CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

BASIC INVESTMENT APPRAISAL

Investment
appraisal
techniques

NPV
IRR Payback ARR

ACCOUNTING RATE OF RETURN (ARR)

Idea: Expresses profits of project as a percentage of capital outlay

Decision Rule:

ARR > target rate accept project

ARR < target rate reject project

ARR = Average annual profit (after depreciations x 100%

Initial capital cost

ARR = Average annual profit (after depreciations x 100%

Average investment

Advantages Disadvantages
• Simple and easy to calculate • Uses accounting profits which can be
subject to different policies and
manipulation
• Uses profit figures that are more reliably • Does not take account of the size of the
understood investment
• Looks at the entire project’s life • It is a relative measure and is not
absolute
• Allows more than one project to be • Ignores the time value of money
compared
• Enhances liquidity

w w w.s tud yi nt er a c ti ve . or g 1
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

PAYBACK PERIOD

Idea: How quickly do you recover your initial investment?

Decision Rule:

Payback period < target accept project

Payback period > target reject project

Advantages Disadvantages
• Quick, simple and easy to understand • Ignores the time value of money
• Focuses on more reliable short term • Ignores the timing of the cash flows
forecasts within the payback period
• Enhances liquidity • Ignores the cash flows after the payback
period

NET PRESENT VALUE (NPV)

Idea: Measures change in shareholder wealth as a result of accepting a project

Decision Rule:

NPV > 0 accept project

NPV < 0 reject project

Advantages Disadvantages
• Considers the time value of money and • Cash flows can be difficult to predict
maximizes shareholder wealth
• Considers relevant cash flows • Inflation and tax can be difficult to
predict
• Incorporates risk in the decision making • Issues with choosing an appropriate
discount rate
• Provides clear, unambiguous decisions

w w w.s tud yi nt er a c ti ve . or g 2
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

EXAMPLE (Congo)

Congo Ltd is considering the selection of one of a pair of mutually exclusive projects. Both would
involve purchase of machinery with a life of five years.

Project 1 would generate annual cash flows (receipts less payments) of £200,000 and the machinery
would cost £556,000, with a scrap value of £56,000

Project 2 would generate annual cash flows of £500,000 and the machinery would cost £1,616,000,
with a scrap value of £301,000.

Congo uses the straight-line method for providing depreciation and its cost of capital is 15%.
Assume that annual cash flows arise on the anniversaries of the initial outlay, that there will be no
price changes over the project lives and that acceptance of one of the projects will not alter the
required amount of working cash capital. Ignore taxation.

w w w.s tud yi nt er a c ti ve . or g 3
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

INFLATION

w w w.s tud yi nt er a c ti ve . or g 4
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

EXAMPLE

A project requires an outlay of £1.5m at the start of the project and will repay cash flows in real
terms (today’s prices) as follows:

Year £’000s
1 670
2 500
3 1,200

The money cost of capital is 15.5%. Appraise the project if inflation is estimated at 5% per annum.

TAXATION

EXAMPLE

A company buy a fixed asset for £10,000 at the beginning of an accounting period (1 January 2001)
to undertake a two year project.

Net trading revenues are £5,000 per annum and the company can sell the asset on the last day of
the second year of the project for £6,000.

Corporation tax is at 33% and writing down allowances are available at 25% reducing balance.

Calculate the net cash flows of the project.

EXAMPLE

A company buy a fixed asset for £10,000 at the end of an accounting period (31 December 2000) to
undertake a two year project.

Net trading revenues are £5,000 per annum and the company will scrap the asset on the last day of
the second year of the project for nil value.

Corporation tax is at 33% and writing down allowances are available at 25% reducing balance.

Calculate the net cash flows of the project.

w w w.s tud yi nt er a c ti ve . or g 5
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

TAXATION – TAX EXHAUSTION

Scenario: Capital allowances for the year > profit before tax (PBT)

EXAMPLE

A company buys a fixed asset for £20million at the beginning of an accounting period to undertake a
five year project.

