Project appraisal techniques

Question 1

What is project appraisal

Answer 1

Project (or investment) appraisal, is the financial and economic appraisal of a project or investment to assess its viability and the value it may generate.

Companies normally undertake investment appraisal to identify the attractiveness
of an investment before committing to high levels of capital expenditure, such as investing in a new factory, buying new machinery or making investment portfolio decisions.

Question 2

What does project appraisal assess?

Answer 2

The costs and benefits of a proposed capital project should be estimated and evaluated over its expected useful life, along with any risks from the projects.

Investment appraisal assesses:

1. costs and benefits over the project’s life
2. the level of expected returns from the project or invested expenditure
3. the risks involved, including uncertainty about the timing and volume of returns

Question 3

What do costs include?

Answer 3

Costs are likely to include expenditure on a non-current asset and running costs for the asset over its expected project life.

These costs could provide benefits through increased sales revenue or through savings in operating costs.

Additionally, the asset might have a ‘residual value’ at the end of its useful life.

For example, it might be sold in a second-hand market or scrapped.

When analysing a project, the following questions need to be asked to ascertain if the project is viable.

1. What for? The objectives of the project – such as launching a new product.
2. How? The process and the internal and external resource requirements.
3. Who? For whom, by whom – project partners, stakeholders.
4. When? The time factor.
5. Where? The location

The questions above are in addition to the core financial questions around how much needs to be invested and what amount of return investors need.

These financial objectives of a project are considered in a formal project appraisal
methodology.

Question 4

The main objective of project appraisal?

Answer 4

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:

1. cash: cash flow is more closely linked to shareholder wealth than profit;
2. 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
3. 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:

1. profits are subjective and cannot be spent
2. cash is required to pay dividends

Question 5

Name 5 relevant factors that affect project appraisal?

Answer 5

Relevant factors are those vital for making investment decisions based on future net incremental cash flows. In the case
of project appraisals, these include the following:

1. Future costs:

An estimated quantification of the amount of a prospective expenditure.

2. Incremental costs:

Additional costs incurred from undertaking an additional activity or increasing the level of production.

3. Cash flows or cash-based costs:

Any expenses or costs that are predicted to be paid in cash.

Non-cash items such as depreciation should be ignored.

4. Financing costs:

Opportunity costs. For example, a company bears an opportunity cost in the interest foregone on cash by investing it in £50,000 of new machinery.

5. The timing of returns:

Early returns are preferred to later ones. Returns can be reinvested to generate a higher value at the later date.

Other factors include:

• Working capital
• taxation
• inflation

Question 6

No relevant to consider on project appraisal?

Answer 6

Non-relevant factors are those that are irrelevant for project appraisal decision making.

They include the following:

1. Sunk costs: past expenditure that cannot be recovered and hence cannot be influenced by the current decision.
2. Committed costs: obligations that cannot be revoked.
3. Noncash items: items such as depreciation which are just accounting entries with no impact on cash flows.
4. Allocated costs: costs that are clearly assigned to specific projects, processes or departments, such as the
   apportionment of overheads that would be incurred in any event

Question 7

What are the two basic approaches to project appraisal?

Answer 7

There are two basic approaches to project appraisal: discounted and non-discounting 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:

1. Payback method
2. Accounting rate of return (ARR)

Discounted cash flow methods:

1. Net present value
2. Internal rate of return
3. Discounted payback

Question 8

What is non-discounting methods: payback period?

Answer 8

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

Where annual cash flows are uneven, the cumulative cash flows over the life of the project is used to calculate the payback period.

Question 9

What are the Decision rules of non-discounting methods: payback period?

Answer 9

Decision rules - pay back period

1. 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.

2. When choosing between mutually exclusive projects, the project with the shortest payback should be chosen.

The project with the quicker or shorter payback period provides more certainty of making a surplus. The longer the payback period, the more uncertain the cash flows and the forecast are likely to be.

Question 10

Advantages of non discounting methods - payback period?

Answer 10

Advantages of non discounting methods - payback period?

1. The payback period uses cash flows, not profits.
2. It is simple to calculate.
3. It is adaptable to changing needs.
4. It encourages a quick return and faster growth.
5. It is useful in certain situations such as those involving rapidly changing technology.
6. It maximises liquidity

Question 11

Dis-advantages of non discounting methods - payback period?

Answer 11

Dis-advantages of non discounting methods - payback period?

1. The payback period ignores cash flows after the project payback period.
2. It is very subjective, as it gives no definitive investment answer to help managers decide whether or not to invest.
3. 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.
4. It only calculates the payback period and ignores profitability.

Question 12

Non-discounted methods: accounting rate of return?

Answer 12

Non-discounted methods: accounting rate of return?

