Chapter 2: Basic investment appraisal

methods

Aims of the chapter

Like the topics in the first chapter of this guide, the topics in this
chapter are integral to the subject as a whole since these basic
techniques of time value of money and discounting are used in
numerous other aspects of financial management. So carefully
learn these concepts, and the process as well as the principles and
the pros and cons concerning them.
This chapter defines and explains the time value of money concept
and applies it to problems of investment appraisal in a certain
world. The relaxation of the assumption of certainty occurs in the
following two chapters. Here we concentrate on the basics since the
technique can be and is used in long-term and short-term
investment appraisal, in evaluation of financing methods, valuing
monetary assets, risk management etc.
We start by describing the time value of money and then explain
the concept and approach to the computational methodology used
in a practical example of investment appraisal and selection. The
net present value (NPV) is described very fully both in principle
and application and in how the decision rules are derived. Different
sets of circumstances are introduced to show how the NPV
approach can cope with the situations met in an imperfect world,
(e.g. taxation, inflation, different interest rates, repeat investments,
mutually exclusive investments, capital rationing). Alternative
methods of appraisal are also described, such as internal rate of
return and pay-back. The major problem of an imperfect world
and uncertain outcomes is dealt with later in Chapters three and
four.

Learning objectives
By the end of this chapter and having completed the essential
reading and activities, you should he able to:
describe and apply the time value of money in project
evaluation, whether it be future or present value oriented
defend the use of NPV as the method of appraisal against other
suggested methods
prepare evaluations of investment proposals and state which
decision rule is appropriate in the specific set of circumstances.

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Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of
Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 4, 7, 8
and 9

Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate
Finance. (McGraw-Hill, 2008) Chapters 2, 3, 6 and 7.
Atrill, P. Financial Management for Decision makers. (FT Prentice
Hall Europe, 2005) Chapters 4 and 5.

Time value of money

Money (i.e. cash) has a different value over time; holders of money
can either spend the money on consumption now or delay the
consumption by investing the money until it is required for
consumption. The reward for the delay in spending is the interest
received by investing. The amount of interest is dependent upon
the amount of time and the rate of interest. The further into the
future a consumer has to wait, the greater the interest
compensation required. So if one knows of a certain future receipt
of cash then there must be a certain value today, which we call the
present value, which will be its equivalent. By receiving today an
amount of cash equal to the present value, the recipient would be
indifferent between the future receipt and today’s receipt. The
difference between the two receipts is the time value, the
compensation for the passage of time. The present value of a future
amount is also known as the discounted value.

Future value and compounding

Whenever someone makes an investment, he or she expects to earn
a return which can take the form of interest when the investment is
in some form of monetary asset. If the interest earned is reinvested
rather than withdrawn then the total amount invested grows at a
compound rate. At the end of the life of the investment (at
maturity) it will have a value F – the future or maturity value. If
P is the amount invested today at r% with compound interest for t
years then the future value will be F.
F = P(1 + r)t

Present value and discounting

The converse of compounding is discounting. This uses as its
basis the sane algebraic relationship but in the opposite way. The
aim of discounting is to determine the present value of a future
amount (i.e. today’s amount) which, if invested at the rate of
interest r, would achieve the future value predicted. With
prospective new investments we can predict the incremental cash
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 Chapter 2: Basic investment appraisal methods

flows which will occur because of the investment, but as these

predictions are all in money terms of differing values they must all
be converted into a value at a common date (i.e. today, the day of
the investment). Therefore we need to convert all cash flows into
present values, today’s values. So if we predict receiving £F in t
years time during which r is rate of interest then £P is the present
value of £F, derived thus:

F 1
P= t
=F×
(1 + r ) (1 + r ) t

1
Note is the discount factor.
(1 + r) t

Using a computer, a table of discount factors for all combinations of

r and t has already been prepared. This can be found at the back of
all reputable texts. You should familiarise yourself with the
compounding and discounting formulae and procedures and where
they are used. Apply this knowledge to annuity payments or
receipts. Remember an annuity is a constant annual amount and so
the annuity factor for any year is the sum of the annual discount
factors up to and including that year.

