Investment appraisal can be described as the decision-making process used by organisations to evaluate different investments and to decide which fixed assets to purchase. Evaluate the different methods of capital investment appraisal available to organisations and clearly show when each method would be used (if at all) illustrating your answer with relevant examples.
Decisions about buying a new machine, building a factory, extending a warehouse, improving a delivery service, instituting a staff training scheme or launching a new product line are all examples of the investment decisions that may be made in the industry. In order to help in making such decisions, and to ensure that they are consistent with each other, a common method of appraisal is required which can be applied equal to the whole spectrum of investment decisions and which should, in terms of the decision structure so far outlined, help to decide whether any particular investment will assist the company in maximizing shareholder wealth.
Almost all investment decisions will involve making forecasts/estimates/guesses about the investment's future performance, and appraisal techniques are applied to the numbers that emerge from that process. The future is, almost without exception, uncertain and so any investment appraisal technique can only produce "advice" based on these forecasts and not a decision that is guaranteed to turn out to be optimal given hindsight. In the following, four different methods of investment appraisal shall be discussed: accounting rate of return (ARR), payback period, net present value (NPV) and internal rate of return (IRR).
Cash Flow
Net Present Value
Investment Appraisal
Payback Period
Profitability Index
Accounting Rate of Return
Internal Rate of Return
What is the payback period of each project ? If AP Ltd imposes a 3 year maximum pay back period which of these projects should be accepted?
The payback period calculates how long it will take to recover the initial cash outflow of the investment. Organisations can set a target payback period or compare the payback periods. By choosing the investment with the shortest payback period, the risk is minimised. Mainly the payback period is considered for two reasons, one for decision making whether it might be accepted or rejected and the other for ranking the projects in that ,which projects is faster paying back period should be selected..
In AP Ltd there are two projects such as A and B. By using payback period method we can choose which project should be accepted.
Calculation: (all the values expressed should be in thousands)
Project A
Year Cash flow
Cash flows
Cumulative
0
(110000)
(110000)
1
20000
20000
2
30000
50000
3
40000
90000
4
50000
140000
5
70000
210000
In the first year the cash saving is same so it's 20000 itself. But for getting the second year cumulative cash saving we should add the first and second year cash saving, i.e 20000+30000 will give 50000 and so on. Our capital investment is £110000.From the table we can clearly see that the capital is lies between the years 3 and 4.but don't know actual period for that further calculations has to be done.
Payback period = 3yrs + 20000
50000
= 3yrs+ ( 0.4 * 12)
= 3yrs and 4 months 24 days
The capital investment is more than 3rd year and less than 4th year, so we must add something to the year 3, and next we must first look how much more must need from 3rd year, in this project 20000 more is needed from 90000 to reach 110000 and so put it as in numerator and that 20000 is get from the 50000 in the 4th year, so that the value in the denominator. By solving we will get the pay period. So for project A the payback period is 3.4years.
Project B
Project B
Year
Cash flow
Cumulative
0
(110000)
(110000)
1
40000
40000
2
40000
80000
3
40000
120000
4
40000
160000
5
40000
200000
The calculation is same as above. The only difference is in the project B is annuity means the cash flow in the project for all the period will be same.
Payback period = 2yrs+ 30000
40000
=2yrs+0.75 * 12
=2years and 9 months
Alternative method (only for annuity):
Payback period =Initial Investment / Actual Cash Flow
=110000/40000
=2.9 years
So the payback period of two projects has been got. The next question will be which one should be selected and also the AP Ltd should get there return in 3 years time, in that point of view we can only accept Project B because it will be return in just 2.9years which is less that 3years and also the payback period of Project A is greater than 3years so B is accepted.
What are the criticisms of the payback period?
Payback period for a capital investment is the length of time before the cumulated stream of forecasted cash flows equal to initial investment .If a project payback period is less than or equal to predetermined threshold figure it is acceptable .
