Investment Appraisal Methods | My Assignment Tutor

24/02/20201LO 2: Investment AppraisalMethodsDr Fidelis AkangaLearning outcomesBy the end of this unit Explain capital investment decision andInvestment appraisal methods Apply the main investment appraisalmethods Understand and discuss the strengths andweaknesses of these methods24/02/20202Principal Assumptions Cash inflows and outflows are known with certainty Sufficient funds available to enable acceptance of allprojects with positive NPV Firms operate in environments with no taxes and noinflation Cost of capital is risk freeCapital Investment AppraisalDefinition of Capital Investment appraisal Capital Investment appraisal is an application of a setof quantitative methods used by managers to makedecisions on how to best invest funds in the long term(Weetman, 2010:261)24/02/20203Types of capital investment Replacement of obsolete assets Cost reduction e.g. IT system Expansion e.g. new building & equipment Strategic proposal: improve delivery service, stafftraining. Diversification for risk reduction Research and DevelopmentNeed for Investment Appraisal Large amount of resources are involved and wrongdecisions could be costly Difficult and expensive to reverse Investment decisions can have a direct impact on theability of the organisation to meet its objectives24/02/20204Investment Appraisal ProcessStages: Identify objectives. What is it? Within the corporateobjectives? Identify alternatives. Collect and analyse data. Examine the technical andeconomic feasibility of the project, cash flows etc. Decide which one to undertake Authorisation and implementation Review and monitor: learn from its experience andtry to improve future decision – making.Investment Appraisal MethodsProposedCapitalProject2.AccountingRate ofReturn1. Payback4. InternalRate ofReturn3. Net PresentValue5.ProfitabilityIndex24/02/20205Investment Appraisal Methods1. Payback period This is the length of time it takes to repay the costof initial investment In case where there are competing projects, theone with the shorter payback period should beacceptedPayback period We can approach payback in two ways; Equation method (for uniform cash flows) Cumulative method (uniform & non uniformcash flows)24/02/20206Payback period In the case of uniform cash flows, paybackperiod can be calculated as:Net initial investmentUniform increase in annual cash flows Then multiply the remainder (decimal) by 12to get number of monthsPayback periodExample 1LBS Ltd uses the payback period as its soleinvestment appraisal method. LBS invests£30,000 to replace its computers and thisinvestment returns £9,000 annually for thefive years. From the information aboveevaluate the investment using the payback.Assume that £9,000 accrues evenlythroughout the year.24/02/20207Payback periodSolution:= 30,0009,000= 3.33330.333x x12 = 3.996 approx 4= 3 years, 4 monthsPayback period Example 2: Cumulative method ABC invests in an investment of £6.2m. Cashflows is as follows: YearCash flow (£)11,200,00022,200,00032,500,00041,700,000 24/02/20208Example 2 SolutionAfter year 3, we stillhave a balance of£300,000 tocomplete payment.So we divide thisbalance by year 4cash flow andmultiply by 12.= 300,0001,700,000= 0.176 x 12 = 2 YearCash flow (£)Cumulativecash flow (£)0(6,200,000)11,200,0001,200,00022,200,0003,400,00032,500,0005,900,00041,700,0007,600,000 Payback period = 3 years, 2 monthsAdvantages of payback• Simple to calculate and understand• Focuses on project’s cash flows rather than accountingprofits. Hence more objectively based• Favours projects with short/quick payback periods. Thistends to minimise risk and may also produce fastergrowth for the company Once the relevant cash flows are calculated, payback iseasy to apply and to explain to management Capital rationing: -it ensures the recycling of cash intonew projects with the least delay.24/02/20209Disadvantages of payback periodmethod Method ignores time value of money Ignores cash flows after the payback periodInvestment Appraisal Methods2. Accounting Rate of Return (ARR) This method takes the average accounting profit whichthe investment will generate and expresses it as apercentage of the original investment or the average ofinitial investment in the project as a measure of aproject’s profitability (or viability). ARR = Average Annual Profit * 100%Original Investment in Project Where there is a scrap value at the end of the useful lifeof the project,24/02/202010Accounting Rate of Return (ARR)Accounting Rate of Return (ARR) In assessing individual project, it is normal forcompanies to have a minimum ARR below whichinvestment will not be undertaken. The minimum could be a rate which previousinvestments have achieved, or it could be anindustry average. Where there are competing projects, the one withthe higher or highest ARR would be accepted.24/02/202011Accounting Rate of Return (ARR)Accounting Rate of Return (ARR)Solution to Example 3.Average Accounting Profit =(- 250 +1000 + 1000 + 20,750) / 4 = 5625Original investment = 45,000ARR = (5625/45000) * 100 = 12.5%24/02/202012Accounting Rate of Return (ARR)Advantages of ARR It is quick and simple to calculate It involves a familiar concept of a percentage return Accounting profits can be easily calculated from financialstatementsDisadvantages of ARR Based accounting profits rather than cash flows, whichare subject