Interest rates, discount rates and real rates

An interest rate is the proportionate return on an investment
appropriate for the risk level of the investment. So it could be the
return on a bond, a company’s investment or the required return a
company has to pay on its loan etc. The expression discount rate
is often used synonymously with interest rates because the discount
factor is derived using an interest rate. Similarly, because
companies use a mixture of capital types to fund their investments,
that mixture has an average cost which the company has to service.
Any investments made from that mix of capital must generate flows
and in the evaluation of those flows we use the discounting process.
We can use the expressions cost of capital, opportunity cost
of funds, as alternatives to discount rate since the discounting
factor is derived using the cost of capital.
You must learn the difference between real and nominal interest
rates. (The terms, money and actual interest rates, are also used to
mean nominal rate). The nominal rate is the rate to be found in
the market place. The real rate is the rate of interest that would
persist if there were no inflation or deflation.
(1 + real rate)(1+ inflation rate) = (1 + nominal rate)
(1+ r)(1+ i) = (1+ n)
N.B. Note the short cut sometimes used to derive the nominal rate
(r+i) = n. Do remember this is only an approximation and will
usually lead to over-valuing the present value of the future flows.
Remember that different items of operating expenditure and
revenues may have their own specific inflation rates and, when

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undertaking an investment appraisal, all cash flows prior to

discounting should be quoted in actual or money flows for the
specific period. All individual and specific inflation rates will have
been separately accounted for (e.g. the degree of inflation may
have been different from year to year or between say wages and
materials). The discount factor used should only incorporate the
inflation rate relevant to the capital providers who have to be
serviced and repaid from the investment.

Activity 2.1
What is the time value of money? How is it different from the real and actual
rates of interest of a risky investment?
 See VLE for solution

Basic investment appraisal techniques

Using BMM learn how to compute the net present value (NPV)
for an investment, as well as an investment’s internal rate of
return (IRR). Likewise learn how to compute the payback
period (PP) and the accounting rate of return (ARR). The
decision rules for each appraisal method should be learnt for the
range of different types of decisions a manager might face, simple
go/no go, selection between mutually exclusive projects and so on.
See BMM sections 7.1 and 7.2.

Activity 2.2
Solve self-tests in BMM, numbers 4.1, 4.3, 4.4, 4.5, 4.8 and 4.14.

You must remember:

that long term projects under consideration should be
consistent with the long term corporate plan
that the estimated cash inflows from the project when
discounted to a common date, the present, exceed the
estimated outflows, also discounted to the present
that the theory in this section assumes certainty of knowledge
and forecasting – this is relaxed in the next chapter
that, in practice, businesses do not wholeheartedly follow the
theoretically correct route of using the net present value
approach (NPV) all the time.
You should learn the process of identifying, analysing and
estimating the investment flows, remembering the projections
should be in cash not profit flows, unless ARR is being used. Profit
flows will need adjustment to cash if only profit estimates are
given. You should learn the theory behind the four main analytical
techniques with emphasis on why NPV is superior to IRR, PP and
ARR. The amount and timing of the net cash flows of a project are
crucial to the viability of an investment.

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Given below is an example of two mutually exclusive investments,

A and B, with an explanation of why only NPV will give the correct
signal to management. Assuming an annual cost of capital of 15%
and estimated net actual annual cash flows as stated, then the four
methods will give conflicting results. Each method has its own set
of decision rules.

