Unit 2 Capital Appraisal Techniques Concept - Part A (ii) - Traditional methods DISCLAIMER The PowerPoint presentations of the Module (BUSS 23001) (Principles of Financial Investment) are created merely to guide me during the delivery of this module in my class. The content included in the slides are only indicative to remind me the sequence which I will be following during the delivery. The content presented in the slides is free from any plagiarism and copyright violations and wherever needed appropriate referencing/citations have been provided. In addition to the content in this PowerPoint presentations, I will also be verbally delivering other important content in the class as well as also writing on the board, some information related to the topic being covered wherever necessary. The student is therefore advised to refer to the text books, reference books and any supplementary materials recommended in the Module Information Guide (MIG) or in the PowerPoint presentations for complete understanding of the topic.
Recommended Books: Arnold, Glen, (2013) Corporate financial management GITMAN, L., J., (2009), Principles of Managerial Finance, Pearson Prentice Hall Paramasivan, C 2009, Financial Management, New Age International Ltd, Daryaganj. https://ebookcentral.proquest.com/lib/mecomanebooks/detail.action?docID=437705 Ramagopal, C 2008, Financial Management, New Age International Ltd, Daryaganj. https://ebookcentral.proquest.com/lib/mecomanebooks/detail.action?docID=442140 Learning outcomes
• Traditional appraisal methods
• Pay back period method • Discounted pay back period method • Average rate of return Capital Budgeting
Investment decisions of a company are generally known as
capital budgeting decisions.
1. Traditional techniques Payback period method Discounted Payback period Method Accounting rate of return
2. Discounted Cash flow techniques
Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Modified Internal Rate of Return (MIRR) The Payback Method • The simplest method of investment appraisal
• This measures how quickly the returns from the
investment cover the cost of the investment
• A firm will calculate the payback period of a project
➢ If it is acceptable then the project will be undertaken
• If there is more than one possible project, then the
one with the shortest payback period will be selected Approaches for Payback
1. When cash flows are same every year
Payback = Total investment average annual cash flows
2. When cash flows differ each year
Pay back = No of exact years + Cash flows to be
recovered from next year/Cash flows of next year An Example of payback A company is considering 1 of the 2 projects outlined below Year Project A Project B
Note that the income is assumed to be spread equally over the 12 month period. Advantages of Payback • It is extremely simple • It is useful where technology changes rapidly ➢ cost of machinery is recovered before new model comes out. • Helps prevent cash flow problems since money will be recovered as quickly as possible. Disadvantages of Payback
❖Cash earned after the payback method is
ignored: e.g. Project Initial Cost Expected Earnings (Years) 1 2 3 4 A 7000 5000 2000 1000 500 B 7000 3500 3500 0 0
Here projects A & B are equal according to the payback
method, yet project A is more profitable. Disadvantages
It does not account for the real value of money:
e.g. Project Initial Cost Expected Earnings (Years) 1 2 3 C 10000 7000 2000 1000 D 10000 1000 2000 7000
• Here the payback method cannot distinguish
between the 2 projects however 7000 in year 1 is worth more than 7000 in year 3 because of inflation • Calculates the time it takes to recover the initial investment in current Rials.
• Incorporates time value of money by adding up
the discounted cash inflows at time 0, using the appropriate hurdle or discount rate, and then measuring the payback period. • • It is still flawed in that cash flows after the payback are ignored.
9-12 Cash Discount Present Cumulative Year flows factors @9% values inflows 0 100,000 1 40,000 0.917 36,680 36,680 2 30,000 0.842 25,260 61,940 3 50,000 0.772 38,600 100,540 4 70,000 0.708 49,560 150,100 Solution: Initial outlay is 100,000 and that is recovered by the end of 3rd year however the management is not factoring the cash inflow after the 3rd year i.e 4th year The Accounting Rate of Return (ARR)
• This method measures the net return each year as a
percentage of the initial cost of the investment. • It is calculated in any one of the two ways: • ARR (%) = Average annual net profits X 100 Initial capital employed or • ARR = Average annual net profits X 100 Average capital employed
• If the ARR is acceptable then the project will be undertaken
• If there is more than one possible project, then the one with the highest ARR will be selected An Example of ARR A business is considering 1 of the 2 investment projects outlined below: Project A Project B Initial Cost 10,000 20,000 Return in Year 1 4,000 9,000 Return in Year 2 5,000 9,000 Return in Year 3 5,000 12,000 Return in Year 4 4,000 10,000 Total Return 18,000 40,000 Average Annual Profit 4,500 10,000 ARR (Original capital employed) 45% 50% ARR (Average capital employed) 90% 100%
Therefore project B would be chosen
Advantages & Disadvantages of ARR Advantages • It clearly shows the profitability of a project • It allows easy comparison between projects • The opportunity cost of investment can be taken into account
Disadvantages • It is not always clear whether the original cost of investment should be used or average amount of capital should be used. • It does not take into account the effects of inflation on the value of money over a time period Exercise - 1
Bahwan Co. is considering investing in a new project. It
is estimated that it will cost RO 100,000 to implement, and the expected net profit after tax will be as follows:
• No residual value is expected.
• Calculate the pay-back period and accounting rate of return of the proposed project. Year 1 2 3 4 5 Net 18,000 47,000 65,000 65,000 30,000 profits Exercise - 2 Modern Electronics LLC is considering the purchase of a machine. There are two proposals with them Machine-A and Machine-B. The initial investment for both the proposals is RO 100,000. The life of both the machines is estimated as 5 years. Calculate the pay-back period and accounting rate of return of the machines. Profits after taxation are expected as follows:
Dyson, J.R., 2010. Accounting For Non-Accounting Students 8th
Edition, Pearson Education Ramagopal, C 2009, Accounting for Managers, New Age International, Daryaganj. Available from: ProQuest Ebook Central. Goel, S 2015, Capital Budgeting, Business Expert Press, New York. Available from: ProQuest Ebook Central. Paramasivan, C 2009, Financial Management, New Age International, Daryaganj. Available from: ProQuest Ebook Central. Collin, P 2007, Dictionary of Business, Bloomsbury Publishing PLC, London. Available from: ProQuest Ebook Central. Paxton, J (ed.) 2002, Dictionary of Financial Abbreviations, Routledge, London. Available from: ProQuest Ebook Central.
