Created by: S.

Ashby
 This is defined as the purchase of capital goods
that is, goods used to produce other goods
and services. In other words, it includes the
expenditure by businesses or people on items
which are used to produce goods and services
in the future, such as equipment and buildings.
 For Expansion of productivity capacity

Purchasing modernised equipment

Replacing obsolete assets

To foster automation of the company

For expansion of the firm itself through

mergers or joint ventures.
 This is a quantitative technique used by firms
to assess the attractiveness and viability of
different capital projects. It describes how
businesses compare and evaluate investment
projects in order to ascertain whether or not
they will be profitable.
 Since these projects are usually funded by large
amounts of expenditure, which cannot easily
be reversed, care must be taken in making such
decisions. In doing so, firms will consider the
initial costs, expected benefits and costs, risk
involved and possible alternatives.
 Payback Period

Average Rate of Return

Net Present value

Internal Rate of Return

 Payback Period is the time that cash inflows
from a capital investment will take to be equal
with the initial outflow of funds. Firms will
normally invest in the project that takes the
shortest time to be repaid that is, the shortest
payback period. This is calculated as follows:

Amount required X 12
Net cash flow per year
 The initial capital outlay for Project A is
$30,000.00 and it is expected that the project
will earn $15,000.00 annually: The payback
period would be equal to:

A) 12 months
B) 2 years
C) 36 months
D) 48 months
 Amount required X 12
Net cash flow per year

= 30,000 X 12 = 24 months or 2 years

15,000
PAYBACK MAY BE CALCULATED IN
A TABULAR FORMAT SEE NEXT SLIDE

KEP Industry is KEP Industry is

thinking of investing in
a new machine, at a cost
of $35,000.00 It is
expected that the
machine will generate
cash inflows of
$10,000.00 and has an
expected life of five
years. Calculate the
payback period.
analysing two
investment options in
an attempt to make a
decision on which one
to invest in. Table 17.1
shows the initial capital
outlay and the annual
cash inflow that each
project is expected to
return.
 Years Annual Cumu- Annual Cumu-
Year Project Project Cash lative Cash lative
A B Flow Cash Flow Cash
Flow Flow
Initial 0 (15,000) (15,000)
investment 0 (15,000) (15,000) (15,000) (15,000)
cash Flow
1 5,000 -10,000 1,500 -13,500
1 5,000 1,500
2 3,500 -6,500 3,000 -10,500
2 3,500 3,000
3 3,000 -3,500 5,000 -5,500
3 3,000 5,000
4 2,500 -1,000 6,000 500
4 2,500 6,000
5 1,000 Nil 6,500 7,000
5 1,000 6,500

Table 17.1: KEP Industry initial capital outlays and annual cash inflows
 Year 0 represents the time when the investment
would be made, while Year 1 means one year
after the investment.

The brackets represent cash outflow

Columns 3 and 5 show the balance at the end

of each year
 Note that Project A would be paid for in Year
5, while Project B would be paid back within
four years.

To calculate the months for Project B, express

the remaining balance as a fraction of the total
outflow for the year and multiply by 12. In
Year 4 only $5,500 remained on the initial
outlay, however, inflow was $6,000. The
calculation is:
 5,500 X 12 = 11 months
6,000

Therefore Project B has a payback period of 3

years 11 months, compared with 5 years for
Project A, and so will be chosen.
ADVANTAGES
Projects that are paid back quickly
can improve the firms growth
and liquidity
Payback is easy to calculate and
interpret
It is said to be more objective since
its focus is on the projects cash
flow rather than on profitability
A project which has a quick
payback period minimises time-
related risks for example, a
decrease in the value of money.
DISADVANTAGES
Payback is mostly a measure
of liquidity and not of the
overall worth of the project
It does not take into account
the expected life of the project.
More than one project may
have the same payback period
even though the annual
inflows are different.
It is not adjusted for the time
value of money.
 Examine the data in Table 17.2 and then answer the
questions that follow.
Calculate the payback period for each of the three
projects below
Which project should be chosen? Give one reason for
your answer.
Year Project A Project B Project C

Initial 0 (30,000) (18,000) (50,000)

Investment
Cash Flow
1 6,500 2,500 15,000
2 7,200 3,100 12,000
3 10,600 5,600 10,550
4 9,800 4,200 9,640
5 10,200 6,900 9,000

Table 17.2: Initial capital outlays and annual cash inflows for three projects.
 Project A Project B Project C