DRAWBACK OF PAYBACK:
The drawback of payback period is that it makes no allowance for the time value of money. The time value of money means that the given sum of money has a different value depending upon when it occurs in time.
If the payback method does not make any allowance for the time value of money its emphasis on the speed of return being purely a consideration of project risk. It ignores the need to compare future cash flows with the initial investment after they had been discounted to their present values. The payback decision rule is too doubtful to give conclusive ruling. The receipts beyond the payback period are ignored. The arbitrary selection of the cut-off point. There is no theoretical basis for setting the appropriate time period and no guesswork. The payback decision is concentrated purely on the cash flows that arise within the payback period, and flows that arise outside this period are ignored.
Determine the NPV for each of these projects? Should they be accepted - explain why?
The main point in calculating NPV is that from that NPV we can identify the expected gain or loss of an industry in a certain discount rates. If the NPV value is positive then it represents gain and if it is negative it represents the loss. In another case, if the value is zero then there is no gain and loss.
In AP Ltd.there are two projects A and Brno we are going to calculate NPV for both the projects and from that we can take the decision which project can be selected.
Calculations. (All the term expressed is in thousands.)
Project A
YEAR
CASH FLOW
DISCOUNT FACTOR (12%)
PRESENT VALUE
0
(110000)
1
1
20000
0.893
17860
2
30000
0.797
23910
3
40000
0.712
28480
4
50000
0.636
31800
5
70000
0.567
39690
TOTAL 141740
LESS INITIAL INVESTMENT 110000
Npv@12%=present value of cash inflows - present value of cash outflows
NPV at 12% = 141740-110000= £ 31740
The NPV of project A is calculated. To get the present value of each year just multiply the corresponding cash flow of the year and their discount rates. After that calculate the net present value, from that net present value deduct the initial investment (cash inflow) we get the NPV.Thats NPV is known as the difference of the cash inflow and cash outflow.
Project B
YEAR
CASH FLOW
DISCOUNT FACTOR (12%)
PRESENT VALUE
1
40
0.893
35720
2
40
0.797
31880
3
40
0.712
28480
4
40
0.636
25440
5
40
0.567
22680
TOTAL 144200
LESS INITIAL INVESTMENT 110000
NPV at 12% = 144200-110000= £ 34,200
The calculation is same as that of Project A. In this case, in both project the NPV value is positive. So we can accept any of the projects .But we always take into account for larger NPV.So here Project B is accepted than Project A.
Describe the logic behind the NPV approach?
NPV is the sum of the present values of a project's cash flow. It accounts for time value of money and the project risk by using the correct discount rate and measures the net increase or decrease in the firm value today due to project. The decision rule is to accept projects that have a positive NPV and reject the project which has negative NPV.NPV is superior to others methods of analysis present in the text because it has no serious flaws. This is the main reason why NPV is approached in AP Ltd projects.
We use NPV to find which project is better for the company. When NPV is calculated for both the projects, the NPV at 12% for project A is 31,740 where the NPV at 12% for project B is 34,000 which tell that the cash flow is higher in Project B. So project B is considered as the best project which has more cash flow than project A and recommend the company to go ahead with project B. The approach of NPV is highly required for this projects to find the difference in cash flow and NPV highly supports in finding the better one.
Advantages:
1. NPV is the most logical method to enhance shareholders value as it considers the economic profit concept.
2. NPV is flexible, simple to understand and able to cope with much complexity.
3. Moreover it takes the risk of the investments into account through the choice of cost of capital or discount rate. The greater the risk so the cost of capital is getting higher.
4. It considers the whole of the economic life of the investment, not just the number of years.
5. Focuses on cash flow and not simply on accounting profit.
Drawbacks:
NPV relies on cash flow and discount rate values that are often estimates and not certain.
What would happen to the NPV if:
The cost of capital increased?
The cost of capital decreased?
1. When the required rate of return is increased, there will also be an increase in the NPV. The main reason for this is the required rate of return that is when the cost of capital increases there seems to be a high cash flow in that particular project in a particular year. So automatically because of the cash flow the NPV increases.
