INVESTMENT APPRAISAL`1

Introduction to Investment Appraisal

 Capital budgeting or investment appraisal as the name
suggests concerns with the capital investments where the
financial feasibility of a long-term project is determined. 
 This technique of determining financial viability attracts
the investor due to the fact that it takes into account cash
flow streams over the life of the project. Moreover cash
flows are discounted to the present value at the investors’
required rate of return hence taking into account time
value of money.
 The above exceptional qualities of capital budgeting make
it superior to any other approach to the
acceptance/rejection criterion of a project.
Investment Appraisal: Meaning

• A means of assessing whether an

investment project is worthwhile
or not
• Investment project could be the
purchase of a new PC for a small firm,
a new piece of equipment in a
manufacturing plant, a whole new
factory, etc
• Used in both public and private sector
 Private Investment Appraisal
Techniques 1) Cost Benefit Analysis
2) Capital Budgeting
(Modern)Techniques
a) Discounting Criteria
• Net Present Value (NPV)
• Internal Rate of Return
(IRR)
• Modified IRR (MIIR)
• Benefit Cost Ratio
(Profitability index)

b) Non-Discounting
Criteria (Traditional
approach)
What factors need to be • Payback Period
considered before investing • Accounting Rate of
in equipment such as this? Return
1) Cost Benefit Analysis
Cost- benefit Analysis: A cost-benefit
analysis is a process by which business
decisions are analyzed. The benefits of a
given situation or business-related action
are summed, and then the costs associated
with taking that action are subtracted. 
Cost Benefit Analysis Process
 The first step in the process is to compile a comprehensive list of all
the costs and benefits associated with the project or decision.
 Costs should include direct and indirect costs, intangible costs,
opportunity costs and the cost of potential risks.
 Benefits should include all direct and indirect revenues and intangible
benefits, such as increased production from improved employee safety
and morale, or increased sales from customer goodwill.
 A common unit of monetary measurement should then be applied to all
items on the list.
 The final step is to quantitatively compare the results of the aggregate
costs and benefits to determine if the benefits outweigh the costs. If so,
then the rational decision is to go forward with project. In not, a review
of the project is warranted to see if adjustments can be made to either
increase benefits and/or decrease costs to make the project viable. If
not, the project may be abandoned.
Net Present Value (NPV)
NPV as the name suggest shows the net present
value of project cash flow.
Net present value (NPV) is the difference
between the present value of cash inflows and
the present value of cash outflows over a period
of time.
NPV is used in capital budgeting to analyze the
profitability of a projected investment or project.
Cost of Capital: The minimum return that the
investor expect from their investment.
Net Present Value (NPV) Conti..
Assume a company is planning to invest
$9000 in a project today.
The project is expected to have a life of four
years.
The expected cash flows at the end of each
next four years are $2000, $3000, $3000 and
$4000.
Let us suppose the bank borrows the invested
amount from bank at the rate 10%. So the cost
of Capital is 10%.
 Net Present Value (NPV) Conti..
Year Cash flow( in dollar)

0 -9000

1 2000

2 3000

3 3000

4 4000
Net Present Value (NPV) Conti..
PV=FV/(1+r)n

Therefore

PV1=FV/ (1+r) 1 = 2000/1.1=1818.18

PV2=FV/ (1+r)2 =3000/(1.10)2 =2473.34
PV3=FV/(1+r)3 =3000/(1.10)3 =2253.94
PV4=FV/(1+r)4 =4000/(1.10)4 =2732.05

PV0 = -9000
PV1 = 1818.18
PV2 = 2479.34
PV3 = 2253.94
PV4 = 2732.05
____________
NPV=283.51
 
Net Present Value (NPV) Conti..
A positive NPV means the combined PV
of all cash inflows exceed the PV of cash
outflows.
In our example the NPV of $283.51
suggests that the combined PV of all cash
inflows exceeds outflows by $283.51
This project is an acceptable one since it
adds $283.51 to the value of the company.
NPV Decision Rule
The NPV decision rule is to accept all the
positive NPV projects.
If projects are mutually exclusive, accept
the one with the highest NPV.
If the NPV is zero, it is a matter of
indifference.
Internal Rate of Return (IRR)
IRR is the rate of return which the project
is likely to generate.
It is the rate of return at which Present
value cash inflow(PVCI)=Present value
cash outflow (PVCO) or It is the rate of
return at which NPV=0
 Example of IRR

