Investment Appraisal: The decision making process Corporate Finance 7

The decision-making process for investment appraisal Empirical evidence on project appraisal techniques used The calculation of payback, discounted payback and accounting rate of return (ARR) The drawbacks and attractions of payback and ARR The balance to be struck between mathematical precision and imprecise reality The capital-allocation planning process

Appraisal techniques

Payback The payback period for a capital investment is the length of time before the cumulated stream of forecasted cash flows equals the initial investment. Payback Project A: 4 years, Project B: 4 years, Project C: 5 years.

Tradfirm: Net Present Values (£m) Exhibit 4.4 Tradfirm: Net Present Values (£m)

Drawbacks of payback It makes no allowance for the time value of money Receipts beyond the payback period are ignored Arbitrary selection of the cut-off point

Exhibit 4.5 Discounted payback: Tradfirm plc (£m) Discounted payback: Tradfirm plc (£m)

Reasons for the continuing popularity of payback Supplements the more sophisticated methods E.g. an early stage filter It is simple and easy to use Projects which return their outlay quickly reduce the exposure of the firm to risk If funds are limited, there is an advantage in receiving a return on projects earlier rather than later It is often claimed that the cash flows in the first few years of a project provide some indication of the cash flows in later years

Accounting rate of return The accounting rate of return (ARR) method may be known by other names such as the return on capital employed (ROCE) or return on investment (ROI) ARR is a ratio of the accounting profit to the investment in the project, expressed as a percentage The decision rule is that if the ARR is greater than, or equal to, a hurdle rate then accept the project

Timewarp plc Invest £30,000 in machinery: life of three years

Time warp plc (continued) (5, , ,000)/3 ARR = –––––––––––––––––––––– × 100 = 33.33% 15,000

Drawbacks of accounting rate of return Wide-open field for selecting profit and asset definitions Profit figures are very poor substitutes for cash flow Fails to take account of the time value of money High degree of arbitrariness in defining the cut-off or hurdle rate

Drawbacks of accounting rate of return (continued) Accounting rate of return can lead to some perverse decisions Suppose that Timewarp uses the second version, the total investment ARR, with a hurdle rate of 15 per cent The appraisal team discover that the machinery will in fact generate an additional profit of £1,000 in a fourth year Original situation New situation (5, , ,000)/3 ARR = –––––––––––––––––––––– = 16.67%. Accepted 30,000 (5, , , ,000)/4 ARR = ––––––––––––––––––––––––––– = 13.33%. Rejected 30,000

Reasons for the continued use of accounting rate of returns Managers are familiar with this ancient and extensively used profitability measure Divisional performance and the entire firm is often judged on a profit-to-assets employed ratio

Internal rate of return: reasons for continued popularity Psychological IRR can be calculated without knowledge of the required rate of return Ranking

The ‘science’ and the ‘art’ of investment appraisal Strategy Social context Expense Stifling the entrepreneurial spirit Intangible benefits

The investment process – pre-appraisal

The investment process – post-appraisal

Post-completion audit Post-completion auditing is the monitoring and evaluation of the progress of a capital investment project through a comparison of the actual cash flows and other costs and benefits with those forecasted Reasons for carrying out a post-completion audit: –1 Financial control mechanism –2 Insight gained may be useful for future capital investment decisions –3 The psychological effect

Lecture review Payback and ARR are widely used methods of project appraisal, but discounted cash flow methods are the most popular Most large firms use more than one appraisal method Payback –Drawbacks –Attractions Accounting rate of return –Drawbacks –Attractions Internal rate of return Mathematical technique is only one element needed for successful project appraisal The investment process is more than appraisal. It has many stages