Project Time periods (years)

0 1 2 3 4 Total
A (25,000) 5,000 12,500 12,500 12,500 £17,500
B (10,000) 5,000 10,000 (1,000) - £4,000

NPV(£) IRR (%) Payback (Years) ARR(%)

A 4,166* 22 2.6 35*
B 1,251 24* 1.5* 26.7

Separately using each evaluation method the pairs of values for

projects A and B are shown above. Using the NPV approach A will
have an NPV of £4166 and B an NPV of £1,251. The decision rule is
to select the investment with the higher NPV regardless of the size
of the original investment. Therefore A will be preferred to B,
which is why it is marked with an asterisk (*). Under each of the
evaluation methods and using the appropriate decision rule the
preferred choice can be made. It is marked with an asterisk (*) in
each case.
Using the payback approach would suggest B is preferred as it has
the shorter payback period. If one only used ARR, then A is
preferred since it has the higher rate. Since neither method is the
correct one, it is by chance one gives us the appropriate selection.
The main reason for disregarding the outcomes under these two
methods is that neither payback nor ARR take into account the
pattern of flows (i.e. the time value of the cashflows). Also payback
does not take into account the post payback flows which, in the
case of A, are considerable, while for B they are less so and it even
has a net outflow in one period. From the textbooks note the
rationales presented for the still considerable use of payback by
managers in practice. See BMM p.202 and PA pp.140–143.
In the example, though B has the higher IRR, the IRR shown is only
one of the two IRRs for that project, the other being a negative
value. This is because of one of the technical problems of using IRR
that are exemplified in B. For example, B has multiple rates of
return because the sign of the annual cash flows changes more than
once in the sequence. For each change in sign in the sequence of
cash flows, there will be a root to the solution of the equation
which produces the IRR. Thus two sign changes, as in B, means two
roots to the equation (i.e. two IRRs). Note it is possible that one or
more root could be the square root of a negative number which is
of no practical value. Also the IRR does not indicate the difference
in the size of the projects, 24% of £10,000 is not as good as 24% of
£25,000. Another problem is that IRR’s reinvestment assumption
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for the fourth year of B is that the funds have been reinvested at
24% to enable comparison with A. This is not necessarily true.
From a practical viewpoint, you should learn the capital budgeting
process and, in particular, the benefits from the post audit
procedure. The post-audit process should involve the comparison of
actual results with the predictions for the project and provoke
explanations of whatever differences have occurred, thus enabling
improved forecasting in the future and improved operations too.

Application problems – some considerations

When considering applications of the NPV analysis to practical
situations, it is important to ensure that all flows are dealt with on
an after tax basis. Similarly, in an inflationary world, when making
estimates of cash flows, the specific rates of price increases must be
incorporated in the analysis. Wages, raw material prices etc. may
be affected by different rates of price changes. In compiling the cost
of capital or opportunity cost of funds, we must use the general
or average rate of inflation since it is assumed that all providers of
funds have the ‘average’ spending pattern used to compute a retail
price index. The cost of capital is the average rate payable to the
providers of the capital for the company. The cost of capital is also
called the hurdle rate and the opportunity cost of funds (capital). It
is called the hurdle rate because it is the minimum that has to be
achieved and the opportunity cost because each element of capital
has got its own opportunity cost. Therefore, you should prepare all
estimates of flows in actual or money terms and then discount the
net flows using the actual or money cost of capital.
Many businesses are faced with decisions regarding projects that
may require repetition on a known cyclical basis. For example, take
a business with a fleet of vehicles. Different groups of vehicles in
the fleet will need replacement on a regular basis. It is important to
identify an optimum replacement period for them. The type and
make of vehicle to be used by the group can be identified on cost
grounds by use of the net perpetuity value and annual
equivalent annuity methods. These are all derived from the NPV
approach and can be learnt from BMM (see pp.197–199).
Finally, businesses have to take investment decisions when their
financial resources are limited. Where the capital restriction will
only last for one time period (normally one year) the profitability
index (PI) should be used to identify the optimal selection of
projects. If the restrictions are multi-period and/or multi-faceted
(e.g. space or personnel) then linear or integer programming
models can be used which maximise the NPV of the portfolio of
projects subject to the constraint introduced.
An alternative way of acquiring the services of an asset is to lease it
rather than buy it. The same principles of evaluation should be
applied to the incremental cash flows arising as a result of taking
out a lease in order to see whether it is a better way of funding the
asset as opposed to buying it.