Project A
Cash outflow 100000
Cash inflow: As shown in the table below
Y FVCI DF PV DF PV DF PV DF PV
1 10 11% 12% 15%
%

1 40,000                

2 50,000                

3 60,000                

PVCI=120,000     PVCI=114000     PVCI=110000     PVCI=100000

     
NPV=(PVCI-PVCO)=20,000 NPV=(PVCI- NPV=(PVCI- NPV=(PVCI-
PVCO)=14,000 PVCO)=10,000 PVCO)=0
IRR
The decision rule is that if NPV is
positive we accept the project and if NPV
is negative we reject the project.
If NPV is positive technically it is
assumed that this project is giving return
more than 10% but how much more. So
the rate of return at which PVCI=PVCO is
IRR
Decision rule for IRR
If IRR> cost of capital then accept the
project.
If IRR< cost of capital then reject the
project
If IRR=cost of capital then it is a matter
of indifference.
If multiple projects are given then we
select the project with greater IRR
Calculate NPV and IRR
Year Project A Project B

0 -1000 -1000

1 500 100

2 450 100

3 350 500

4 300 600

5 100 700

Cost of Capital=5%
Benefit Cost Ratio
It is an analysis of the relationship between
the costs of undertaking a task or project,
initial and recurrent, and the benefits likely to
arise from the changed situation, initially and
recurrently. It considers the present value of
money.
-Benefit Cost Ratio= PVB/I
-Net Benefit Cost Ratio= (PVB-1)/I=BCR-1
Where PVB is the present value of benefits and
I is the initial investment.
Project Cash flow outlay
Initial Investment 5,000,000

Revenue

Year 1 1,000,000

Year 2 2,000,000

Year 3 2,000,000

Year 4 3,000,000

Year 5 2,000,000

Let us take a project which is being evaluated by an organization that has a cost
of capital of 15 percent with the information given in the above table.
 Benefit Cost Ratio
Now we calculate PVB
PVB=FV/(1+r)n
PVB1=FV/ (1+r) 1 = 1000000/1.15 = 869565.22
PVB2=FV/ (1+r)2 =2000000/(1.15)2 =1512287.335
PVB3=FV/(1+r)3 = 2000000/(1.15)3 =1314924.392
PVB4=FV/(1+r)4 =3000000/(1.15)4 =1715265.866
PVB5 = FV/(1+r)5 =2000000/(1.15)5 =994530.085
_______________________________________
PVB= 6406572.8975
BCR=6406572.8975/5000000=1.28
NBCR=BCR-1=1.28-1=0.28
Decision criteria
When BCR
>1 Accept the project
=1 Indifferent
< 1 Reject the project
When NBCR
> 0 Accept the project
=0 Indifferent
< 0 Reject the project
Payback Method
• It is the length of time taken to repay the
initial capital cost
• Requires information on the revenue the
investment generates.
 Payback method
• Payback could occur during a year
• Can take account of this by reducing the
cash inflows from the investment to days,
weeks or years
Days/Weeks/Months x Initial Investment
Payback = ------------------------------------------
Total Cash Received
 Payback Method
• e.g.
Income
– Cost of machine =
£600,000
– Annual income
streams from
Year 1 255,000
investment =
£255,000 per year Year 2 255,000
• Payback = 36 x
600,000/765,000 Year 3 255,000
– = 28.23 months
– (2 yrs, 6¾ months)
Discounted Pay Back Period
Assume the following cash flow for 2 projects

Years Project S (Rs) Project L(Rs)

0 -1000 -1000

1 500 100

2 400 300

3 300 400

4 100 600

Assume that the cash flows are occurring at the end of the year. Find
out the discounted payback period for these projects, if the cost of the
capital is 10% for both the project
Project S
Year Cash flow Discounted cash Cumulative
flow discounted cash
flow

1 454.5 454.4
500
2 330.6 785.1
400
3 225.4 1010.5
300
4 68.4 1078.8
100

Payback= Years before full recovery +(Unrecovered amount at the

start of the period)/Cash flow during the period
= 2 + 214.9/225.4
= 2 + 0.95= 2.95 years
Project L
Year Cash flow Discounted cash Cumulative
flow discounted
cash flow

