Chapter 11

Investment appraisal
techniques
 Learning objectives
C1: Calculate the net present value, internal
rate of return, payback period or accounting
rate of return for a given project
C2: Identify the advantages and
disadvantages of the investment appraisal
techniques
 Making investment appraisal decisions

The investment decision-making process

• Origination of proposals
• Project screening: đánh giá toàn bộ dự án
• Analysis and acceptance
• Monitoring and review
 Payback Period Exh.
25-2

The
The payback
payback period
period of
of an
an investment
investment
is
is the
the time
time required
required for
for the
the cash
cash inflows
inflows
from
from aa capital
capital investment
investment project
project to
to equal
equal
the
the initial
initial cash
cash outflow(s).
outflow(s).

Payback Cost of Investment

=
period Annual Net Cash Flow
Managers prefer investing in projects
with shorter payback periods.
 Payback Period with Even Cash Flows
FasTrac is considering buying a new machine that will be used
in its manufacturing operations. The machine costs $16,000
and is expected to produce annual net cash flows of $4,100.
The machine is expected to have an 8-year useful life with no
salvage value.

Calculate the payback period.

Payback Cost of Investment
=
period Annual Net Cash Flow

Payback $16,000
= = 3.9 years
period $4,100
 Payback Period with
Uneven Cash Flows
In the previous example, we
assumed that the increase in cash
flows would be the same each year.
Now, let’s look at an example where
the cash flows vary each year.

$5,000

$4,100
 Payback Period with
Uneven Cash Flows Exh.
25-3

Cumulative
Annual Net Net Cash
FasTrac wants to Year Cash Flows Flows
install a machine 0 $ (16,000) $ (16,000)
that costs $16,000 1 3,000 (13,000)
and has an 8-year 2 4,000 (9,000)
useful life with 3 4,000 (5,000)
zero salvage 4 4,000 (1,000)
value. Annual net 5 5,000 4,000
cash flows are: 6 3,000 7,000
7 2,000 9,000
8 2,000 11,000
 Payback Period with
Uneven Cash Flows Exh.
25-3

Cumulative
We recover the $16,000 Annual Net Net Cash
purchase price between Year Cash Flows Flows
years 4 and 5, about
0 $ (16,000) $ (16,000)
4.2 years for the
payback period. 1 3,000 (13,000)
2 4,000 (9,000)
3 4,000 (5,000)
4 4,000 (1,000)
4.2
5 5,000 4,000
6 3,000 7,000
7 2,000 9,000
8 2,000 11,000
Using the Payback Period

Ignores the
time value
Unacceptable for of money.
projects with long
lives where time
value of
money effects
are major.
Ignores cash
flows after
the payback
period.
Using the Payback Period
Consider two projects, each with a five-
year life
and each costing $6,000.
Project One Project Two
Net Cash Net Cash
Year Inflows Inflows
1 $ 2,000 $ 1,000
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000

Would you invest in Project One just because it has a shorter

payback period?
 Disadvantages of the payback
period
• Unable to distinguish between
projects with the same payback
period
• The choice of any cut-off payback
period by an organisation is arbitrary
• Excessive investment in short-term
projects
• Does not take account of the
variability of those cash flows
Accounting Rate of Return Exh.
25-5,6

The accounting rate of return focuses on

annual income instead of cash flows.

Accounting
Accounting = Annual
Annualafter-tax
after-taxnet
netincome
income
rate
rateof
ofreturn
return Initial
Initialinvestment
investment

Accounting
Accounting = Annual
Annualafter-tax
after-taxnet
netincome
income
rate
rateof
ofreturn
return Annual
Annualaverage
averageinvestment
investment

Beginning book value + Ending book value

2
Accounting Rate of Return Exh.
25-5,6

Reconsider the $16,000 investment being considered by

FasTrac. The annual after-tax net income is $2,100.
Compute the accounting rate of return.

Accounting
Accounting Annual
Annualafter-tax
after-taxnet
netincome
income
rate =
rateof
ofreturn
return Annual
Annualaverage
averageinvestment
investment

Beginning book value + Ending book value

2
 Accounting Rate of Return Exh.
25-5,6

Cash
Reconsider the flow
$16,000 $ 4,100being considered by FasTrac.
investment
Depreciation
The annual 2,000 is $2,100. Compute the
after-tax net income
Income accounting rate of return.
$ 2,100

Depreciation = ($16,000 - 0) ÷ 8 years

Accounting
Accounting = Annual
Annualafter-tax
after-taxnet
netincome
income
rate
rateof
ofreturn
return Annual
Annualaverage
averageinvestment
investment

Beginning book value + Ending book value

2
 Accounting Rate of Return Exh.
25-5,6

Reconsider the $16,000 investment being

considered by FasTrac. The annual after-
tax net income is $2,100. Compute the
accounting rate of return.

