Most of the decisions management have to deal with are tactical and short-run but on occasion they may have to consider a decision that relates to a long period of time. Once the decision is taken the business has to live with it and may find it difficult to disinvest or reverse so a great deal of care has to be taken in these decisions.. In the planning process the company may have decided to persue a growth strategy so there may have to be investment in capital projects to sustain the growth in sales and productive capacity. Capital expenditure on new buildings, plant and machinery may be needed from time to time. Again the company may decide rather than grow organically a strategy of merger or takeover is best. Whatever the stategy the various investment projects have to be properly appraised. Capital projects have to chosen and decisions as to the financing of them has to be determined.
Definition:
Capital investment appraisal is the process of evaluating the cost and benefits of a proposed investment in operating assets.
The appraisal process consists of measuring the inflows of cash against the outflows of cash which arise as a consequence of the decision.
There are five main appraisal techniques:
1 Payback
This technique considers the length of time it takes to recover the initial invesment outlay and the project starts to pay for itself. If a company invests £100,000 on a capital project the question is how long does it take to get back £100,000 cash from the project. Cash flow does not include any non-cash items such as depreciation. Therefore, if the investment returns are given in profit after depreciation terms the annual depreciation is added back. Net cash flow is the difference between cash received and cash paid during a defined period of time.
Example:
A company is considering investing in a new machine which costs £100,000.
The following information is available:
| | £ | £ |
| Initial outlay | | 100,000 |
| Net cash flow | | |
| Year 1 | 20,000 | |
| Year 2 | 30,000 | |
| Year 3 | 40,000 | |
| Year 5 | 20,000 | 110,000 |
| | -------- | -------- |
| Net profitability | | 10,000 |
| | | ------- |
Required:
What is the project’s payback period?
The project pays for itself after 41/2 years. At the end of that period the project produces net cash flows of £100,000 equal to the cost of the original investment.
The payback method has universal appeal because of its simplicity and the fact that it tends to favour less risky capital projects. Projects that take too long to pay for themselves are riskier and this method tends to reject these.
2 Accounting rate of return
This method establishes the relationship between the capital cost of a project and the profits accruing. The accounting rate of return is calculated by the following formula.
Average annual profit
------------------------------- x 100
Average cost of investment
An average profit is calculated over the life of the project. The average cost of investment is calculated by adding the initial cost of the investment and the value at the end of its useful life divided by two.
Example:
A company has two alternative projects A and B, each involving an outlay of £500,000 and £600,000
Each project has an economic life of 5 years. Project A has a residual value of £50,000. Annual profits before depreciation is £200,000 before depreciation.
| | Project A | Project B |
| | £ | £ |
| Initial outlay | 500,000 | 600,000 |
| Annual profits (Yr. 1-5) | 1,000,000 | 1,000,000 |
| Less depreciation (Yr. 1-5) | 500,000 | 550,000 |
| | ---------- | ---------- |
| Profits after depreciation | 500,000 | 450,000 |
| | --------- | --------- |
| Average net profit | 100,000 | 90,000 |
| | ---------- | -------- |
| Accounting rate of return | 40% | 28% |
The ARR method is easy to administer and is understood by business in general because of is similarity with the return on investment (ROCE) ratio.
The main disadvantage with payback and accounting rate of return is both ignore the time value of money. Money has a value in time, namely, a rate of interest. If £1 is invested for 1 year at a rate of interest of 10% the investment grows to £1.10 at the end of year 1. If £1.10 is invested in year 2 the investment
grows to £1.21 at the end of year 2. This process is called compounding which is represented by the formula £1(1 + r)n.
The opposite of compounding is discounting. This answers the question ‘ what is £1 receivable in a year’s time worth in today’s value?’ In present value terms £1 receivable in a years time (assuming the rate of interest is 10%) is £0.909. The formula for discounting is: £1
-----------
(1 + r)n
Investment appraisal compares the cash outflows with the cash returns from the project and these cash flows take place over a lengthy period of time.
Discounting allows all the cash flows to be converted to present day values which permits meaningful comparison. The following investment appraisal methods employ the discounting of cash flows.
