Chapter 6

INVESTMENT APPRAISAL METHODS

Prepared by: Agnes V. Manito, CPA

CAPITAL BUDGETING DECISIONS
What is capital budgeting?
Capital budgeting is the process of
planning and controlling investments
for long-term projects and programs.
CAPITAL BUDGETING DECISIONS
What are the reasons why capital investment decisions should be
evaluated carefully and thoroughly?

 Once made, capital budgeting decisions tend to be relatively

inflexible because the commitments extend well into the future.
 Without proper timing, additional capacity generated by the
acquisition of capital assets may not coincide with changes in
demand for output, resulting in capacity excess or shortage.
 Accurate forecasting is needed to anticipate changes in demand so
that full economic benefits flow to the firm when the capital asset
is available for use.
CAPITAL BUDGETING DECISIONS
 A capital budget usually involves substantial expenditures. The
sources of these funds are critical.
 Planning is important because of possible changes in capital
markets, inflation, interest rates, and the money supply.
CAPITAL BUDGETING DECISIONS
What are the stages in the capital budgeting process?
1. Identification and definition of projects and programs.
2. Search for potential investments.
3. Information-acquisition state.
4. Selection.
5. Financing.
6. Implementation and Monitoring.
 PRESENT VALUE USING THE TABLE
Cassandra wants P500,000
in 8 years. Find how much
= 3%
Cassandra must invest now
at 6% interest compounded
semiannually in order to
have P500,000, 8 years
from now.
3%
1

Cassandra must invest P311,583.50 now to

be able to obtain P500,000 in 8 years at 6% 16 0.623167
interest compounded semiannually.
 PRESENT VALUE USING THE CALCULATOR
Cassandra wants P500,000
in 8 years. Find how much
Cassandra must invest now Using the scientific calculator….
at 6% interest compounded
semiannually in order to (1÷1.03)^16 = 0.6231669392; Answer x 500,000 = P311,583.50
have P500,000, 8 years
Using the non-scientific calculator….
from now.
1.03 ÷÷……..press the division sign for 16 times
and you will get the table factor 0.623167
Cassandra must invest
P311,583.50 now to be able to
obtain P500,000 in 8 years at
6% interest compounded
semiannually.
 PRESENT VALUE using the formula on the
book “Basic Finance” by Mclaney
Cassandra wants P500,000
in 8 years. Find how much
Cassandra must invest now
at 6% interest compounded
semiannually in order to If you are using a non-scientific calculator….
the denominator can be computed by pressing
have P500,000, 8 years 1.03 xx (press the multiplication sign for 15
from now. times) and you will get 1.60470643904.

Cassandra must invest = P311,583.46

P311,583.50 now to be able to
obtain P500,000 in 8 years at
6% interest compounded
semiannually.
 TABLE FACTORS FOR PERIODS BEYOND THE TABLE
Determine the new table
factor and find the present
= 1%
value of P200,000, if the
interest rate is 12%
compounded monthly, for
20 years. Since 240 is not within the Table 2, think of any
number combinations within the “n” period that
adds up to 240. Example, 200 and 40.
Table factor for 200 periods at 1% = 0.136686
Table factor for 40 periods at 1 % = 0.671653
If somebody invested P18,361.11 now, Multiply the table factors for the two periods:
and the agreement is that the interest is 0.136686 x 0.671653 = 0.09180556195
12% to be compounded monthly for 20
years, the future value of this will be (1÷1.01)^200 = 0.1366863805; (1÷1.01)^40 = 0.6716531389
P200,000. (1÷1.01)^240 = 0.09180556195; Ans x 200,000 =P18,361.17
 PRESENT VALUE using the formula on the book
“Basic Finance” by Mclaney
Determine the new table = 1%
factor and find the present
value of P200,000, if the
interest rate is 12%
compounded monthly, for
20 years.
It will be impractical if you will use the non-
If somebody invested scientific calculator here because 240 periods
P18,361.11 now, and the will take you so much time to compute.
agreement is that the interest is Instead, use a scientific calculator!!!
12% to be compounded monthly
for 20 years, the future value of Using the scientific calculator….
this will be P200,000.
 NET PRESENT VALUE
 the difference between the present value of the estimated net
cash inflows and the present value of the net cash outflows.
Cassandra wants P500,000 Net Present Value = P500,000 – P311,583.46
= P188,416.54
in 8 years. Find how much
Cassandra must invest now Had Cassandra failed to invest her
at 6% interest compounded P311,583.46 cash right now with the
agreement that it will yield a 6% interest
semiannually in order to compounded semiannually in 8 years, she
have P500,000, 8 years will have an opportunity cost of
from now. Also, calculate P188,416.54.

