Investment appraisal – Step by Step

INVESTMENT APPRAISAL

One of the key areas of long-term decision-making that firms must harness is that of investment – the need to commit funds by purchasing land, buildings, machinery and so on, in prevision of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the life-time of the investment, the degree of risk attached and the cost of obtaining funds.

The main stages in the investment appraisal are as follows:

1. Forecasting investment demands.

2. Identifying project(s) to meet demands.

3. Appraising the choices.

4. Selecting the best choices.

5. Making the consumption

6. Monitoring project(s).

Investment is a key part of building for us business. New assets such as machinery can boost productivity, cut costs and give us a competitive edge. Investments in product development, research and development, expertness and new markets can open up exciting growth opportunities.At the same time, we need to avoid overstretching limited financial resources or restricting your ability to pursue other options. Deciding where to focus our investment is an essential part of making the most of our potential. Even a project that is improbable to generate a profit should be subjected to investment appraisal to identify the best way to achieve its aims.

TYPES OF INVESTMENT APPRAISAL

The range of methods that business organization use can be categorized one of two ways: traditional methods and discounted cash flow techniques. Traditional methods include all these methods Average Rate of Return (ARR) and the Payback method; discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return techniques.

Payback Method: It is probably best to regard payback as one of the first methods we use to assess competing projects. It could be used as an initial screening tool, but it is inappropriate as a basis for perverted investment decisions.

Average Rate of Return method: ARR calculates the return, rendered from net income of the proposed capital investment. When comparing investments, the higher the ARR, the more captivating the investment.

Net Present Value: A positive NPV means that the project is worthwhile because the cost of tying up the firm’s capital is paid for by the cash inflows that result. When more than one project is being evaluated, the firm should choose the one that produces the highest NPV.

Internal Rate of Return (IRR): The IRR is the annual percentage return accomplished by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested.

PAYBACK PERIOD

The payback is another method to evaluate an investment project. The payback method focuses on the payback period. The payback period is the length of time that it takes for a project to withhold its initial cost out of the cash receipts that it generates. This period is some times mentioned to as” the time that it takes for an investment to pay for itself.” The basic premiss of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. When net annual cash inflow is the same every year, the following formula can be used to calculate the payback period.

The formula is as follows:

Payback period = Investment required / Net annual cash inflow

(http://www.accountingformanagement.com/pay_back_method_of_capital_budgeting_decisions.htm)

WORKED EXAMPLE:

Two investment opportunities have the following expected cash flows:

PROJECT A PROJECT B

£000 £000

Year 1 20 40

2 30 40

3 40 40

4 50 40

5 70 40

CALCULATION OF PAYBACK:

PROJECT-A NCF

20 20

30 50

40 90

50 140

70 210

Payback of project A: 3 + 20 / 50

: 3.4

: 3 years and 3 months.

PROJECT-B NCF

40 40

40 80

40 120

40 160

40 200

Payback of project B: 2 + 30 / 40

: 2.75

: 2 years and 9 months.

SOLUTION:

* Project A has a payback period of 3 years and 3 months

* Project B has a payback period of 2 years and 9 months

Since B has the quicker payback, it is the preferred project.

CRITICISM OF PAYBACK PERIOD:

– No solidify decision criteria that indicate whether the investment increases the firm’s value

– Requires an approximate of the cost of capital in order to calculate the payback

– Ignores cash flows outside the discounted payback period

– It lacks objectiveness, who decides the length of optimal payback time.

– Cash flows are regarded as either pre-payback or post-payback , but the latter incline to be ignored.

– Payback takes no account of the result on business profitability. Its exclusive concern is cash flow.

Net Present Value:

The Net Present Value (NPV) is the first Discounted Cash Flow (DCF) technique. It trusts on the concept of opportunity cost to place a value on cash inflows arising from capital investment.

Remember that opportunity cost is the calculation of what is sacrificed or foregone as a result of a particular decision. It also referred to as the ‘real’ cost of taking some action.

The concept of present value as being the cash equivalent now of a sum receivable at a later date. So how does the opportunity cost affect receiptses that we can expect to receive later? Intimately, imagine what a business could do now with the cash sums it must wait some time to receive.

In fact, if we receive cash we are quite likely to save it and put it in the bank. So what a business sacrifices by having to wait for the cash inflows is the interest doomed on the sum that would have been saved.

Looked at one more way, it is likely that the business will have borrowed the capital to invest in the project. So, what it preceding by having to wait for the revenues arising from the investment is the interest paid on the borrowed capital.

