INVESTMENT

APPRAISAL

Chapter 3
 Learning outcome

Upon completion of topic, students will be able to:

 Understand how to identify the sources and types of profitable
investment opportunities.
 Evaluate investment opportunities using the net present value
and describe why it is the best measure to use.
 Use the payback, discounted payback, accounting rate return,
internal rate return, modified internal rate return and profitability
index criteria to evaluate investment opportunities.
 Understand current business practice with respect to the use of
capital budgeting criteria.
 OVERVIEW OF CAPITAL
BUDGETING
 Capital budgeting is the process of analysing on real asset investments and decide
which one to accept.
 Capital budgeting process at any firm in terms of two basic phases:
 Firm’s management identifies promising investment opportunities.
 Once an investment opportunity has been identified, its value creating potential- what
some refer to as its value proposition.
 Types of Capital Investment Projects
 Revenue-enhancing investments
 Cost-reducing investments
 Mandatory investments that are a result of government mandates.
 NET PRESENT VALUE
 Net present value (NPV) is the difference between the present values of the
cash inflows and outflows.
 NPV estimates the amount of wealth that the project creates.
1st step
 Obtain the cash flow data from the proforma cash flow statement.
 The discounted cash flow (DCF) method discount the future cash flow
to the value of cash flow at the current time PV of future cash flow.
2nd step
 PV of the future cash flow - PV of the cost of investment = NPV
 An investment project should be accepted if the NPV is positive and reject if
the NPV is negative.
 NET PRESENT VALUE (CONT’D)

 An estimate of the value added to shareholder wealth if an investment is

undertaken.
 NPV represents the amount by which the value of the investment cash
flows exceeds the cost of making an investment.
Independent vs Mutually Exclusive
Investment Projects
 Independent project is one that stands alone and can be
undertaken without influencing the acceptance or rejection.
 Eg: A firm may be considering whether or not to construct a
shipping warehouse.
 Mutually exclusive project prevents another project from being
accepted.
 Eg: A firm maybe interested in investing in an accounting
software system and has two viable choices.
 Independent vs Mutually Exclusive
Investment Projects (Cont’d)
 Evaluating an independent projects can be demonstrated through NPV
method.
 NPV analysis entails simply calculating its NPV to see if it is positive or not.
 If the NPV is positive, the investment opportunity adds value to the firm and
should be undertaken.
 Firm cannot undertake all the positive NPV projects, this must be viewed as
mutually exclusive projects.
 Two circumstances will be considered when firm is faced with choosing from
a set of mutually exclusive projects:
 Substitutes – Analyzing two or more alternative investments with same functions,
the mutually exclusive alternatives are substitutes.
 Firm constraints – Limits the ability to take every project that has a positive NPV.
Eg: limited managerial time, limited financial capital.
 Mutually exclusive project with same useful life use NPV then choose the
projects with positive NPV, if it has different useful life then need to use
equivalent annual cost (EAC).
 EXAMPLE

Suppose we believe the cash revenue from our fertilizer

business will be $20,000 per year, assuming everything
goes as expected. Cash costs will be $14,000 per year. We
will wind down the business in 2 years. The plant, property
and equipment will be worth $2,000 as salvage at that
time. The project costs $10,000 to launch. The discount
rate is 15%.
Is this a good investment ?
 SOLUTION

Net Present value = -$10,000+ $6,000/(1+0.15)1 + $6,000/(1+0.15)2 +

$2,000/(1+0.15)2
= -$10,000+ $5,217.39 + $4,536.86 + $1,512.29
= -$10,000 + $11,266.54
  = $1,266.54
Yes, this is a good investment because the NPV > 0.
An investment accepted if the NPV is positive and rejected if it is negative.
 FURTHER EXAMPLE 1

Project Long requires an initial investment of $100,000 and is expected to

generate cash flows of $70,000 in Year 1, $30,000 per year in Year 2 and 3,
$25,000 in Year 4, and $10,000 in Year 5.The discount rate for this project is
17%. Is Project Long a good investment opportunity?

