INVESTMENT APPRAISAL

INTRODUCTION

Long-term capital expenditure decisions:

e.g. Investment in a new factory/new machinery;

Launching a new product;
Choosing between buying or renting equipment.

How can a firm compare possible investments?

METHODS OF INVESTMENT APPRAISAL

PAYBACK:

Length of time (usually expressed in years) which it takes for the

project's net cash inflows to recoup the original investment.
Usual decision rule is to accept the project with the shortest
payback period.

EXAMPLE:

XYZ Ltd are considering investment in one of two mutually exclusive

projects. Both involve the purchase of machinery which is expected
to last five years and have no scrap value. The machinery for
project A would cost £70,000, while B would cost £85,000.

The cash inflows for the projects are expected to be as follows:

Y EAR P RO JE CT A P RO JE CT B

1 £2 0 , 5 0 0 £ 32 , 0 0 0

2 2 0, 9 00 30 , 50 0

3 2 1, 3 50 30 , 00 0

4 3 5, 0 00 28 , 00 0

5 4 0, 0 00 25 , 00 0

REQUIRED:

You are asked to compare the projects using suitable investment

appraisal techniques and to give your advice on which should be
chosen.

1
Calculation of payback periods:
P R O J E C T A P R O J E C T B

Y E A R N E T C A S H C U M U L A T I V E N E T C A S H C U M U L A T I V E

F L O W C A S H F L O W F L O W C A S H F L O W

0 - 7 0 0 0 0 - 7 0 0 0 0 - 8 5 0 0 0 - 8 5 0 0 0

1 2 0 5 0 0 - 4 9 5 0 0 3 2 0 0 0 - 5 3 0 0 0

2 2 0 9 0 0 - 2 8 6 0 0 3 0 5 0 0 - 2 2 5 0 0

3 2 1 3 5 0 - 7 2 5 0 3 0 0 0 0 7 5 0 0

4 3 5 0 0 0 2 7 7 5 0 2 8 0 0 0 3 5 5 0 0

5 4 0 0 0 0 6 7 7 5 0 2 5 0 0 0 6 0 5 0 0

P
AYB
ACKP
ERI
O D
S:

7
250

P
ROJ
ECT
A:= 3
.00 + -
--
--
--
--
--
-= 3
.21 Y
EAR
S

3
500
0

2
250
0

P
ROJ
ECT
B:= 2
.00 + -
--
--
--
--
--
-= 2
.75 Y
EAR
S

3
000
0

ADVANTAGES AND DISADVANTAGES OF PAYBACK METHOD

Advantages:

• Simple to calculate and understand.

Favours quick return projects which may produce faster growth for
the business
Choosing projects which pay back earliest will tend to minimise
risks related to time

Disadvantages:

• Ignores time value of money.

Ignores cash flows after payback period
Payback periods chosen have little theoretical basis

NET PRESENT VALUE METHOD

• Recognises the time value of money.

The present values of all cash flows are calculated using an
appropriate discount rate.
If the total value of these discounted cash flows is positive,

2
 usually the project is acceptable.

THE TIME VALUE OF MONEY:

If the interest rate is 10%:

£1 receivable at the end of one year has a present value of :

1 1
1/(1 + 10%) = 1/(1+0.1) = 1/(1.1) = 0.909

£1 receivable at the end of two years has a present value of :

2 2
1/(1 + 10%) = 1/(1+0.1) = 1/(1.21) = 0.826

NPV EXAMPLE (Using the above figures and a discount factor of 15%):
NET PRESENT VALUE CALCULATIONS:

PROJECT A PROJECT B

YEAR DISCOUNT NET CASH PRESENT NET CASH PRESENT

FACTOR FLOW VALUE FLOW VALUE

£ £ £ £

0 1 -70000 -70000 -85000 -85000

1 0.87 20500 17835 32000 27840

2 0.756 20900 15800 30500 23058

3 0.658 21350 14048 30000 19740

4 0.572 35000 20020 28000 16016

5 0.497 40000 19880 25000 12425

NET PRESENT VALUES 17584 14079

ADVANTAGES OF NPV

• Takes all cash flows into account

Allows for time value of money

DISADVANTAGE

• Need to estimate the discount factor

THE INTERNAL RATE OF RETURN

The discount factor which would result in a zero net present value.

It can be found by trial and error - or by using the IRR

3
spreadsheet function.

Usually a project with an IRR greater than the firm's cost of

capital is acceptable.

In the case of mutually exclusive projects the one with the highest
IRR should be chosen.

In the example above the IRRs are:

PROJECT A PROJECT B
23.86% 22.08%

COMPARISON OF IRR WITH NPV

Advantages of IRR over NPV

• Managers like to compare % rates of return

• No need to calculate a pre-set rate of return as with NPV

Advantages of NPV over IRR

• Unlike NPV, IRR doesn't allow for different scale of projects

• Some projects (with non-conventional cash flows) can have more
than one IRR
• NPV is simpler to calclate
• With NPV different discount rates ca be used at different
stages of project life (e.g. to take account of different risk
levels)
• IRR assumes that funds can be re-invested at IRR – usually not
true.

In summary NPV is more theoretically sound.

Summary of results:
P
r
oj
e c
tA P
r
oj
ectB S
el
e c
ti
on

P
ay
ba
ckp
er
i
ods(
yea
r
s) 3
.
21 2
.
75 B

N
etp
r
ese
ntv
al
ues £
17
,5
84 £
14
,0
79 A

I
R R
s 2
3.
86% 2
2.
08% A

ADVICE:

Although Project B has a shorter payback period, Project A has a

4
much better net present value and a higher internal rate of return.
Therefore, other things being equal, project A should be chosen.