CAPITAL APPRAISAL

A company will have numerous projects to consider for investment. These projects
will have various projected lives, different costs and revenues. Decisions have to be
made with the view of selecting the best projects (most profitable) for the company.
Sometimes the investment could be based on new investment using different
equipment again which option generates the maximum benefit. This is especially
important when, as is often the case, the demand for capital expenditure is greater
than the funds available. When demand is greater than supply then senior
management need to decide which projects are approved and which are rejected this
is known as CAPITAL RATIONING.
Capital Appraisal Techniques tend to involve Relevant Cash Flows. These cash
flows relate to the project(s) under consideration and do not involve other aspects of a
companys operations.
The 4 main methods of appraising projects are:1 Payback
2 Accounting Rate of Return ARR
3 Net Present Value NPV
4 Internal Rate of Return IRR
Note numbers 3 & 4 use what is called Discounted Cash Flow (DCF)

Normally assumptions are made for calculations.

1 Capital outlay is immediate and called Year 0
2 All other cash flows occur at the end of the year

Example
Proctor Hedges Ltd manufactures a wide range of gardening equipment. Market
research costing 20,000 has produced favourable results for a new product. This
product will be launched in the near future. In order to manufacture the new product a
new machine is needed. Two possibilities Machine A and Machine B were identified.
The product is expected to have a life of 5 years then production will cease. The
machine will then be either sold or moved to alternative duty in some other area of the
companys operations.
Data on these are
Machine A
450,000
50,000
80,000
80,000
4.00
2

Capital Outlay
Residual Value after 5 years
Annual Depreciation
Machine Hours per year
Profit per unit (excluding depreciation)
Machine hours per unit

Sales Estimates
Year
1
2
3
4
5

Machine B
600,000
100,000
100,000
120,000
4.10
2

Demand
60,000
48,000
42,000
25,000
25,000

Solution
First establish the facts
20,000 was spent on marketing & research. This is money already spent, so is
irrelevant to future calculations. Consider if the marketing showed that the product
was not feasible then the costs already incurred would be written off. These costs are
called SUNKEN COSTS
Check the production capability of the machines. Machine A has a maximum
production of 40,000( i.e. 80,000/2) therefore production and sales if machine a is
selected is 40,000.
Then we establish an Operations plan

Year

Demand

1
2
3
4
5

60,000
48,000
42,000
25,000
25,000

Machine A
Production &
Sales
40,000
40,000
40,000
25,000
25,000

Machine B
Production & Sales
60,000
48,000
42,000
25,000
25,000

Now we create profits values before depreciation

Year
1
2
3
4
5

Machine A
40,000 x 4
40,000 x 4
40,000 x 4
25,000 x 4
25,000 x 4

Total Profit

Machine B
60,000 x 4.10
48,000 x 4.10
42,000 x 4.10
25,000 x 4.10
25,000 x 4.10

160,000
160,000
160,000
100,000
100,000
680,000

246,000
196,800
172,200
102,500
102,500
820,000

MACHINE B HAS THE BETTER PROFIT FORECAST

1 PAYBACK
Payback is the simplest of all capital appraisal techniques. How long does it take for
the project to pay for itself?
Year
0
1
2
3
4
5

Machine A K
-450
+160
+160
+160
+100
+100

Cumulative K
-450
-290
-130
+30
+130
+230

Machine B K
-600.0
+246.0
+196.8
+172.2
+102.5
+102.5

Payback for both projects takes more than 2 years but less than 3 years
Machine A is 2 + (12x 130 / 160) months 2 Years 10 months
Machine B is 2 + (12x 157.2 / 17 2.2) months 2 Years 11 months
MACHINE A HAS THE BETTER PAYBACK PERIOD
2 ACCOUNTING RATE OF RETURN - ARR
ARR = Average Accounting Profit / Average Capital Employed
ARR is expressed as a percentage

Cumulative K
-600.0
-354.0
-157.2
+15.0
+117.5
+320.0

Firstly calculate the Average Accounting Profit. This is done by adding depreciation
back into the cash profits calculated earlier.

Year
1
2
3
4
5

160 - 80
160 -80
160 - 80
100 - 80
100 -80

Machine A K
80
80
80
20
20

Machine B K
246.0 - 100
146.0
196.8 - 100
96.8
172.2 - 100
72.2
102.5 -100
2.5
102.5 -100
2.5