= $18,378
Since the NPV is positive, thus accept the project.
 FURTHER EXAMPLE 2

Suppose your bottling plant needs a new bottle capper. You are considering two different
capping machines that will perform equally well but that have different expected lives.
The more expensive one costs $30,000 to buy, requires a payment of $3,000 per year for
maintenance and operation expenses, and will last for five years. The cheaper model
costs only $22,000, requires operating and maintenance costs of $4,000 per year, and
lasts for only three years. Regardless of which machine you select, you intend to replace
it at the end of its life with an identical machine with identical costs and operating
performance characteristics. Because there is not a market for used cappers, there will be
no salvage value associated with either machine. Let’s also assume that the discount rate
on both of these machines is 8%.
 SOLUTION

= -$41,978

Project Short – 3 years life

Since EAC of long project, -$10,514, is less than EAC of short project -
$12,537 thus we should purchase the long project machine.
 NET PRESENT VALUE
(CONT’D)
 NPV method Computations are mechanical in nature
 Real difficulty Estimating or forecasting future cash flows
 Firms with experience in producing and selling a particular type
of product can generate fairly accurate estimates of sales
volumes, prices and production costs.
 Problem can arise when project team are too optimistic about
the cash flow projections.
 NET PRESENT VALUE
(CONT’D)
 Calculated NPV values estimate based on management’s
informed judgement they are not real market data.
 They can be put high or too low
 The only way to determine the project’s “true” NPV put the
asset up for sale and see what market price participants are
willing to pay for it.
 There is nothing wrong using estimates to make business
decisions as they are informed judgements and no guesses.
 Reason: Most business managers Required to make decisions
that involve expectations about future events
 NET PRESENT VALUE
(CONT’D)
Advantages Disadvantages
• Uses the discounted cash flow • Can be difficult to understand
valuation technique to adjust for the without an accounting and finance
time value of money. background.

• Provides a direct (dollar) measure

of how much a capital project will
increase the value of the firm.

• Consistent with the goal of

maximising stockholder value
 PAYBACK PERIOD
 Payback period for an investment opportunity is the number of years needed to recover
the initial cash outlay required to make the investment.
 Investment acceptable if its calculated payback period is equal or less than a
prespecified number of years (payback period).
 PB = Years before cost recovery + (Remaining cost to recover)/(Cash flow during the
year)
 The payback rule -> Has some severe shortcomings.
 There is no discounting involved -> Ignoring time value of money.
 Also fail to consider risk differences -> the payback would be calculated the same way
for both very risky and very safe project.
 Biggest problem -> deriving the right cutoff period.
 The number is arbitrarily chosen-> there is no economic rationale for looking at
payback.
 Generally, biased towards short-term investment.
 EXAMPLE
Year Cash Flow
0 -$70,000 (Investment Cost )

1 $30,000

2 $30,000

3 $20,000

4 $15,000

 What is the Payback period?

 SOLUTION

 PB = Years before cost recovery + (Remaining cost to

recover)/(Cash flow during the year)
= 2 years + ($70,000 - $60,000)/$20,000
 Payback period = 2 years + 0.5 years
= 2.5 years
 Conclusion, if the investment can recover the cost in 2.5 years or
less, that investment will be accepted.
 FURTHER EXAMPLE
The Payback Rule method could also lead to choose investment with negative
NPV.
Example: i=15%, NPV?

Year Project A Project B

0 -$250 -$250
1 100 100
2 100 200
3 100 0
4 100 0
 SOLUTION
Project A =>
= $35.50
Project B =>
= -$11.81

Conclusion: The payback rule could be misleading because it could lead to the
selection of an investment project with negative NPV.
 FURTHER EXAMPLE 2

A firm has 2 capital projects, A and B, which are under review for funding.
Both projects cost $500 and the projects have the following cash flows:

Year Project A Project B

0 -$500 -$500
1 100 400
2 200 300
3 200 200
4 400 100

What is the payback period for each project? If the projects are
independent, which project should management select? If the projects are
mutually exclusive, which project should management accept? The firm’s
payback cutoff point is 2 years.
 SOLUTION

PB = Year before cost recovery+(remaining cost to recover/cash flow during the

year)

