CAP1 Finance Session 2 Slides

Session 2
Capital Investment Appraisal

(An Introduction)
CAP1 Finance, Academic Year 2011 / 2012

Chartered Accountants Ireland
Session 2 Capital Investment Appraisal

By the end of todays session(s), you should be able to:
Understand the context of investment appraisal decisions
Evaluate capital projects using the ARR, the payback period
method, the discounted payback period, the IRR and the NPV
techniques.
Discuss the advantages and disadvantages of each method
Explain research findings in respect of the practical application of
the methods.
Overall aim of three lectures on this topic to enable trainees to select
appropriate investment methods and to calculate investment returns for
competing projects and to justify a course of action including consideration
of relevant non-financial factors and financing options.

Competency Wheel
Financial Reporting
Management Accounting & Finance
Ethics & Professionalism

Objectivity
Audit & Assurance

Tax & Law
Strategy
Perceptiveness of own knowledge,

values and limitations
Strategic Thinking & Problem Solving

Communication
Managing Self & Others:
Leadership
IT Awareness
Project Management &
Change Awareness
Stakeholder Management

Mapping
This lecture maps specifically to 2.1 on the Competency Statement

Functional
Competencies
Business
Competencies
Explain and demonstrate

the ability to use the
payback, discounted
payback, accounting rate of
return, net present value
and internal rate of return
techniques.
Be able to appraise a
variety of different projects
for communication to
management.
Recommend and justify a

course of action, including
consideration of nonfinancial factors.
Evaluate and communicate

an appropriate course of
action given the entitys
unique characteristics and
the environment

Core Professional
Values & Skills
The need to be objective
when evaluating differing
projects.
Difficulties with Project Appraisal

Difficulties facing project appraisal
Goal congruence
Relevant cash flows
Time value of money
Profit versus cash
Capital rationing
Projects with unequal lives
Risk (next class)
Financing

Goal Congruence
Ultimately the projects outcome should increase equity holder value.
Decision makers - view the big picture, which may involve rejecting
projects that have short-term returns in favour of projects with higher
overall long-term returns.
Take liquidity into consideration.

Relevant cash flows

Not all cash flows should be brought into the appraisal process
only relevant cash flows.
Relevant cash flows are incremental cash flows and opportunity
cash flows.
They exclude:
Sunk costs
Apportioned costs that were going to be incurred anyway

Cash flows explained
Incremental cash flows are those that will occur only as a

consequence of a project being undertaken.
Opportunity cash flows are cash flows forgone from other
investments, or actions that have been changed, as a result of
the project being implemented.
Cash flows that occur as a result of decisions made in the past,
which cannot be changed are deemed to be sunk cash flows.

The time value of money/cash V profit
In finance CASH IS KING.

Cash is very different to profit.
Management performance is usually assessed using profitability.
However, the pattern of cash is more important for project appraisal
because of the time value of money.
Example (assume you are assessing a 5 year period) in terms of
profitability /1m each year for 5 years is the same as /5 million
at the end of year 5.
In finance, the latter option is valued much LOWER because of the
time value of money

10
Financing
BRIEF POINTS
Matching principle match the life of the project with the
life of the finance
Self-liquidating try to ensure that the finance selected
has liquidity commitments that can be serviced from the
project itself
Cash synchronisation match the timing of the cash flows
resulting from the investment with the timing of the
repayments on the source of finance.
Cost of finance take into account the companys current
cost of capital
Note: This topic is covered in detail later in the course
Project appraisal - techniques
Accounting Rate of Return (ARR)

Payback period
Discounted payback period
Internal rate of return (IRR)
Net present value (NPV)

12
Accounting Rate of Return

13
ARR
The accounting rate of return estimates the rate of accounting
profit that a project will generate over its entire life.
It compares the average annual profit of a project with the
average cost (book value) of the project.

14
ARR - calculation
ARR = Average annual profit x 100

Average capital invested
Where the average annual profit is the total profit for the
whole period (after depreciation) divided by the life of the
investment in years; and
The average capital invested is the initial capital cost plus the
expected disposal value divided by two.

15
ARR example
Cow Ltd. is considering three projects (each costing /240,000).
The following cashflows are predicted:
Friesian
Aberdeen
Cashflows
/
/
Year 1
160,000
120,000
Year 2
60,000
120,000
Year 3
120,000
40,000
Year 4
140,000
Year 5
20,000
Year 6
10,000
Saler
/
238,000
2,000
35,000
REQUIRED
Given that Cow Ltd. has a target average accounting rate of return of 10% per
annum which of the above projects should be accepted, if any? (Assume that the
asset is specialised and cannot be sold at the end of the project).
How would the results be affected were you informed that the asset could be sold
after three years for /60,000 and after six years for /30,000.

