Investment Appraisal Techniques

Question 1

what is investment appraisal techniques

Answer 1

capital budgeting - tools for evaluating large (often long-term) investments

typicall involves non-current assets and long payback periods

Question 2

four investment appraisal techniques

Answer 2

• Payback
• Accounting rate of return (ARR)
• Net present value (NPV)
• Internal rate of return (IRR)

Question 3

payback

Answer 3

when will I get my money back

Question 4

reason for maximum payback time periods

Answer 4

We may set maximum payback time period, say 2 years. The longer the payback period, the higher the risk due to higher uncertainty. If there are a number of investments to choose from we accept the quickest (but only if it pays back within 2 years).

Question 5

advantages of the payback appraisal technique

Answer 5

1. It is very simple.
2. It shows how long you won’t have money (out-of-pocket)
3. It recognises risk by ignoring cash flows which arise in the more distant future.

Question 6

cons of the payback appraisal technique

Answer 6

1. It ignores the time value of money (cash today is worrth more than the same amount of cash in the future; inflation: money is increasingly worth less).
2. Cash flows after the payback period are ignored (other choices might be more profitable)
3. No clear decision is given in a simple accept/reject situation, just gives data on when you are paid back.

Question 7

linear annual depreciation formula

Answer 7

(cost of asset - scrap value) / lifetime = annual depreciation

Question 8

how to turn a profit figure into cashflow

Answer 8

add back depreciation to the profit figure

Question 9

how to turn a cashflow figure into a profit figure

Answer 9

deduct depreciation from the cashflow figure

Question 10

Accounting Rate of Return (ARR)

Answer 10

average profit / investment = ARR

Tells you the return of the investment using additional accounting profit, not cashflows.

Question 11

beneftis of ARR

Answer 11

1. Simple to calculate
2. Uses profits which may be seen in the financial accounts (it’s easy to use profits)
3. Gives a percentage measure which may be more readily understood by management and conforms to the result of ROCE calculations

Question 12

cons of ARR

Answer 12

1. Ignores the time value of money
2. Profits are arrived at after taking accruals and provisions into account. However, as we have seen, only actual cash flows increase shareholders’ wealth. Profit can be subjective, and manipulated.

Question 13

Discounting cash flows techniques (DCF)

Answer 13

Discounting cash flows is an investment appraisal technique which takes into account both the time value of money and also total profitability over a project’s life (considers future cashflows).

• NPV
• IRR

Discount the cashflow back to the value of today, the day of the appraisal, and see whether the inverstment is viable.

It’s basically compound interest in reverse. Money is worth less in the future, so we have to account for that. 110€ in two years may only be 100€.

In short: By discounting all payments and receipts from a capital investment to a present value, they can be compared on a common value basis which takes account of when the cash flows arises.

• DCF look at the cash flows, not profits.
• The timing of the cash flows is taken into account by discounting them. The effect of discounting is to give a bigger value per £1 for cash flows that occur earlier in the life of the project.

Question 14

net present value (NPV)

Answer 14

The NPV is the value obtained by discounting all cash inflows and outflows of a capital investment project by a chosentargetrate of return or “cost of capital”.

The Present Value (PV) of the cash-inflows minus the PV of the cash outflows is the NPV.

• Positive NPV - means that the future discounted cash inflows from a capital investment are greated than the cash outflows.
  
  • Do the project (if the cost of capital is the organisation’s target rate of return).
• Negative NPV - dont do it.
• Zero NPV - maybe.

Question 15

cost of capital

Answer 15

when we get capital (loan, investors, etc.), we have to give them something back

• interest %, in the case of banks
• annual % of the profit, in the case of shareholders

Question 16

NPV example

Answer 16

So the PV of cash inflows exceeds the PV of cash outflows by £56,160. Which means that the project will earn a DCF yield that is greater than the 15%, that I need to account for.

The £56,160 reflects the increase in shareholder wealth that will be brought about by the investment. In other words, if there are a million shares in the company then the share price will increase by 5.6p.

(Divide £56,160 by 1,000,000) provided the market is efficient. It should therefore be undertaken.

Question 17

pros of NPV

Answer 17

1. It is the only capital investment appraisal technique that gives the “correct” decision advice i.e. advice that leads to the maximisation of shareholders’ wealth.
2. The NPV is an absolute measure and it is easy to make a comparison between the NPV of different investments.
3. The NPV represents the increase in the market value of the shareholders’ equity (i.e. share value) by undertaking the project.