Accounting
Accounting $2,100
$2,100
= = 26.25%
rate
rateof
ofreturn
return $8,000
$8,000

$16,000 + $0
2
 The ARR and the comparison of
mutually exclusive projects
The ARR method of capital investment appraisal can
also be used to compare two or more projects which
are mutually exclusive.
 Using Accounting Rate
of Return
 Quick and simple to
calculate
 Familiar concept of The advantages?
percentage return
 Easily calculated from
financial statements
 Looks at the entire
project life
P2 Using Accounting Rate
of Return
 Income may vary from So why
year to year.
would I ever
 Takes no account of the want to use
sixe of the investment
this method
 Takes no account of the anyway?
length of the project
 Time value of
money is ignored.
 Depreciation may be
calculated several
ways.
 Net Present Value
Now let’s look at a capital budgeting model
that considers the time value of cash
flows.
P3

Net Present Value

 Discount the future net cash flows from the
investment at the required rate of return.
 Subtract the initial amount invested from
sum of the discounted cash flows.
FasTrac is considering the purchase of a
conveyor costing $16,000 with an 8-year useful
life with zero salvage value that promises
annual net cash flows of $4,100. FasTrac
requires a 12 percent compounded annual
return on its investments.
P3
Net Present Value
with Even Cash Flows
Exh.
26-7

Present Present
Annual Net Value of $1 Value of
Year Cash Flows Factor Cash Flows
1 $ 4,100 0.8929 $ 3,661
2 4,100 0.7972 3,269
3 4,100 0.7118 2,918
4 4,100 0.6355 2,606
5 4,100 0.5674 2,326
6 4,100 0.5066 2,077
7 4,100 0.4523 1,854
8 4,100 0.4039 1,656
Total $ 32,800 $ 20,367
Amount to be invested (16,000)
Net present value of investment $ 4,367
P3
Net Present Value
with Even Cash Flows
Exh.
26-7

Present value factors Present Present

for 12 percent
Annual Net Value of $1 Value of
Year Cash Flows Factor Cash Flows
1 $ 4,100 0.8929 $ 3,661
2 4,100 0.7972 3,269
3 4,100 0.7118 2,918
4 4,100 0.6355 2,606
5 4,100 0.5674 2,326
6 4,100 0.5066 2,077
7 4,100 0.4523 1,854
8 4,100 0.4039 1,656
Total $ 32,800 $ 20,367
Amount to be invested (16,000)
Net present value of investment $ 4,367
P3
Net Present Value
with Even Cash Flows
Exh.
26-7

Present Present
Annual Net Value of $1 Value of
Year Cash Flows Factor Cash Flows
1 $ 4,100 0.8929 $ 3,661
2 4,100 0.7972 3,269
3 4,100 0.7118 2,918
4 4,100 0.6355 2,606
5 4,100 0.5674 2,326
6 4,100 0.5066 2,077
7A positive net4,100
present value0.4523
indicates that this
1,854
project earns more than 12 percent on the investment.
8 4,100 0.4039 1,656
Total $ 32,800 $ 20,367
Amount to be invested (16,000)
Net present value of investment $ 4,367
 Using Net Present Value
General decision rule . . .
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return.

Acceptable, since it promises a

Zero . . . return equal to the required rate
of return.

Not acceptable, since it

Negative . . . promises a return less than the
required rate of return.
P3
Net Present Value
with Uneven Cash Flows
Exh.
26-8

Pre se nt
Va lue of
Ne t Ca sh Flow s $1 Fa ctor PV of Ne t Ca sh Flow s
Ye a r A B C a t 10% A B C
1 $ 5,000 $ 8,000 $ 1,000 0.9091 $ 4,546 $ 7,273 $ 909
2 5,000 5,000 5,000 0.8264 4,132 4,132 4,132
3 5,000 2,000 9,000 0.7513 3,757 1,503 6,762
Tota l $ 15,000 $ 15,000 $ 15,000 $ 12,435 $ 12,908 $ 11,803
Am ount inve ste d (12,000) (12,000) (12,000)
Ne t Pre se nt Va lue $ 435 $ 908 $ (197)