to a number of different accounting policies. It does not take into account of the length of the project It ignores the time value of moneyInvestment Appraisal MethodsDiscounted Cash flow (DCF) methods Net Present Value (NPV) Internal Rate of Return Both use cash flow (rather than accountingprofits) Cash-flows covering the whole life of the projectare taken into account; Both take into account time value of money24/02/202013Discounted Cash flow (DCF)methods DCF methods operate on the principle that moneyreceived or paid at different times cannot be compareddirectly. Rather they need to discounted (or reduced) to equivalentpresent values before any comparison can be made. Note: time value of money concept still applies even ifthere is no inflation (i.e. inflation rate 0%). The presence of inflation simply increases thediscrepancy in values of monies received or paid atdifferent times.Discounted Cash flow (DCF)methods DCF methods operate on the principle that moneyreceived or paid at different times cannot be compareddirectly. Rather they need to discounted (or reduced) to equivalentpresent values before any comparison can be made. Note: time value of money concept still applies even ifthere is no inflation (i.e. inflation rate 0%). The presence of inflation simply increases thediscrepancy in values of monies received or paid atdifferent times.24/02/202014Discounted Cash flow (DCF)methods1. Net Present Value (NPV) Present value:- the amount of money you must invest orlend at the present time so as to end up with aparticular amount of money in the future. Discounting: -finding the present value of a future cashflow Net Present Value (NPV) – the difference between thepresent values of cash inflows and outflows of aninvestment Opportunity cost of undertaking the investment is thealternative of earning interest rate in the financialmarket.Net Present Value (NPV) Net Present Value of an Investment is the presentvalue of all its present and future cash flows,discounted at the opportunity cost of those cashflows. In case of competing projects, the project withHighest NPV is accepted NPV calculations can be approached in two ways; Summation method Columnar method24/02/202015Net Present Value (NPV)Net Present Value (NPV)Example 4 A company can purchase a machine at the price of£2200. The machine has a productive life of threeyears and the net additions to cash inflows at theend of each of the three years are £770, £968 and£1331. The company can buy the machine withouthaving to borrow and the best alternative isinvestment elsewhere at an interest rate of 10%.Evaluate the project using the NPV method24/02/202016Net Present Value (NPV)Discounted Cash flow (DCF)methods2. Internal rate of Return (IRR) Internal Rate of Return – is the discount ratethat equates the present values of aninvestment’s cash inflows and outflows. Internal Rate of Return (IRR) – is the discountrate that causes/brings an investment’s NPVto be zero24/02/202017Internal Rate of Return (IRR)Internal Rate of Return (IRR)Example 5 A company can purchase a machine at the price of£2200. The machine has a productive life of threeyears and the net additions to cash inflows at theend of each of the three years are £770, £968 and£1331. The company can buy the machine withouthaving to borrow and the best alternative isinvestment elsewhere at an interest rate of 10%.Evaluate the project using the IRR method24/02/202018Internal Rate of Return (IRR)Solution to Example 5IRR Try 15%Year Cash flow Discount DiscountedPV Factor (15%) Cash flow0 (2200) 1.000 (2200)1 770 0.8696 669.592 968 0.7561 731.903 1331 0.6575 875.13NPV 76.62Internal Rate of Return (IRR)• 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 36.0124/02/202019Internal Rate of Return (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)Internal Rate of Return (IRR)Using the formula above the IRR canbe computed as follows.15+(76.62/76.62- – 4.86)x(17-15)15+(76.62/81.48)x(2)15+(0.940353461)x2= 16.88%24/02/202020Investment Appraisal Method3. Profitability Index The Profitability Index (PI) is based on thecomparison of the net present value of the cashflow with the amount of the original investment. It is, therefore, a measure of the increase in thecapital sum that the net present valuerepresents. Projects are thus ranked in order of profitability.Profitability Index The profitability index is calculated in the followingmanner: Present value of cash flows = profitability indexOriginal amount invested (PI)The index shows the return (in Present Value terms)per each of £1 of original investment.24/02/202021Profitability IndexThus, the higher the profitability index, thehigher the return earned on the project. The lower the profitability index, the lessprofitable the project; And if the index falls below 1, this means thatthe project has failed to meet the requiredrate of return.Profitability IndexExample 6.We have 3 Projects : ABCCostPV of Cash-flows@ 10%100,00050,000200,000110,99363,444214,450NPVProfitability Index(110,993/100,000)10,9931.11013,4441.26914,4501.072 Thus, although all 3 projects have positive NPVs, project B provides abetter return for each £ invested.24/02/202022Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 13.

QUALITY: 100% ORIGINAL PAPER – NO PLAGIARISM – CUSTOM PAPER

Leave a Reply

Your email address will not be published. Required fields are marked *