INVESTMENT APPRAISAL

INVESTMENT

Refers to the purchasing of capital goods such as equipment, vehicles and new buildings; and improving fixed assets

INVESTMENT APPRAISAL

Evaluating the profitability or desirability of an investment project. It assesses the economic viability of potential investment options so as to arrive at the most acceptable alternative depending on the criteria used for comparing these projects

INVESTMENT APPRAISAL TECHNIQUES

• Payback Period - Uses Cash Flows

• Average Accounting Rate of Return (ARR / AARR)- Uses Net Profit

• Net Present Value (NPV) - Uses Cash Flows

• Internal Rate of Return (IRR) - Uses Cash Flows

PAYBACK PERIOD

This is the length of time necessary to recover the entire cost of an investment from the resulting annual net cash flows.

Payback Period = (Number of years before recovery of initial investment) + ([Amount of investment remaining to be recaptured / Total cash flow during year of payback] x 12)

EXAMPLE

The following refers to information relating to the investment in two projects:

YEAR PROJECT A PROJECT B

0 (Initial Investment)

($500,000) ($500,000)

1 $300,000 $10,000

2 $200,000 $20,000

3 $50,000 $200,000

4 $10,000 $135,000

5 $5,000 $200,000

CALCULATING PAYBACK PERIOD

• Calculate cumulative cash flowYEAR PROJECT A PROJECT A

CUMULATIVE CASH FLOW

PROJECT B PROJECT B CUMULATIVE CASH FLOW

0 ($500,000) ($500,000) ($500,000) ($500,000)

1 $300,000 ($200,000) $10,000 ($490,000)

2 $200,000 $0 $20,000 ($470,000)

3 $50,000 $50,000 $200,000 ($270,000)

4 $10,000 $60,000 $135,000 ($135,000)

5 $5,000 $65,000 $200,000 $65,000

CALCULATING PAYBACK PERIOD cont’d

• Payback will occur where the cumulative cash flow is equal to zero (0).

• Project A – Payback period is 2 years. (Straightforward)• Project B – Payback Period = 4yrs and ? (To Calculate) ? = (Amount of investment remaining to be recaptured / Total cash flow during year of payback) x 12 = ($135,000/ $200,000) x 12 = 8.1 monthsFinal Answer is 4yrs and 8.1mths

ADVANTAGES OF PAYBACK METHOD

• It is easy to calculate and understand• It focuses on risk and therefore promotes

prudence and caution• By focusing on liquidity (cash flow) rather than

profitability, this method is looked upon favorably by lenders of capital

DISADVANTAGES OF PAYBACK METHOD

• It fails to take into account cash flows after the payback period

• It does not take into consideration the time value of money

• It only looks at cash flows and does not consider overall profitability

Average Accounting Rate of Return (AARR / ARR)

Unlike other appraisal methods, the ARR uses profit instead of cash flows. This method therefore give profitability of the investment as a percentage of the initial investment. The usual difference in a question between cash flow and profitability is depreciation. In order to arrive at profit when given cash flows, you need to minus depreciation per year from the cash flows.

AARR / ARR EQUATION

ARR = (Average Annual Profit /Initial Investment) x 100

CALCULATING ARR /AARR

• Calculate profit if depreciation per year is $10,000 for Project A and $15,000 Project B

YEAR CASH FLOW

PROJECT A

PROFIT PROJECT A

CASH FLOW

PROJECT B

PROFIT PROJECT B

0 ($500,000) ($500,000)

1 $300,000 $290,000 $10,000 ($5,000)

2 $200,000 $190,000 $20,000 $5,000

3 $50,000 $40,000 $200,000 $185,000

4 $10,000 $0 $135,000 $120,000

5 $5,000 ($5,000) $200,000 $185,000

Total $515,000 $490,000

CALCULATING ARR /AARR cont’d

• Project A = [($515,000/5) / $500,000] x 100 = ($103,000 / $500,000) x 100 = 20.6%• Project B = [($490,000/5) / $500,000] x 100 = ($98,000 / $500,000) x 100 = 19.6%

ADVANTAGES OF AARR / ARR

• It focuses on profitability in all years unlike payback

• It focuses on profitability, which is the central objective of many business decisions

• The result is easy to understand and compare with other projects

DISADVANTAGES OF AARR / ARR

• It ignores the timing of profit flows. This could result in two projects having the same ARR but with different paybacks

• The time value of money is ignored

NET PRESENT VALUE (NPV)

This method takes into consideration the fact that future cash flows will lose value over time. This method therefore discounts all future cash flows and brings them to present values. (Using a Present Value Interest Factor [PVIF] table) This summed total of all of the Present Values is then subtracted from the initial investment in order to calculate the Net Present Value. The project with the highest positive NPV would be chosen.

CALCULATING NPV

PROJECT A

YEAR CASH FLOW 10% DISCOUNT

FACTOR

PRESENT VALUE

0 ($500,000) 1 ($500,000)

1 $300,000 0.9091 $272,730

2 $200,000 0.8264 $165,280

3 $50,000 0.7513 $37,565

4 $10,000 0.6830 $6,830

5 $5,000 0.6209 $3,104.50

NPV ($14,490.50)

CALCULATING NPV

PROJECT BYEAR CASH FLOW 10%

DISCOUNT FACTOR

PRESENT VALUE

0 ($500,000) 1 ($500,000)

1 $10,000 0.9091 $9,091

2 $20,000 0.8264 $16,528

3 $200,000 0.7513 $150,260

4 $135,000 0.6830 $92,205

5 $200,000 0.6209 $124,180

NPV ($107,736)

ADVANTAGES OF NPV

• It takes into account the time value of money• It considers the cash flows for the entire

project

DISADVANTAGES OF NPV

• It is more complicated to calculate• The discount rate is only an estimate, this

could change at any moment

INTERNAL RATE OF RETURN (IRR)

Attempts to find the discount rate where NPV is equal to zero.(ie. When the cost or initial investment = discounted cash flows). This rate is then compared to the interest rate which is charged when borrowing to invest (Cost of Capital)If that rate is more than the cost of capital then the project should be profitable. The IRR is therefore the rate at which the company internally generates profit on its investment. (Not required to work it out for exams)