13. Project appraisal techniques Flashcards
What are the basic decision-making factors to consider when
making a choice between two or more projects using payback
period?
A few factors need to be considered in deciding whether to accept this project:
a project is acceptable if it pays back within the target period when
choosing between two or more projects, the project(s) with the fastest
payback is chosen.
How do depreciation and sunk costs affect the decision-making
process in project appraisal?
Sunk costs and depreciation are non-relevant factors for project appraisal. Sunk costs are past expenditure that cannot be recovered and hence cannot influence the current decision. Depreciation is a non-cash item and does not affect future cash flows.
Identification and analysis of projects
A project can be defined as a work plan that is carefully designed to achieve
a specific objective, within a specified time limit, while consuming a planned
amount of resources.
2.1 Costs, benefits and risks
When analysing a project, the following questions need to be asked to ascertain
if the project is viable.
What for? The objectives of the project – such as launching a new
product.
How? The process and the internal and external resource requirements.
Who? For whom, by whom – project partners, stakeholders.
When? The time factor.
Where? The location.
Factors affecting project appraisal
Most project approval decisions are made by company directors who have a
duty to act in the interests of their shareholders. The most common investment
appraisal objective is to maximise shareholder value. This is linked to:
cash: cash flow is more closely linked to shareholder wealth than profit;
return on the cost of capital: a company or a project is in profit when
the returns from the investment exceed the cost of capital; and
long-term value: the stock market places a value on the company’s future
potential, not just its current profit levels.
Future cash flows are more relevant than accounting profits in capital
investment appraisal because:
profits are subjective and cannot be spent
cash is required to pay dividends
Long-term cash flow forecasting of revenues, savings and costs is an essential
part of project appraisal. It is extremely difficult to produce reliable forecasts
but every effort should be made to make them as reliable as possible. This
often involves making assumptions during the decision-making process, taking
relevant factors into consideration.
Relevant factors: future costs, incremental costs, cash flows, financing costs, timing of returns, working capital, taxation, furture inflation
Non-relevant factors: Sunk costs, committed costs, non-cash items, allocated costs
Project appraisal techniques
These methods evaluate a project’s viability, considering factors such as available
funds and the economic climate. A good project will service debt and maximise
shareholder wealth. Appraisal of capital projects typically involves the estimation
of future costs and benefits over the project life, particularly the forecasting of
revenues, costs and savings.
There should also be an assessment of expected returns
compared with the expenditure or investments made.
The initial capital cost of a project could include any of the following:
the purchase cost of a non-current asset
realisable value of existing assets to be used in the project
investment in additional working capital
capitalised research and development expenditure
There are two basic approaches to project appraisal: discounted and nondiscounting
cash flow methods. Discounted cash flow methods based on the
time value of money are more sophisticated.
Some of the key project appraisal techniques include:
Non-discounting methods
Payback method
Accounting rate of return (ARR)
Discounted cash flow methods
Net present value
Internal rate of return
Discounted payback
Non-discounting methods: payback
The payback period is the time (number of years) it takes for a project to recover the original investment. It is based on expected cash flows rather than profits and provides a measure of liquidity. It ignores non-cash items such as depreciation. The payback period is based on cash flows. The formula for the payback period method is:
Original cost of investment or initial cash outflows ÷ annual cash inflows
A project is accepted when it pays back the original investment within the
specified time period or a target period. The company must therefore set a
target payback period.
When choosing between mutually exclusive projects, the project with the
shortest payback should be chosen.
Advantages:
5.1 Advantages
The payback period uses cash flows, not profits.
It is simple to calculate.
It is adaptable to changing needs.
It encourages a quick return and faster growth.
It is useful in certain situations such as those involving rapidly changing
technology.
It maximises liquidity.
5.2 Disadvantages
The payback period ignores cash flows after the project payback period.
It is very subjective, as it gives no definitive investment answer to help
managers decide whether or not to invest.
It ignores the timings of the cash flows. This can be resolved using the
discounted payback period which accounts for the time value of money.
It only calculates the payback period and ignores profitability.
Non-discounting method: ARR
The accounting rate of return (ARR) method is also known as the return on capital employed (ROCE) method. It uses accounting profits to estimate the average rate of return that a project is expected to yield over the life of the investment.