the Net Present Value of Opportunity cost refers to the benefits

the investment. forgone in rejecting an alternative.
 NET PRESENT VALUE based on the formula
on the book “Basic Finance” by Mclaney
Cassandra wants P500,000 in
8 years. Find how much
Cassandra must invest now at
6% interest compounded where t is the life of the opportunity in years.
semiannually in order to have
In other words, the NPV of an opportunity is the sum,
P500,000, 8 years from now. taking account of plus and minus signs, of all of
What is the NPV of the the annual cash flows each one discounted according to
how far in the future it will arise.
investment?
Cash outflow (-) sign
(amount to be invested now)
Future value or Compound amount = P500,000 (given) Future cash inflow (+) sign
(amount to be received after 8 yrs.))
We arrived at the same opportunity
NPV = -P311,583.46 + P500,000 = P188,416.54
cost if Cassandra failed to invest her
P311,583.46 now.
 Sample case.
Seagull plc has identified that it could make operating cost savings in production by buying
an automatic press. There are two suitable such presses on the market, the Zenith and the
Super. The relevant data relating to each of these are as follows:
Zenith Super
Cost (payable immediately) P 20,000 P 25,000
Annual savings:
Year 1 4,000 8,000
2 6,000 6,000
3 6,000 5,000
4 7,000 6,000
5 6,000 8,000
The annual savings are, in effect, opportunity cash inflows in that they represent
savings from the cash outflows that would occur if the investment were not
undertaken. Which, if either, of these machines should be bought if the financing cost
is a constant 12 per cent p.a.?
 Answer: Zenith Super
Present value of cash flows:
Year 0 (P20,000) (P25,000)
Year 1

Total P 479 (P1,163)

The business should buy Zenith, as this would have a positive effect on its wealth,
whereas the Super would have a negative effect. It should not be prepared to buy the
Super even if it were the only such machine on the market, as to do so would be to
the detriment of the business’ wealth.
Conclusions on NPV
 It is directly related to the objective of maximization of
shareholders’ wealth.
 It takes full account of the timing of the investment outlay
and of the benefits; in other words, the time value of money
is properly reflected.
 All relevant, measurable information concerning the decision
is taken into account.
 It is practical and easy to use.
Despite NPV’s clear logic in appraising investments,
research shows that there are three other approaches.
These are:

internal rate of return;

payback period; and
accounting rate of return.
INTERNAL RATE OF RETURN
 The internal rate of return (IRR) approach seeks to identify
the rate of return that an investment project yields on the
basis of the amount of the original investment remaining
outstanding during any period, compounding interest
annually.
 IRR is sometimes known as ‘DCF (discounted cash flow)
yield’. The IRR for a particular project is the discount rate
that gives the project a zero NPV. Identifying the IRR, at least
by hand, can be laborious.
INTERNAL RATE OF RETURN
Sample case.