2. When the required rate of return in decreased the NPV decreases, because the cost of capital or the required rate of return is not having a sufficient cash flow therefore it automatically leads NPV to come down.
Therefore to have a good net present value the initial cost of capital must be high which the required rate of return is increased where there is a constant increase in the NPV.
In these projects of the AP Ltdthe cash flow has too much of difference in project A and project B. In project A its 20,30,40,50,60,and 70 even when there is a increase of cash flow every year it has never remained constant but where as in project B the cash flow is 40 for every year even though there is no increase in the cash flow every year but it remains constant which is more sufficient for the project.
Determine the IRR for each project. Should they be accepted?
In this method of investment appraisal, we are finding the cost of capital where the NPV is zero. Now we can have a look at how the IRR is calculated in AP Ltd. Which have two projects A and B.?
Calculation:
Project A
We already find out the,
NPV at 12% = £ 31740
Absolutely this is a positive value, but in IRR we are finding the percentage where the NPV is zero. So we can't find it directly, for that we need a negative NPV value also. As the cost of capital increases the NPV will fall to a negative value. So assume a bigger cost of capital and find a negative NPV.Based on that we can conclude that the IRR should be somewhere between the two cost of capital. By looking through the calculation we can clearly understand what we are saying about.
In this Project we are assuming a cost of capital of 20%
First of all we have to know discount rates of this particular cost of capital; it will vary in each year.
So now we can find out the NPV at 20%.( all the values are in thousands)
YEAR
CASH FLOW
DISCOUNT FACTOR (20%)
PRESENT VALUE
1
20000
0. 833
16660
2
30000
0. 694
20820
3
40000
0.579
23160
4
50000
0.482
24100
5
70000
0.402
28140
TOTAL 112880-
LESS INITIAL INVESTMENT 110000
( 2880)
So NPV at 20% is (2880) is a negative value.
A general format to find the IRR is that,
IRR= Lowest discount rates + NPV at lower rate * Difference in rates
Difference between the NPV`s
IRR= 12% + 31740 / (31740-2880)*20-12=20.798%
So in project A NPV is zero at the cost of capital 20.798%.
Project B
NPV at 12% = £34200
In this also we are assuming a cost of capital of 20%.The method of calculation is as above.
(All values are in thousands)
YEAR
CASH FLOW
DISCOUNT FACTOR (20%)
PRESENT VALUE
1
40
0. 833
33320
2
40
0. 694
27760
3
40
0.579
23160
4
40
0.482
19280
5
40
0.402
16080
TOTAL 119600-
LESS INITIAL INVESTMENT 110000
(9600)
So NPV at 20% is (9600 )
A general format to find the IRR is that,
IRR=Lowest discount rates + NPV at lower rate * Difference in rates
Difference between the NPV`s
IRR= 12% + 34200/ (34200-9600)*20-12 = 21.12%
So in project A NPV is zero at the cost of capital 21.12%.
In this projects, both the IRR`s are greater than the given cost of capital so we can accept both the project. Among the we always accept the project having higher IRR. So here also Project B is accepted.
How does a change in the cost of capital affect the project's IRR?
As we seen yet, the IRR and required rate of return is mutually related. If any change takes place in cost of capital then it will surely affect the project`s IRR.IRR is mainly used as a decision making unit in investment appraisal and we know IRR is the cost of capital where the NPV is zero. The main point in this is that how we can decide where the IRR is acceptable or not.
If the IRR is greater than the cost of capital of the project then that project is acceptable.
If the IRR is less than that of the cost of capital of the project then the project is rejected.
And if IRR equals the cost of the capital of the project then also the project is acceptable, because the owner will return what he invested in the project.
From these concept the IRR is used as a decision making. In this case we have two projects A and B.In both these projects the required rate of return is 12%.As per the formula of IRR its clear that if the required rate of return increases IRR will also increases and if it lowers IRR will also decrease.
