UNIVERZITET U NOVOM PAZARU

Suad Bećirović

DYNAMIC AND STATIC METHODS OF

INVESTMENT APPRAISAL

Novi Pazar, 2006.

 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

CONTENTS

1. Investment and Finance......................................................................................................7

2. Acquisition Costs................................................................................................................7
3. Residual Value....................................................................................................................7
4. Useful Life..........................................................................................................................7
5. Cost of Capital....................................................................................................................8
1.1. Overview..........................................................................................................................9
1.2. Equivalent Annual Cost Method....................................................................................10

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

List of Illustrations

Illustration 1: Overview of the several types of investment..................................................4

Illustration 2: Steps in Project Appraisal...............................................................................5

Illustration 3: Different types of useful life.............................................................................8
Illustration 4: Factors for determining the cost of capital....................................................8
Illustration 5: Methods for Investment Appraisal.................................................................9
Illustration 6: Operands and Characteristics of the Static Methods...................................9
Illustration 7: Example for an Equivalent Annual Cost Method.......................................12
Illustration 8: Example for a Profit Comparison Method..................................................13
Illustration 9: Example for an Accounting Rate of Return Method..................................14
Illustration 10: Example for Simple Payback Method........................................................15
Illustration 11: Example for Non-Monetary Criteria in the Value Benefit Analysis.......17
Illustration 12: Example of Two Competing Investments..................................................18
Illustration 13: Example for a Net Present Value calculation............................................19
Illustration 14: Example for Using the Net Present Value Method in Comparing Two
Alternatives..............................................................................................................................19
Illustration 15: Example for Determining the Internal Rate of Return with the
Approximation Method..........................................................................................................21
Illustration 16: Example for Calculating an Annuity..........................................................22
Illustration 17: Example for Dynamic Payback Method....................................................23

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

Introduction
Organisations operate in a dynamic environment. Therefore they have to meet the
challenges that the dynamic nature of the environment brings. To meet these challenges, a
company has to invest large sums of money, in order to have an advantage compared to their
competitors. The need for investments is a daily occurrence in a company: obsolescence and
excess of age of machines, means of transportation and buildings; increasing expenses for
maintenance and servicing; innovation of modern production equipments and processes or
changes in the markets of the manufactured products. All these causes require new
investments. Figure 1 gives an overview of the several types of investment or reasons for an
investment.
Type of investment Examples:
Diversification Investment − A company decides to produce its product in a foreign country
for the foreign market
Expansion Investment − Due to high demand, the available capacity will be expanded
Modernisation Investment − An existing IT-equipment will be replaced by a more powerful
equipment
Rationalisation Investment − A machine falls regularly out, so it has to be decided whether it
should be replaced by a better machine
⇒ Contrary to a modernisation investment, rationalisation
investments are intended to change the production process, in
order to minimize the production costs
Maintenance investment − A machine will not be replaced, but repaired
First or Construction − A supplier announces to increase its prices, so the company will
Investment produce the part on its own
− Start-up of a company
− Construction of a branch
Finance Investment − A company wants to buy shares of a supplier for a strategic
partnership
− Temporary investment of excess liquidity in stocks and shares
Security Investment − Increase of safety stock of raw materials
Personnel Investment − Expenditures for education of personnel
Illustration 1: Overview of the several types of investment
Source: Schulte, S., Script Investition und Finanzierung, p. 8
For a company, the decision for an investment means to give up liquidity. As
compensation of this abandonment and the fact that the company cannot use this liquidity
anymore for other purposes, the company expects a profit, in order to have more liquidity in
future. For this purpose, an investment can be defined as “spending of money now in the hope
of higher returns in future.”1
As every investment contains risks, the decision for an investment takes place in several
steps, which can be seen in illustration 2.

