CHAPTER 1: Capital Investment Decisions: Appraisal

methods
Learning Objectives:
1)
2)
3)
4)
5)
6)
7)

8)

Define capital budgeting and the purpose for it

Explain the OC of an investment (minimum rate of return)
Identify the types of projected costs & revenues used to evaluate
alternatives for capital investment
Distinguish between compounding and discounting (concept of time
value of money)
Explain the concepts of and analyse capital investment proposals using
the NPV and IRR
Justify the superiority of NPV over the IRR
Explain the concepts of and analyse capital investment proposals using
the
Payback
and
AROR
methods;
Explain
the
limitations
of
payback
and
AROR;
&
Explain the wide use of payback and AROR in practice
Describe the effect of performance measurement on capital investment
decisions

1)Capital Investment Decisions

Capital investment
- long term investment decisions which require initial outlay in
return for a series of future benefits / returns
from time of commitment of funds to recoupment of
investment and benefits
takes more than 1 year
hence, because long term, it involves interest cost (i.e. short
term if at all there is interest cost, can be ignored as amount is
very marginal)

Capital Investment Decisions

- Managers apply capital investment analysis to ensure that:
resources are used wisely - Most important decisions to
managers as involves commitment of large resources and
cannot be reversed
their choice maximises the contribution towards future
profits
Their choice maxsimises shareholder wealth

Capital Investment Decisions

- Some examples of capital investmenst include:
for business: plant; machinery; R&D; advertising;
warehouse facilities
for individuals: car; house; durables like fridge etc.
for public sector: roads; airports; schools; hospitals
- To simplify capital investment decisions, this chapter will
assume that cash flows are certain (riskless); there are
sufficient funds to spend on all profitable projects; there are
no taxes and no inflation.

2)Opportunity cost of investment (OC)

Investors can invest in debt / equity securities traded on
financial markets
(a) debt

corporate bonds

(b) equity

govt. bonds

ordinary shares /
common stock

Opportunity cost of investment (OC)

(a) Govt. bonds
Risk-free gilt-edged securities
absolutely riskless as issued by govt.
Fixed returns (principal + interest)

Opportunity cost of investment (OC)

(b) Risky ordinary shares
Shares of companies listed on stock exchange
returns vary from year to year depending on co.
performance & future expectations
investors invest in risky securities only if they can obtain
greater returns for the increased risk assumed.
Eg. If riskless govt. securities offer 10% returns, investors
would only invest in risky ordinary shares if they can
obtain more than 10%, i.e. eg. 15%, therefore expected
returns is 15%.

Opportunity cost of investment (OC)

Suppose investor invests in Co.X ordinary shares which
promises 15% returns

investor expects Co.X to invest in capital projects that

return 15%
if capital project dos not return 15%, investor would expect
Co.X to invest in other co.s ordinary shares with same risk
that offers 15% returns or
Co.X should repay investment back to investor in the form
of dividends so that investor can invest this himself to earn
the15%

Opportunity cost of investment (OC)

Hence, rates of return offered on securities (short-term
investment) traded on financial markets such as govt. securities
and ordinary shares
represent the opportunity cost (OC) of investment in capital
projects because these returns are forgone
i.e. cash invested in a capital project cannot be invested elsewhere
to earn a return
OC of investment: cost of capital (COC); minimum required
rate of return; discount / interest rate

Exhibit 2.1

Figure shows that higher risk investments give higher return and investors expect
higher returns from projects that have higher risk
Firms should only invest in capital projects that yield higher returns than the
OC of investment, i.e. returns that are higher than the COC.

Opportunity cost of investment (OC)

Practice Question
Lowest returns are offered by riskless govt. securities i.e. (10%).
There is opportunity to invest in a capital project of similar risk,
i.e. 0 risk. What will motivate the co. to invest in the capital
project and not the securities?
.

Opportunity cost of investment (OC)

Answer:
Capital project must yield returns in excess of returns offered by
securities, i.e. > 10%. If this is so, co. will invest in capital
project. Returns on securities become the OC of investment.
However, if capital project does not offer returns in excess of
that from securities, then co. should invest in other similar risk
projects which offers > 10% or repay investors in the form of
dividends so that they can invest this amount themselves.

