Chapter 15 - Project Appraisal Techniques

Question 1

What are the factors affecting project appraisal?

Answer 1

1) cash: cash flow is more linked to shareholder wealth than profits;
2) return on the cost of capital: a business or a project is in profit, when the returns from the investment exceed the cost of capital; and
3) long-term value: the stock market places a value on the company’s future potential, not just its current profit levels.

Question 2

What are relevant factors in project appraisal and give some examples?

Answer 2

Vital for making investment decisions based on future net incremental cash flows.

These include:
• Future cost – estimated quantification of the amount of prospective expenditure
• Incremental cost – additional costs incurred from undertaking an additional activity or increasing level of production
• Cash flows or cash-based costs – any expense/cost expected to be paid in cash.
• Financing costs – opportunity costs e.g. interest forgone in investing in machinery
• Timing of returns – early returns are preferred to later ones. Returns can be reinvested to generate a higher value at a later date
• Working capital – new projects require additional working cap such as inventory and receivables
• Taxation – profits subject to tax and tax relief from capital cost must be considered
• Future inflation – future revenue and costs will be affected by inflation to different degrees.

Question 3

What are non-relevant factors in project appraisal and give some examples?

Answer 3

Irrelevant to project appraisal decision making, including:
• Sunk costs – past expenditure that cannot be recovered and cannot influence a decision
• Committed costs - obligations that cannot be revoked
• Non-cash items – such as depreciation and accrued revenue which are accounting entries
• Allocated costs – costs which are assigned to specific projects, processes or departments such as appointment of overheads that would be incurred in any event.

Question 4

What are project appraisal techniques?

Answer 4

Project appraisal methodologies are used to assess a proposed project’s potential success.

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.

Companies normally undertake investment appraisal before committing to capital investment.

Question 5

What does the appraisal of capital projects include?

Answer 5

1) Estimation of future costs and benefits over the project life including forecasting of revenues, savings and costs. Forecasting should be as reliable as possible and assumptions should be stated clearly for assessment and approval by the senior manager on behalf of the shareholders; and
2) Assessment of expected returns compared with the expenditure or investments made.

Question 6

What are the 2 basic approaches to project appraisal?

Answer 6

1) Non-discounting methods
a. Payback method
b. Accounting rate of return (ARR)

2) Discounted cash flow methods (based on the time value of money)
a. Net present value (NPV)
b. Internal rate of return (IRR)
c. Discounted payback

Question 7

What is the payback period?

Answer 7

• Payback period is the time (number of years) it takes a project to recover the initial investment.
• Based on expected cash flows rather than profits and provides a measure of liquidity
• Ignores non-cash items such as depreciation
• Where cash flows are uneven, the cumulative cash flow over the life of the project is used to calculate the payback period
• Projects are accepted when it pays back the original investment within the specified time period or target period. The company must set a target payback period
• When choosing between mutually exclusive projects, the project with the fastest payback should be chosen. Project with the fastest payback has more prospects of making a surplus. The longer the payback, the more uncertain the future cashflows.

Original cost of investment or initial cash outflows ÷ annual cash inflows

Question 8

What are the advantages/disadvantages of the payback period?

Answer 8

Advantages:

• It uses cash flow, not profit.
• It is simple to calculate.
• It is adaptable as per changing needs.
• It encourages a quick return and faster growth.
• It is useful in certain situations such as rapidly changing technology.
• It maximises liquidity.

Disadvantages:

• It 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.

Question 9

What is the Accounting rate of return (“ARR”)?

Answer 9

• AKA return on capital employed (ROCE) method
• Uses accounting profits to estimate the average rate of return the project is expected to yield over the life of the investment
• Project is accepted when ARR is equal to or greater than the target rate of return
• When choosing between mutually exclusive projects, the project with the highest ARR (& that meets the target) is chosen.

Average annual profits ÷ initial capital cost or average capital cost x 100

Where:
Average capital cost = initial investment + scrap value ÷ 2
Average annual profits = total accounting profit over the investment period ÷ years of investment

Question 10

What are the advantages/disadvantages of ARR?

Answer 10

Advantages:

• It is widely accepted and very 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 upon to some degree.
• It focuses profitability for the entire project period.
• It is easy to compare with other projects as it links with other accounting measures.

Disadvantages:
- It 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.
- Accounting rate of return is based on accounting profits that vary depending on accounting policies (such as depreciation policy).
- Accounting rate of return does not take into account the time value of money.
- Accounting rate of return can be calculated using different formulas. For example, ARR can be calculated using profit after tax and interest, or profit
before tax thus leading to different outcomes. It is important to ensure that ARR are calculated on a consistent basis when comparing investments.
- It is not useful for evaluating projects where investment is made in parts at different times.
- It does not take into account any profits that are reinvested during the project period.

Question 11

What are the 3 DCF methods are used to evaluate capital investments?

Answer 11

1. Net present value (NPV)
2. Internal rate of return (IRR)
3. Discounted payback period.

Question 12

What is time value of money?