1 90.9 90.9
100
2 247.9 338.8
300
3 300.5 639.3
400
4 409.8 1049.1
600

Payback= Years before full recovery +(Unrecovered amount at the

start of the period)/Cash flow during the period
= 3 + 360.7/409.8
= 3 + 0.88= 3.88 years
Accounting Rate of Return
• A comparison of the profit generated by
the investment with the cost of the
investment
Average annual return or annual
profit
ARR = --------------------------------------------
Initial cost of investment
Accounting Rate of Return
• e.g.: An investment is expected to yield cash flows of
£10,000 annually for the next 5 years
• The initial cost of the investment is £20,000
• Total profit therefore is: £30,000
• Annual profit = £30,000 / 5
= £6,000
ARR = 6,000/20,000 x 100
= 30%
A worthwhile return?
Profitability Index
• Allows a comparison of the costs and
benefits of different projects to be
assessed and thus allow decision making
to be carried out
Net Present Value
Profitability Index = ---------------------
I
nitial Capital Cost
Profitability Index
NPV=Total present value-NCO
If the profitability index is more than 1
then accept the project but if it is less than
1 then reject the project
Discounted Cash Flow
• An example:
• A firm is deciding on investing in an energy
efficiency system. Two possible systems are under
investigation
• One yields quicker results in terms of energy
savings than the other but the second may be
more efficient later
• Which should the firm invest in?
Discounted Cash Flow – System A
Year Cash Flow (£) Discount Factor Present Value
(4.75%) (£)
(CF x DF)
0 - 600,000 1.00 -600,000

1 +75,000 0.9546539 71,599.04

2 +100,000 0.9113641 91,136.41

3 +150,000 0.8700374 130,505.61

4 +200,000 0.8305846 166,116.92

5 +210,000 0.7929209 166,513.39

6 +150,000 0.7569650 113,544.75

Total 285,000 NPV =139,416

Discounted Cash Flow – System B
Year Cash Flow (£) Discount Present Value
Factor (£) (CF x
(4.75%)
DF)
0 - 600,000 1.00 -600,000
1 +25,000 0.9546539 23,866.35
2 +75,000 0.9113641 68,352.31
3 +85,000 0.8700374 73,953.18
4 +100,000 0.8305846 83,058.46
5 +150,000 0.7929209 118,938.10
6 +450,000 0.7569650 340,634.30
Total 285,000 NPV =108,802.70
 Discounted Cash Flow
System A represents the better
investment
• System B yields the same return after
six years but the returns of System A
occur faster and are worth more to the
firm than returns occurring in future
years even though those returns are
greater
Cash flow Analysis
A cash flow statement is best defined as a
listing of expected cash inflows and
outflows for an upcoming period (usually
a year).
The length of the sub period depends
upon whether a monthly or quarterly cash
flow statement is used.
Cash flow analysis
A cash flow statement is used to evaluate
cash inflows and outflows to determine
when, how much, and for how long cash
deficits or surpluses will exist for a farm
business during an upcoming time period.
That information can then be used to
justify loan requests, determine repayment
schedules, and plan for short-term
investments.
Cash flow Analysis
Cash flow analysis
Cash Inflow Cash Outflow

•Cash Sales
•Receipts From Trade •Payment of Wages and
Salaries
•Sale Of Spare Assets
•Payment of supplies
•Investment of share capital •Buying equipments
•Receipt of Bank Loan •Interest on Bank
•Government grants •Loan or Overdraft
•Payment of Dividends
•Payment of Leasing
A cash flow statement identifies sources
and uses of cash as a result of three
activities:
Operating activities
Investing activities
Financing activities
Operating activities represent the main
source of cash inflow and outflow that
arise out of regular business operations.
For example, operating activities
include collections from customers, payments
to suppliers and employees and payments of
interest and income tax to the government.
Investing activities relate to increases and
decreases in long-term assets, which are used
by the company over a period of time to
generate revenue.
Examples of investing activities include the
purchase and sale of capital assets such as
machinery and equipment, as well as collections
of loans made to others. Next to operating
activities, investing activities represent the most
important source and use of cash.
Financing activities represents finding
ways to generate finance.
Example: Cash inflow in financing
activities includes issue of share, issue of
debenture, issue of equity share, issue of
preference share. Cash outflow in financing
activities includes pay interest on
debenture, pay dividend to equity
shareholder.
Assignments-1
Define Project management. List out and
explain factors influencing quality of the
project.
What do you mean by project appraisal?
Mention the importance of project appraisal.
What is cost-benefit analysis? How does it
help in project appraisal?
What do you mean by Investment appraisal?
Describe the importance of cash flow analysis
in managing project.