CAPITAL INVESTMENT APPRAISAL FOR LONGTERM DECISIONS

What is Capital Investment Appraisal?

Capital Investment Appraisal is about deciding, which fixed assets to acquire or which long-term projects to invest in, e.g. factories, machinery, offices, etc. Large amounts of money are involved over long periods of time. The cost of reversing a CIA decision is very high.

CIA Abbreviations
PBP = payback period ARR = accounting rate of return

NPV = net present value

IRR = internal rate of return

DCF = discounted cash flow

Summary of CIA Methods

Non-DCF methods: ARR PBP profit-based cash-flow-based
Covered in Managing Financial Resources

DCF methods:

NPV

cash-flow-based

IRR

cash-flow-based

The Time Value of Money

1. If todays prevailing rate of interest is 5%, would you prefer to receive 900 now or 900 in a years time? (Assume both inflation and the risk to be negligible) 2. Would you prefer 900 now or 1,000 in a years time?

(Think how much you would get in a years time if you invested 900 now.)
3. What if the prevailing rate of interest was 15%?

The Time Value of Money (Continued)

900 now has a greater value than 900 in a years time as it can be invested for the year to earn interest. Thus, a 1 in 1 year is not worth the same as a 1 from another year.

When looking at cash flows over a number of years, to be sure of comparing like with like, future amounts should be reduced by the prevailing interest rate. This rate is more usually known as the discount rate.

Future cash flows should be discounted to present values.

Compounding
Compounding is the effect of repeatedly adding interest earned to the lump sum invested so that interest will be paid on larger and larger amounts as time passes. *********** E.g. What is the value of 751 invested at 10% p.a. for 3 years? Year 1 Year 2 Year 3 751 1.10 = 826 826 1.10 = 909 909 1.10 = 1,000

LE 1: Compounding
If 500 is invested at 7.5% p.a. compound for 4 years, how much will it be worth at the end of the 4 years?

Solution

Discounting
Discounting can be viewed as the opposite process to compounding.

E.g. You own a machine, which will produce a cash income of 1,000 p.a. for each of the next three years. What is the present value of this income stream if the discount rate is 10% p.a.? Year 1 2 3 Cash 1,000 1,000 1,000 10% discount factor Present value x 0.9091 909 x 0.8264 826 x 0.7513 751 Total present value = 2,486

LE 2: Discounting
Discount the cash flows of the manicure parlour to the present time using a rate of 3% p.a.
Year Year Year Year Year 1 2 3 4 5 50,000 60,000 70,000 80,000 65,000

What is the total of these present values?

Solution

Illustration of Compounding and Discounting

(after Atrill & McLaney, Introduction to Management Accounting: An Active Learning Approach (Blackwell))

Net Present Value

The NPV is the sum of all the present values of all the relevant cash flows connected with the project.
If NPV is positive, accept the project. If several projects are mutually exclusive, accept project with highest positive NPV. If NPV is negative, reject the project.

Calculating the NPV

1. Define

annual cash flows (adjust profits as necessary) inflows are positive, outflows are negative.

2. Determine the discount rate.

3. Discount future cash flows to present values calculate the factors or use PV tables. 4. Combine all the annual PVs to give the net PV.

NPV Example
A vending machine costs 2,500. It will produce positive net cash inflows of 1,000 a year for each of the next 3 years (residual value = nil). What is the NPV if the discount rate is 10% p.a.? ************** Year 0 1 2 3 Cash in/out (2,500) 1,000 1,000 1,000 10% discount factors Present value 1.000 = (2,500) 0.909 = 909 0.826 = 826 0.751 = 751 NPV = (14)

x x x x

Limitations of NPV
Apart from the initial cash outlay to create the project, the cash flows for each year are assumed to occur all on the last day of the year. This is clearly unrealistic. (This is because discounting is the exact opposite of annual compounding.)

The cost of capital is assumed to remain constant over the whole lifetime of the project. This is very unlikely to be the case.

Internal Rate of Return

The IRR is the average annual rate of return of cash that the project is expected to produce (allowing for the time value of money). It is numerically equal to the discount rate, which gives the project an NPV of zero. For the project to be acceptable, the IRR should be equal to, or greater than, the minimum rate of return set by the business ( hurdle rate). Where projects are mutually exclusive, the one with the greatest IRR is chosen. NB: If the IRR decision conflicts with the NPV, the NPV decision is used as it is expressed in rather than in %.

Calculating the IRR

1. Perform the NPV process using your best guess of the discount rate which will give an NPV of zero.

2. If your NPV is positive, repeat the process using a higher discount rate in order to give a negative NPV. (If first NPV is negative, try a lower rate.) 3. When you have one positive and one negative NPV, use interpolation to find the rate giving NPV = 0.

NB: This is an iterative technique using trial and error.

IRR - Interpolation

Where, A = the given Discount rate NPVA = NPV for Discount rate A
B

e.g. 10%

= Assumed Discount rate (if NPVA is a positive number use a larger Discount rate) NPVB = NPV for Discount rate B

Example of an IRR Calculation

Project costs 100,000 and produces net cash flows as shown. What is the IRR?
Year 0 1 2 3 4 Cash Flow (100,000) 20,000 35,000 45,000 50,000 Discount Rate 10% 1.000 0.909 0.826 0.751 0.683 NPV PV (100,000) 18,180 28,910 33,795 34,150 + 15,035 Discount Rate 20% 1.000 0.833 0.694 0.579 0.482 PV (100,000) 16,660 24,290 26,055 24,100 - 8,895

IRR = 10% + [15035 / (15035 + 8895) (20% - 10%)] = 10% + [15035 / (23930) x (10%)] = 10% + 6.28% = 16.28% +71 0 gap = 360

LE 3: Internal Rate of Return

You are considering investing in production facilities for a new product with an estimated lifespan of 4 years. The fixed assets will cost 49,500 and will have zero value after 4 years. The net cash inflows will be 20,000 for each of the first 2 years and 10,000 for each of the last 2 years. If the companys cost of capital (i.e. discount rate) is 10% p.a., what is the IRR of the project? Would you recommend going ahead? (Use 3 decimal places for your PV factors.)

Solution
Year Cash Flow Discount Rate 10% PV Discount Rate ___% PV

NPV

Limitations of IRR
Multiple rates of returns can occur when a project has unconventional cash flows It is assumed that the cash flows received from a project are re-invested at the IRR and not the cost of capital It cannot deal with different sized projects. For example, it is better to earn a return of 35% on 100,000 than 40% on 10,000.

Choice of Method
If the choice of projects is to be decided upon the results

of NPV and IRR, the NPV results are preferred over IRR. NPV has none of the flaws of IRR and returns the value in monetary terms which are more realistic than percentages. NPV values can be easily amended for risk by increasing or decreasing the discount rate. NPV calculations can accommodate changes in inflation and tax thus making the results more robust.

Overall Limitations of CIA

Capital investment appraisals are only as good as the forecasts of profit or cash flow on which they are based. The long-term nature of capital investment appraisal compounds this weakness. The further into the future the forecast goes, the less reliable it becomes.