3 Net Present Value
A particular rate of interest is used to discount future flows of cash to present values. The discount rate used might reflect the cost of obtaining capital, or a target rate/cut-off rate,or a risk-adjusted rate. Once the future cash flows are discounted to present-day values they are totalled and compared with the cost of the project. If the discounted cash flows exceed the cost the difference is the net cash flow. In general, if the NPV is positive the project is worth considering.
Example:
A company wishes to evaluate a capital project based on the following information. The initial outlay is £100,000 and the project has an economic life of 5 years and realises £5,000 when it is sold at the end of year 5. The profits after depreciation have been estimated as year 1-3 £10,000 and £15,000 in the final two years. The rate of interest is 10%.
| | | | | |
| Year | Cash flow | Discount factor | Present value | Cumulative PV |
| | £ | | £ | £ |
| 0 | (100,000) | 1 | (100,000) | |
| 1 | 29,000 | 0.909 | 26,361 | 26,361 |
| 2 | 29,000 | 0.826 | 23,954 | 50,315 |
| 3 | 29,000 | 0.751 | 22,939 | 73,254 |
| 4 | 34,000 | 0.683 | 23,222 | 94,476 |
| 5 | 34,000 | 0.621 | 21,114 | 117,590 |
| 6 | 5,000 | 0.564 | 2,820 | 120,410 |
| | | | --------- | |
| | | | NPV =20,410 | |
| | | | -------- | |
Since theNPV is +£20,410, the project is worthwhile.
4 Discounted payback
In the calculation of the NPV in the previous example a column records the cumulative present value of the cash flows. Since the payback method is criticised for ignoring the time value of money it is possible to remedy this shortcoming by using the discounted cash flows to ascertain the payback period.
In this example, the payback period is just over 4years. There is a shortfall of £5,524 which has to be generated in year 5.
£5,524 365 days
--------- x = 17 days
£117,590
The discounted payback period is 4yrs. 17 days.
5 Internal Rate of Return
Sometimes the company wishes to know the internal rate of return (IRR) ie. the yield of a capital project. The company may operate a cut-off point in respect to projects and should a project’s yield be below this target or threshold it will be rejected. The method is to discount cash flows using different discount rates until the NPV = 0. At that point the total present value of the cash flows is equal to the outlay on the project. The discount rate which produces a NPV = 0 is the internal rate of return of the project. In effect, the company could borrow money at a rate of interest equal to the internal rate of return to finance the project and the returns from the project would allow the company to break even. If the company’s target rate of return for capital projects is less than a project’s yield (IRR) the project is worth consideration.
Example:
Using the data from the previous NPV example work out the projects IRR.
At a discount rate of 10% the NPV = +£20,410. To produce a negative NPV a higher discount rate needs to be chosen. The method proceeds on a trial and error basis. What is the result if a discount rate of 20% is used.
| Year | Cash flow (£) | Discount factor 20% | Present Value (£) | |
| 0 | (100,000) | 0 | (100,000) | |
| 1 | 29,000 | 0.833 | 24,157 | |
| 2 | 29,000 | 0.694 | 20,126 | |
| 3 | 29,000 | 0.579 | 16,791 | |
| 4 | 34,000 | 0.482 | 16,388 | |
| 5 | 34,000 | 0.402 | 13,668 | |
| 6 | 5,000 | 0.335 | 1675 | |
| | | | -------- | |
| | | | NPV= - 7,245 | |
| | | | ------- | |
To determine the discount rate which produces NPV = 0 a process of interpolation is used. Alternatively, it may be solved graphically.
The formula for interpolation is:
IRR = A + [ a / a -b ] x ( A - B )
10% + £20,410
---------------- X 20% - 10% = 17%
(£20,410 + £7,245)
The yield or IRR of the project is 17%. If this is higher than the company’s target rate for projects it is worth consideration.
6 Profitability Index
In the case where a company has a number of alternative projects and has limited resources it is useful to find a way of ranking these in relation to their potential profitability. The method is to divide the discounted cash flows by the initial cost of the project.
Profitability index for project X = £120410
----------- = 1.2
£100,000
For every £1 invested £1.2 worth of cash flow is generated.
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