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CHAPTER 3

CAPITAL INVESTMENT
APPRAISAL
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Investment Appraisal
A means of assessing whether an investment project is
worthwhile or not
Investment project could be the purchase of a new PC for a
small firm, a new piece of equipment in a manufacturing
plant, a whole new factory, etc
Used in both public and private sector
As investments involve large resources, wrong investment
decisions are very expensive to correct
Managers are responsible for comparing and evaluating
alternative projects so as to allocate limited resources and
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maximize the firms wealth

Investment appraisal methods

Considering the time value of


money concept

Net present value


Internal rate of return

Ignoring the time value of


money concept

Payback period
Accounting rate of return

Payback period

Payback period
Payback period is the period of time it takes
for a company to recover its initial
investment in a project
The method measures the time required for
a projects cash flow to equalize the initial
investment

Acceptance criterion
< predetermined cutoff period Accept the project
> Predetermined cutoff period Reject the project

Example

A company is considering making the following mutually exclusive


Investments in the production facilities for the new products with
an Estimated useful life of four years. The cash inflow and
outflows are Listed as follows:
Project A
$
900000

Project B
$
1000000

Initial investment
Cash inflow at the end of year
Year 1
700000
600000
Year 2
100000
400000
Year 3
100000
400000
Year 4
1300000
400000
Project A : 3 years
Project B: 2 years
Project B takes only two years to recover its initial investment. With
The shortest payback period, the company will accept project B

Advantages of payback period


Easy to adopt
Facilities further evaluation

After obtaining an acceptable payback period,


the project will be evaluated by other financial
capital budgeting techniques

Disadvantages of Payback period


Ignore the cash flows after payback period
Adopt an arbitrary standard for the payback
period
Ignores the timing of cash flow

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Discounted payback period


The payback period method is criticized for
ignoring the timing of cash flows, therefore
discounted cash flows are used to calculate
the discounted payback period

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Example

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A company is considering making the following mutually exclusive


investments in the production facilities for the new products with an
estimated useful life of four years. The cash inflow and outflows are
listed as follows:
Project A

Project B

900000

1000000

Year 1

700000

600000

Year 2

100000

400000

Year 3

100000

400000

Year 4

1300000

400000

Initial investment
Cash inflow at the end of year

Discount cash inflow (20%)

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Project A
$
900000

Project B
$
1000000

Initial investment
Discounted cash flow
Year 1
700000 = 583333
400000 = 500000
1.21
1.21
Year 2
100000 = 69444
400000 = 277778
1.22
1.22
Year 3
100000 = 57870
400000
= 231481
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3
1.2
1.2
Year 4
100000 = 626929 400000 = 192901
1.24
1.24
Discount payback period
Project A
3+ 900000-710647 = 3.3 years
626929
Project B

2+ 100000-777778 = 2.96 years


231481

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Accounting rate of return

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Accounting rate of return


The accounting rate of return compares the
average accounting profit with the average
investment cost of project
The accounting profit can be expressed
either before tax or after tax

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Calculation procedures
Average net profit per year (over the life of the project)
ARR =
Average investment cost
Total profit
Average net profit per year = No. of life of the project
Initial investment
Average investment cost =
2

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Acceptance criterion
In evaluating an investment project, the ARR of the project is
compared with a predetermined minimum acceptable accounting
Rate of return:

ARRs
< minimum acceptable rate
= minimum acceptable rate
> minimum acceptable rate
Highest

Comments
Reject project
Accept project
Accept project
Choose highest ARR
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Example

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A company is considering whether to buy specialized machines


For a new production line. The purchase price of machinery is
$400000 and its estimated useful life is four years. There is no scrap
Value after four years
The project income statements:
Year1
Year 2
Year 3
Year 4
$
$
$
$
Revenue
310000
280000
280000
310000
Depreciation 10000
100000
100000
100000
Other expenses150000
100000
110000120000
Profit before tax 60000
80000
70000
90000
Taxation (15%) 9000
12000
10500
13500
51000
68000
59500
76500
Should the company buy the new machinery if the minimum acceptable
Rate of return is 20%?
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51000+68000+59500+76500 = $63750
Average net income =
4
400000+0
= $200000
Average investment =
2
The cost of machinery is $400000 at the beginning
The cost of machinery is $0 at the end as depreciation is provided
On straight line method and there is no scrap value

$63750
ARR = $200000 = 31.875%
Since the ARR is 31.875%, which is higher than the minimum
Acceptable rate of 20%, the company should invest in the new
machinery.

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Advantages of ARR
It is easy to understand and compute
It avoids using gross figures. Therefore, it
enables comparisons to be made between
projects with different useful lives

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Disadvantages of ARR
It ignores the time value of money
ARR method seems to be less reliable than
the NPV method. It adopts the accounting
profit instead of cash flows calculation. The
change of depreciation method may also
alter the accounting profit

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Net present value method

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Net present value method


Net present value (NPV) method is a process that
uses the discounted cash flow of a project to
determine whether the rate of return on that
project is equal to, higher than, or lower than the
desired rate of return
With the NPV method, we can compare the return
on investment in capital projects with the return on
an alternative equal risk investment in securities
traded in financial market
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Calculation procedures
Determining the discount rate
2. Calculating the NPV:
1.