Years Annual Cumulative Annual Cumulative Annual Cumulative

Cash Cash Cash Cash Cash Cash
Flow Flow Flow Flow Flow Flow
0 (30,000) (30,000) (18,000) (18,000) (50,000) (50,000)
1 6,500 -23,500 2,500 -15,500 15,000 -35,000
2 7,200 -16,300 3,100 -12,400 12,000 -23,000
3 10,600 -5,700 5,600 -6,800 10,550 -12,450
4 9,800 4,100 4,200 --2,600 9.640 -2,810
5 10,200 14,300 6,900 4300 9,000 6,190

5700
9800X 12 = 6.97 = 7 months. Payback period is 3 years and 7 months
For Project A (the best choice)
 This is also referred to as accounting rate of
return. It shows the average profit per year
expressed as a percentage of the initial outlay.
This is calculated as follows:

Average return (profit) per annum x 100

Initial investment

Before the calculation is done the following steps

should be taken
1. Calculate the profit from each project. This done by
subtracting the initial capital outlay
from the total cash inflows of the project.

2. Calculate the average profit per annum by

dividing the profit, from step 1 by the
duration of the project.

3. Calculate the ARR with the formula given

on previous slide.

4. After the ARR is arrived at for each project, the

project with the highest percentage is chosen.
 Year Project Project
A B
Capital Outlay 35,000 25,000
Cash inflow 1 6,000 5,000
2 8,000 7,000
3 8,000 8,000
4 10,000 10,000
5 12.000 10,000
Total cash inflow 44,000 40,000

Table17.3: Initial Capital outlays and annual cash

inflows for two projects
 Step 1: Profit:
Project A ($44,000 $35,000 = $9,000)
Project B ($40,000 - $25,000 = $15,000)

Step 2: Average profit per annum:

Project A ($9,000/5) = $1,800
Project B (15,000/5) = $3,000

Step 3: Average rate of return:

Project A 1800 X 100 = 5.14%
35000

Project B 3000 X 100 = 12%

25000

Project B should be chosen, since it has a higher ARR than

that of Project A.
 Year Project A Project B
Capital Outlay 160,000 200,000
Cash inflow 1 15,000 25,900
2 40,000 45,700
3 46,800 66,400
4 62,200 68,900
5 57,500 62,500
Total cash inflow 221,500 269,400

Table17.4: Forecasted data for Projects A and B

1. Calculate the average rate of return for both products

2. State, with reason, which of the two products should be

made.
 Step 1: Profit for each year:
Project A ($221,500 $160,000 = $61,500)
Project B ($269,400 - $200,000 = $69,400)

Step 2: Average profit per annum:

Project A ($61,500/5) = $12,300
Project B (69,400/5) = $13,880

Step 3: Average rate of return:

Project A 12300 X 100 = 7.69%
160,000

Project B 13880 X 100 = 6.94%

200,000
Project A should be chosen, since it has a higher ARR than that
of Project B.
ADVANTAGES
It is easily calculated and
understood
It fosters comparison
between the companys
profitability and the
expected profitability after
the project is implemented
It accounts for all the cash
flows over the life of the
investment.
DISADVANTAGES
The timing of outflows and inflows
of cash is ignored
There are a number of methods for
calculating ARR but none are
universally accepted
Does not take into consideration the
time value of money
The duration of the project is not
considered in its calculation
The average profit, used to calculate
the ARR, may not be representative
of any year.
 This is a technique that takes into account the
time value of money by equating its future
value to what it is worth now. The DCF is
normally used when calculating the NPV and
the internal rate of return. It is evident that
whatever our money is worth now will not be
the same as it will be in the future. In other
words, money will lose its purchasing power,
especially as inflation rises.
 The firm would rather receive money owed to
it now, as deferring payment may mean loss of
revenue if its debtors are unable to pay in the
future and the firm could invest the money
now in order to generate interest.
 Two important features of the DCF are:

Cash flows are used to calculate the return on a

project instead of accounting profit.

