Methods of
project appraisal
Chapter 3
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• Explain the distinction between cash
flow and profit and the relevance of
cash flow to capital investment
appraisal.
Objectives • Identify relevant cash flows for
individual investment decisions.
• Calculate and interpret the results of
NPV, IRR and payback period.
Content
• Project appraisal
• The payback period
• Compound and discounting interest
• Discounted cash flow
• Relevant and non-relevant costs
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Project
appraisal
Mean to evaluate a
project/or projects’
benefits and costs
with the aim of
business growing.
4
The payback period
• The time taken for the initial investment to be recovered in the
cash inflows from the project.
• Suitable when:
❑There are liquidity problems; or
❑Distant forecasts are very uncertain.
5
The payback period
• Advantages:
✓It is easy to calculate and understand.
✓It is widely used in practice as a first screening method.
✓Its use will tend to minimise the effects of risk and help
liquidity.
• Disadvantages:
✓Total profitability is ignored.
✓The time value of money is ignored.
✓It ignores any cash flows that occur after the project has paid
for itself.
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Compound and discounting interest
• Compound interest:
• S = P(1 + R)n
• Discounting interest
• P = S(1 + R)-n
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Compound
and
discounting
interest
• What if the compound intervals are shorter than a
year?
• Effective annual rate of interest
• (1 + R) = (1 + r)n
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Compound and discounting interest
• Nominal rate of interest: interest rate expressed as a per
annum figure although the interest is compounded over a period
of less than one year.
• Effective rate of interest: annual compound interest rate.
• Ex: A building society may offer investors 10% per annum
interest payable half-yearly. If the 10% is a nominal rate of
interest, the building society would in fact pay 5% every 6
months, compounded so that the effective annual rate of interest
would be:
[(1.05)2 – 1] = 0.1025 = 10.25% per annum.
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Discounted cash flow
• Discounted cash flow: a technique of evaluating capital
investment projects, using discounting arithmetic to determine
whether or not they will provide a satisfactory return.
• Time value of money = minimum profit or return of an
investment will compensate the investor (the business) for the
length of time which the investor must wait before the profits are
made.
• 1$ in today would be more preferable than 1$ in tomorrow!
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• The net present value
• Internal rate of return
• Discounted payback
method
Discounted cash flow
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Discounted cash flow
• The net present value
• This method calculates the present value of all cash flows, and
sums them to give the net present value (NPV).
• Thumb up rules:
• NPV > 0 → accept the project
• NPV < 0 → reject the project
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The net present value
Advantages:
• Maximise shareholder wealth.
• Takes into account the time
value of money.
Discounted • It is based on cash flows which
cash flow are less subjective than profit.
Disadvantages:
• Identify an appropriate discount
rate.
• Cash flows are sometimes all
assumed to occur at year ends.
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Discounted cash flow
• The net present value
• Annuities are annual cash payments or receipts
which are the same amount every year for a
number of years.
• PV = Annuity amount * sum of the present value factors
• Perpetuity is an annuity that lasts forever.
• PV = Annuity amount * (1/r)
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• Internal rate of return (IRR): determine
the discount rate which produces the
NPV of zero.
Discounted
cash flow
15
Internal rate of return (IRR)
Advantages:
• Takes into account the time value of money.
• It indicates how sensitive calculations are to changes in
interest rates.
Disadvantages:
• IRR may be confused with return on capital employed
(ROCE).
• It cannot accommodate changing interest rates.
Discounted cash flow
Discounted cash flow
• Discounted payback method:
applies discounting to arrive at a
payback period after which the NPV
becomes positive.
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Discounted cash flow
Discounted payback
Advantage: Disadvantage:
method
Failing to take
Taking some account of positive
account of the time cash flows occurring
value of money. after the end of the
payback period.
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Relevant and non-relevant costs
• Relevant costs:
✓Future incremental cash flows.
✓Avoidable costs.
✓Differential costs.
✓Opportunity costs are all relevant
costs.
✓Directly attributable fixed costs.
✓Variable costs.
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Relevant and non-relevant costs
• Non-relevant costs:
✓Sunk costs.
✓Committed costs.
✓Notional (imputed) costs.
✓General fixed overheads.
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