Exhibit 2.2

3. Opportunity cost of investment = returns available to shareholders in

financial markets from investments with the same risk as the project.

3.1)Projected cash flows - Relevant Cash Flows

When making capital investment decisions
all relevant cash flows directly related to the capital investment must be
accounted for
includes all inflows and outflows related to the investment
includes savings on cash outflows which is also an inflow
(e.g. purchase of new machinery that reduces repairs / operational costs)
depreciation on asset is not included as it is a book entry, and not a cash
expense (it is already deducted as initial investment); it is also not
relevant as it represents sunk cost

3.2)Projected cash flows - Timing Of Cash Flows

Simplified assumption is all cash flows occur at year end
However, more realistic assumption is cash flows could occur at end of
every month
hence, need to convert annual percentage rate (APR) to monthly rate
Monthly rate = (12 1 + APR) 1
E.g.: 12.68% annually is (12 1 + 0.1268) 1 = 0.01 or 1% monthly
Similarly, monthly discount rates can be converted to annual rates for
annual cash flows
(1 + k) 12 1
E.g.: 1% monthly is (1 + 0.01) 12 1 = 12.68% annually

4)Difference between compounding &

discounting
In making capital investment decisions
need to calculate and compare returns on capital projects
with OC of investment (COC)
technique for comparison

Discounted Cash Flow

analysis (DCF)

to understand DCF, must first understand compounding

interest concept.

Difference between compounding &

discounting
(a) Compounding interest
- finding the future value of present value cash flows

FVn = V0(1 + K)n

- Eg. 100,000 today invested in a risk-free security
yielding 10% at the end of every year for 4 years
The future value at the end of 4 years
FV4 = 100,000(1.10)4
= 146,410

100,000 compounded annually at 10% and reinvested for 4 years

Total
End of year
Interest earned
investment

0
100 000
0.10 100 000
10 000
1
110 000
0.10 110 000
11 000
2
121 000
0.10 121 000
12 100
3
133 100
0.10 133 100
13 310
4
146 410
- All these year end values are equal to 100,000 at year 0 (equal at one point in
time), i.e. 1 today is to 1 tomorrow
time value of money

Difference between compounding &

discounting
(b) DCF
- converting cash to be received in the future to present value
using interest rate (present value of future value cash flows)
present value at time 0 V0 = FVn / (1 + K)n
years money
invested for
future value at return rate
nth year

- All future year end values can be discounted to find its present
value cash flow

Eg. 121 000 receivable in year 2 has a PV of:

121 000 = 100 000
(1 +0.10)2
and 146 410 receivable in year 4 has a PV of:
146 410 = 100 000
(1 +0.10)4

5) NPV & IRR

5.1)Net Present Value (NPV)
present value of net cash inflows less initial outlay
calculate & compare returns of capital investment projects (using
DCF) with equivalent risk investments on securities traded at financial
markets
if project returns are > than returns from equivalent risk investment in
securities, NPV is positive
Accept
if project returns are < than returns from equivalent risk investment in
securities, NPV is negative
Reject
if NPV is 0, no concern as to whether to accept / reject project

E.g.1: Referring to the example below, all projects (A,B, C, D) have the same
NPV i.e. NPV = PV of cash flows Initial cost
= 100,000 - 100,000 = 0
Hence, no concern whether accept projects or to invest in equivalent risk investment in securities
as both have same returns. Assumption is COC is 10% (returns of equivalent risk investment).

Project investment
outlay
End of year
cash flows
Year 1
Year 2
Year 3
Year 4
Present value =

100 000

100 000

100 000

100 000

110 000
0
0
0
110 000
1.10
=100 000

0
121 000
0
0
121 000
(1.10)2
=100 000

0
0
133 100
0
133 100
(1.10)3
=100 000

0
0
0
146 410
146 410
(1.10)4
=100 000

NPV =PV of cfs Investment cost

The decision rule is to accept only those projects with positive NPVs (e.g.if the initial investment
costs were less than 100 000 then the projects would be preferable to investing in financial securities as
they would have positive NPVs).

NPV
E.g. 2: Bothnia Company is evaluating 2 projects with an expected life of
3 years and investment outlay of 1,000,000. These are the following
net cash inflows:Project A ()
Project B ()
__________________________________________
Year
1
300,000
600,000
2
1,000,000
600,000
3
400,000
600,000
COC is 10%.