16
ARR - advantages
Advantages include:
As it is based on profits management understand it better.
Profits are important, a project should not only have positive cash flows but
should also be profitable.
It is a useful target for screening projects

17
ARR - disadvantages
Disadvantages include:
It ignores cash flows

It ignores the time value of money.
It ignores the size of a project (risk)
It ignores the duration of a project (risk)
A project that has a longer life but is overall more profitable and has more
cash inflows will be penalised because of its long life.
Subjective (hurdle rate)

18
Payback period

19
Payback period
The payback period method ranks investments in order of the
speed at which the initial cash outflow is paid back by
subsequent cash inflows.
This method focuses on cash flows not profits, therefore
depreciation and accrual accounting is ignored.
This method calculates the number of years it takes for
cumulative cash flows to achieve breakeven point.

20
Payback Period
The following cash flows are predicted:
Yearly profits
Friesian
Aberdeen
Saler
Before depreciation
/
/
/
Year 1
160,000
120,000
238,000
Year 2
60,000
120,000
1,000
Year 3
120,000
40,000
36,000
Year 4
140,000
Year 5
20,000
Year 6
10,000
REQUIRED
Using the payback method, advise Cow Ltd. as to the investment to
undertake.

21
Payback method - advantages
Advantages include:
Simple and quick to calculate.

Readily understandable.
Useful risk screening technique
Focuses management attention on projects with more reliable estimates.
Useful for companies with liquidity issues
Helps decide between two projects with similar ARRs.

22
Payback method - disadvantages
It ignores the time value of money.

It ignores the profitability of a project (risk)
It ignores cash flows received after the payback period
It ignores the impact of a project (strategic)

23
Discounted Payback Period

24
Discounted payback period
The discounted payback period method

overcomes one of the weaknesses of the
payback period method, as it takes the time
value of money into consideration.
This method ranks investments according to the

speed at which the cumulative discounted
cash flows (DCF) of an investment cover the
initial cash outlay.

25
Discounted payback method - example

Yearly profits
Friesian
Aberdeen
Saler
Before depreciation
/
/
/
Year 1
160,000
120,000
238,000
Year 2
60,000
120,000
1,000
Year 3
120,000
40,000
36,000
Year 4
140,000
Year 5
20,000
Year 6
10,000
REQUIRED
Which of the above projects should Cow Ltd. invest in. Cow Ltd. has to
borrow funds at 10%. Management decide that this is an appropriate
discount rate to use and it is company policy to use the discounted payback
period method for capital investment appraisal.

26
Discounted payback method - advantages

Advantages include:
Simple and quick to calculate.

Readily understandable.
Useful risk screening technique
Focuses management attention on projects with more reliable estimates.
Useful for companies with liquidity issues
Helps decide between two projects with similar ARRs
Takes the time value of money into consideration.

27
Discounted payback method - disadvantages

It ignores the profitability of a project (risk)
It ignores cash flows received after the
payback period
It ignores the impact of a project (strategic)

28
Net Present Value (NPV)

29
Net Present Value (NPV)

The NPV method of project appraisal, discounts the cash
inflows and outflows of an investment, to their present
value.
Use of the correct discount rate is very important.
If the NPV is positive then a project should be accepted; as
the positive amount will increase equity holder value.
If the NPV is negative then a project should be rejected as
acceptance will damage equity holder value.

30
NPV method example

Yearly profits
Friesian
Aberdeen
Saler
Before depreciation
/
/
/
Year 1
60,000
120,000
238,000
Year 2
60,000
120,000
1,000
Year 3
100,000
40,000
36,000
Year 4
130,000
3,000
Year 5
20,000
Year 6
10,000
REQUIRED
Calculate each project's NPV and rank the resulting information for
reporting to management. The company has a WACC of 16% and all
the projects being considered are of similar risk to the current operating
activities of the company.

31
NPV method - advantages

Advantages include:
The time value of money is taken into consideration.

All relevant cash flows are considered in the appraisal process.
The discount rate can be adjusted for risk.
When there are several alternatives the alternative with the largest NPV will
maximise equity holder value.
Unlike the IRR, when cash flows are not conventional, the NPV will provide
one answer.

32
NPV method - disadvantages

Time consuming calculations (though can be
compiled by a computer).
It does not provide a method of deciding
which investment provides the best value for
money.
It considers the absolute amount of money
available over a projects life.
It does not consider scale, hence risk.
33
Internal Ratio of Return (IRR)

34
Internal Rate of Return (IRR)

The IRR, sometimes referred to as the discounted cash flow yield
method also involves discounting future cash flows to their
present value.
It could be considered a type of break-even analysis, which focuses
on trying to find the discount rate at which the present value of
the discounted future cash flows (inflows and outflows combined)
equals the initial investment cash outlay.
This discount rate is then compared to a hurdle rate to determine if
the project should be accepted or not.