= 1.33 years

Conclusion: Whether the project are independent or mutually exclusive,

management should accept only project B since project A’s payback period >
cutoff period (2 years).
 PAYBACK PERIOD (CONT’D)
Advantages Disadvantages
• Easy to understand. • Ignores time value money.
• Adjusts for uncertainty of later • Requires an arbitrary cutoff point.
cash flows. • Ignores cash flows beyond the
• Biased towards liquidity. cutoff date.
• Biased against long term projects
such as R&D and new projects.
 DISCOUNTED PAYBACK PERIOD
 An investment acceptable if its discounted payback is is equal or less than a
prespecified number of years (discounted payback period).
 The discounted payback period (DPB) number of years needed to recover
back the cost of investment.
 DPB = Years before cost recovery + (Remaining cost to recover)/(Discounted
cash flow during the year)
 The cutoff -> still has to be arbitrarily set.
 Cash flows beyond the cutoff -> ignored
 As a result -> may lead to wrong investment selection.
 Projects which have +NPV may be rejected because the discounted payback
period > cutoff period
 Generally better than the ordinary payback period -> because it considers time
value of money.
 EXAMPLE

Year Discounted Cash Flow at i=10%

0 -$40,000 (Investment Cost )

1 $18,182 (Cash flow from investment

project)
2 $16,529 (Cash flow from investment
project)
3 $15,026 (Cash flow from investment
project)

Should the investment be accepted if the cutoff period is 2 years?

 SOLUTION
Discounted payback period = Years before cost recovery + (Remaining cost
to recover)/(Discounted cash flow during the year)
= 2 years + (($40,000 - $18,182 - $16,529) / $15,026)
= 2.35 years
The project should not be accepted since the DPBP, 2.35 years > cutoff
period 2 years.
 DISCOUNTED PAYBACK PERIOD
(CONT’D)

Advantages Disadvantages
• Includes time value of money • May reject positive NPV
• Easy to understand investments
• Does not accept negative • Require arbitrary cutoff point
estimated NPV investments • Ignores cash flows beyond the
• Biased towards liquidity cutoff date
• Biased against long-term projects
such as R&D and new projects.
 ACCOUNTING RATE RETURN
(ARR)
 The ARR method calculate the return on a capital project
using accounting numbers.
 ARR = Average Net Income / Average Book Value
 Based on the ARR method, a project is acceptable if its ARR
exceeds a target average accounting return.
 ARR is not true rate of return -> it ignores time value of money.
 There is no specific way to calculate the target ARR.
 ARR does not tell the impact of an investment project on the
share price.
 EXAMPLE
Suppose we are deciding whether to open a store in a new
shopping mall. The required investment in improvements is
$500,000. The store would have a 5-year life because
everything reverts to the mall owners after that time. The
average net income for 5 years is $50,000.
What is the accounting rate of return (ARR) ?
Is this investment acceptable if the target ARR is 19% ?
 SOLUTION
Since, the investment started with a book value of $500,000 and
ended up with $0, the average book value = ($500,000 + 0)/2 =
$250,000.
ARR = Average net income / Average book value
= $50,000 / $250,000
= 0.2 or 20%

Conclusion : The investment is acceptable because the ARR > 19%.

 FURTHER EXAMPLE
Net income = $100,000 (1st year), $150,000 (2nd and 3rd year), $0 (4th
year) and -$50,000 (5th year).
Initial book value= $500,000
Final book value = $0
What is accounting rate of return (ARR)?
 SOLUTION
ARR = Average net income/Average book value
Average net income = $100,000+150,000+150,000+0+(-50000)/5 =
$70,000.
Average book value = (500,000+0)/2 = $250,000
ARR =$70,000/$250,000 = 28%
ACCOUNTING RATE RETURN
(ARR) (CONT’D)
Advantages Disadvantages
• Easy to calculate • Not a true rate of return
• Needed information will • Time value money is ignored
usually available • Uses an arbitrary benchmark
cutoff rate
• Based on accounting (book)
values; not cash flow and
market value
 INTERNAL RATE RETURN
(IRR)
 Closely related to the NPV method
 Based upon the calculation of NPV.
 NPV is set to zero.
 Example :
 NPV = PV (Future cash flow) – PV (Cost of investment)
 NPV = 0
 0 = PV (Future cash flow) – PV (Cost of investment)
 What is the discount rate for the above equation ?
 The discount rate => IRR.
 Based on the IRR rule, an investment acceptable if the IRR exceeds the
required return. It should be rejected otherwise.
INTERNAL RATE RETURN (IRR)
CONT’D
 EXAMPLE