Tax written down allowances are given at 20% straight line with the tax allowable in the year.
Corporation tax is at 25%. Profits before tax for each year of the project are estimated to be:

Year 1 2 3 4 5
PBT £6m £5m £4m £3m £8m

Calculate the net after tax cash flows for each year of the project.

w w w.s tud yi nt er a c ti ve . or g 6
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

INTERNAL RATE OF RETURN (IRR)

Idea: Discount rate which equates future cash inflows to initial cash outflow (i.e. DR
that gives NPV=0)

Decision Rule:

Discount rate < IRR accept project

Discount rate > IRR reject project

Advantages Disadvantages
• Easily understood by financial managers • Ignores the relative size of the
investment
• Discount rate does not have to be • It cannot incorporate changes in discount
specified rate

w w w.s tud yi nt er a c ti ve . or g 7
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

CAPITAL RATIONING

Capital rationing – limited finance available so unable to undertake all positive NPV projects.

Hard capital rationing – external restrictions on raising finance

Soft capital rationing – internal restrictions on raising finance

SINGLE PERIOD CAPITAL RATIONING

Single period capital rationing – finance limited at one period during the project’s life.

1. Mutually exclusive

2. Independent and divisible

3. Independent and indivisible

EXAMPLE

Banden Ltd is a highly geared company that wishes to expand its operations. Six possible capital
investments have been identified, but the company only has access to a total of £620,000. The
projects may not be postponed until a future period. After the project’s end, it is unlikely that
similar investment opportunities will occur. Expected net cash inflows (including salvage value) are:

Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the
company’s existing capital investments. Banden’s cost of capital is 12% per year.

Calculate the NPV of each project and recommend which projects should be accepted if:

(i) The projects are indivisible

(ii) The projects are divisible

w w w.s tud yi nt er a c ti ve . or g 8
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

MULTI PERIOD CAPITAL RATIONING

Multi-period capital rationing – finance limited at more than one period during the project’s life.

1. Independent and divisible

2. Independent and indivisible

EXAMPLE

The management team of Toby Ltd has identified four indivisible projects. The funds required to be
invested over the next four years and the resulting NPVs are as follows.

Project A Project B Project C Project D

£ £ £ £
Year 0 17,500 22,500 - 12,500
Year 1 25,000 - 15,000 15,000
Year 2 10,000 30,000 20,000 17,500
NPV 20,000 27,500 15,000 10,000

The board of directors has approved the following capital expenditure programme as follows.

£
Year 0 40,000
Year 1 35,000
Year 2 42,500

Calculate the optimum mix of projects.

w w w.s tud yi nt er a c ti ve . or g 9
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

RISK AND UNCERTAINTY

Risk – where both the outcome and likelihood of the outcome are known.

• Probability distribution

• Expected values

• Monte Carlo simulation

• Portfolio theory

• CAPM

• Risk adjusted betas

Uncertainty – where the outcome is known but the likelihood of the outcome is unknown.

• Minimum payback period

• Increasing discount rate

• Prudent estimates

• Best vs. worst case scenario

• Sensitivity

PROBABILITIES AND EXPECTED VALUES

Idea: Narrowing a spread of possible outcomes to one number (the Expected Value).

Advantages
• Information is reduced to a single
number for each choice
• Idea of an average is readily understood
Disadvantages
• Probabilities may be difficult to estimate
• Average may never materialize
• Ignores risk – no spread of outcomes

w w w.s tud yi nt er a c ti ve . or g 10
CH AP T E R 2 – AD V A N C ED I N V ES T M E NT APP R AI S A L : S EC TI O N 1

SENSITIVITY ANALYSIS

Idea: Take each uncertain forecast and calculate change necessary for NPV to fall to zero.

• Cash flows

• Number of units

• Discount rate

• Project life

EXAMPLE

A three year project has the following cash flows and calculated NPV.

Year Cash flows Discount PV

factor
£’000s @10% £’000s
0 Initial investment (100) 1 (100.00)
1-3 Revenues 40 2.487 99.48
3 Scrap values 10 0.751 7.51
6.99

Calculate the sensitivity to each of the variables

Strengths Weaknesses
• Easy to understand • Assume can only change one variable at a
time
• Identifies critical variables • Does not identify probability of change

w w w.s tud yi nt er a c ti ve . or g 11