COM 4310 1

Capital Investment Decisions

(Project Appraisal)

Capital investment decisions are those decisions that

involve current outlays (costs) in return for a stream of

benefits in future years.

The distinguishing feature between short-term

decisions and capital investment (long-term) decisions

is time.4/29/2011

COM 4310 2

Appraisal methods

• NPV

• IRR

• Payback / Discounted payback

• ARR

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COM 4310 3

Appraisal methods

The concept of Net Present Value (NPV)

• By using discounted cash flow techniques we can calculate Net Present Value.

• Present value is the today’s value (year 0) of any future cash flow after discounting it by an appropriate discount rate.

• The process of converting cash to be received in the future into a value at the present time by the use of an interest rate is called as discounting.

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COM 4310 4

Present value = FV

(1 + K)^

• Compounding is the opposite of discounting, since it is the future value of present cash flows.

Future Value = PV (1 + K)^

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• Calculation of Net Present Value,– Example:

The Master company is evaluating a project with an expected life of three (3) years and investment outlay of Rs. 10 million. The estimated net cash inflows are as follows.

– Year 1 3 million– Year 2 6 million– Year 3 4 million

The opportunity cost of capital is 10%. You are required to calculate the net present value of the project.

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COM 4310 6

The Internal Rate of Return (IRR)

This is the discount rate that will cause the net

present value of an investment to be zero.

That is, IRR is the Effective Interest Rate (EIR) of the

project.

IRR is also known as Discounted Rate of Return.

IRR is the “maximum cost of capital” that can be

allowed to finance a project. If your cost of capital is

greater than IRR , then you are incurring losses.

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COM 4310 7

The IRR can be found by trial and error by using a number

of discount factors until the NPV equals zero.

However, we can use Interpolation method to calculate IRR.

This method gives an approximation of the IRR.

IRR = LR + LR NPV x (HR – LR)

LR NPV – HR NPV

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• Calculate the IRR of the previous example…

• IRR has a technical shortcoming. That is, when cash flows of the project are unconventional multiple IRRs are possible for a project. But, only one IRR is economically significant in determining whether or not the investment is possible.

• Therefore, when unconventional cash flows involve, NPV method is more appropriate to decide whether project is accepted or not.

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COM 4310 9

Timing of cash flows To simplify the presentation, our calculations have been based on the assumption that any cash flows in future years will occur in one lump sum at the year end.

Both NPV and IRR methods take into account the time value of money.

Techniques that ignore the time value of money

Payback Method

Accounting rate of return (ARR)

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COM 4310 10

Payback Method

• The payback method is defined as the length of

time that is required for a stream of cash inflows

from an investment to recover the original cash

outlay of the investment.

• Payback period is a simple method but could result

in selecting a wrong project since it does not

consider time value of money.

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COM 4310 11

• However, to minimize the problems with payback

period, it can be adjusted to show the time value

of money and discounted payback method is

used.

• Calculate the payback period and

discounted payback period for previous

example.

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Accounting rate of return (ARR)

The Accounting rate of return (ARR) , also known as the

return on investment and return on capital employed .

This method differs from other methods in that profits

rather than cash flows are used.

ARR = average annual profits x 100

average investments

However, ARR method ignores the time value of money.

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Example ….

A project has an initial outlay of Rs. 20 million. It is assumed that project will have an scrap value of Rs.5 million. Average annual profit expected from the project is Rs. 3 million.

ARR = average annual profits x 100

average investments

3 X 100

(20+5)/2

24%

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Decision criteria• Accept the project if NPV is positive.

• Accept the project if Discount rate < IRR

• Accept the project if payback is comparatively

shorter.

• Accept the project if ARR > expected rate of

return

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COM 4310 15

Mutually exclusive projects

Mutually exclusive projects exist where the acceptance

of one project excludes the acceptance of another

project .

It is recommended to use NPV method to rank

mutually exclusive projects.

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COM 4310 16

Qualitative factors

Not all investment projects can be described

completely in terms of monetary costs and benefits.

Therefore, even if some costs and benefits cannot be

quantified they should be considered in investment

decisions.

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COM 4310 17

Capital rationing

Situations may occur where there are

insufficient funds available to a firm to

undertake all those projects that yield a

positive net present value. This situation is

described as capital rationing.

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COM 4310 18

The term “soft capital rationing” is often used to

refer to situations where, for various reasons the

firm internally imposes a budget ceiling on the

amount of capital expenditure.

Where the amount of capital investment is

restricted because of external constraints such as

the inability to obtain funds from the financial

markets, the term “hard capital rationing” is used.

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COM 4310 19

Whenever capital rationing exists,

management should allocate the limited

available capital in a way that maximizes

the NPVs of the firm.

For ranking projects “profitability index”

is used.

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COM 4310 20

Profitability index = PV of cash inflows

investment

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Example………Sade company operates under the constraint of capital

rationing has identified four (4) independent investments from which to choose. The company has Rs. 10 million available for capital investment during the current period. Which projects should the company choose?

Projects Investment requiredRs. Mn

Present value of InflowsRs. Mn

Net Present value

Profitability Index (PI)

Ranking as per PI

P 5 5.6 0.6 1.12 3Q 3 3.5 0.5 1.17 2R 6 6.2 0.2 1.03 4S 2 2.4 0.4 1.20 1

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COM 4310 22

Weighted average cost of capital (WACC)

Most companies are likely to be financed by a

combination of debt and equity capital. The overall

cost of capital is also called as weighted average

cost of capital.

WACC = (% of Debt capital x cost of debt) + (% of Equity capital x cost of

equity)

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Example…..

Assume that after tax cost of debt capital is 8% and the required rate of return on equity capital is 12% and the company intends to maintain a capital structure of 40% debt and 60% equity. The overall cost of capital for the company is calculated as ,

(8% x 40%) + (12% x 60%) = 10.4%

Can we use the WACC as the discount rate to calculate a project’s NPV ?

Yes , provided that the project is of equivalent risk to the firm’s existing assets and firm intends to maintain its target capital structure.

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