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.

Question 13

What are the decision rules for ARR?

Answer 13

Decision rules

1. The project is undertaken when ARR is equal to or greater than the target rate of return.
2. Where projects are mutually exclusive, the project with highest ARR (that also meets the target rate) is selected.

Question 14

Advantages of ARR?

Answer 14

Advantages

1. ARR is widely accepted and simple to calculate.
2. 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.

3. It focuses on profitability for the entire project period.
4. It is easy to compare with other projects as it is linked with other accounting measures.

Question 15

Dis-advantages of ARR?

Answer 15

Disadvantages of ARR:

1. 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.
2. It is based on accounting profits that vary depending on accounting policies (such as depreciation policy).
3. It does not take into account the time value of money.
4. 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.

5. It is not useful for evaluating projects where investment is made in stages at different times.
6. It does not take into account any profits that are reinvested during the project period

Question 16

Discounted cash flow techniques based on the time value of money?

Answer 16

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.

Question 17

The time value of money ?

Answer 17

The 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.

1. 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.

2. Impact of inflation:

the 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 18

Compounding?

Answer 18

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:

1. After one year: £10,000 × 1.10 = £11,000
2. After two years: £10,000 × (1.10)2 = £12,100
3. After three years: £10,000 × (1.10)3 = £13,310.

Formula

The formula for compounding is as follows:

FV = PV(1 + r)n

Where:

• FV = future value
• PV = present value
• r = rate of compound interest
• n = number of years

The compound interest rate for each year can either be calculated or found using compounding tables.

Question 19

Discounting?

Answer 19

Discounting?

The timing of cash flows is taken into account by discounting.

This is the opposite of compounding: it starts with a future value (FV) to reach a present value (PV).

This provides a ‘discounted value’ of a future sum of money or stream of cash flows using a specified rate of return.

Present value means a current cash equivalent of a discounted sum of money receivable or payable at a future date.

A discount rate is the rate of return used in discounted cash flow analysis to determine the present value of future cash flows.

The discount rate will give the current worth of the future value. For example, at any discount rate, £1 earned after one year will have a current worth or present value of less than £1.

The formula is:

PV = FV ÷ (1 + r)n

Where:

• FV = future value
• PV = present value
• r = rate of compound interest
• n = number of years

The present value factor (PV factor) is calculated as:

1 ÷ (1 + r)n

Question 20

Discounted cash flow methods: net present value (NPV)?

Answer 20

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.

Question 21

Net present value (NPV) decision rules?

Answer 21

1. The project could be undertaken if its NPV is positive.
2. When comparing mutually exclusive projects, the project with the highest positive NPV is selected.

When NPV is:

A. Positive

Returns from investment or PV of net cash inflows exceeds the cost of capital. The project could be undertaken.

B. Negative

Returns from investment or PV of net cash inflows are less than the cost of capital. The project should not be undertaken.

C. Nil

Returns from investment or PV of net cash inflows is equal to the cost of capital.

Question 22

Net present value (NPV) Advantages?

Answer 22

Advantages

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

Question 23

Net present value (NPV) Dis-advantages?

Answer 23

Disadvantages

1.The NPV method can be difficult to explain to managers as it uses cash flows rather than accounting profits.

2. The calculation of discount rates can be challenging and requires knowledge of the cost of capital.
3. It is relatively complex compared to non-discounting methods such as the payback period and ARR

Question 24

Annuity factors

Answer 24

An annuity factor (AF) is used to calculate the present value of an annuity.

The PV of an annuity stream is the current
value of future periodic payments, calculated by multiplying the fixed periodic payment by the annuity factor.

Annuity factors are based on the number of years involved and an applicable rate of return or discount rate.

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

see Test yourself 13.5

Question 25

Discounting a perpetuity

Answer 25

Discounting a perpetuity

A perpetuity is a type of annuity or a constant stream of cash flow that continues indefinitely.

Certain types of government bonds pay annual fixed coupons for as long as the bondholders hold the bonds.

Discounting a perpetuity is used in
valuation methodologies (such as shareholder value analysis or SVA) to find the present value of a company’s cash flows
when discounted at an applicable rate of return.

The PV formula for a perpetuity is as follows:

PV = annuity per period (cash flow) ÷ discount rate

Question 26

Worked example 13.7

Answer 26

Worked example 13.7

Assume the cash inflow of £55,000 (per annum) for Konyak Ltd’s Project A continues indefinitely, rather than just for five years.

What is the PV of the annuity if the interest rate is 10%?

Solution

• PV = annuity ÷ discount rate
• PV = £55,000 ÷ 0.10
• PV = £550,000

As the interest rate is 10%, the PV of the annuity that continues into perpetuity is £550,000.

