INVESTMENT

APPRAISAL
PREPARED BY
OFFICE ADDRESS
:
:
EMMANUEL JOSEPH MUSSAH
UNIVERSITY OF MALAWI- THE POLYTECHNIC, DEPARTMENT OF ACCOUNTANCY
MOBILE PHONE : 0993 692 163/0881 280 821
EMAIL : [email protected]
 Introduction
 Terminology
 Relevant cash flows for a project
 Cash flows from accounting numbers
 Capital investment appraisal techniques
 Simple pay back period method
 Discounted payback period method
 Average Accounting Return (AAR)
 Internal rate of return
 Modified internal rate of return
 Net present value

OUTLINE OF THE PRESENTATION

INTRODUCTION
 Before
committing to high levels of capital spend, companies normally
undertake investment appraisal.
A 'typical' capital project involves an immediate purchase of a non-
current asset. The asset is then used for a number of years, during
which it is used to increase sales revenue or to achieve savings in
operating costs. There will also be running costs for the asset. At the
end of the asset's commercially useful life, it might have a 'residual
value'. For example, it might be sold for scrap or in a second-hand
market. (Items such as motor vehicles and printing machines often
have a significant residual value.)

INTRODUCTION
Sunk Costs
 A cost that we have already paid or have already incurred the liability to pay.
 Sunk costs cannot be changed as a result of accepting or rejecting the project.
 Sunk Costs are not considered in an investment decision.

Opportunity Costs
 The most valuable alternative that is given up if a particular project is undertaken.
 If you use land that is already paid for, to create an organic farm, what other use
for the land did you give up?
 At minimum, an opportunity cost is what you could have sold it for.

TERMINOLOGY
Erosion (Cannibalism)
 The cash flows of a new project that come at the expense of other projects.
 Think of new product line that takes away from sales of an existing product line.
 Cash Flow relevant only when it would not otherwise be lost: existing product line
or competition.
NWC
 Short-term NWC (cash, inventory, AR, AP) that project will need.
 Firm supplies NWC at beginning of project and recovers it at end of project (like a
loan).

TERMINOLOGY (CONT…)
Financing Costs
 Interest and Dividends are not analyzed as part of the project. They are analyzed
separately.
 They are not cash flow from or to assets.
 They are cash flows from or to creditors or stockholders

TERMINOLOGY (CONT…)
RELEVANT
CASH FLOWS
FOR A PROJECT
 Incremental Cash Flows = difference between future cash flows with a project &
without the project.
 Any cash flow that exists regardless of whether or not a project is undertaken in not
relevant.
 Incremental Cash Flows = After-tax Incremental Cash Flows
 Sunk Costs not relevant
 Opportunity Costs are relevant
 Side Effects/Erosion are relevant
 Change in Net Working Capital is relevant
 Financing Costs are dealt with as a managerial variable and are not considered with
the projects cash flows (Cash Flow To/From Creditors or Stockholders.

RELEVANT CASH FLOWS FOR A PROJECT

 Include
only cash flows that will only occur if the project is
accepted
 Incremental cash flows
 The stand-alone principle allows us to analyze each project in
isolation from the firm simply by focusing on incremental cash flows

RELEVANT CASH FLOWS

COST INCLUDE
Sunk” Costs No

Opportunity Costs Yes

Side Effects/Erosion Yes

Net Working Capital Yes
Financing Costs No

SUMMARY OF RELEVANT CASH FLOWS

CASH FLOWS FROM
ACCOUNTING
NUMBERS
Pro forma financial statements:
 Projected Financial Statements estimating the unknown
future.
 Operating cash flow:
OCF = EBIT + Depr – Taxes
 OCF = NI + Depr if no interest expense
 Cash Flow From Assets:
 CFFA = OCF – NCS –ΔNWC
 NCS = Net capital spending

CASH FLOWS FROM ACCOUNTING NUMBERS

CAPITAL INVESTMENT
APPRAISAL TECHNIQUES
PAYBACK
PERIOD
METHOD
The payback period is defined as being the number
of years it takes for a project to recoup the original
investment in cash terms.
Payback period is one of the easiest methods of
capital investment appraisal techniques.

PAYBACK PERIOD METHOD

 Calculate the time for a project to payback or recover the
initial investment cost (break-even analysis)
 Compare the payback period with a target period.
 If
the project pays for itself sooner then it should be accepted, if
not then it should be rejected.
 The payback period is useful when the future flows have a high
level of uncertainty. The further into the future we are
forecasting, then the more uncertain the flows are likely to be.
By choosing projects with faster payback periods, we are more
certain that the projects will indeed end up making a surplus.