FV1
FV2
+
NPV = (1+r)1
(1+r)2

FV3
(1+r)3

FVn
(1+r)n - I0

where FV = future value of an investment


n = no. of years
r = Rate of return available on an equivalent risk
security in the financial market
I 0= initial investment
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3. Interpreting the NPV derived as follows:


NPVs Comments
Reasons

<0

Reject the project

The rate of return from the project is


small than the rate of return from an
equivalent risk investment

=0

Indifferent to accept
or reject the project

The rate of return from the project is


equal to the rate of return from an
equivalent risk investment

>0

Accept the project

The rate of return from the project is


greater than the rate of return from an
equivalent risk investment

Highest Accept the project

If various project are considered, the


project with highest positive NPV
should be chosen
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Example

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A company is considering making several investments in the


Production facilities for the new products with an estimated useful
Life of four years. The cash inflows and outflows are listed as follows:
Project
A
B
C
D
$
$
$
$
Initial investment
900000
1000000
303730 1500000
Cash inflow
Year 1
120000
400000
100000 10000
Year 2
250000
400000
100000 10000
Year 3
400000
400000
100000 1000000
Year 4
1300000
400000
100000 1000000
The appropriate discount rate of these investment is 12%

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Required:
(a) Calculate the NPV of each investment and determine whether
to accept it or not (assuming the company has unlimited
resources)
(b) If the company has limited resources, determine which
investment should be accepted by referring to the highest NPV

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(a)

Project A
120000
250000
400000
1300000
+
+
+
NPV = 1.12
2
3
1.12
1.12
1.124 - 900000
= $517327 (accepting)
Project B
40000
NPV = 1.12

400000
+
1.122

400000
400000
+
+
3
1.12
1.124 - 1000000

= $214920(accepting)

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(a)

Project C
100000
100000
100000
100000
+
+
+
NPV = 1.12
2
3
1.12
1.12
1.124 - 303730
= $0 (indifferent to accept or reject)
Project D
10000
NPV = 1.12

10000
+
1.122

1000000
1000000
+
+
3
1.12
1.124 - 1500000

= -$135801(rejecting)
(b) With limited resources, the company should only accept project A
because it generates the highest NPV

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Advantages of NPV
Consistency with the time value of money
concept
Consideration of all cash flows
Adoption of cash flows instead of
accounting profit

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Internal rate of return

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Internal rate of return


The internal rate of return is the annual percentage
return achieved by a project, of which the sum of
discounted cash inflow over the life of the project
is equal to the sum of discounted cash outflows
If the IRR is used to determine the NPV of a
project, the NPV will be zero.
The company will accept this project only if the
IRR is equal to or higher than the minimum rate of
return or the cost of capital
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Calculation procedures
1.

By trial and error, find out the discount rate that


will give a zero NPV
FV1
FV2
FV3
NPV = (1+r)1 + (1+r)2 + (1+r)3 +
where FV = future value of an investment
n = no. of years
r = internal rate of return
I 0= initial investment

2.

FVn
(1+r)n - I0 = 0

If the NPV is positive, try a higher discount rate in


order to give a negative NPV and vice versa
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3.

After getting one positive NPV and one


negative NPV, use interpolation to find
out the rate giving zero NPV
P
IRR = L +
(H L)
PN
Where L = Discount rate of the low trial
H = Discount rate of the high trial
P = NPV of cash flows of the low trial
N = NPV of cash flows of the high trial
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4.

In evaluating an investment project, the


IRR is compared with the managements
predetermined rate

IRRs

Comments Reasons

< lowest acceptable level of return Reject

NPV<0

= lowest acceptable level of return Accept

NPV=0

> Lowest accepted level of return

Accept

NPV>0

Highest

Accept

If several project are


considered, the
highest IRR should
be chosen
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Example

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A project costs $400 and produces a regular cash inflow of $200 at


the end of each of the next three years. Calculate the IRR. If the
minimum rate of return is 15 %, suggest with reason whether you
Should accept the project or not.
$200
$200
NPV = (1+r)1 + (1+r)2

$200
+
(1+r)3

Assuming the discount rate is 22%


$200
$200
$200
+
+
NPV = 1.22
1.222
1.223
Assuming the discount rate is 24%
$200
$200
$200
NPV = 1.24 + 1.242 + 1.243

- $400 = 0

- $400 = 8.4

- $400 = -3.8

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P
IRR = L +
(H L)
PN
Where L = Discount rate of the low trial
H = Discount rate of the high trial
P = NPV of cash flows of the low trial
N = NPV of cash flows of the high trial
IRR = 22% +

8.4
(24 22)%
8.4 (-3.8)

= 23.38%
Since the IRR (23.38%) is higher than the minimum rate of return (15%),
The project should be accepted
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