35
Calculating the IRR

Step 1: Select two discount rates at random
Step 2: Discount the cash flows at the discount rates to find

the net present value
Step 3: Use interpolation to find the rate at which the NPV of
the cash flows is zero.
IRR = Rate 1 + NPV 1 (Rate 2 Rate 1)

NPV 1 - NPV 2

36
IRR method example

Cow Ltd. is considering a project (costing /240,000).
Yearly profits
Friesian
Before depreciation
/
Year 1
160,000
Year 2
60,000
Year 3
120,000
Year 4
40,000
Year 5
30,000
REQUIRED
Calculate the IRR of the above named project using interpolation.

37
IRR method - advantages

Advantages include:
The time value of money is taken into consideration.
All cash flows are considered in the appraisal process.

38
IRR method - disadvantages

Time consuming calculations (though can be compiled by a computer).

The linearity assumption that underlies the interpolation process.
It ignores the scale of projects.
It is difficult to utilise when investments have unconventional cash flows, as more
than one IRR will result.

39
Research findings
The payback method is the most commonly used method used
as screening device the remaining projects are usually
assessed using either the ARR or the IRR.
Most companies set a subjective IRR/ARR hurdle rate and
accept projects with a higher return.
Academics consider the NPV to be the most appropriate method
Recent research has shown that use of DCF techniques is
increasing particularly in large entities with a preference for the
use of the NPV or a combination of the NPV and the IRR

40
Summary
There are many factors which have to be considered

before undertaking investment appraisal
Identifying relevant cash flows

The timing of cash flows
The strategic fit of the project
The impact on other areas
The correct appraisal approach
Financing
Several methods
ARR
Payback
Discounted payback
Net present value
IRR
In most instances all are used with qualitative information

to inform the decision.


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Session 2

Capital Investment Appraisal

CAP1 Finance, Academic Year 2011 / 2012

Session 2 Capital Investment Appraisal

CAP1 Finance, Academic Year 2011 / 2012

Ethics & Professionalism

Audit & Assurance

Perceptiveness of own knowledge,

Strategic Thinking & Problem Solving

CAP1 Finance, Academic Year 2011 / 2012

This lecture maps specifically to 2.1 on the Competency Statement

Explain and demonstrate

Recommend and justify a

Evaluate and communicate

CAP1 Finance, Academic Year 2011 / 2012

Difficulties with Project Appraisal

CAP1 Finance, Academic Year 2011 / 2012

Difficulties facing project appraisal

CAP1 Finance, Academic Year 2011 / 2012

CAP1 Finance, Academic Year 2011 / 2012

Relevant cash flows

CAP1 Finance, Academic Year 2011 / 2012

Cash flows explained

Incremental cash flows are those that will occur only as a

CAP1 Finance, Academic Year 2011 / 2012

The time value of money/cash V profit

In finance CASH IS KING.

CAP1 Finance, Academic Year 2011 / 2012

Project appraisal - techniques

Accounting Rate of Return (ARR)

CAP1 Finance, Academic Year 2011 / 2012

Accounting Rate of Return

CAP1 Finance, Academic Year 2011 / 2012

CAP1 Finance, Academic Year 2011 / 2012

ARR = Average annual profit x 100

CAP1 Finance, Academic Year 2011 / 2012

CAP1 Finance, Academic Year 2011 / 2012

CAP1 Finance, Academic Year 2011 / 2012

It ignores cash flows

CAP1 Finance, Academic Year 2011 / 2012

CAP1 Finance, Academic Year 2011 / 2012

CAP1 Finance, Academic Year 2011 / 2012

CAP1 Finance, Academic Year 2011 / 2012

Payback method - advantages

Simple and quick to calculate.

CAP1 Finance, Academic Year 2011 / 2012

Payback method - disadvantages

It ignores the time value of money.

CAP1 Finance, Academic Year 2011 / 2012

Discounted Payback Period

CAP1 Finance, Academic Year 2011 / 2012

Discounted payback period

The discounted payback period method

This method ranks investments according to the

CAP1 Finance, Academic Year 2011 / 2012

Discounted payback method - example

CAP1 Finance, Academic Year 2011 / 2012

Discounted payback method - advantages

Simple and quick to calculate.

CAP1 Finance, Academic Year 2011 / 2012

Discounted payback method - disadvantages

CAP1 Finance, Academic Year 2011 / 2012

Net Present Value (NPV)

CAP1 Finance, Academic Year 2011 / 2012