Question 18

cons of NPV

Answer 18

1. The higher the risk of a project, the higher will be the company’s cost of capital. So while a 10% discount rate may be appropriate for one project it may be inappropriate for another. The risk factor therefore makes the calculation of the cost of capital difficult.
2. The stock price may not follow. The NPV rule assumes that the NPV equates with the increase in shareholders’ wealth (through increasing the share price). However, this link may be broken if the stock market uses some other method of valuing shares e.g. asset based valuation.
3. The NPV assumes the existence of a “Perfect Market” i.e. that the firm will be able to secure funds necessary to invest in the project, at its cost of capital which can be precisely identified. However, a perfect market might not exist. The funds might not be available as the company is having problems with liquidity.
4. It can be difficult to identify the appropriate discount rate.
5. Management may misunderstand the meaning of NPV. They may dispute the advice if it appears that another investment shows a higher profit (managers are used to profit not cashflow figures).

Question 19

Internal rate of return (IRR)

Answer 19

If the NPV is positive, the investment is earning more than the cost of capital. But it doesnt actually tell you how much. What was actually the return? That is the IRR is for.

The IRR is the cost of capital that gives you an NPV of 0. In other words, where the cash outflows are equal to the discounted value of the future cash inflows. The IRR is the discount rate at which the NPV is 0.

The IRR gives an average measure of the return on an investment and uses the rule that a project should be accepted if the IRR is greater than the cost of capital.

Question 20

Steps calculating IRR

Answer 20

1. Calculate the NPV of a project using a low discount rate (say 5%). This should give you a positive NPV.
2. Calculate the NPV of the project using a high discount rate (say 20%). It is preferable, though not essential, that this should give you a negative NPV.
3. Use the formula. LR = lower rate, HR = higher rate

Question 21

IRR example

Answer 21

Question 22

Limitations of IRR

Answer 22

It’s merely a relative measure (NPV is absolute, in contrast) and does not deal adequately with different sized projects. For example, which is better? 12% or 15%. What about 12% of £200,000 and 15% of £10,000?

Also, it assumes that all cash flows can be reinvested immediately on receipt in some other project to yield a return equal to the IRR. But the IRR is unique to each investment and might not be available anywhere else.

Question 23

How many appraisal techniques should you use?

Answer 23

Many of them, because they each have flaws.

However, the NPV being the most objective one, usually choose a project that has the highest NPV above all other measures.

Question 24

the main advantage of NPV

Answer 24

Being absolute money measure which takes account of the scale of the investment as well as the quality.

The other methods (payback, ARR and IRR) provide measures which express returns relative to the investment. Thus, Investments of comparable relativequality will have the same return regardless of size.

For example, an annual profit of £20 on an investment of £100 will have the same relative return as an annual profit of £200,000 on an investment of £1,000,000 i.e. 20%.

So if you are merely concerned with the quality of an investment then one of the 3 relative measures will provide the ranking.

However, if the objective is to generate wealth, the desirability of an investment should be measured by the surplus net present value (NPV) generated over and above the cost of capital.

Question 25

What do you discount to adjust for changing money value?

Answer 25

You should discount cash flows only

don’t discount depreciation

Question 26

influence of different interest rates on NPV

Answer 26

The higher the interest rate, the lower the NPV of a project.​

Question 27

what is it called when the cost of capital (like the interest rate of a bank loan) at which the NPV is zero

Answer 27

The cost of capital at which the NPV is zero is called the Internal Rate of Return. The IRR is an interest rate peculiar to a particular investment and in DCF terms it represents the breakeven rate of interest of a project.

Question 28

can the NPV be used for decision making alone? what about the other measures?

Answer 28

The NPV of a project is an absolute measure of the increase or decrease in the net wealth of a firm (and hence its shareholders) making a particular investment and can therefore be used to rank alternative projects. It can be used on its own for making decisions. If a project has a positive NPV you accept it; otherwise you reject it.

The IRR, on the other hand, is a relative measure so it can’t be used on its own in making a decision.

Question 29

cash flow re-investments: NPV vs. IRR

Answer 29

The NPV assumes that cash flows will be reinvested at the firm’s cost of capital. This is a realistic assumption since the firm’s cost of capital should be approximately in line with market rates. I get 60,000i n Y1 and will reinvest that 60,000.

The IRR assumes that cash flows will be reinvested but at the IRR of a particular investment, which may have no relationship at all to the interest rates obtainable in the market place. This is an unrealistic assumption and the biggest flaw of IRR.