1
Wöhe, G., Einführung in die Allgemeine Betriebswirtschaftslehre, p. 618

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

Motivation for an Investment

⇓
Initial Investigation
⇓
Evaluation of the Investment Investment Appraisal

⇓
Decision for an Investment
⇓
Implementation of the investment
⇓
Investment Controlling
Illustration 2: Steps in Project Appraisal
Source: Schulte, S., Script Investition und Finanzierung, p. 13
Firstly, there must be a reason or cause for an investment. The main motivation for an
investment is profit maximisation. To realise this goal, the types of investment, shown in
figure 1, can be used. After realisation of the necessity of an investment and what type of
investment the company wants to conduct, the investor has to check, whether the project is
technically feasible and commercially viable. This involves assessing the risks and deciding
whether the project is in line with the company's long-term strategic objectives. After making
this decision, the investor has to check the economic efficiency of the project. Therefore, a
detailed investigation will take place in order to examine the projected cash flows of the
project. In order to make the correct decision, several methods for investment appraisal have
been developed, which will be discussed in detail in this paper. By means of these methods a
decision will be made, which project is the most efficient and allows the greatest possible
profit. At the stage of implementation of the investment proposal, responsibility for the
project is assigned to a project manager or another responsible person. This person supervises
that the project will be realised within the technical standards and the planned finance and
time frame.2 After realisation of the project, the planned cash flows have to be compared with
the actual cash flows. Such a comparison is important for two reasons. On the one hand, the
investor has to implement retaliatory action, on the occasion of an accounting variance. On
the other hand this assessment enables the investor to do a better forecast for future
investments.3
This short description of the steps in a project appraisal shows what importance investment
appraisals have in the framework of this process. Investment appraisals are aids to forecast
and assess the future success of an investment. So these methods play an important role in the
appraisal of a project. On the other hand, this also shows the danger, if an investment
appraisal is not executed correctly, because this will lead to a misinvestment. A
misinvestment occurs, when the actual cashflows are so much behind the original
expectations that it would have been better for the investor not to undertake the investment.4

2
Wöhe, G., Einführung in die Allgemeine Betriebswirtschaftslehre, p. 625
3
Ibid.
4
Ibid., p. 622

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

Methodology

1. Goals of the Thesis

Due to the great importance of the investment appraisals in project appraisal, this study has
the goal to investigate the standard methods, which are mentioned in the literature for this
purpose. So, we will investigate, whether these methods are able to meet the required tasks.

2. Means of Research
In order to fulfil the mentioned goals, the following steps will be carried out:
1. At the beginning of the study, we will clarify essential fundamental terms of finance
and investment. Thus, the reader should be able to separate these terms, in order to
have a better understanding of the methods of investment appraisal.
2. After this, we will present the different methods of investment appraisal. Besides the
method, we will discuss the advantages and disadvantages of every single method. So,
it will be possible to assess, whether these methods are useful or not.

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

I. Fundamental Terms

1. Investment and Finance

The terms investment and finance have to be differentiated, because they describe
contrasts. These terms have the following meaning:
Finance: Investment:
Provision of liquid funds, e.g. by taking a An investment is the dedicated, usually long-
credit to finance a project term, capital lockup in order to receive future
returns.5

2. Acquisition Costs
Normally there is no problem to determine the costs for the acquisition of an investment
object. It has to be observed that all costs for the acquisition are recorded. Therefore it is
important to add all costs, which occur, until the investment object can be used. Examples for
such additional costs, besides the acquisition price, can be:
- Costs for rebuilding due to changes and displacement of the available machines or
other assets
- Installation costs for assembly, installation etc.
- Launching costs for implementing, test runs, orientation etc.
- Engineering costs for necessary investigations, advisory opinions etc.
Besides the acquisition of the investment object from outside, the object can be
manufactured by the company itself. In this case it has to be calculated with the production
costs.

3. Residual Value
Besides the acquisition costs, the value of the investment object at the end of the useful life
has to be considered. The residual value is the expected sales revenue of an investment object
at the end of the calculated useful life.
The residual value has to be considered, because it effectively decreases the acquisition
costs in the calculation of the investment appraisal.

4. Useful Life
The useful life is the period, in which the investment object is used according to its
purpose. In practice, there are several types of useful life, which are shown in the following
table:

5
Gabler Wirtschaftslexikon, p. 1636

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

Technical Useful Life Economic Useful Life Average Useful Life Legal Useful Life
Period, in which an asset Useful life, which leads Average useful life is The legal useful life
(especially machines, to the biggest possible usually determined by is in particular
buildings) is technically profit of an investment the tax authorities, in relevant for intangible
able to fulfil its purpose. object. Therefore, the order to limit the assets like licences,
It is possible to extend main problem in maximum possible property rights and
this period substantially determining the depreciation of an furthermore for
by preventive economic useful life is object. Therefore the leasing contracts.
maintenance and repair. the calculation of the main disadvantage of This length is
Therefore the technical optimal replacement this type is that this determined by the
useful life is longer than time, i.e. when an old useful life is respective contracts.
the economic one. object should be determined according
Determination is made replaced by a new one. to the taxation policy
according to statistical and not according to
Important factors here
investigations or economic aspects.
are:
experience figures.
• Technical wear out
• Technical
development
• Economic
development
Illustration 3: Different types of useful life
Source: See Script Investition und Finanzierung & Gabler Wirtschaftslexikon
For the investment appraisals, the economic useful life is the most important.