Question 27

Discounted cash flow methods: internal rate of return

Answer 27

Discounted cash flow methods: internal rate of return

The internal rate of return (IRR) calculates the rate of return at which the NPV of all the cash flows from a project or investment equals zero. In other words, IRR is the discount rate at which NPV is zero – the discount rate that allows the project to break even.

IRR uses the same concepts as the NPV method.

Decision rules

1. Projects should be accepted if the IRR is greater than the cost of capital.
2. If IRR is less than the target rate (often WACC), the investment does not add value to the company.
3. If the IRR exceeds the cost of capital or the discount rate, it is worth undertaking the project.
4. If IRR is greater than the target rate (often WACC), the investment adds value to the company. In case of mutually exclusive projects, the project yielding the highest IRR should be selected.

Question 28

Advantages of IRR

Answer 28

Advantages of IRR

1. The IRR method evaluates potential returns and the attractiveness of potential investments.
2. It uses real cash flows rather than profits, which can be manipulated by the use of different accounting policies.
3. It takes account of the time value of the money.
4. It considers risk of future cash flows (through comparison with the cost of capital in the decision rule).
5. Excess IRR over the cost of capital indicates the excess return for the risk contained in the project.
6. 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

Question 29

Disadvantages of IRR

Answer 29

Disadvantages IRR

1. The IRR is a relative measure that gives a percentage rate that can be compared to a target cost of capital.

It ignores other factors such as project duration, future costs and the 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.

2. 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.
3. It is the most complex of all the investment appraisal methods to calculate. Interpolation by trial and error only
   provides an estimate, thus requiring a spreadsheet for a more accurate estimate.
4. It may not lead to value maximisation when used to compare mutually exclusive projects.
5. It may not lead to value maximisation of projects when used to choose projects when there is capital rationing.
6. 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.
7. 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 30

Discounted cash flow methods: discounted payback

Answer 30

Discounted cash flow methods: discounted 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.

Question 31

Advantages to discounted payback method

Answer 31

Advantages to discounted payback method

1. The discounted payback method considers the time value of money.
2. It uses cash flows, not profit.
3. It considers the riskiness of the project’s cash flows (through the cost of capital).
4. It determines whether the investments made are recoverable.

Question 32

Dis - advantages to discounted payback method

Answer 32

Dis - advantages to discounted payback method

1. The discounted payback method is subjective as it gives no concrete decision criteria that indicates whether the
   investment increases the firm’s value.
2. It requires an estimate of the cost of capital in order to calculate the payback period.
3. It ignores cash flows beyond the discounted payback period.
4. Calculations can become complex if there are multiple negative cash flows during the project’s life

Question 33

Capital rationing and use of the profitability index

Answer 33

Capital rationing and use of the profitability index

Shareholder wealth is maximised if a company undertakes all possible positive NPV projects.

However, when there are insufficient funds to do so, investment capital is rationed or limited.

Capital rationing is a strategy implemented when a company has more acceptable projects than can be financed from existing funds.

A choice will have to be made between
acceptable projects. Capital rationing can apply to a single reporting period or to multiple periods.

Question 34

Types of capital rationing?

Answer 34

Types of capital rationing

There are two types of capital rationing.

1. Hard capital rationing:

when lending institutions impose an absolute limit on the amount of finance available.

The reasons may include:

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.

This is contrary to the rational view of shareholder of wealth maximisation.

The reasons may include:

a. internal company policies;

b. limited management skills for handling multiple financing options

c. the desire to maximise return on a limited range of investments;

d. limiting exposure to external finance; and

e. focusing on existing substantial profitable businesses or divisions.

Question 35

Dealing with single-period capital rationing using the profitability index?

Answer 35

Dealing with single-period capital rationing using the profitability index?

When there is a shortage of funds for one period, it is referred to as single-period capital rationing.

Divisible projects :

Projects are considered to be divisible when any fraction of the project can be undertaken.

The returns from the project should be generated in exact proportion to the amount of investment undertaken.

The profitability index (PI) or benefit–cost ratio can be used for dealing with divisible projects or comparing individual projects.

The profitability index calculates the present value of cash flows generated by the project per a unit of capital outlay.

It can provide a solution when the company cannot undertake all acceptable projects due to limited budgets.

The PI formula is as follows:

PI = NPV ÷ original cost of investment or initial cash outflows

Question 36

Decision rules for Divisible projects?

Answer 36

Decision rules

1. When there are alternative projects, rank the projects according to PI and allocate funds according to the projects’ rankings – for example, projects with the highest PI would be approved
2. The aim when managing capital rationing is to maximise the NPV earned for each pound invested in a project.