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Worked example 1
A business is considering an investment in equipment which requires an initial
outlay of £10 million. The investment will be allowed a 20% writing down
allowance (depreciation) on a straight line basis for tax purposes. It is estimated
the equipment will be sold at the end of the project, the end of the fourth year for
£3 million. Any tax received on a loss, or paid on a gain, arising from the sale of
the equipment would occur in the fifth year.
The incremental revenues and costs and the annual price rises incorporated in the
estimates arising from the investment are as follows:

£million
Years 1 2 3 4
Sales 30 40 50 4
Wages (4% p.a. increases) 10 11 15 16
Materials (20% p.a. increases) 7 13 17 19
Other costs (5% p.a. increases) 10 11 12 13
Book depreciation 2 29 2 37 2 46 1 49
Net trading surplus 1 3 4 5
Increases in working capital 1 0.5 0.5 (2.0)

The business estimates that the average annual inflation rate will be 4.5% p.a.
during the five years and the business’s real after tax opportunity cost of capital is
10% p.a. The corporate tax rate for each of the five years is 30% payable a year
in arrears.
Required:
Compute the NPV, IRR, Payback and ARR for the project.

Solution to Worked example 1

First compute the depreciation for tax purposes. Obviously one uses the tax
regime requirements appropriate to the country in which one is investing.
Writing down allowance computation (straight line)
Tax allowance
Outlay 10
Year 1 (20%) 2 2
8
Year 2 (20%) 2 2
6
Year 3 (20%) 2 2
4
Year 4 Sale 3
Year 4 1 Loss on sale 1
(The same approach can be used for reducing balance based allowances.)
Then compute the tax payments or receipts based upon the taxable profits. This
may require a transfer of tax depreciation for book depreciation (in this case they
are similar).

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Tax computation (£million)

Years
1 2 3 4
Net trading surplus 1 3 4 5
Add book depreciation 2 2 2 1
Trading surplus (adjusted) 3 5 6 6
Less tax depreciation 2 2 2 1
Taxable profit 1 3 4 5
Tax (30%) £0.3 £0.9 £1.2 £1.5
Tax is paid in year following the year in which the profits were earned, i. e. tax on
year 1’s profits of £0.3 paid at end of year 2.
Cost of capital (discount rate) (i)
The actual or money rate is the rate to use. Then:
(1+i) = (1 + 0.1)(1 + 0.045)
= (1 + 0.1495)
Thus i = 0.15 (i.e. 15%)
(Some authors and businesses use the quick way and get an approximate value
by summing the real and inflation rates. Here: 10% + 4.5% = 14.5% = 15%.
You should use the theoretically correct method given above unless an
approximation is called for.)
To calculate the NPV
£’million
Year 0 1 2 3 4 5 Total
Outlay (10.0) (10.0)
Trading surplus (adjusted) 3.0 5.0 6.0 6.0 20.0
Working capital change (1.0) (0.5) (0.5) 2.0 –
Sale of equipment 3.0 3.0
Tax payments – (0.3) (0.9) (1.2) (1.5) (3.9)
Net cash flows (10.0) 2.0 4.2 4.6 9.8 (1.5) 9.1

Discount factors (15%) 1.0 0.8696 0.7561 0.6575 0.5718 0.4972

Discounted flows (10.0) 1.739 3.176 3.025 5.604 (0.746) 2.798

Discount factors (28%) 1.0 0.7813 0.6104 0.4768 0.3725 0.2910

Discounted flows (10.0) 1.563 2.564 2.179 3.651 (0.437) (0.480)

The NPV at 15% cost of capital is therefore the aggregate discounted flows of
£2.798 million shown above in the Total column. To obtain the NPV note that
the accrued profits have been converted into cash flows by the changes in the
working capital; that in arriving at the annual flows the specific price changes
were used in estimating the wages, materials etc; that the average actual cost of
capital had to be calculated and used; that the tax shield is provided by the
writing down allowance (tax depreciation) and that tax is paid a year in arrears.
(The last point depends on the individual country’s tax regime). All cash flows are