Answer:
Using formula:
1. NPV = [FV1 / (1+K) 1 + FV2/ (1+K)2 + FV3/ (1+K)3 +.... FVn/ (1+K)n ] - I0
NPV = [300,000 / (1.10)1 + 1,000,000 / (1.10)2 + 400,000 / (1.10)3]
1,000,000
= 399,700
2. Or use the discount tables:(look for yr. & discount rate)
Year
Net cash inflow()
Disc. Factor
PV (000)
1
300,000
0.909
272,700
2
1,000,000
0.826
826,000
3
400,000
0.751
300,400
1 399,100
Less investment cost
1 000,000
NPV
399,100
Since NPV is positive, accept the project. Accepting this project means present
consumption of the shareholders who have invested in this company is increased
i.e.
Initial investment needed is 1mil, but the value of all future generated cash inflows now is
1.399mil, this means shareholders have extra 0.399mil to spend now max. sh/h wealth.

NPV
Annuities
If future net cash inflows are identical
Annuity
investment / asset that pays a fixed sum each period for a
specific no. of periods

NPV
E.g. Referring to example 2, Project B generates 600,000 for 3 years at 10%. Using the annuity table:
Annual future net
Discount factor
PV ()
cash inflows ()
___________________________________________________
600,000 2.487 1,492,200
(-) Initial Investment
(1,000,000)
NPV
492,200
Using formula:
PV = A / r [1 1/(1+r) n] PV = 600,000 / 0.10 [1 1/(1.10)3
= 1,492,200
annuity NPV = PV Initial cost
discount rate
= 1,492,200 - 1,000,000
= 492,200 Positive : Accept

5.2)Internal Rate Of Return (IRR)

IRR (K)
true interest rate earned on investment over its economic life
discounts all future cash flows to a PV that is equal to the
PV of the initial outlay
i.e. Total PV of cash flows Initial outlay = NPV = 0
Hence, IRR makes NPV = 0

IRR
IRR is also termed discounted rate of return / max.
required rate of return / max. cost of capital
it is used to finance a project at a point where it still does
not cause harm to shareholders (the last point of safety),
i.e. since IRR makes NPV=0, this is the last point of safety
(breaking even on the investment)
use PV table and / or interpolation to find IRR of an
investment project

IRR
Using PV table:
Look for the discount factors that make the PV of future cash flow
equal or close to the initial outlay
i.e. making NPV=0
Note: Lower discount rate higher discount factor
higher PV of cash flows
higher NPV
Higher discount rate
lower discount factor
lower PV of cash flows lower NPV

IRR
Referring to E.g. 2 in NPV:
Apply 25% discount rate
Year
Net cash flow ()
1
300,000
2
1,000,000
3
400,000

Discount factor PV of cash flows

0.800
240,000
0.640
640,000
0.512
204,800
1,084,800
(-) Initial Outlay
(1,000,000)
NPV
84,800

IRR
Referring to E.g. 2 in NPV:
Apply 35% discount rate
Year
Net cash flow ()
1
300,000
2
1,000,000
3
400,000

Discount factor
0.741
0.549
0.406

(-) Initial Outlay

NPV

PV of cash flows
222,300
549,000
162,400
933,700
(1,000,000)
(66,300)

IRR
Referring to E.g. 2 in NPV:
Hence, IRR must be between 25% and 35% to make NPV=0.
Apply 30% discount rate
Year
Net cash flow ()
Discount factor PV of cash flows
1
300,000
0.769
230,700
2
1,000,000
0.592
592,000
3
400,000
0.455
182,000
1,004,700
(-) Initial Outlay
(1,000,000)
NPV
4,700
NPV close to 0, hence IRR is close 30%

IRR
Using Interpolation:
IRR = LT % + [((NPV LT) / LT NPV HT NPV) x (HT % - LT %)]
Referring to E.g. 2 from NPV:
IRR = 25% + [(84,800 / 84,800 (66,300)) x (35% - 25%)]
= 30.61%
Note: LT = Low Trial; HT = High Trial

IRR
Rule:

When IRR is > than COC

project is profitable
accept project, NPV will be positive
When IRR is < than COC
project is not profitable
reject project, NPV will be negative