A project has an immediate cash outflow of $7,000,

and then cash inflows of $4,000 in years 1 and 2.
What is the IRR ? Is this investment acceptable if
the required rate of return is 6% and 15%
respectively ?
 SOLUTION

If we take the cash flows and discount them at 5% and 20%, the
following results are gained.
SOLUTION (CONT’D)
 SOLUTION (CONT’D)

The IRR is estimated 9.9%. This is the return that is

forecasted for the project. If the target return was
6%, then the project would be accepted; if the target
return was 15%, then the project would be rejected.
 FURTHER EXAMPLE

 Problems with IRR arise -> when cash flows are not conventional
and when we are comparing 2 or more investments to select the
best.
 Example (when cash flows are not conventional):

Year Cash flow

0 -$60
1 $155
2 -$100
 SOLUTION

To find the IRR for this project:

Let IRR =
0=-$60+
60= +
60 =
=

= 0.25 @ 25% or 0.333 @ 33.33%

 INTERNAL RATE RETURN (IRR)
CONT’D

 Conclusion : when cash flows are unconventional i.e. there are

positive and negative cash flows in the investment project, there
could be a possibility of TWO IRRs as the example shown.
 Problem also arise when we select between 2 or more
investments to select the best investment project.
 The IRR for a project could be higher than another project but its
NPV could be lower -> there is a conflict
 MODIFIED INTERNAL RATE RETURN

 In the MIRR method the cash flow is modified first and then, the IRR is
calculated.
 Rearrange the project cash flows so that there is only IRR.
 Discounting all the negative cash flows after the initial cash outflow back to Year 0
and adding them to the initial cash outflow.
 Steps are as follows:
 Step 1: Modify the project cash flow stream by discounting the negative future cash
flows back to the present using the required rate return.
 Step 2: Calculate the MIRR as the IRR of the modified cash flow stream
 An investment acceptable if the MIRR exceeds the required return. It should
be rejected otherwise.
 EXAMPLE
The project has three cash flows: a - $235,000outlay in Year 0 a $540,500 cash
inflow in Year 1, and a -$310,200 outflow at the end of year 2. The required rate
of this project is 12%.
Step 1 : Discount Year 2 negative cash flow back to Year 0 and add back to
initial outlay at Year 0.

= -$247,290-235,000 = -$482,290
Step 2: Calculate the IRR for these modified cash flow.
MIRR is 12.08%
Since the MIRR > the required rate return of 12%, thus accept the project.
 PROFITABILITY INDEX

 Also called the benefit-cost ratio.

 PI = Present value of future cash flows / Cost of the Investment
 The PI measures the value created per dollar invested.
 Often proposed as a measure of performance for government or
other non-profit investments.
 However, PI measurement may lead to selection of lower NPV
projects.
 When the PI greater 1, then the NPV will be positive so the
project should be accepted and vice versa.
 PROFITABILITY INDEX (CONT’D)

Advantages Disadvantages
• Closely related to NPV, • May lead to incorrect
generally leading to identical decisions in comparisons of
decisions mutually exclusive
• Easy to understand and investments.
communicate
• May be useful when available
investment funds are limited
 EXAMPLE
Year Cash Flow

0 -$560

1 240

2 240

3 240
 SOLUTION

What is the PI? Discount rate = 12%

PV (Cash flows) = +
= $576.45
PV (Cost) =$560
PI = PV(Cash flow)/ PV(Cost)
= $576.45/$560
= 1.029
 REFERENCES

 Gitman, L.J., Joehnk, M.D., Smart, S., & Juchau, R.H. (2017).
Fundamentals on investing. Pearson Education.
 Parrino, R., Kidwell, D. (2009). Fundamentals of corporate finance:
John Wiley & Sons.
 Ross, S. A., Westerfield, R.W., Jordan, B.D., Lim, J. Tan, R. (2012).
Fundamentals of corporate finance (9th ed.). Singapore: McGraw-
Hill.