University of Sussex

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University of Sussex

• Finance Course
• Corporate Finance Principles and Practice

Investment Appraisal
Heather Stone FCCA
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Methods of Investment Appraisal

• ROCE
• Payback
• Discounted Payback
• Net Present Value (NPV)
• Internal Rate of Return (IRR)

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ROCE

• Accounting Profit divided by investment
• ROCE, ROI, ARR
• Investment could be
• Average investment
• Opening investment
• Consider scrap values
• Final investment

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Payback method

• Identify cash inflows and outflows per year
• Accumulate cash flows
• Identify when original investment returned
• Most popular method
• Usually used for initial screening of a project

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Payback method

• Disadvantages
• Estimates timings
• Estimates time of receipt
• Earliest return rather than greatest profit
• Total cash return ignored
• Time value of money ignored

• Advantages
• Simple to understand
• Simple to calculate

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Discounting Time Value of Money

• I need 100 next year.
• The Building Society Interest Rates are 10
• How much should I Invest Now ?
• How much should I invest if I do not need the
  money for two years ?

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Discount Factors

• 1/(1rn)
• 10 1.000, 0.9091, 0.8264, 0.7513
• 12 1.000, 0.8929, 0.7972, 0.7117
• 14 1.000, 0.8772, 0.7695, 0.6750
• Etc.

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Discounted Payback Method

• Advantages
• Easy to understand
• Easy to calculate
• Focuses on cash recovery of investment
• Considers time value of money
• Considers more of real cash flows

• Disadvantages
• Difficult to estimate timings
• What rate of interest should be used ?
• Ignores receipts after payback period

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Net Present Value

• 1. Estimate Cash Flows
• 2. Choose Cost of Capital
• 3. Look up Discount factors
• 4. Discount Cash Flows
• 5. Summate
• 6. Compare NPV with Outlay
• 7. If ve accept, if -ve reject

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Net Present Value

• Advantages
• Emphasizes Liquidity
• Different A/C policies do not affect result
• Easy to compare different projects

• Disadvantages
• Estimation of initial costs
• Estimating of cash flows
• Selecting rate of return

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Internal Rate of Return

• What Cost of Capital would be required to assure
  that NPV equal to original cost?
• Calculate NPV at 2 rates
• Apply Formulae -
• IRR p0 a/(a b) X p1-p0

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Internal Rate of Return

• Advantages
• Emphasizes Liquidity
• Considers timing of cash flows
• No Rate of Return to estimate
• Clear calculated

• Disadvantages
• Not easy to understand
• Often needs a computer to calculate
• Only approximate IRR
• Can give misleading results in complex situations

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Capital rationing

• Hard Capital rationing restriction in external
  sources of finance
• Soft Capital rationing restriction in internal
  sources of finance
• Single period capital rationing
• Defer project
• Rank projects
• Divisible or indivisible projects

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Relevant Cash Flows

• Sunk costs
• Opportunity Costs
• Apportioned Fixed Costs
• Incremental costs only need be considered

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Taxation effect on capital investments decisions

• Capital allowances
• Tax allowable costs
• Timing of payments
• Ignore tax effect of financing decision

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Sensitivity analysis

• Cash flows will be based on estimates
• Can calculate degree of accuracy of cash flows
• Can test each variable for effect on NPV and this
  how sensitive that variable is
• Determines risk of investment project

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Simulation Models

• Estimate probability distributions for each
  project variable
• Use computer to generate random numbers and use
  to select value for variables and determine
  effect of variation on NPV
• Referred to as Monte Carlo Method