280

320

Total Profit
Average Profit
280 / 5

56

320 / 5

64

600 + 100 / 2

600
100
350

64x100/350

18.3%

Now we calculate the average capital Employed

Year 0
Year 5
Avg Capital

450 + 50 / 2

450
50
250

ARR

56x100/ 250

22.4%

MACHINE A HAS THE BETTER ACCOUNTING RATE OF RETURN

3 NET PRESENT VALUE NPV

In order to appreciate NPV we need to understand the term TIME VALUE OF
MONEY.
Consider if you had 100 and invested it say in the bank what would it be worth in a
year if the interest rate was 10%. The answer is 110 (100+ (100x 10%)). If it was left
untouched for another year then it would be worth 121 and so on.
However if we receive 100 in a years time what id it worth in todays value.
The answer is 100/(100+10) = 90.91. Similarly 100 received in 2 years time would
be worth 100/ (100+10)*(100+10) = 82.64.
Essentially 1 today is worth less in the future, so when we invest money in a capital
program our future cash returns are in pounds when received and so we need to
correct these cash flows into the current days pounds, then we are comparing cash
returns in cash of the same value. The correction factor is called the DISCOUNT
RATE.
The rate to be used will usually be provided. The rate usually is based on the
companys COST OF CAPITAL The expected return on investment expected by the

company. If NPV is positive then the project can go ahead. If negative then the
project is rejected. Usually the project with the highest NPV is the preferred project
when capital is rationed.
Discount rates are obtained from Discount Tables
In our example (Remember year 5 machine sold)
Year
0
1
2
3
4
5

Discount
Rate 10%
1.000
0.909
0.826
0.751
0.683
0.621

Machine A
Cash Flow
-450,000
160,000
160,000
160,000
100,000
150,000

NET PRESENT VALUE

DCF
-450,000
145,440
132,160
120,160
68,300
93,150

Machine B
Cash Flow
-600,000
246,000
196,800
172,200
102,500
202,500

109,210

DCF
-600,000
223,614
162,557
129,332
70,008
125,732
111,253

Both Projects have a positive NPV so both are acceptable

MACHINE B HAS THE BETTER ACCOUNTING NET PRESENT VALUE

4 INTERNAL RATE OF RETURN IRR

IRR is an extension of NPV. Looking at our example Machine B gives the better
return but it also needs higher capital expenditure. IRR allows the discounted cash
flows to be compared. This is done by calculating the NPV at a second rate
hopefully a rate which gives a negative answer say 20%
Year
0
1
2
3
4
5

Discount
Rate 20%
1.000
0.833
0.694
0.579
0.482
0.402

Machine A
Cash Flow
-450,000
160,000
160,000
160,000
100,000
150,000

NET PRESENT VALUE

DCF
-450,000
133,280
111,040
92,640
48,200
60,300
-4,540

Machine B
Cash Flow
-600,000
246,000
196,800
172,200
102,500
202,500

DCF
-600,000
204,918
136,579
99,704
49,405
81,405
-27,989

We can now calculate the IRR for each project using the difference between the
NPVs.
Calculation is
Initial Discount rate + [NPV from lower rate/ Absolute Difference between both rates]
x Difference between the rates
For Machine A
IRR = 10% + [10% x [109,210/ (109,210+4,540)]]
IRR =10% + 9.43% = 19.60%
For Machine B
IRR = 10% + [10% x [111,253/ (111,253+27,989)]]
IRR =10% + 7.99% = 17.99%

SUMMARY
Method
Cost
Profit
Payback
ARR
NPV at 10%
IRR

Machine A
450,000
680,000
2 years 10 months
22.4%
109,210
19.60%

Machine B
600,000
820,000
2 years 11 months
18.3%
111,253
17.99%

Decision

Machine A
Machine A
Machine B
Machine A

Initial profit forecasts show that Machine B would be the better choice but this
machine requires significantly higher investment.
When Capital appraisal techniques are used Machine A would appear to be the most
beneficial acquisition. These techniques all have their advantages and disadvantages
when used and compared to each other. In our example there is not much to pick
between the two machines, slight changes to any of the contributory data for these
calculations could tilt the favour more towards A or B. Sensitivity analysis may be
required

STRENGTHS AND WEAKNESSES

METHOD

PAYBACK

ACCOUNTING RATE
OF RETURNING

NET PRESENT VALUE

INTERNAL RATE OF
RETURN

STRENGTHS
Calculation Straight
Forward
Rapid return of investment
high priority
Easily understood by non
financial managers
Calculation Straight
Forward
Widely used as ROCE at
Company level easy to
compare with company

WEAKNESSES
Treats all future cash flows
the same
Rapid return of investment
not high priority
Cash Flow after payback
ignored
Treats all future cash flows
the same
Calculated on basis of
Accounting Profits not
cash flows- includes
depreciation
Easily understood by non
Fails to take into account
financial managers
of relative size of projects
Builds value of money into Can be difficult to explain
calculations
to non financial managers
Considers all future cash
Accuracy of Discount Rate
flows
Allows projects to be
ranked in absolute values
Builds value of money into Can be difficult to explain
calculations
to non financial managers
Considers all future cash
Ignores absolute values
flows
Complex cash flow
forecasts can make IRR
very difficult to calculate /
explain

Graph on next page shows Net Present Value against Discount Rate. Note the Points
where NPV is zero is the IRR.

Adapted from Business Accounting & Finance for non-specialists by Catherine

Gowthorpe

Net Present Value

120
100

Net Present Value

80
60
40
20
0
10%

11%

12%

13%

14%

15%

16%

17%

-20
-40
Discount Rate
Machine A

Machine B

18%

19%

20%