The cash flow for each year should be discounted so

that the annual return is representative of the
present value of money.
 The discount factor can be calculated using the
following formula:

1/(1 + r ) n

where

r = interest rate

n = period in number, usually years

(you are not required to calculate this, as it is usually given)
 Interest Rates (c) %
Period 6% 8% 10% 12% 14% 15% 16% 18% 20%
(n)
years
1 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833
2 0.890 0.857 0.826 0.797 0.769 0.756 0.743 0.718 0.694
3 0.840 0.794 0.751 0.712 0.675 0.658 0.641 0.609 0.579
4 0.792 0.735 0.683 0.636 0.592 0.572 0.552 0.516 0.482
5 0.747 0.681 0.621 0.567 0.519 0.497 0.476 0.437 0.402
6 0.705 0.630 0.564 0.507 0.456 0.432 0.410 0.370 0.335
7 0.665 0.583 0.513 0.452 0.400 0.376 0.354 0.314 0.279
8 0.627 0.540 0.467 0.404 0.351 0.327 0.305 0.266 0.233

Source: Table A from Costing by T Lucey (5th edn), p. 552

Table 17.5: An extract of discount factors for $1

 If you examine the table carefully, you will
realise that, first, the higher the interest rate,
the less the figure at which the money will be
valued at the present time and, second, the
longer the period of time (years), the less will
be the value of the money received. This is
seen by observing the figures by row and then
by column. The discount factors are used to
calculate the present value of the net cash flow.
This leads us to the next investment appraisal
method.
 This represents the value that the firm obtains
when it discounts its cash flows and outflows
of a future investment project. It is calculated
by multiplying the annual cash flows by the
discount factor for a given interest rate. At the
end of the period (usually in years), the present
value of the cash is added to give the final
figure or NPV.
 The firm will evaluate the proposed investment
by analysing the NPV after the specified years
for the project. There are three main things to
look for in the analysis of the NPV of a project.
If the NPV is:

1. Positive then the cash inflows will yield higher

returns than it will cost the company to invest in it.
In other words, the NPV will be more than the
interest rate paid by the firm to obtain the capital,
The project would be feasible.

2. Negative - Then the returns from cash inflows are

lower than the interest rate being paid or the cost to
obtain the capital. In this cash the project would
not be feasible.

3. Zero Then the cash inflows will yield a return that

is equal to the interest rate or the cost to acquire the
capital. The project is still feasible. This will be
examined further in the next section.
 Furniture Depot is thinking of purchasing a
new machine. The estimated cash flows are
shown below:
Year Cash Flows
($) The cost of capital is 10%.
0 (150,000)
Calculate the NPV of the project and
1 40,000 then assess whether or not it should
2 60,000 be undertaken.
3 50,000
4 30,000
5 15,000
 Year Cash Flow Discount Factor Present Value
($) @ 10% ($)
0 (150,000) 1.000 (150,000)
1 40,000 0.909 36,360
2 60,000 0.826 49,560
3 50,000 0.751 37,550
4 30,000 0.683 20,490
5 15,000 0.621 9,315
Net +3,275
Present
Value
Based on the calculation, the present value of cash
inflows surpasses the present value of cash outflow by
$3,275.00. This means that if the project is undertaken, it
will earn discounted returns in excess of 10 percent. The
project should therefore be undertaken.
 J & K Ltd is thinking of investing in a new
plant. The estimated cash flow is shown
below:
Year Cash Flows
($) The cost of capital is 8%.
0 (500,000)
Calculate the NPV of the project and
1 240,000 then assess whether or not it should
2 200,000 be undertaken.
3 150,000
4 110,000
5 80,000
6 50,000
 Year Cash Flow Discount Factor Present Value
(s) @ 0.540($)
8%
0 (500,000) 1.000 (500,000)
1 240,000 0.926 222,240
2 200,000 0.857 171,400
3 150,000 0.794 119,100
4 110,000 0.735 80,850
5 80,000 0.681 54,480
6 50,000 0.630 31,500
Net Present 179570
Value (NPV)

Based on the calculation, the returns from cash inflows are

lower than the interest rate being paid or the cost to obtain the
capital. In this case the project would be feasible.
ADVANTAGES
Takes into account the size and
time value of cash flow
Includes interest rates in the
calculation of present values
It is seen as a direct measure of
the per dollar contribution to
investors.
It is flexible in terms of changing
economic conditions, as discount
rate can be adjusted to reflect the
market situation.
DISADVANTAGES
The results gained are largely
dependent on the discount rates
used in its calculation. Therefore
if the expectation of interest rates
is inaccurate, the results will also
be inaccurate.
It may be difficult to calculate, as
it is largely numerical.
It ignores the qualitative factors
affecting a decision.
 DFG Company Ltd has three options in terms of projects to invest
in. The information for the three projects is shown below:

Project L Project M Project N

Initial cost 60,000 48,600 52,000
Year 1 16,000 12,200 9,400
2 17,200 13,400 12,400
3 17,400 10,200 13,500
4 18,000 9,600 14,800
5 18,650 8,750 16,800

The cost of capital is 12 per cent.