NPV is a technique where cash inflows anticipated in future years are discounted back to their present value. This is calculated by using a discount rate equivalent to the interest that would have been received on the sums, had the inflows been saved, or the interest that has to be paid by the firm on funds took over.

v BASIC FORMULA:

PV= CF n / (l + r) n

Worked Example:

PROJECT A PROJECT B

£000 £000

Year 1 20 40

2 30 40

3 40 40

4 50 40

5 70 40

CALCULATION OF NPV:

PROJECT-A RATE @ 12% P.V

20 0.893 17.86

30 0.797 23.91

40 0.712 28.48

50 0.636 31.80

70 0.567 39.69

Total= 141.74

= 141740 – 110000

NPV = £31,740.

PROJECT-B RATE @ 12% P.V

40 0.893 35.72

40 0.797 31.88

40 0.712 28.48

40 0.636 25.44

40 0.567 22.68

Total= 144.2

= 144200 – 110000

NPV = £34,200.

The projects have a positive NPV and should be accepted.

LOGIC BEHIND NET PRESENT VALUE APPROACH

NPV, Net Present Value, allows to value a companies assets at their correct current value, usually at year end when the accounts are prepared.

The logic behind the NPV method- for valuating capital projects is based on the effect of adopting a project based on shareholder wealth.

§ If NPV > 0, the PV of expected future cash flows > project cost. Thus, firm value is increased and so is shareowner wealth.

§ If NPV=0, no change in shareowner wealth.

§ If NPV<0, shareowner wealth is destroyed.

§ If NPV< 0, shareowner wealth is destroyed.

The computation of NPV takes into account the assets original cost, less all accumulated depreciation allowed against that asset in previous tax computations.

The idea of NPV is to take future cash flows received or paid and convert them into value using the rate of return that we should earn on your investments. If we have two competing investments with cash flows that occur at different dates, finding their NPVs is a way to compare them against each other in day values.

f) EFFECT OF COST OF CAPITAL ON NPV:

NPV is inversely proportional to COC

1) If cost of capital increases then the net present value decreases.

2) If cost of capital decreases then the net present value increases.

g) INTERNAL RATE OF RETURN:

The IRR is the annual percentage return attained by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of capital invested.

Another way for IRR is the rate of interest that reduces the reduces the NPV to zero. The NPV calculates the net receipts and compares it with the initial investment if it is greater than return which the company is relishing and what rate of return of the company must give to make end meet. This rate is determined by the Internal Rate of Return.

IRR is the discounting rate which equals the discounted net revenue i.e. the rate which will result in nil NPV.

CALCULATION OF IRR:

YEAR Discount Rate P.V Discount Rate P.V

@ 20% @ 21%

1 0.833 16.66 0.826 16.52

2 0.694 20.82 0.683 20.49

3 0.579 23.16 0.564 22.56

4 0.482 24.1 0.466 23.3

5 0.402 28.14 0.385 26.99

112.88 109.86

IRR of Project A= 20% + 2880/3020 >< 1%

= 20.9536%

IRR of Project B= 21% + 2120/2360 >< 1%

= 23.8983%

The IRR of Project B > IRR of Project A, so Project B should be selected because it possess higher returns.

h) EFFECT OF COST OF CAPITAL ON INTERNAL RATE OF RETURN

The cost of capital finds how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested its money somewhere else with similar risk. Internal Rate of Return is independent of Cost of Capital. Therefore, neither IRR of Project A nor IRR of project B will change if the Cost of Capital changes.

i)WHICH METHOD IS BEST? NPV OR IRR? WHY?

There are three main reasons NPV is usually the best choice for measuring project value.

1. NPV assumes that project cash flows are invest again at the company’s required rate of return; the IRR assumes that they are reinvested at the IRR. Since IRR is higher than the required rate of return, in order for the IRR to be accurate, the company would have to keep finding projects that would invest again the cash flow at this higher rate. It would be difficult for a company to keep this upfront, thus NPV is more accurate.

2. NPV measures project value more instantly than IRR. This is for NPV actually calculates the project’s value. If there is more than one project lined up, the manager can simply add the values in concert to get a total.

3. Often times, during the life of a project, cash flows must be invest again to cover depreciation. This will give a negative cash flow for that period, thus contributing to more than one IRR. If there is more than one IRR, than computing only 1 IRR for the project is not reliable. NPV almost used for this type of project.