INTERNAL RATE OF RETURN
Sample case.
 If the project were P120 initial outlay, followed by inflows of P69
at the end of each of the following two years?
 Despite the total inflows being P138 , the IRR is not 15%because
this project runs over two years, not one.
 Nor is it 7.5% (that is, 15 ÷ 2) because much of the P120 is repaid
in year 1 and so is not outstanding for both years. In fact, the first
P60 represents interest a payment of the interest on the investment
during the first year plus a repayment of part of the capital (the
P120). By the same token, the second P69 represents interest on
the remaining capital outstanding after the end of year 1, plus a
second installment of capital such that this second installment will
exactly repay the P120 initial outlay.
INTERNAL RATE OF RETURN
Sample case. (ANSWER)


Where IRR is used to assess projects, the decision rule is that only
those with an IRR above a predetermined hurdle rate are accepted.
Where projects are competing, the project with the higher IRR is
selected.
NPV vs. IRR
Net Present Value Internal Rate of Return

The NPV method implicitly Internal Rate of Return

assumes that the project cash implicitly assumes that the
flows are reinvested at the project cash flows are
project’s cost of capital. reinvested at the project’s
IRR.

The cost of capital is a weighted average of the various debt and

equity components such as the cost of debt, cost of retained
earnings, cost of new external ordinary equity, and cost of
preference share.
Conclusions on IRR
 Like NPV, IRR takes full account both of the cash flows and
of the time value of money.
 All relevant information about the decision is taken into
account by IRR, but it also takes into account the irrelevant,
or perhaps more strictly the incorrect, assumption.
 IRR can be an unwidely method to use, if done by hand.
(manual)
 IRR cannot cope with differing required rates of return
(hurdle rates).
 The IRR model does not always produce clear results.
 PAYBACK PERIOD
 How long will it take for the investment to pay
for itself out of the cash inflows that is expected
to generate?
The decision rule for the PBP method is that projects will
be selected only if they pay for themselves within a
predetermined period Competing projects would be
assessed by selecting the one with the shorter PBP
(provided it was within the predetermined maximum).
 The payback period of Zenith
Zenith
Year 1 (P4,000)
Cost (payable P 20,000
immediately)
Initial Year 2 (P6,000)
Annual savings: Investment
(P20,000)
Year 1 4,000
Year 3 (P6,000)
2 6,000

3 6,000 Year 4 (P7,000)

4 7,000

5 6,000 Year 5 (P6,000)

 The payback period of Super
Super
Year 1 (P8,000)
Cost (payable P 25,000
immediately)
Initial Year 2 (P6,000)
Annual savings: Investment
(P25,000)
Year 1 8,000
Year 3 (P5,000)
2 6,000

3 5,000 Year 4 (P6,000)

4 6,000

5 8,000 Year 5 (P8,000)

 The payback period of Zenith vs. Super
 Formula:

Zenith

Super

Decision: The Zenith project will be chosen because the

payback period is lower.
Conclusions on PBP
Payback Period
Badly flawed to the extent that it does not relate to the
wealth maximization criteria.
It promotes the acceptance of short-term projects and
thus promotes liquidity rather than increased value.
Takes account the timing of the cash flow only in the
most perfunctory way.
It divides the life of the project into two portions: the
payback period and the period beyond it.
Conclusions on PBP
Payback Period
Not all relevant information is considered. It ignores
anything that occurs beyond the payback period.
Very easy to use, and it will always give clear results.
The questions are:
 How those results are interpreted is not so
straightforward though.
 How does the business decide what is the maximum
acceptable payback period?
ACCOUNTING RATE OF RETURN
 Compare the annual profit increase, after taking the cost of
making the initial investment into account, with the amount of the
initial investment. The outcome is usually expressed as a
percentage.
Let us consider again the two investment proposals…
Zenith Super
Cost (payable immediately) P 20,000 P 25,000
Annual savings:
Year 1 4,000 8,000
2 6,000 6,000
3 6,000 5,000
4 7,000 6,000
5 6,000 8,000
 ARR
 Formula:

Zenith

Super

Decision: The Zenith project will be chosen because it yields

a higher ARR.
Conclusions on ARR
 Does not relate directly to wealth maximization but pursues
maximization of a rate of return measured by accounting
profits.
 Almost completely ignores the timing of cash flows and
hence the financing cost.
 All the relevant information on the cash flows (except their
timing) is used in arriving at the ARR of the investment
prospect.
 Easy to use, but the fact that it can be defined in two different
ways can lead to confusion.
 end