Lecture 2- Capital Investment Appraisal: Appraisal process and methods

1
Lecture 2- Capital Investment Appraisal
Appraisal process and methods

• Objectives
• Describe the nature of capital investment
  appraisal
• Apply the main investment appraisal techniques
• Recognise the limitations of investment
• appraisal technique

2
Definition of Investment

• Any act which involves the sacrifice of an
  immediate and certain level of consumption in
  exchange for the expectation of an increase in
  future consumption.
• forgo the present consumption in order to
  increase resources in future

3
Types of capital investment

• Replacement of obsolete assets
• Cost reduction e.g. IT system
• Expansion e.g new building equipment
• Strategic proposal improve delivery service,
  staff training.
• Diversification for risk reduction

4
Need for Investment Appraisal

• Large amount of resources are involved and wrong
  decisions could be costly
• Difficult and expensive to reverse
• Investment decisions can have a direct impact on
  the ability of the organisation to meet its
  objectives

5
Investment Appraisal Process

• Stages
• identify objectives. What is it? Within the
  corporate objectives?
• Identify alternatives. Use CAD, CAM or use
  external service.
• Collect and analyse data. Examine the technical
  and economic feasibility of the project, cash
  flows etc.

6
Investment Appraisal Process

• Stages
• decide which one to undertake
• authorisation and implementation
• review and monitor learn from its experience and
  try to improve future decision - making.

7
Appraisal Methods

• Payback method - length of time it takes to
  repay the cost of initial investment

8
Payback Period

• Lecture Example 2.1
• LBS Ltd uses the payback period as its sole
  investment appraisal method. LBS invests 30,000
  to replace its computers and this investment
  returns 9,000 annually for the five years. From
  the information above evaluate the investment
  using the payback. Assume that 9,000 accrues
  evenly throughout the year.

9
Payback Period

• Solution 2.1
• Year Yearly cash flow cumulative net cash
  flow
• 0 (30,000) (30,000)
• 1 9,000 (21,000
• 2 9,000 (12,000)
• 3 9,000 (3,000)
• 4 9,000 6,000
• 5 9,000 15,000
• Therefore 3years 27,000 then 3000/9000 x 12
  4
• Payback period 3 years 4months

10
Example 2.2

11
Example 2.2 solution

• Undiscounted pay back
• For A 4 years
• For B 5 years

12
Example 2.2 solution

13
Example 2.2 solution

• For A, payback is outside the projects life
• For B payback is 6.25 yeas (how?)

14
Advantages and disadvantages of payback

• Read on page 13

15
Reasons for payback popularity (page 13)

• Once the relevant cash flows are calculated,
  payback is easy to apply and to explain to
  management
• Capital rationing -it ensures the recycling of
  cash into new projects with the least delay.
• Convenient for risk averse because of short
  payback periods

16
Accounting Rate of Return (ARR)

17
Lecture Example 2.3
18
Example 2.3 - solution

• Average Accounting Profit
• (- 250 1000 1000 20,750) / 4 5625
• Average investment 45,000 / 2 22500
• ARR (5625/22,500 x 100 25

19
ARR

• Read on
• Advantages and disadvantages (page 14)

20
Appraisal Methods

• Net Present Value (NPV) - the difference between
  the present values of cash inflows and outflows
  of an investment
• Opportunity cost of undertaking the investment is
  the alternative of earning interest rate in the
  financial market.

21
NPV
22
Definitions

• Present value- the amount of money you must
  invest or lend at the present time so as to end
  up with a particular amount of money in the
  future.
• Discounting -finding the present value of a
  future cash flow

23
Quick exercise
24
Example 2.4

• A company can purchase a machine at the price of
  2200. The machine has a productive life of
  three years and the net additions to cash inflows
  at the end of each of the three years are 770,
  968 and 1331. The company can buy the machine
  without having to borrow and the best alternative
  is investment elsewhere at an interest rate of
  10.
• Evaluate the project using the
• Net present value method.
• Internal rate of return

25
Example 2.4 solution
26
Net Present Value

• Lecture Example 2.5
• A firm invest 180,000 in a project that will
  give a net cash inflow of 50,000 in real terms in
  each of the next six years. Its real pre-tax cost
  of capital is 13.
• Required
• Calculate NPV

27
Net Present Value

• Solution 2.5
• Year Cash Flow PV factor 13 Present value
• 0 (180,000) 1.00 (180,000)
• 1 50,000 0.885 44,250
• 2 50,000 0.783 39,150
• 3 50,000 0.693 34,650
• 4 50,000 0.613 30,650
• 5 50,000 0.543 27,150
• 6 50,000 0.480 24,000
• NPV 19,850
• Positive NPV indicates viability of the project.
• Negative NPV indicates non-viability of the
  project.

28
Alternative solution to 2.5

• Use the annuity table
• Year Cash flow DF _at_13 PV
• 0 (180,000) 1 (180,000)
• 1-6 50,000 3.998 199,900
• NPV 19,900

29
Appraisal Methods

• Internal Rate of Return - is the discount rate
  that equates the present values of an
  investments cash inflows and outflows.
• Internal Rate of Return (IRR) - is the discount
  rate that causes an investments NPV to be zero

30
IRR
31
Example 2.6

• Using Lecture example 2.4 (above), calculate the
  internal rate of return for the project.

32
Internal Rate of Return

• Solution to 2.6
• IRR Try 15
• Year Cash flow Discount Factor
  (15) PV
• 0 (2200) 1.000 (2200)
• 1 770 0.8696 669.59
• 2 968 0.7561 731.90
• 3 1331 0.6575 875.13
• NPV 76.62

33
Internal Rate of Return

• Year Cash flow DC (16) PV
• 0 (2200) 1.000 (2200)
• 1 770 0.8621 663.83
• 2 968 0.7432 719.42
• 3 1331 0.6407 852.77
• NPV 36.01

34
IRR

• Year Cash flow DCF (17) PV
• 0 (2200) 1.000 (2200)
• 1 770 0.8475 652.58
• 2 968 0.7305 711.48
• 3 1331 0.6244 831.08
• NPV (4.86)
• Interpolation
• 16 36.01 / 40.87 16.88

35
Appraisal Methods

• Please read more on the advantages and
  disadvantages of these techniques
• Why is the NPV considered superior over the
  other methods, even the IRR?

36
End of Lecture 2

• Any question please?