IRR= Lowest discount rates + NPV at lower rate * Difference in rates
Difference between the NPV`s
Here the required rate of return (12%) is used as the lowest discount rate. So the change in the required rate of return will automatically affect the IRR.
Why is the NPV method often regarded to be superior to the IRR method?
In a single-period world we have see that both the NPV and IRR decision rules will give the same, correct decision advice (even if some fairly complex adjustments sometimes have to be made to the IRR rule).
Both methods should enable a company to locate optimally on its physical investment line. However, problems can occur for the IRR decision rule once this two-dimensional world is left behind.
Average and marginal rates of return
As soon as the assumption of a single time period is explicitly relaxed, we get new support for the rationale of the NPV approach and a new perspective from which to view the "reinvestment" assumption. We can see the examples below and understand easily what we talking.
E.g.:
Image a project(N) and his castles are given below. In this case, the annual market interest/discount rate is expected to be 10% over the coming year and 15% over the following year.
Project N:
Year Cash flow (£) Discount factor
0 -100 x 1 = -100
1 +60 x (1.10)-1 = +54.55
2 +60 x (1.10)-1 x (1.15)-1 = +47.43
NPV= +1.98
The IRR of Project is approximately 13%.
We can see that Project N's NPV is positive after its cash flows have been discounted by the appropriate market discount rate for each time period.
What about the IRR rule of Project N? If its IRR is greater than the decision criterion, Project should be accepted. But we can easily see in the example that IRR of N is greater than the market interest rate in one period, and less than the rate in the other period. So, a single-figure IRR is just not valid for decision making purposes.
Multiple IRRs
Another problem for the IRR decision rule, which arises out of the mathematics of its computation, comes to light when the investment time horizon is extended. Any particular investment project may have more than one internal rate of return ( there may be more than one rate of discount which will reduce the project's cash flow to a zero NPV), or it may not have any IRR at all. This uncommon but important phenomenon can be examined in terms of the NPV profiles of projects on the basis that the IRR is given by the point at which the profile line cuts the graph's horizontal axis.
We should define what have become known as 'conventional' and 'non-conventional' cash flows. A conventional cash flow is one where a cash outflow, or a series of cash outflows, is followed by a cash inflow or series of cash inflows. The essence of the definition is that in a conventional cash flow, there is only one change in sign(+,-) between the time periods. All three cash flows given below are therefore conventional:
E.g.:
Years 0 1 2 3 4
Projects
A -2000 +800 +1000 +1600 +100
B -2000 -1000 -1200 +3000 +4000
C -1000 -1200 +4000
The one change of sign for Project A comes between year 0 and year 1, for Project B it comes between year 2 and year 3, and for Project C it comes between year 0 and year 1.
Non-conventional cash flows can therefore be defined as those which involve more than one change in sign, such as shown below:
E.g.:
Years 0 1 2 3 4
Projects
D -50 +10 -25 +40 +85 3 changes of sign
E -50 +30 +40 -10 2 changes of sign
In sum, our analysis puts forward a very strong case for the use of the NPV decision rule for investment appraisal. At best, the IRR method might be used as a support and as a communication device on the basis of management's familiarity with rates of return, rather than net present values, for the decision advice given by the NPV rule. NPV technique will be approach that should be used by companies in making investment appraisals. It is the only technique from the four investigated that can be relied upon to give advice that will lead towards the maximizing of shareholder wealth.
Conclusion:
This report has now explained the investment appraisal techniques of payback, ARR, IRR and NPV. The benefit and limitation of each have been discussed individually. Furthermore other factors and which method to choose-why and the calculation regarding the projects we were given above have been examined. In the above report, we have seen SAP Ltd. `s projects A and B. We have applied the concept of investment appraisal for both the projects. In the NPV method, Project B has greater NPV.So it can be accepted for the business. In the IRR also Project B is acceptable because it has greater rate. So in both the methods project B is acceptable than A. So Project B is acceptable.