The ARR is measured as:
Average annual profits ÷ average capital investment × 100%
Where:
Average capital cost = (initial investment + scrap value) ÷ 2
And:
Average annual profits = total accounting profit over the investment period
÷ years of investment
Decision rules
The project is undertaken when ARR is equal to or greater than the target
rate of return.
Where projects are mutually exclusive, the project with highest ARR (that
also meets the target rate) is selected.
Advantages
ARR is widely accepted and simple to calculate.
It uses profits which are readily recognised by most managers. Managers’
performance may be evaluated using ROCE. As profit figures are audited, it
can be relied on to some degree.
It focuses on profitability for the entire project period.
It is easy to compare with other projects as it is linked with other
accounting measures.
6.2 Disadvantages
ARR ignores factors such as project life (the longer the project, the greater
the risk), working capital and other economic factors which may affect the
profitability of the project.
It is based on accounting profits that vary depending on accounting
policies (such as depreciation policy).
It does not take into account the time value of money.
The return calculated via ARR can be calculated using different formulas.
For example, the return can be calculated using profit after interest
and tax, or profit before tax – thus leading to different outcomes. It is
important to ensure that returns calculated via ARR are calculated on a
consistent basis when comparing investments.
It is not useful for evaluating projects where investment is made in stages
at different times.
It does not take into account any profits that are reinvested during the project period
Discounted cash flow techniques based on the time value of money
The use of discounted cash flows (DCF) is important for investment appraisal.
It is based on the concept of the ‘time value of money’, as well as the discount
rate (or cost of capital, introduced in Chapter 12).
Three DCF methods are used
to evaluate capital investments:
Net present value (NPV)
Internal rate of return (IRR)
Discounted payback period
Discounted cash flow models take into account the timing of cash flows over a project’s life. They look at the cash flows of a project, not accounting profits, because cash flows show the costs and benefits of the project when they actually occur and ignore notional costs such as depreciation.
Discounted cash flow methods: net present value
The DCF method can be used to calculate the net present value (NPV) of a
company or an investment.
Net present value is the net value of a capital investment or project, obtained
by discounting all cash outflows and inflows to their present values by using an
appropriate discounted rate of return.
Net present value is a commonly used DCF method of project appraisal. It uses cash flows (that can be spent and have an opportunity cost) rather than accounting profits (that cannot be spent). It ignores non-cash items such as depreciation while including the initial cost of the project and any residual value in the calculation of net cash flows.
The timings of the cash flows are important. Initial investment occurs at the
start of the year (T0). By convention, other cash flows start at the end of the first
year (T1) and the end of each subsequent year. The NPV method compares the present values of cash inflows with the present value of cash outflows for an
investment.
It can be summarised as:
NPV = PV of cash inflows – PV of cash outflows
The project or investment could be undertaken if its NPV is positive.
Decision rules
The project could be undertaken if its NPV is positive.
When comparing mutually exclusive projects, the project with the highest
positive NPV is selected.
When NPV is:
Positive - Returns from investment or PV of net cash inflows exceeds
the cost of capital - The project could be undertaken.
Negative - Returns from investment or PV of net cash inflows are
less than the cost of capital - The project should not be
undertaken.
Nil - Returns from investment or PV of net cash inflows is equal
to the cost of capital.
Advantages:
Based on cash flows - not profits
Absolute measure of return
Considers all cash flows throughout the life of project
Disadvantages:
Difficult to explain (as based on cash flows, not profits)
Calculation challenging
More complex than ARR and payback period
Discounting annuities
An annuity is a series of fixed payments made at regular intervals during a
specified period of time. When a loan is repaid in annuity, each instalment is a
fixed amount usually consisting of a repayment of part of the principal and the
interest expense for the period. The principal repayment increases over time
while the interest expense decreases.
The AF is the sum of the individual discount factors. The PV of an annuity can be
found using the formula:
PV = annual cash flow × AF
Where:
AF = [1 – (1 + r)–n] ÷ r
r = the discount rate
n = the number of periods in which payments will be made
The above formula is used to find the PV when the FV of the annuity is known.
The higher the discount rate, the lower the PV of the annuity. Annuity factors
can also be found using the annuity tables.
Discounted cash flow method payback
The discounted payback period method (or adjusted payback period) helps
determine the time period required by a project to break even. It combines
the techniques used in the payback period and DCF to calculate a discounted
payback period. This involves discounting the cash flows and then calculating
how many years it takes for the discounted cash flows to repay the initial
investment.