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assumed to arise at the end of the year concerned except for the initial outlay on
equipment. The discount factors came from the present value tables and are
based on a cost of capital of 15%. The annual discounted flows are computed
from the product of the actual net cash flow for a year times its discount factor. (2
× 0.8696 = 1.739). The row of discounted flows are summed to give the NPV in
the final column.
Calculation of IRR
Using the two discount rates 15% and 28% we have obtained two different
NPVs, one positive and one negative. By increasing the discount rate from 15%
to 8% – an increase of 13%, the NPV declined from £2.798 to a negative
£0.180, a total decline of £3.278. The IRR is the rate which gives an NPV
equal to zero, so the rate must lie somewhere between 15% and 28%.
The reduction in NPV by £2.798 from £2.798 to zero will require increasing
the interest rate from 15%. The 13% increase in interest rate produced a
£3.278 reduction in NPV. So if the interest rate is increased by an amount equal
to the proportion of 2.798 to 3.278 of the 13% it should move from 15% to
the appropriate rate which is the IRR.
Thus the IRR is
⎡ 2.798 ⎤
(28 − 15) ⎢ ⎥ + 15
⎣ 2. 798 − ( −0. 480 ) ⎦

= 11.1 + 15

= 26.1%

Note: A quicker, but more approximate value could have been obtained by using
the NPVs of £9.1 and £2.798 at 0% and 15% respectively. This approach
would have given a much less accurate estimate of 21.66% using an
extrapolation procedure (check your understanding of the method by
doing your own calculation and check with the answer given).
Payback
Taking the net cash flows:
Year Flows (£ million)
0 (10.00)
1 2.0
2 4.2 6.2
(3.8)
3 4.6
Surplus 0.8

Payback = 2 + 3.8/4.6 = 2.83 years

Accounting rate of return (ARR)
Average inflow = Total inflow/Project life = 19.1/4 = 4.775
Average outlay = Outlay/2 = 10/2 =5
ARR = Average inflow/Average outlay = (4.775/5) ×100 = 95.5%

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Profitability Index (PI)

PI = NPV = 2.798 = 0.28
Initial investment 10.00
Now assume that the business has three other projects it has evaluated. Their
characteristics are given below in the table along with those of the project just
evaluated. If the four projects were mutually exclusive, then the asterisk indicates
the preferred choice under that evaluation method.

Project evaluation table

Project Outlay NPV IRR Payback ARR PI
A £10m £2.8m 26.1% 2.83 yrs 96%* 0.280*
B £25m £4.5m* 18.0% 2.5 yrs 50% 0.180
C £15m £2.0m 20.0% 1.9 yrs* 60% 0.133
D £15m £3.0m 26.4%* 3.0 yrs 80% 0.200

Conceptually B is the preferred project from amongst the four evaluated because
it has the highest NPV of £4.5 million.
Using the same data and assuming now that all four projects are available for
selection and are not mutually exclusive, then if the business has a maximum of
£40 million to invest, the following combinations of projects are possible. The PI
is used to indicate the order of selection, starting with project A.

Combination (£million)
Combination Outlay NPV Average PI
AD 25 5.8 0.232
AB 35 7.3 0.209
ADC 40 7.8 0.195
DB 40 7.5 0.188

The objective is to maximise the NPV of the portfolio of investments. Here it is

assumed that each project is discrete and cannot be split up. The process is to go
through the projects, one by one, in descending order of PI, continuing to
combine those projects that satisfy the limit placed on available funds. Here the
addition of project D to A used the two highest ranked projects and had a
£25 million outlay. Third ranked project is B but combining its outlay to A and Ds
exceeds the limit, so the project with the next best PI is included that does not
exceed the outlay limit. The combination of ADC provides the highest NPV,
though some combinations seem to have higher PIs (e.g. AD). However that is a
false comparison because the balance of unused funds of £15 million should be
included with its zero NPV, thus giving a lower corrected average PI of 0.145.
If it is assumed that all projects could be undertaken fractionally if necessary, then
the combination would have been A, D and 3/5 of B, derived as follows by
using the PI ranking:

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Project PI Outlay NPV

A 0.322 10 2.80
AD 0.200 15 3.00
3/5B 0.180 3/5 × 25 2.70
0.2125 40 8.50

Try and understand the applied type problems and examples used in the texts, in
particular those in BMM. Understand the conceptual weaknesses and strengths of
theoretical methods used and learn how to critique your methods and results.

