Chapter 2 Investment Appraisal - Introduction
Nature and Stages of Investment Appraisal
Nature
Replacement Investment
Investment Expansion
Product Improvement/Cost Reduction
New Ventures
Stages
1. Identification
Ideas may generate from all level of the organization Initial screening may reject those that are unsuitable (technically/too
risky/cost/incompatible with company objectives) Remainder are investigated in greater depth (regarding sales, costs)
2. Evaluation
Identification of expected incremental cash flows Measure against some agree criteria (Payback Period/ARR/NPV/IRR) Consider effect of
different assumptions (Sensitivity Analysis) Consultation with other interest parties (Accountants, production staff, marketing staff, trade
unions)
3. Authorization
Submit to appropriate management level for approval/rejection/modification The large the expenditure, the higher the management level
Reappraise investment reassess assumptions and cash flow Evaluate how investment fits within corporate strategy and capital
constraints
4. Monitor & Control
Regularly review to ascertain if any major variations from cash flow estimates If Significant variations consider continuation or abandonment
Post audits useful (Encourage more realistic estimate at evaluation stage and help to learn from past mistakes)
Investment Appraisal Techniques
Payback Period
Time taken in years for the project to recover the initial investment
The shorter the payback, the more valuable the investment
Initial investment of 50,000 in a project is expected to yield the following cash flows:
Yea
r
1
2
3
4
5
6
Cash
Flow
20,000
15,000
10,000
10,000
8,000
5,000
Payback Period: 3 years
The cash inflows for that period equal the initial outlay of 50,000
Acceptable? Must be compared to the target which management has set. If all
projects require to be payback within, 4 years acceptable. If the target is 3 years
not acceptable.
Advantages
Simple and easily understood
Gives an indication of liquidity
Considers cash flow rather than profit profit is more easily manipulated
Disadvantages
Cash Flows after the Payback Period are ignored
Ignores the timing of the cash flows (Time Value of Money)
No clear decision is given in an accept/reject situation
Accounting Rate of Return (ARR)
Based upon accounting profits, not cash flows
Average Annual Accounting Profits
ARR =
=
Average Investment
Company is considering an investment of 100,000 in a project which is expected to last for 4 years. Scrap value of
20,000 is estimated
to be available
the end of the project
Accounting
Rate ofatReturn:
Yea
r
1
2
3
4
Profits
Total Profits Before
Depreciation
50,000 Less Total Depreciation
50,000
30,000 Total Accounting Profits
10,000
140,00
0
(80,00
0)
60,00
0
Average Annual Profits (4 years)
Alle Profits zusammengerechnet
Investment Scrap Value
60,000
= 15,000
ARR =
15,000
Advantages
Simple
Based upon profits Shareholders see that in the reported in the
annual accounts
Provides a % measure More easily understood
Disadvantages
Crude averaging method (3 out of 4 project could make loses but
there could be a result, that implies all 4 make profits)
Does not take the timing of the profits into account
Net Present Value (NPV)
Converts future cash flows to a common point in time (Present Value), by discounting them
Present values of the individual cash flows are aggregated to arrive at the Net Present Value
NPV figure represents the change in shareholders wealth from accepting the project
Independent project
Accept if the NPV is positive
Reject if the NPV is negative
Mutually project (Select only one)
Calculate the NPV of each project
Select the one with the highest NPV
Company is considering a project, which is expected to last for 4 years and requires an investment of 20,000.
Inflows are erstimated at 7,000 for each of the first two years and 6,000 for each of the last years. Companys
cost of capital is 10% and the scrap value is zero.
Calculate the NPV and recommend if the project should be accepted
Yea
r
0
1
2
3
4
Cash
Flow
(20,000)
7,000
7,000
6,000
6,000
Discount Factor
10%
1.0
0.909
0.826
0.751
0.683
Net Present
Value
Project should be accepted
Present
Value
(20,000)
6,364
5,785
4,508
4,098
+ 755
Long-Term Projects
Outlay of 40,000 and annual cash profits of 4,500 pa in perpetuity (paid forever) Cost of capital: 12%
Present Value
Cash Profit
Cost of Capital
Present Value
4,500
0.12
= 37,500
Present Value
=
Advantages
Correctly accounts for the time value of money
Uses all cash flows
Absolute measure of the increase in wealth
Outlay
Net Present Value
37,500
(40,000)
(2,500)
Disadvantages
Difficult to estimate cost of capital
Not easily interpreted by management Management untrained
in finance often have difficulty in understanding the meaning of a
NPV
Internal Rate of Return (IRR)
Produces a percentage return
Determines the discount rate at which the NPV would be zero present value of the outflows = present value of the inflows
If IRR exceeds the companys target rate of return accepted project. Less than target rate of return reject project
1
2
3
Calculate two NPVs, using two different discount rates
One calculation will produce a positive NPV and the other a negative NPV
If first attempt produces a positive NPV, generally a higher discount rate will be required to produce a negative NPV and vice versa.
Using the cash flows of example NPV. Discount Rate of 10% produces a positive NPV of 755. In attempt to find
a negative NPV discount rate used of 15%
Calculate the NPV and recommend if the project should be accepted
Yea
r
0
1
2
3
4
Cash
Flow
(20,000)
7,000
7,000
6,000
6,000
Discount Factor
15%
1.0
0.869
0.756
0.658
0.572
Net Present
Value
Present
Value
(20,000)
6,083
5,292
3,948
3,432
- 1,245
Advantages
Often gives same decision rule as NPV
More easily understood than NPV
Considers the time value of money
Considers all relevant cash flows over a projects life
Disadvantages
Relative, not absolute return (Ignores relative size of investments)
Looks at projects individually (Results cannot be aggregated)
Cannot cope with interest rate changes
Other Factors
Other factors that should be taken into account before a decision about investment is made
Impact on staff morale Redundancies
Reaction of Competitors
Does the company has the necessary know-how?
Necessary skills and ability to deliver expected quality
Does it fit to the company overall strategy
Relevant Cash Flows
Depreciation is excluded (Abschreibung) Non-cash item
Present written-down value is not relevant (Buchwert) Merely an accounting book entry
Variable overheads are always relevant
Fixed overheads may or may not be relevant
Relevant: Additional fixed cost (Everything that has to be rent/bought/hired for a product is an additional/new fixed cost
Not relevant: Existing fixed cost, allocated fixed cost
Sunk cost ( Cost that haven been spend in the past) can be ignored
Opportunity costs must be taken into account (Amount of reduced sales units * (Sale price variable costs per unit)
Interest costs should not be included
Working capital flows back into the organization once the project is finished