Discounted payback was developed to overcome the limitations of the
traditional payback period method, which ignores the time value of money.
Discounted payback is calculated using the same formula as the straight
payback method, but uses discounted cash flows to take into account the time
value of money.
Discounted payback period = original cost of investment or initial cash
flows ÷ PV of annual cash flows
The concept of time value of money
The time value of money is the concept that money received today is worth
more than the same sum received in the future. This occurs for three reasons.
The potential for earning interest and savings on the
cost of finance: if money is received today it can either be spent or
reinvested to earn more in future. Hence, investors have a preference for
having cash/liquidity today. Savings now can also be used to repay debts,
saving on cost of finance.
Impact of inflation: the value of future cash flows can be eroded by
inflation.
Effect of risk: Future cash receipts may be uncertain, unlike cash received
today.
Compounding
Money invested today will earn interest in future. Compounding calculates
the future value (FV) of a given sum invested today for a number of years.
For example, if £10,000 is invested to earn 10% interest on the base amount,
we would expect the initial amount to be compounded in future years. In the
next three years the base amount will be compounded as follows:
After one year: £10,000 × 1.10 = £11,000
After two years: £10,000 × (1.10)2 = £12,100
After three years: £10,000 × (1.10)3 = £13,310.
Formula:
FV = PV(1 + r)n
Where:
FV = future value
PV = present value
r = rate of compound interest
n = number of years
Chapter summary
Project or investment appraisal is the financial and economic appraisal of projects or expenditure incurred now in order to determine its feasibility and return in the future. When a proposed capital project is identified, the costs and benefits of the project should be estimated and evaluated over its expected useful life; any risks from the project should be considered.
The common objective in investment appraisal is to maximise shareholder
value, which is linked to cash flows, the cost of capital and long-term
value. A long-term cash flow forecasting of revenues, costs and savings
is an essential part of project appraisal. This often involves making
assumptions by taking into consideration the relevant factors such as
cash flow, financing costs, timing of returns, incremental costs, additional
working capital, inflation and tax. Non-relevant factors include sunk costs,
overhead costs and depreciation.
Two basic appraisal techniques are discounted and non-discounted cash
flow methods.
Non-discounted methods include the payback period and the accounting
rate of return method.
The payback period is the time (number of years) it takes a project to
recover the original investment.
The accounting rate of return (ARR) method is also known as the return on
capital employed (ROCE) method. It uses accounting profits to estimate the
average rate of return that the project is expected to yield over the life of
the investment or project.
Compounding is the process of determining the future value of present
investment or cash flows, by considering interest that can be earned in the
amounts invested today.
Discounted cash flow (DCF) techniques are based on the concept of the
‘time value of money’. Discounting is the process of determining the
present value of future cash flows by using a discount rate that considers
factors such as inflation, risk of an uncertain future and the ability to
earn interest. There are three methods of using DCF to evaluate capital
investments – the net present value method, internal rate of return and
discounted payback.
The net present value (NPV) method produces a positive, negative or neutral
NPV. The project is undertaken when NPV is positive. When comparing
mutually exclusive projects, the project with the higher positive NPV is
selected.
Internal rate of return (IRR) calculates the rate of return at which the
NPV of all the cash flows (both positive and negative) from a project or
investment equals zero. Projects should be accepted if IRR is greater than
the cost of capital.
The discounted payback period method (or adjusted payback period)
helps to determine the time period required by a project to break even. It
combines the techniques used in the payback period and DCF techniques
to calculate a discounted payback period.
Inflation affects both the cash flows to be estimated and the discount rate
to be used. The nominal (money) returns and real returns are linked by the
Fisher equation. The NPV calculation compares the present value of money
today to the present value of money in the future, taking inflation and
returns into consideration.
Tax impacts must be considered in any investment appraisal. The tax
effect is incorporated into the overall discount rate (WACC) by using the
after-tax discount rate to calculate the cost of debt. The impact of tax on
profits, capital allowances and tax on capital gains are incorporated in the
calculation of the net cash flows.
Capital rationing is a strategy that firms implement to place limitations on
the amount of new investments or projects that can be undertaken by a
company, prioritising limited funds for the most profitable projects.
