ABM312

Business Finance

Investment Appraisal

Facilitation session 3
Outline of Lectures

1. Why investment appraisal is important

2. The Investment Decision Making Process.

3. Methods of Investment Appraisal:

(a) Non-DCF (Discounted Cash Flow) Based Methods
(b) DCF-based Methods

4. Issues in calculating and applying investment appraisal

techniques
 The factors influencing the returns required by
investors from a project

Interest Required Inflation

foregone return

Risk
premium

Source: P. Atrill and E. McLaney, Accounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.
 Why Investment Appraisal?

 Essential feature - Time

 A decision to invest in new plant, machinery, buildings and
similar long-term assets.
 Important because decision usually involves:
(a) A significant outflow of cash at the outset (and
sometimes also at other planned points in time)

(b) “Recovery” of the benefits (inflows), usually

in a stream of smaller amounts over a long
period of time.
 Why Investment Appraisal ?

(c) Commitment to a course of action and difficult/costly to

bail out if the investment does not generate the intended
benefits

(d) Priority given to particular project due to limited funds

available – which one is best?

Role of financial manager – to demonstrate financial implications

and consequences (e.g. how much and when to invest?, do
intended financial benefits outweigh investment?)
Investment appraisal methods

Four methods of
evaluation

Accounting rate of
return (ARR)

Payback period (PP)

Net present value

(NPV)

Internal rate of return

(IRR)
Methods of Investment Appraisal

Non Discounted Cash Flow (DCF) Methods

•Payback Period (PP)
•Accounting Rate of Return (ARR)
(Note - ARR focuses on accounting profits not cash flows)

Discounted Cash Flow Methods

•Net Present Value (NPV)
•Internal Rate of Return (IRR)
Payback Period

What is the time period over which the investment will be

'paid back‘ using net cash inflows?

This payback period is then compared to some standard

period to decide whether to accept the project.

If a number of projects are being ranked, look for the

shortest payback period.
 PP decision rule

Project should have a shorter payback period

than the required maximum payback period

If competing projects have payback periods

shorter than maximum payback period, the one
with the shortest payback period is selected
 Payback Period

Example
Two investment projects: A B

Investment outlay (payable immediately) (1,900) (1,500)

Annual Cash Year 1 500 550

Inflows
Year 2 900 500

Year 3 800 200

Year 4 700 500

Payback Period (cont…)

Project A “pays” back K1,900 (assuming cash flows evenly

generated over a year)

= 500 (yr1) + 900 (yr2) + (500/800 x 12) (yr 3)

= 2 years 8 months

What is the payback for project B?

Accounting Rate of Return (ARR)

The ARR method involves the estimation of the average accounting

profit and expressing the profit as a percentage of the average
investment over the life of project.

ARR = Average Annual Profit x 100

Average Investment

At this stage (and simplistically):

(a) Accounting Profit = cash flows - depreciation

(b) Depreciation = investment/number of years
(c) Average Investment = (Opening investment + closing scrap value)/2
ARR (Example)
A project has the following investment and profit flows (K):

Initial investment 100,000

Profits before depreciation:
Year 1 20,000
Year 2 40,000
Year 3 60,000
Year 4 60,000
Year 5 20,000
Disposal Proceeds 15,000

What is the project’s ARR?

 ARR (Answer)

Annual Depreciation= Investment–Disposal Value

Period
= (100,000-15,000)/5 = K17,000

Average Profit = (20+40+60+60+20)/5 = 40,000

Average Profit after depreciation = K23,000

Average Investment = 100,000+15,000/2 = 57,500

Hence, ARR = 23,000/57,500 x 100 = 40%

 ARR decision rule

For a project to be acceptable, it must achieve

at least a minimum target ARR

Where competing projects exceed the

minimum rate, the one with the highest ARR
should be selected
 ARR (issues)

- ARR understandable and compared to benchmark rates

- Viewed as similar to Return on Capital Employed (ROCE)

ratio, can use historical ROCE

- Dependent on profits, not cash flows hence ignores time

factor and cash is measure economic wealth not profit.

- Ratio-based – confusion with projects of different sizes.

Can lead to nonsensical decisions (e.g. Atrill, p. 102 3rd
Ed.)
Example
A Company Attlee plc is faced with a decision regarding a new expansion strategy.
The two possible courses of action are:

1. Expand current facilities by building a temporary factory extension at the main

plant in the Midlands. This would cost a total of K300,000. The temporary
extension has an anticipated useful life of four years.

2. Build a new distribution hub in the South of England at a cost of K1,500,000,

with an anticipated useful life of four years.
Both projects assume a scrap value of zero when they reach the end of their
respective lives.
Each is depreciated on a straight line basis over their respective lifetimes.
Example cont….
 The estimates profit flows before depreciation for each
option are given below.
 Using payback period and ARR, which project would you
recommend to the board of Attlee plc ?
Example solution
 Payback:
1) 300,000 – 135,000 -120,000 = 45,000
45,000/100,000 x 12 = 5.4

2 years 6 months

2) 1,500,000 – 600,000 -450,000 – 350,000 = 100,000

100,000/600,000 x12 = 2

3 years 2 months (2, 10 months)

Example answer
 ARR = Average Accounting
Profit/Average Annual Investment
x 100%
 Project 1: Average
investment = (300,000 + 0/2) =
150,000
 Average annual profit =
(135,000+120,000+100,000+100
,000)/4 = 113,750
 Less average annual depreciation =
75,000
 Ave annual profit after depreciation
= 38,750
 38,750/150,000 = 0.258 = 25.8%
 Project 2: Average investment
= (1,500,000 + 0)/2 = 750,000
 Average annual profit =
(600,000+450,000+350,000+600,
000)/4 = 500,000
 Less average annual depreciation =
375,000
 Average annual profit after
depreciation = 500,000-375,000 =
125,000
 125,000/750,000 = 16.667%
Reading

Atrill Ed. 6th edition. Chapters 4 + 5