Answer 12

Concept that money received today is worth more than the same sum received in the future. Occurs for 3 reasons:

1) Potential for earning interest and savings on the cost of finance: money can be spent or invested. Investors have a preference for having cash/liquidity today. Savings now can be used to repay debts saving on costs of finance
2) Impact of inflation: value of future cash flows can be eroded by inflation
3) Effect of risk: future cash receipts may be uncertain, unlike cash received today.

Question 13

What is compounding?

Answer 13

money invested today will earn interest in the future. Compounding calculates the future value (FV) of a given sum invested today for a number of years. Compound interest rate can either be calculated or found using compounding tables.

FV = Present Value x (1+r)^n

Where;
R = rate (compound interest)
N = number of years

Question 14

What is discounting?

Answer 14

Opposite of compounding. Starts with future value (FV) to calculate present value (PV) which provides a ‘discounted value’ of a future sum of money using a specified rate of return. Discount rate = rate of return used in discounted cash flow analysis to determine the PV of future cash flows. Discount rate will give the current worth of the future value.

PV = Future Value ÷ (1+r)^n

The present value factor is the current value today per £1 received at a future date. The future value can be calculated by multiplying the present value factor by the amount received at a future date:

1 ÷(1+r)^n

Question 15

What is Net Present Value (“NPV”) (discounted cash flow)?

Answer 15

• NPV 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
• NPV is a commonly used discounting cash flow method of project appraisal
• Ignores non-cash items such as depreciation & includes initial cost of the project and residual value
• Initial investment occurs at the start of the year (T0)
• Cash flows start at the end of the first year (T1)
• Project is accepted when NPV is positive
• When choosing between mutually exclusive projects, the project with the highest NPV is selected

NPV = Present value of cash inflows – present value of cash outflows

Question 16

What are the advantages/disadvantages of Net Present Value (“NPV”) (discounted cash flow)?

Answer 16

Advantages:
Theoretically, the NPV method of investment appraisal is superior to all others.
- It considers the time value of money through the discount rate.
- It is an absolute measure of return.
- It is based on cash flows not profits (which vary depending on accounting policies).
- It takes into account all cash flows throughout the life of a project.
- It maximises shareholder wealth by undertaking projects with positive NPVs that ensures a surplus over and above the costs of finance.

Disadvantages:

• It can difficult to explain to managers as it uses cash flows rather than accounting profits.
• The calculation of discount rates can be challenging and requires knowledge of the cost of capital.
• It is relatively complex compared to non-discounting methods such as ARR and the payback period.

Question 17

What are discounting annuities?

Answer 17

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, the instalment is a fixed amount usually consisting of the principal repayment and the interest expense. Principal repayment increases over time whilst the interest expense decreases.

Question 18

What are annuity factors?

Answer 18

Annuity factors are used to calculate the present value of an annuity. Annuity factors are based on the number of years involved and an applicable rate of return or discount rate. Annuity factor is the sum of the individual discount factors. PV of an annuity can be calculated as:

PV = Annual cash flow x Annuity factor

Where;
AF = [1-(1+r)^n]÷ r

Question 19

What are discounting perpetuities?

Answer 19

Perpetuity = type of annuity or constant stream of cash flows that continue indefinitely. Discounting a perpetuity is used in valuation methodology to find the present value of a company’s cash flows when discounted at an applicable rate of return:

PV = Annuity ÷ discount rate

Question 20

What is Internal Rate of Return (“IRR”) (discounted cash flow)?

Answer 20

• Calculates the return of return at which the NPV of all cash flows from a project or investment equals zero. IRR is therefore the discount rate at which NPV is zero (the discount rate that allows the project to break even)
• IRR works well where cash flows have traditional patters (outflow then series of steady inflows)
• Projects should be accepted if IRR is greater than the cost of capital
• If IRR is less than a target rate, the investment does not add value
• For mutually exclusive projects, the project yielding the highest IRR should be accepted

〖CF〗_1/〖(1+r)〗^1 + 〖CF〗_2/〖(1+r)〗^2 +〖CF〗_3/〖(1+r)〗^3 + ….. – initial investment = 0

Where; CF1 = cash flow of year 1 etc & r = cost of capital

IRR can also be calculated by interpolation that requires its estimation by trial and error. Steps to calculate:
Find discount rates that give a positive NPV and negative NPV. If NPS is positive, use a higher discount rate to get a negative NPV. If negative, use a lower to get a positive NPV
Estimate a discount rate between those two rates that will produce a zero NPV
Calculate IRR using the following formula (remember: LLL, HH, L):

IRR = L% + (〖NPV〗_L ÷ (〖NPV〗_L-〖NPV〗_H)) x (H%-L%)
Where;
〖NPV〗_L = lower NPV discount rate
〖NPV〗_H = higher NPV discount rate

Question 21

What is Discounted payback (discounted cash flow)?