Exb. 5.2: Finding IRR using Interpolation

IRR

IRR for Annuities

find discount factor
discount factor = Initial investment
Annual cash flow
Referring to E.g. 2 of NPV, Project B:
Discount factor = 1,000,000 / 600,000
= 1.666
Hence, look for discount rate with 1.666 in PV table
In year 3, 1.666 is between 1.673 & 1.652
i.e., IRR is between 36% & 37%, hence since IRR > COC of 10%
Accept the project

6) NPV vs. IRR

Most of the time NPV & IRR will provide the same decision on an
investment project
i.e. accept / reject decisions are the same
E.g.: True for projects with conventional cash flows [initial outlay
(-ve) and a series of future cash flows (+ve)] that are independent
However, sometimes NPV & IRR provide different decisions:-

NPV vs. IRR

Reasons that make NPV more superior than IRR:6.1) Percentage (%) returns
- NPV expressed in monetary terms
- IRR expressed in % terms (can be misleading)
E.g.: Available investment is 100,000. Compare investing 10,000 at 50% or
100,000 at 25%. COC is 10%. Only 1 project can be undertaken.
At one look, based on %

50% looks better

However, total returns works out to be 14,000 only for first option, i.e,
:50% of 10,000 = 5,000
:surplus of 90,000 uninvested must be utilised / invested at COC of 10% (assuming
no other suitable investment), i.e. 10% of 90,000 = 9,000
: hence total returns from 100,000 is 5,000 + 9,000 = 14,000
However, for the second option, 25% of 100,000 = 25,000 returns (better option)
hence, IRR gives a misleading decision sometimes. NPV gives a more accurate
measure of decisions.

NPV vs. IRR

6.2) Unconventional cash flows
- Cash flows that start with initial outlay (-ve)
results in a series of future cash
inflows (+ve) and later results in cash flows that are negative (-ve) again.
Initial (-ve)
future cash flows (+ve)
environmental and disposal costs (-ve)

future cash flows due to e.g.

this results in more than 1 IRR

E.g.: When IRR is 5% and 50%, NPV is 0 at 2 points (when IRR is 5% and 50%);
COC is 10%. If only the first IRR (5%) is calculated and hence used to compare
with a COC of 10%, the project may be rejected as the IRR (5%) is smaller than the
COC (10%).
This decision is a wrong decision this project has another IRR (50%), which is
bigger than the COC of 10%. Hence, since here the IRR is larger than the COC, the
project should be rightly accepted
this makes IRR inaccurate as a basis for evaluating capital projects. Hence
NPV is more accurate!

NPV vs. IRR

6.3) Reinvestment assumptions
- According to NPV: cash flows (proceeds) from a project are reinvested at COC
- According to IRR: cash flows (proceeds) from project are reinvested at a rate of
return equal to IRR of original project
NOT POSSIBLE
Because all projects that have been accepted must have an IRR > than COC
Hence balance of investments available are those that are unsuitable (rejected, i.e.
IRR < than COC) or at COC.
Hence reinvestment should be based on COC not IRR!
IRR becomes inaccurate basis. This makes NPV assumptions more accurate!

NPV vs. IRR

6.4) Mutually exclusive projects
- Projects such as choosing location for factory / choosing 1 investment only (i.e.
choosing only one option and sacrificing the rest)
here, IRR can incorrectly rank projects because of the reinvestment assumption, i.e.
reinvestment can only be made on COC not on rate equal to IRR of original
project
IRR can also incorrectly rank projects due to their misleading percentage (%)
representation, for e.g.:
IRR
NPV
%

Project A
22
1 530
Project B
18
1 728
Here, co. may incorrectly choose Project A as it gives a higher return. However, its
NPV is lower than Project B (lesser immediate consumption for sh/h). Hence NPV
is more accurate / superior than IRR as a basis for evaluation.

7) Payback & AROR

7.1)Payback
most frequently used for capital investment appraisal
because it is easy to use
Time required for the cash inflows / proceeds of an investment to recoup the initial
outlay / cost. Choose project with shorter payback, however with caution!
1) For annuities

Payback = Initial Investment / Annual cash proceeds

E.g.1: if investment requires 60,000 as an initial outlay to produce annual cash flows
of 20,000 per year for 5 years,
Payback period = 60,000 / 20,000 = 3 years

Payback
2) For cash flows that are not constant
Payback = Add up total cash inflows until equal to initial outlay
E.g.2:

- Project A cash inflows in year 1 is enough to recoup initial cost.