1. Calculate the NPV for each of the three projects
2. Assess which of the three projects should be undertaken
 This was done in class.
 Like the NPV, discounted cash flow is also
used to calculate the internal rate of return.
The IRR refers to a discounted rate of return
which, when calculated, give an NPV of zero.
When assessing the viability of an investment
project, the firm may compare the IRR with the
interest rates. Where the interest rate is less
than the IRR, the project will yield a positive
NPV and so is viable for investment.
Conversely, where the interest rate is greater
than the IRR, the project will yield a negative
NPV and so should not be considered.
 The calculation of the IRR can be tedious, even
though it can be done with a programmed
calculator or spreadsheet program.

Methods of calculating IRR:

1. Interpolation Method
2. Firms can randomly choose different discount rates
until one returns an NPV of Zero.

Both of the above methods are time consuming.

 Based on our discussions so far, it is evident
that the higher the interest rate or cost of
capital, the lower the NPV. This therefore
suggests that there is an indirect relationship
between NPV and the discounted rate.
 1. choose two discount rates one that will return a positive NPV and
the other a negative NPV (for example, 10 per cent and 16 percent, as seen
in the table below:

Year Cash 10% DCF 16% DCF

Flows
0 (initial (10,000) 1.000 (10,000) 1.000 (10,000)
outlay)
1(Net 3,000 0.909 2,727 0.862 2,586
Receipts)

2 3,000 0.826 2,478 0.743 2,229

3 3,000 0.751 2,253 0.641 1,923
4 3,000 0.683 2,049 0.552 1,656
5 3,000 0.621 1,863 0.476 1,428
Net +1370 -178
Present
Value
 2. Plot the two points on a graph (see next
slide). From the graph, you will realise that the
NPV becomes zero somewhere between the
discounting rates of 14 percent and 16 per cent.
 3 Use the formula below to calculate the exact IRR:

Formula
NPV1 x (R2 - R1)
Internal Rate of Return = R1 +
(NPV1 - NPV2)
Where:
R1 = Lower discount rate
R2 = Higher discount rate
NPV1 = Higher Net Present Value (derived from R1)
NPV2 = Lower Net Present Value (derived from R2)
IRR = 10% + 1370 x (16% 10%)
(1370 - -178)
= 10% + 8220
1548
= 10% + 5.31%
= 15.31%
 3.Compare the IRR with the cost of capital. If
the cost of capital is less than the IRR, then the
project can be undertaken, and vice versa.
ADVANTAGES DISADVANTAGES

It considers the amount Its calculation can be a

and the time value of cash very tedious process
flows

It is more concerned with It sometimes gives

the percentage return than unrealistic rates of
cash flows, therefore can return
be used for meaningful
comparisons among
projects with different
initial outlays
 The result of investment appraisal is only as
reliable as the data. The projections made are
based on expectations and should not be taken as a
guarantee

It only considers quantitative factors and ignores

important qualitative factors such as employee and
community reaction to the proposal made

The techniques used depend on the skills and

ability of its users in interpreting the results as it
relates to an investment project.
 When assessing an investment project, it is also
advisable to take into consideration the qualitative
factors, including:

How employees will react to the proposed investment

project
Whether or not there are any environmental implications
of undertaking a project
The social consequences of the investment decision
The sources and availability of funds
An assessment of the correlation of the firms objectives
and the planned investment project.
Appraisal Method Measurement Similarities/Differences
Payback Measures liquidity of While similar to NPV in terms of
the firm in terms of considering the ability of the annual cash
how soon a project can inflows and the ability to recover the
pay itself amount invested, it does not take the time
value of money into consideration. This
means that in reality, the projected inflows
could be overstated in real terms.
ARR Measures profits in Profits could be over-stated, especially since
terms of how it does not account for changes in the
profitable each present value of money, unlike the NPV
investment project is and IRR.
expected to be.
NPV Measures the time This is only as reliable as the discount rate
value of money. that is used to calculate it. The wrong
Shows how a project discount rate could distort the final
will be paid for using calculation. However, considering the time
the present value of value of money gives the firm a more
the cash inflows. realistic view of the project and its ability to
generate inflows to pay for itself.
IRR Measures the returns While the IRR considers the time value of
to be received from money, using it alone to make a decision
investment. This is regarding investment may not be advisable,
then compared with as a very high projection for IRR may not be
the interest rates realistic.
 Book
Jerome Pitterson (2014). Management of Business For
Cape Examinations. 1st ed. UK: Macmillan Publishers
Limited, London