Although all projects require the same investment and have

the same total net cash flows, project B has a higher net present
value because of a larger net cash flow in year 1.
Timing of cash flows: conventions used
in DCF
• A cash outlay to be incurred at the beginning
of an investment project occurs in time 0. The
present value of £1, in time 0, is £1 regardless
of the value of the discount rate r.
• A cash flow which occurs during the course of a
time period is assumed to occur all at once at
the end of the time period.
• A cash flow which occurs at the beginning of a
time period is taken to occur at the end of the
previous time period.
 Net Present Value
Cash flows, not accounting profits
• DCF are based on the cash flows of a project, not the
accounting profits.
• DCF is concerned with liquidity, not profitability
• Discount tables for the PV of £1
• Discount tables for a range of integer values of r and n.
• Annuities
• Is a series of constant cash flows for a number of years.
• Net terminal value
• Is the cash surplus remaining at the end of a project
after taking account of interest and capital repayments.
 Net Present Value
Advantages:
• It is directly linked to the assumed objective of maximising
shareholder wealth as it measures, in absolute £ terms,
the effect of taking on the project now, ie year 0
• It considers the time value of money, ie the futher away
the cash flow the less it is worth in present terms
• It considers all relevant cash flows, so that it is unaffected
by the accounting policies which cloud profit-based
investment appraisal techniques such as ARR
• Risk can be incorporated into decision making by
adjusting the company’s discount rate
• It provides clear, unambiguous decisions, ie if the NPV is
positive, accept; if it is negative, reject.
 Internal Rate of Return (IRR)
The interest rate that makes . . .

 Present Present
value of = value of
cash inflows cash outflows

 The net present value equal zero.

Internal Rate of Return (IRR) Exh.
26-9

Projects with even annual cash flows

Project life = 3 years
Initial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.

1. Compute present value factor.

2. Using present value of annuity table . . .

Internal Rate of Return (IRR) Exh.
26-9

Projects with even annual cash flows

Project life = 3 years
Initial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.

1. Compute present value factor.

$12,000 ÷ $5,000 per year = 2.4

2. Using present value of annuity table . . .

 Internal Rate of Return (IRR) Exh.
26-9

1. Determine the present value factor.

$12,000 ÷ $5,000 per year = 2.4000

2. Using present value of annuity table . . .

Locate the row Periods 10% 12% 14%

whose number 1 0.90909 0.89286 0.87719
equals the 2 1.73554 1.69005 1.64666
periods in the 3 2.48685 2.40183 2.32163
project’s life.
4 3.16987 3.03735 2.91371
5 3.79079 3.60478 3.43308
Internal Rate of Return (IRR) Exh.
26-9

1. Determine the present value factor.

$12,000 ÷ $5,000 per year = 2.4000

2. Using present value of annuity table . . .

In that row, Periods 10% 12% 14%
locate the
1 0.90909 0.89286 0.87719
interest factor
closest in 2 1.73554 1.69005 1.64666
amount to the 3 2.48685 2.40183 2.32163
present value 4 3.16987 3.03735 2.91371
factor. 5 3.79079 3.60478 3.43308
P4

Internal Rate of Return (IRR) Exh.

26-9

1. Determine the present value factor.

$12,000 ÷ $5,000 per year = 2.4000

IRR is
2. Using present value of annuity table . . . approximately
12%.
IRR is the Periods 10% 12% 14%
interest rate 1 0.90909 0.89286 0.87719
of the column
in which the
2 1.73554 1.69005 1.64666
present value 3 2.48685 2.40183 2.32163
factor is found. 4 3.16987 3.03735 2.91371
5 3.79079 3.60478 3.43308
 Internal Rate of Return –
Uneven Cash Flows
If cash inflows are unequal, trial and error
solution will result if present value tables
are used.
Sophisticated business calculators and
electronic spreadsheets can be used to
easily solve these problems.
 Using Internal Rate of Return

Internal Rate of Return

 Compare the internal rate
of return on a project to a
predetermined hurdle rate (cost of
capital).
 To be acceptable, a project’s rate
of return cannot be less than the
cost of capital.
 Comparing Methods
Payback Accounting Net present Internal rate
period rate of return value of return
Basis of Cash Accrual Cash flows Cash flows
measurement flows income Profitability Profitability
Measure Number Percent Dollar Percent
expressed as of years Amount
Easy to Easy to Considers time Considers time
Understand Understand value of money value of money
Strengths Allows Allows Accommodates Allows
comparison comparison different risk comparisons
across projects across projects levels over of dissimilar
a project's life projects
Doesn't Doesn't Difficult to Doesn't reflect
consider time consider time compare varying risk
value of money value of money dissimilar levels over the
Limitations projects project's life

Doesn't Doesn't give

consider cash annual rates
flows after over the life
payback period of a project