- Project B needs inflows from year 1 & 2 to recoup initial cost.
Hence, here co. may choose Project A as it has a shorter payback period.
However, Project B has a higher and positive NPV as compared to Project A
which has a lower and negative NPV.
- Hence, the decision to choose Project A based on payback period is incorrect!

Payback
Benefits of Payback
1) Good for co.s with liquidity problems. Co.s want to know how fast it will take
to recoup cost
2) Good for risky investments (where product changes fast and cash flows are
uncertain)
payback shows how fast co. can recoup cost and start earning income
longer paybacks are exposed to more risk where as shorter paybacks are exposed
to lesser risk
3) Good as initial screening tool
payback method is best used as an initial
screening tool
pick investments with shorter payback and later test
investments with IRR / NPV for thorough investigation. Referring to E.g. 2 for
payback, it demonstrates that the payback method alone is not accurate, it needs
to be tested thoroughly with NPV / IRR.

Payback
Limitations of Payback Method
1) Does not take into account cash flows earned after payback period (which is
inaccurate as the investments profitability depends on all cash flows)
2) Does not take in account time value of money
future cash flows cannot be compared validly to initial outlay as their values are at
different points in time.
future cash flows need to be discounted to PVs first before calculating payback, i.e.
discounted / adjusted payback period
BUT even with this, payback still ignores cash flows after payback

7)Payback & AROR

7.2)Accounting Rate of Return (ARR)
return on investment or return on capital employed
ARR = Average annual profits / Average investment cost
also known as average investment cost
i.e. total revenues total cost**
life of investment

*if straight line used, i.e. initial cost + scrapvalue

ARR is different from other methods of investment appraisal as it uses profits instead of cash
flows
profits are not equal to cash flows, i.e. profits = revenue expenses (matching / accruals
concept)
* Depends on depreciation method used

** net investment cost / total depreciation charge

E.g. 1: ARR
Project X

Book value
Cash flow
Depreciation
Profit

Years
0
1
2
3
000 s 000 s 000 s 000 s
24
16
8
0
12
11
10
(8)
(8)
(8)
4
3
2

Revenue Cost = Profit

33,000 - 24,000 = 9,000 or Profit = 4 + 3 + 2 = 9
a)Hence, Average annual profit = 9,000 / 3 years = 3,000
b)Average investment cost = 24,000 /2 + 0 (no scrap) = 12,000
ARR = 3,000 / 12,000 = 25%

E.g. 1: ARR
Project Y

Book value
Cash flow
Depreciation
Profit

Years
0
1
2
3
000 s 000 s 000 s 000 s
24
16
8
0
10
11
12
(8)
(8)
(8)
2
3
4

Revenue Cost = Profit

33,000 - 24,000 = 9,000 or Profit = 2 + 3 + 4 = 9
a)Hence, Average annual profit = 9,000 / 3 years = 3,000
b)Average investment cost = 24,000 /2 + 0 (no scrap) = 12,000
ARR = 3,000 / 12,000 = 25%

ARR
AROR for both projects are the same although project Ys cash flows occur
later (i.e. payback for Project X is faster than Project Y)
Project X payback = 2 + (1 / 10) = 2.1 years
Project Y payback = 2 + (3 / 12) = 2.25 years
ARR and payback used as initial screening, hence need to test with NPV for final decision

Benefits of ARR
- more superior to payback

it allows for differences in useful lives

Limitations of ARR
- ignores time value of money
referring to Project X & Y, Project X payback is faster than Project Y, but ARR is
the same for both projects. Hence, shorter payback projects may have same ARR as
longer payback projects

8
The effect of performance measurement
There is a danger that managers will be motivated to choose the investment that maximizes their
performance measure rather than maximizing NPV.

The effect of performance measurement

(contd)

ARR
Independent
A-50% B-35%
COC-10%

C-15% D-5%

Choice A B C----proceeds reinvest, NPV-10%

IRR 5%
Mutually excl
A-50% B-35%
COC-10%
Choice ANPV-10%
IRR-35%