INVESTMENT APPRAISAL

INVESTMENT
Refers to the purchasing of capital goods such as
equipment, vehicles and new buildings; and
improving fixed assets
 INVESTMENT APPRAISAL
Evaluating the profitability or desirability of an
investment project. It assesses the economic
viability of potential investment options so as to
arrive at the most acceptable alternative
depending on the criteria used for comparing
these projects
 INVESTMENT APPRAISAL TECHNIQUES

• Payback Period - Uses Cash Flows

• Average Accounting Rate of Return (ARR /

AARR)- Uses Net Profit

• Net Present Value (NPV) - Uses Cash Flows

• Internal Rate of Return (IRR) - Uses Cash Flows

 PAYBACK PERIOD
This is the length of time necessary to recover
the entire cost of an investment from the
resulting annual net cash flows.

Payback Period = (Number of years before

recovery of initial investment) + ([Amount of
investment remaining to be recaptured / Total
cash flow during year of payback] x 12)
 EXAMPLE
The following refers to information relating to
the investment in two projects:
YEAR PROJECT A PROJECT B
0 (Initial ($500,000) ($500,000)
Investment)
1 $300,000 $10,000
2 $200,000 $20,000
3 $50,000 $200,000
4 $10,000 $135,000
5 $5,000 $200,000
 CALCULATING PAYBACK PERIOD
• Calculate cumulative cash flow
YEAR PROJECT A PROJECT A PROJECT B PROJECT B
CUMULATIVE CUMULATIVE
CASH FLOW CASH FLOW
0 ($500,000) ($500,000) ($500,000) ($500,000)
1 $300,000 ($200,000) $10,000 ($490,000)
2 $200,000 $0 $20,000 ($470,000)
3 $50,000 $50,000 $200,000 ($270,000)
4 $10,000 $60,000 $135,000 ($135,000)
5 $5,000 $65,000 $200,000 $65,000
 CALCULATING PAYBACK PERIOD
cont’d
• Payback will occur where the cumulative cash flow is
equal to zero (0).
• Project A – Payback period is 2 years. (Straightforward)
• Project B – Payback Period = 4yrs and ? (To Calculate)
? = (Amount of investment remaining to
be recaptured / Total cash flow during year of payback) x
12
= ($135,000/ $200,000) x 12
= 8.1 months
Final Answer is 4yrs and 8.1mths
ADVANTAGES OF PAYBACK METHOD
• It is easy to calculate and understand
• It focuses on risk and therefore promotes
prudence and caution
• By focusing on liquidity (cash flow) rather than
profitability, this method is looked upon
favorably by lenders of capital
DISADVANTAGES OF PAYBACK METHOD

• It fails to take into account cash flows after the

payback period
• It does not take into consideration the time
value of money
• It only looks at cash flows and does not
consider overall profitability
 Average Accounting Rate of Return (AARR /
ARR)
Unlike other appraisal methods, the ARR uses
profit instead of cash flows. This method
therefore give profitability of the investment as
a percentage of the initial investment. The usual
difference in a question between cash flow and
profitability is depreciation. In order to arrive at
profit when given cash flows, you need to minus
depreciation per year from the cash flows.
 AARR / ARR EQUATION
ARR = (Average Annual Profit /Initial Investment)
x 100
 CALCULATING ARR /AARR
• Calculate profit if depreciation per year is
$10,000 for Project A and $15,000 Project B
YEAR CASH PROFIT CASH PROFIT
FLOW PROJECT A FLOW PROJECT B
PROJECT A PROJECT B
0 ($500,000) ($500,000)
1 $300,000 $290,000 $10,000 ($5,000)
2 $200,000 $190,000 $20,000 $5,000
3 $50,000 $40,000 $200,000 $185,000
4 $10,000 $0 $135,000 $120,000
5 $5,000 ($5,000) $200,000 $185,000
Total $515,000 $490,000
 CALCULATING ARR /AARR cont’d
• Project A = [($515,000/5) / $500,000] x 100
= ($103,000 / $500,000) x 100
= 20.6%
• Project B = [($490,000/5) / $500,000] x 100
= ($98,000 / $500,000) x 100
= 19.6%
 ADVANTAGES OF AARR / ARR
• It focuses on profitability in all years unlike
payback
• It focuses on profitability, which is the central
objective of many business decisions
• The result is easy to understand and compare
with other projects
 DISADVANTAGES OF AARR / ARR
• It ignores the timing of profit flows. This could
result in two projects having the same ARR but
with different paybacks
• The time value of money is ignored
 NET PRESENT VALUE (NPV)
This method takes into consideration the fact
that future cash flows will lose value over time.
This method therefore discounts all future cash
flows and brings them to present values. (Using
a Present Value Interest Factor [PVIF] table) This
summed total of all of the Present Values is then
subtracted from the initial investment in order
to calculate the Net Present Value. The project
with the highest positive NPV would be chosen.
 CALCULATING NPV
PROJECT A

YEAR CASH FLOW 10% PRESENT

DISCOUNT VALUE
FACTOR
0 ($500,000) 1 ($500,000)
1 $300,000 0.9091 $272,730
2 $200,000 0.8264 $165,280
3 $50,000 0.7513 $37,565
4 $10,000 0.6830 $6,830
5 $5,000 0.6209 $3,104.50
NPV ($14,490.50)
 CALCULATING NPV
PROJECT B
YEAR CASH FLOW 10% PRESENT
DISCOUNT VALUE
FACTOR
0 ($500,000) 1 ($500,000)
1 $10,000 0.9091 $9,091
2 $20,000 0.8264 $16,528
3 $200,000 0.7513 $150,260
4 $135,000 0.6830 $92,205
5 $200,000 0.6209 $124,180
NPV ($107,736)
 ADVANTAGES OF NPV
• It takes into account the time value of money
• It considers the cash flows for the entire
project
 DISADVANTAGES OF NPV
• It is more complicated to calculate
• The discount rate is only an estimate, this
could change at any moment
 INTERNAL RATE OF RETURN (IRR)
Attempts to find the discount rate where NPV is
equal to zero.(ie. When the cost or initial investment
= discounted cash flows). This rate is then compared
to the interest rate which is charged when
borrowing to invest (Cost of Capital)If that rate is
more than the cost of capital then the project
should be profitable. The IRR is therefore the rate at
which the company internally generates profit on its
investment. (Not required to work it out for exams)