PAYBACK PROCEDURE
When the net annual cash flow is the same each
year, this formula can be used to compute the
payback period.

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑
Payback period =
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

THE PAYBACK AND EVEN CASH FLOWS

 Themanagement of BLE 3 Real Estate wants to build a new commercial
building.
Cash flows associated with the new commercial building are as follows:
 Cost K1,400,000 and has 10- year life.
 K350,000 net annual cash flows will be generated.
 Management requires a payback period of 5 years or less on all its
investments.

Required:
 Usepayback period and conclude whether or not the project should
be accepted.

ACTIVITY 1: PAYBACK METHOD

When the cash flows associated with an investment
project change from year to year, the payback
formula introduced earlier cannot be used.
Insteadthe unrecovered investment must be
tracked year by year.

PAYBACK WITH UNEVEN CASH FLOWS

A building will cost K80,000.
 It has an expected life of 4 years with an anticipated scrap value of
K10,000.
 Expected net operating cash inflows each year are as follows:
Year Cash inflows
1 20,000
2 30,000
3 40,000
4 10,000

Required
 Calculate the payback period of the project.

ACTIVITY 2: PAYBACK PERIOD WITH UNEVEN CASH

FLOWS
Details Year Building A Building B Building C
K’000 K’000 K’000
Initial outlay 0 (50,000) (50,000) (50,000)
Net cash flow 1 10,000 10,000 10,000
2 20,000 10,000 20,000
3 20,000 10,000 20,000
4 20,000 20,000 3,500
5 10,000 30,000 3,500
6 0 30,000 3,500
7 0 30,000 3,500

Required:
Calculate the payback period for the three buildings and if
the capital is limited, select which building to be considered

ACTIVITY 3: ANALYSING PROJECTS

DISCOUNTED
PAYBACK PERIOD
METHOD
 Payback period and DCF techniques are often combined by
calculating 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.
 capital investment appraisals using discounted payback
period is similar to payback period but here, the time value
of money or discounted value of cash flow is considered for
calculation of payback period.

DISCOUNTED PAYBACK PERIOD METHOD

 BLE 3 Real Estate management requires a 12.5% return on new
investments. The management has an investment that costs K300 and
has cash flows of K100 per year for five years.

Required
 Calculate the discounted payback period of the investment.

ACTIVITY 4: PAYBACK PERIOD WITH UNEVEN CASH

FLOWS
Simple to apply
Serves as a screening tool
Identifies investments that recoup cash
investments quickly
Identifies projects that recoup initial investment
quickly

PROS OF PAYBACK PERIOD

Ignores the time value of money except the
discounted payback method
Ignores cash flows after the payback period

CRITICISM OF PAYBACK METHOD

AVERAGE
ACCOUNTING
RATE OF RETURN
(AAR)
 This
approach is an accounts based measure and considers
the expected profitability of an investment.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
 ARR =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

 Based
on the AAR rule, the project is acceptable if its AAR
exceeds a target AAR.

AAR
Suppose BLE 3 Real Estate is deciding whether to invest in a
shopping mall. The required investment in construction is
K50,000. The mall will have a five-year life and will have a
scrap value of zero after the end of its useful life. The required
investment would be 100% depreciated (straight-line) over 5
years. The tax rate is 25%. Table in the next slide contains the
projected revenue and expenses. Net income (accounting
profit) in each year, based on these figures, is also shown.

ACTIVITY 1: ARR ILLUSTRATIVE EXAMPLE

 Year 1 Year 2 Year 3 Year 4 Year 5
K K K K K
Revenue 433,333 450,000 266,667 200,000 133,333
Expenses (200,000) (150,000) (100,000) (100,000) (100,000)
Earnings before 233,333 300,000 166,667 100,000 33,333
depreciation
Depreciation (100,000) (100,000) (100,000) (100,000) (100,000)
Earnings before taxes 133,333 200,000 66,667 0 (66,667)
Taxes (25%) (33,333) (50,000) (16,667) 0 16,667
Net income (profit) 100,000 150,000 50,000 0 (50,000)

ACTIVITY 1: ARR ILLUSTRATIVE EXAMPLE FURTHER

INFORMATION
Requirement:
 Calculate
the project’s AAR and conclude whether the investment is
acceptable if the firm has a target AAR of less that 20 percent.

ACTIVITY 1: ARR ILLUSTRATIVE EXAMPLE FURTHER

INFORMATION
WHAT ARE THE
ADVANTAGES AND
DISADVANTAGES OF
AAR?
INTERNAL RATE OF RETURN
MODIFIED INTERNAL RATE OF RETURN
NET PRESENT VALUE