year end of sixth year, the original investment of RM 500,000 will have been covered.

• However, the exact years that investments will be covered is 5 years and 5 months [(RM 8,000 / RM 19,000) x 12 months].

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Accounting Rate of Return

• The accounting rate of return(ARR) method attempts to compare the profit of a project with the capital invested in it.• Using the formula :

ARR = Average annual net profit before interest and taxation x 100

Initial capital employed on the project

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3. Accounting Rate of Return

RM RMTotal cost project (5 years)

50,000

Estimated net profit:Year 1 12,000 2 18,000 3 30,000 4 25,000 5 5,000Total Net Profit 90,000

Bridge Limited is considering investing in a new project, the details of which are as follows:

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Accounting Rate of Return• The accounting rate of return would be calculated as follows : Average annual net profits x 100

Cost of the investment

Average annual net profits = RM 18,000 (RM 90,000/5) » Accounting Rate of Return = RM 18,000 x 100 =

36 % RM 50,000

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Accounting Rate of ReturnIn evaluating an investment project, the ARR of the project is compared with a predetermined minimum acceptable accounting Rate of return:

ARRs Comments< minimum acceptable rate Reject project= minimum acceptable rate Accept project> minimum acceptable rate Accept projectHighest Choose highest ARR

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4. Net Present Value

• The NPV method recognizes that cash received today is preferable to cash receivables sometimes in the future. • When facing different investment proposals, the management should

choose the project that can generate the greatest addition of value to the company. • Net present value (NPV) method is a process that uses the discounted

cash flow of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return• With the NPV method, we can compare the return on investment in

capital projects with the return on an alternative equal risk investment in securities traded in financial market

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Steps to be considered in calculating NPV

• 1. Calculate the annual net cash flows expected to arise from the projects.• 2. Select an appropriate rate of interest, or required rate

of return.• 3. Compare the total net present value with the initial

outlay.• 4. Accept the project if the total NPV is positive.

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Net Present ValueProject ALPHA BETA

Estimated life 3 years 5 yearsCommencement date 1.1.2001 1.1.2001Project cost at year 1 100,000 100,000Estimated net cash flows:Year 1 20,000 10,000 2 80,000 40,000 3 40,000 40,000 4 0 40,000 5 0 20,000

140,000 150,000

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Net Present ValueYear ALPHA BETA

Net Cash FlowRM

Discount Factor 10 %

Present ValueRM

Net Cash FlowRM

Discount Factor10%

Present ValueRM

(1) (2) (3) (4) (5) (6) (7)1 20,000 0.9091 18,182 10,000 0.9091 9,0912 80,000 0.8264 66,112 40,000 0.8264 33,0563 40,000 0.7513 30,052 40,000 0.7513 30,0524 - 0 - 40,000 0.6830 27,3205 - 0 - 20,000 0.6209 12,418

Total present value 114,346 111,937Less : Initial cost (100,000

)(100,000)

Net present value 14,346 11,937

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Interpreting the NPV derived as follows:

NPVs Comments Reasons <0 Reject the project The rate of return from the project is

small than the rate of return from an equivalent risk investment

=0 Indifferent to accept or reject the project

The rate of return from the project is equal to the rate of return from an equivalent risk investment

>0 Accept the project The rate of return from the project is greater than the rate of return from an equivalent risk investment

Highest Accept the project If various project are considered, the project with highest positive NPV should be chosen

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Internal Rate of Return• The internal rate of return is the annual percentage return

achieved by a project, of which the sum of discounted cash inflow over the life of the project is equal to the sum of discounted cash outflows• If the IRR is used to determine the NPV of a project, the NPV

will be zero.• The company will accept this project only if the IRR is equal to

or higher than the minimum rate of return or the cost of capital

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Internal Rate of ReturnExample :• Bruce Limited is considering whether to invest RM 50,000 in a new

project. The project’s expected net cash flows would be as follows: Year RM

1 7,000

2 25,000

3 30,000

4 5,000

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Internal Rate of ReturnYear Net Cash

FlowDiscount Factors Present Value

(1) (2) (3) (4) (5) (6)10 % 15% 10% 15%

RM RM RM1 7,000 0.9091 0.8696 6,364 6,0872 25,000 0.8264 0.7561 20,660 18,9033 30,000 0.7513 0.6575 22,539 19,7254 5,000 0.6830 0.5718 3,415 2,859

Total present values

52,978 47,574

Initial cost (50,000) (50,000)Net Present Value 2,978 (2,426)

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Internal Rate of Return• Break-Even Rate of Return

IRR = Positive Rate + Positive NPV x Range of rates Positive NPV + Negative NPV*

So, solution : IRR = 10% + 2,978 x (15% - 10 %) (2,978 + 2,426)

= 10 % + (0.5511 x 5%)= 10% + 2.76%= 12.76%

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INVESTMENT APPRAISAL

ADVANTAGES AND DISADVANTAGES OF METHODS OF CAPITAL INVESTMENTS APPRAISAL

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The PAYBACK MethodAdvantages Disadvantages

1. Payback can be important: long payback means capital tied up and high investment risk.

1. It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return.

2. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept.

2. It ignores the time value of money. Only suitable for short-term only.

3. Can be used as a supplementary. It focuses on the cash recovery of an investment.

3. It is unable to distinguish between projects with the same payback period.4. It may lead to excessive investment in short-term projects.

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Accounting Rate of ReturnAdvantages Disadvantages

1. The method is compatible with a similar accounting ratio used in financial accounting.

1. Does not take account of the time value of money

2. It is relatively easy to understand and not difficult to compute.

2. ARR method seems to be less reliable than the NPV method. It adopts the accounting profit instead of cash flows calculation. The change of depreciation method may also alter the accounting profit

3. It draws attention to the notion of overall profit.

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Net Present ValueAdvantages Disadvantages

1. Consistency with the time value of money concept

1. It is difficult to estimate accurately the net cash flow for each year of the project’s life.

2. Consideration of all cash flows 2. Some difficulties may incurred in estimating the initial cost of the project and the time periods in which instalments must be paid back.

3. Adoption of cash flows instead of accounting profit

3. It is not easy to select an appropriate rate of interest.

4. It is easy to compare the NPV of different projects and to reject projects that do not have an acceptable NPV.

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Internal Rate of ReturnAdvantages Disadvantages

1. Attention is given to the timing of net cash flows.

1. It is not easy to understand.

2. An appropriate rate of return does not have to be calculated.

2. It is difficult to determine which two suitable rates to adopt.

3. The method gives a clear percentages return on a investments.

3. The method gives an approximate rate of return.

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Conclusion

• NPV is considered to be a highly acceptable method of Capital Investment Appraisal. It takes into the timing of net cash flows, the project’s profitability, and the return of the original investment.• However, an entity would not necessarily accept a project just

because it had an acceptable NPV, because there are many non-financial factors that must be allowed for. • Furthermore, other less profitable projects (or even projects with a

negative NPV) may ahead, perhaps because they are concerned with employee safety or welfare.