1. Capital Investment Appraisal: Appraisal process and methods
Objectives:
Describe the nature of capital investment appraisal
Apply the main investment appraisal techniques
Recognise the limitations of investment
appraisal technique

2. Definition of Investment
Any act which involves the sacrifice of an immediate and certain level of consumption in exchange for the expectation of an increase in future consumption.
forgo the present consumption in order to increase resources in future

3. Types of capital investment
Replacement of obsolete assets
Cost reduction e.g. IT system
Expansion e.g new building & equipment
Strategic proposal: improve delivery service, staff training.
Diversification for risk reduction

4. Need for Investment Appraisal
Large amount of resources are involved and wrong decisions could be costly
Difficult and expensive to reverse
Investment decisions can have a direct impact on the ability of the organisation to meet its objectives

5. Investment Appraisal Process
Stages:
identify objectives. What is it? Within the corporate objectives?
Identify alternatives.
Collect and analyse data. Examine the technical and economic feasibility of the project, cash flows etc.

6. Investment Appraisal Process
Stages:
decide which one to undertake
authorisation and implementation
review and monitor: learn from its experience and try to improve future decision - making.

7. Appraisal Methods

8. Payback Method
Payback method - length of time it takes to repay the cost of initial investment

9. Payback Period Lecture Example 1
LBS Ltd uses the payback period as its sole investment appraisal method. LBS invests £30,000 to replace its computers and this investment returns £9,000 annually for the five years. From the information above evaluate the investment using the payback. Assume that £9,000 accrues evenly throughout the year.

10. Payback Period Solution 1
Year Yearly cash flow cumulative net cash flow
£ £
0 (30,000) (30,000)
1 9, (21,000
2 9, (12,000)
3 9, (3,000)
4 9, ,000
5 9, ,000
Therefore 3years = 27,000 then 3000/9000 x 12 = 4
Payback period = 3 years 4months

11. Example 2

12. Example 2 solution
Payback period
For A = 4 years
For B = 5 years

13. Advantages and disadvantages of payback
Read on page 13

14. Accounting Rate of Return (ARR)

15. Lecture Example 3

16. Example 3 - solution Average Accounting Profit
( ,750) / 4 = 5625
Average investment = 45,000 / 2 = 22500
ARR = (5625/22,500 x 100 = 25%

17. ARR Advantages It is quick and simple to calculate
It involves a familiar concept pf a percentage return
Accounting profits can be easily calculated from financial statements
Disadvantages
Based accounting profits rather than cash flows, which are subject to a number of different accounting policies.
It takes no account of the length of the project
It ignores the time value of money

18. Net Present Value
Net Present Value (NPV) - the difference between the present values of cash inflows and outflows of an investment
Opportunity cost of undertaking the investment is the alternative of earning interest rate in the financial market.

19. NPV

20. Definitions
Present value:- the amount of money you must invest or lend at the present time so as to end up with a particular amount of money in the future.
Discounting: -finding the present value of a future cash flow

21. Quick exercise

22. Example 4
A company can purchase a machine at the price of £ The machine has a productive life of three years and the net additions to cash inflows at the end of each of the three years are £770, £968 and £ The company can buy the machine without having to borrow and the best alternative is investment elsewhere at an interest rate of 10%.
Evaluate the project using the
Net present value method.
Internal rate of return

23. Example 4: solution

24. Net Present Value Lecture Example 5
A firm invest £180,000 in a project that will give a net cash inflow of 50,000 in real terms in each of the next six years. Its real pre-tax cost of capital is 13%.
Required:
Calculate NPV

25. Net Present Value Solution 2.5
Year Cash Flow PV factor 13% Present value
0 (180,000) (180,000)
1 50, ,250
2 50, ,150
3 50, ,650
, ,650
, ,150
, ,000
NPV ,850
Positive NPV indicates viability of the project.
Negative NPV indicates non-viability of the project.

26. Alternative solution to 2.5
Use the annuity table
Year Cash flow PV
0 (180,000) 1 (180,000)
, ,900
NPV ,900

27. Appraisal Methods
Internal Rate of Return - is the discount rate that equates the present values of an investment’s cash inflows and outflows.
Internal Rate of Return (IRR) - is the discount rate that causes an investment’s NPV to be zero

28. IRR

29. Example 6
Using Lecture example 4 (above), calculate the internal rate of return for the project.

30. Internal Rate of Return
Solution to 6
IRR Try 15%
Year Cash flow Discount Factor (15%) PV
0 (2200) (2200)
NPV

31. Internal Rate of Return
Year Cash flow DC (16%) PV
0 (2200) (2200)
NPV

32. IRR Year Cash flow DCF (17%) PV 0 (2200) 1.000 (2200)
0 (2200) (2200)
NPV (4.86)

33. Using the formula above the IRR can be computed as follows.
15+(76.62/ )x(17-15)
15+(76.62/81.48)x(2)
15+( )x2
= 16.88%

34. Appraisal Methods
Please read more on the advantages and disadvantages of these techniques
Why is the NPV considered superior over the other methods, even the IRR?

35. End of Lecture
Any question please?