Answer 21

• Determines the time period required by a project to break even.
• Involves discounting cash flows and then calculating how many years it takes for discounted cash flows to repay the initial investment
• Developed to overcome limitations of the traditional payback period method which ignores time value of money

Discounted payback period = PV of investment ÷ PV of annual cash flow

Question 22

Advantages/disadvantages of IRR

Answer 22

Advantages:

• The IRR method evaluates potential returns and the attractiveness of potential investments.
• It uses real cash flows rather than profits, which can be manipulated by different accounting policies.
• It takes account of the time value of the money.
• IT considers risk of future cash flows (through cost of capital in the decision rule).
• Excess IRR over the cost of capital indicates the excess return for the risk contained in the project.
• It gives a percentage rate that can be compared to a target (cost of capital). This is easier for management to understand and interpret than the concept of NPV.

Disadvantages
- Internal rate of return is a relative measure that gives a percentage rate that can be compared to a target cost of capital. It ignores other factors like project duration, future costs and relative size of the investments. A larger project with a lower IRR may generate a larger surplus than a smaller project with a higher IRR.
- It is not a measure of profitability in absolute terms (unlike the NPV method). The IRR method does not measure the absolute size of the investment or the return.
- It is the most complex of all the investment appraisal method to calculate. Interpolation by trial and error only provides an estimate, thus requiring a spreadsheet programme for an accurate estimate.
- It may not give the value maximisation of a project when used to compare mutually exclusive projects.
- It may not give the value maximisation of project when used to choose projects when there is capital rationing.
- The interpolation method cannot be used for non-conventional cash flows. A project that has large negative cash flows later in its life may give rise to
multiple IRRs.
- It assumes that the positive future cash flows are reinvested to earn the same return as the IRR. This may not be possible in real life.

Question 23

What is the impact of inflation on interest or discount rates?

Answer 23

In terms of inflation, lenders will require a return made up of:
1) A real return to compensate for the use of their funds (the expected return with no inflation); and
2) An additional return to compensate for their lost purchasing power from inflation.
Nominal rate and real rate of return are linked as follows:

[real interest rate = nominal interest rate – inflation]
If a loan has a 10% interest rate and inflation rate is 3%, then the real return is 7%.

A further calculation was created to estimate the relationship between nominal and real interest rates under inflation:

Real discount rate = (1 + nominal discount rate) x (1 + inflation rate) -1

For the above example this would be (1+10%) x (1+3%) -1 = 6.8%

Question 24

What is the impact of inflation on cash flows?

Answer 24

Inflation is incorporated into NPV calculations using one of the following two methods:

1) Using nominal future cash flows that incorporate expected inflation by building in expected price increases, and discounting using the nominal discount rate. This takes into account price increases
2) Using real cash flows that are expressed at today’s price level and discounting them using the real discount rate. It is assumed the future price changes will be the same as the general rate of inflation.

Question 25

What are the most common tax impacts on cash flows for NPV purposes?

Answer 25

• tax charges on profit figures;
• tax relief for an acquired asset in the form of capital allowance or writing down allowances; or
• tax on the sale or disposal of an asset at the end of the project.

Tax is usually payable 1 year in arrears and is therefore included in NPV within a 1-year delay. Discount rate can be pre- or post-tax.

Question 26

What are writing down allowances?

Answer 26

Capital allowances.

Tax relief is an alternative to depreciation deductions from accounting profits. Provides a tax benefit. These are claimed as early as possible in the asset’s life and are claimed annually until the total allowances equate to the cost less any scrap proceeds.

A balancing allowance arises in the year of disposal if the disposal proceeds are lower than the tax written-down value. Balancing charges can arise in the opposite situation.

Question 27

What are the 2 types of capital rationing?

Answer 27

1) Hard capital rationing: when lending institutions impose an absolute limit on the amount of finance available due to:
a. Industry-wide factors limiting funds; or
b. Company-specific factors like a poor track record, lack of asset security or poor management limiting funds

2) Soft capital rationing: when a company voluntarily imposes restrictions that limit the amount of funds available for investment in projects. Reasons may include:
a. Internal company policies
b. Limited management skills for handling multiple financing options
c. Desire to maximise return on a limited range of investments
d. Limiting exposure to external finance; and
e. Focusing on existing substantial profitable business.

Question 28

Single period capital rationing using the profitability index

Answer 28

• When there is a shortage of funds for one period.
• Projects are divisible when any fraction of the project can be undertaken. Returns from the project should be generated in exact proportion to the amount of investment undertaken.
• Profitability index (PI) can be used for dealing with divisible projects. Calculates the present value of cash flows generated by the project per a unit of capital outlay.
• When PI is greater than 1, project should be accepted
• When PI is less than 1, project should be rejected
• Where there are alternative projects, rank the projects according to PI & allocate funds according to the rankings
• Aim is to maximise the NPV earned for each pound invested in a project
• If projects are indivisible they must be undertaken in their entirety or not at all

PI = NPV ÷ present value of investment or initial investment

Question 29

Dealing with multi-period capital rationing

Answer 29

• When there is a shortage of funds in more than one period
• PI cannot be used to find a solution
• Solution can be quite complex but objective is to maximise NPV per £ invested
• Where projects are divisible, linear programming can be used
• Where projects are non-divisible integer programming can be used
• Computer programmes are needed to solve both issues.