FINANCIAL ANALYSIS (AC6913)

MSc in Management Practice

December 2012

Investment Appraisal Decisions

Appendix of Supporting Examples

Module Leader:
James Browne FCCA; Dip IFR; Adv Dip (T & D)

Dublin Business School

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Example 1: The Accounting Rate of Return:

A company has a target accounting rate of return of 20%, and is now considering the

following project.

Capital cost of asset €80,000

Estimated life 4 years

Estimate profit before depreciation

Year 1 €20,000

Year 2 €25,000

Year 3 €35,000

Year 4 €25,000

The capital asset would be depreciated by 25% of its cost each year, and will have no

residual value.

Required:

Assess whether the project should be undertaken using ARR.

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Solution 1: The Accounting Rate of Return:

The annual profits after depreciation, and the mid-year net book value of the asset,
would be as follows:

Profit after Mid-year net ARR in the

Year depreciation book value year
€ € %
1 0 70,000 0
2 5,000 50,000 10
3 15,000 30,000 50
4 5,000 10,000 50

As the table shows, the ARR is low in the early stages of the project, partly because of
low profits in Year 1 but mainly because the net book value of the asset is much
higher early on in its life.

The project does not achieve the target ARR of 20% in its first two years, but exceeds
it in years 3 and 4. So should it be undertaken?

When the accounting rate of return from a project varies from year to year, it makes
sense to take an overall or ‘average’ view of the project’s return. In this case, we
would look at the return as a whole over the four-year period.

Total profit before depreciation over four years 105,000

Total profits after depreciation over four years 25,000
Average annual profit after depreciation 6,250
Original cost of investment 80,000

Average net book value over the four year period (80,000 + 0) = 40,000
2

ARR = 6250 = 15.6%

40,000

Conclusion:

Based on the assessment above the project would not be undertaken because it would
fail to yield the target return of 20%

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Example 2

Payback (Ignoring future high returns)

Question:

PROJECT P PROJECT Q

Capital Investment 60,000 60,000

Profit before depreciation (i.e. cash inflow)

Year 1 20,000 50,000
Year 2 30,000 20,000
Year 3 40,000 5,000
Year 4 50,000 5,000
Year 5 60,000 5,000

Solution:

Cumulative Profits Year 1 20,000 50,000

Year 2 50,000 70,000
Year 3 90,000 75,000
Year 4 140,000 80,000
Year 5 200,000 85,000
Cost (60,000) (60,000)
Possible Profit 140,000 25,000

Payback: 2.25 years 1.5 years

Problem:

Payback would choose Project Q - totally ignoring future high returns of Project P.

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Example 3

Payback (Ignoring timing of cashflows)

Question:

PROJECT A PROJECT B

Investment 10,000 10,000

Cash Inflows Year 1 1,000 8,000

Year 2 1,000 1,000

Year 3 8,000 1,000

Solution:

Payback: 3 years 3 years

Problem:

Payback cannot differentiate between the two and ignores time value of money.

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Example 4

Simple e.g. to Prove that Discounting is Opposite of Compounding:

Compound Interest:

Question:

Say €100 @ 10% for 2 years.

Answer:

Formula: = S = P(1 + r)n

S = Future Value (Cap & Int)
P = Present Value
R = Rate
N = No. of Periods.

Apply Formula:

S = 100 (1.1)2 = 121

PROOF: Year 1 Capital 100

Interest @ 10% 10
Year 2 Capital 111
Interest @ 10% 11
121 After 2 years.

Discounting:

We want to find out what an amount in the future is worth to us NOW. i.e. PV of a
future amount.

Formula: P = S x 1
(1 + r)n

=> P = 121 x 1 = 100

(1.1)2

=> If I offered €100 now or €121 in 2 years you would be indifferent.

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Example 5:

NPV:

Slogger Ltd is considering a capital investment, where the estimated cash flows are as

follows:

Year Cash Flow

O (i.e. now) (100,000)

1 60,000

2 80,000

3 40,000

4 30,000

The company’s cost of capital is 15%.

Required:

Calculate the NPV of the project, and assess whether it should be undertaken.

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Solution 5:

Year Cash Flow Discount Factor Present Value

€ 15% €

0 (100,000) 1.00 (100,000)

1 60,000 1 = 0.870 52,200
(1.15)
2 80,000 1 = 0.756 60,480
(1.15)2
3 40,000 1 = 0.658 26,320
(1.15)3
4 30,000 1 = 0.572 17,160
(1.15)4
NPV = 56,160

(Note. The discount factor for any cash flow ‘now’ (year 0) is always = 1, regardless
of what the cost of capital is).

The PV of cash inflows exceeds the PV of cash outflows by €56,160, which means
that the project will earn a DCF yield in excess of 15%. It should therefore be
undertaken.

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Example 6:

Find the IRR of the project given below and state whether the project should be

accepted if the company requires a minimum return of 17%.

TIME €
0 Investment (4,000)
1 Receipts 1,200
2 Receipts 1,410
3 Receipts 1,875
4 Receipts 1,150

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Solution 6:

The initial estimate of the IRR that we shall try is to be considered at 14%

Try 14% Try 16%

Time Cashflow Discount Factor PV Discount Factor PV
€ 14% € 16% €
0 (4,000) 1.000 (4,000) 1.000 (4,000)
1 1,200 0.877 1,052 0.862 1,034
2 1,410 0.769 1,084 0.743 1,048
3 1,875 0.675 1,266 0.641 1,202
4 1,150 0.592 681 0.552 635
NPV 83 NPV (81)

The IRR must be less than 16%, but higher than 14%. The NPV’s at these two costs

of capital will be used to estimate the IRR.

Using the interpolation formula

14 + 2
( 83

(83 + 81)
) = 15.01%

The IRR is, in fact, exactly 15%.

Conclusion:

The project should be rejected as the IRR is less than the minimum return demanded.

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Example 7:

Question:

X plc wants to buy a machine for €80,000 which will save €20,000 p.a. for 5 years
and will have a resale value of €10,000 in year 5.

Required:

If Co. policy is to only undertake projects with a yield of at least 10%, should the
machine be bought?

Solution 7:

Try an initial estimate of say 9%:

YEAR CASHFLOW P.V. FACTOR @ 9% P.V.

0 (80,000) 1 (80,000)
1-5 20,000 3.890 77,800
5 10,000 0.650 6,500
N.P.V. 4,300

Try 12% P.V. Factor @ 12% P.V.

0 (80,000) 1 (80,000)
1-5 20,000 3.605 72,100
5 10,000 0.567 5,670
N.P.V. (2,230)

Apply Formula:

Cost of Cap + change

( No. of steps to zero
Total No. of steps taken
)
= 9 + 3
( 4,300
(4,300 + 2,230)
)
= 9 + 1.975 = 10.975%
Approx. = 11% > 10% => ACCEPT

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