‘What-if’ questions
Now that you’ve learnt the basic techniques for the analysis of
investment proposals, on the assumption of operating in a world of
certainty, relax that assumption and consider that in the real world,
fewer things will actually occur than might have been predicted.
Managers need to evaluate the effects of these possibilities in their
initial prediction. There are various ways of doing this. The first is
by the use of sensitivity analysis. This requires an estimate of
the effect on the predicted outcome, usually NPV, of changes in
each variable. Effects of changes of combinations of variables can
also be evaluated.
It can be identified from this evaluation those variables whose
changes might influence the outcome the most. Arising out of that
identification, managers can assess the likelihood of the variable
change, and whether it can be influenced by managerial efforts.
The overall impact on the final outcome of the potential changes
can be evaluated and aid the decision as to whether or not the
proposal can be accepted.
An extension of sensitivity analysis is breakeven analysis which
can be used to assess the magnitude of change that will reduce the
originally predicted NPV to zero separately for each variable.
When a number of variables are interrelated, then the different
combinations can be reviewed as separate possible scenarios. This
is called scenario analysis, for example, managers may call for
three different but consistent combinations of variables, one is the
set of the most optimistic outcomes, another the set of most likely
and the third, the set of the most pessimistic outcomes. This is
sometimes called three-point estimates. An extension of this
approach, calling for a more sophisticated knowledge of probability
distributions of outcomes, is called simulation analysis.

The examination
Extracts from discount and annuity tables will be supplied in the
examination for unit 59 Financial management if these are

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relevant for any question. You can however use your own
calculator to generate the factors if you so wish.

; A reminder of your learning outcomes

By the end of this chapter and having completed the essential
reading and activities, you should be able to:
describe and apply the time value of money in project
evaluation, whether it be future or present value oriented
defend the use of NPV as the method of appraisal against other
suggested methods
prepare evaluations of investment proposals and state which
decision rule is appropriate in the specific set of circumstances.

Sample examination questions

1. What is the time value of money?
2. Discuss the pros and cons of NPV, IRR and payback period as
methods of appraising investments.
3. Make a case to support the reported managerial preference for
the use of IRR and payback methods in real world situations.

Practise question 2.1

Snowdon plc has a fund of £15million to invest in new projects. It
has a number of proposals to consider. The first proposal, A, is a
large proposal requiring an initial investment of £13million in plant
and equipment which at the end of the project’s life of 4 years will
have a resale value of £4.0million. The company has £100,000 still
to pay to the consultants under the research and development
contract for this project of £3million. The contractual obligation
will be met in 3 months time. A working capital fund of £2million
will be needed immediately to finance the build up of stock and
debtors. At the end of the project’s life only £1.8million will be
recovered when stocks of the product are rundown and debtors pay
up.
The life cycle predictions for sales volumes, prices and variable
costs are as follows:

Years 1 2 3 4
Sales volume (‘000) 1200 1920 960 600
Sales price/unit (£) 20 20 18 13
Variable cost/unit(£) 4 4 4 4

The incremental fixed costs were forecast to remain constant over

the product’s life which for the annual production fixed overheads
were £4.15million p.a. and administration and selling were

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£8.20million p.a.. In calculating these fixed overheads the

accountant had included £3.25million p.a. for the annual
depreciation write off of the new equipment.
The company has a cost of capital of 15%.

REQUIRED
(a) Calculate the payback period and accounting rate of return for
project A.
(b) Calculate the net present value to the company of project A.
 See VLE for solution

Problems
In BMM attempt the following problems:
Chapter 7, pp.204–7, numbers 15, 19, 20, 25, 27 and 30
Chapter 8, p.234, numbers 18 and 25
Chapter 9, p.258, numbers 5 and 6.

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Notes

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