5. Cost of Capital
Cost of capital represents the minimum interest rate demanded by the investor. Therefore
those costs are included into the calculation. Illustration 4 shows several methods for
determining the cost of capital.
Methods for Determining the Cost of Capital
Costs of Financing Opportunity Costs Other Methods
− Cost for loan capital − Choice of the interest rate − Rate of return of the
of the next best excluded company
− Cost for equity capital
alternative as internal rate
− Rate of return of
of return.
similar companies
− Determination via the
Bank interest modified
internal rate of return
by:
method
− expected inflation rate
− tax rate
− risk surcharge
Illustration 4: Factors for determining the cost of capital
Source: Schulte, S., Script Investition und Finanzierung, p. 9

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

II. Overview over the Different Methods for Investment Appraisal

Methods for Investment Appraisal

Static Methods Dynamic Methods
Equivalent Annual Cost Method Net Present Value Method
Profit Comparison Method Annuity Method
Accounting Rate of Return Dynamic Payback Method
Static Payback Method
Illustration 5: Methods for Investment Appraisal
Source: Own Picture
The methods for investment appraisal are divided into static and dynamic methods. The
main difference between these types is that static methods usually consider only one period
and particularly do not consider the interest on capital (especially compound interest).
Therefore static methods are more and more ousted by the dynamic methods, which consider
the time value of money in their appraisals.6

1. Static Methods
In the static methods, costs, revenues, profits and rate on returns are compared. They do
not consider the time factor, i.e. they usually calculate only with one period. Therefore, the
results are only useful for relatively short periods.

1.1. Overview
With regard to the used operands and number of planning periods, the following methods
can be differentiated:
Operands Number of the considered
periods
Equivalent Annual Cost Method costs one
Profit Comparison Method costs and revenues one
Accounting Rate of Return costs and revenues one
Static Payback Method cash flows several
Illustration 6: Operands and Characteristics of the Static Methods
Source: Wöhe, G., Einführung in die Allgemeine Betriebswirtschaftslehre, p. 629
In the following, we will present and discuss these methods.

6
Knapps Enzyklopädisches Lexikon des Geld-, Bank- und Börsenwesens, p. 1027

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

1.2. Equivalent Annual Cost Method

1.2.1. Character
The equivalent annual cost method compares the costs of several investment alternatives.
According to this method, the alternative with the minimal costs has to be chosen. Therefore,
all occurring costs should be included into this calculation.
This method can be used in comparing, whether a replacement investment is favourable
(comparison: old asset/new asset). Furthermore, it can be used in comparing several
comparable replacement investments.
In the following section, we will present the single types of costs, which should be
included into this calculation.

1.2.2. Determination of the Single Types of Costs

1.2.2.1. Determination of the Cost of Capital

The cost of capital is calculated in order to consider the costs for the acquisition of the loan
or equity capital. On the one hand, if a credit is taken from a bank, the interest on this loan has
to be paid. On the other hand, if the project is financed by equity capital, it has to be
considered that this money could also be invested in interest-bearing investments, so the
investment causes opportunity costs.
The interest charges are calculated on the basis of the average capital employed. The
average capital employed bases on a simple calculation of the average. However, if a residual
value exists, this has to be considered at calculating the average. So we can conclude the
following formula for this calculation:
C + RV
Cc = *i
2
Cc = cost of capital
C = acquisition costs
RV = residual value
i = interest rate

1.2.2.2. Determination of the Cost Accounting Depreciation

With the cost accounting depreciation, the depreciation of the investment object is
considered. In investment appraisals, linear depreciation is usually used. The cost accounting
depreciation can be calculated with the following formula:
C − RV
Cd =
UL
Cd = cost accounting depreciation
C = acquisition costs
RV = residual value
UL = useful life

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

If there is a residual value at the end of the period, it has to be subtracted from the
acquisition costs, in order to get the real depreciation of the investment object.

1.2.2.3. Determination of the Operating Costs

The operating costs consist especially of the following types of costs:
 Personnel costs:
- Wages
- Salaries
- Fringe benefits
 Material costs:
- Raw materials
- Auxiliary material
- Operating supplies
 Maintenance costs:
- Repair costs
- Inspection costs
- Service costs
 Occupancy costs
 Energy costs
 Tooling charges

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

1.2.3. Example
The following table shows two investment alternatives with their respective costs.
Machine 1 Machine 2
1. Acquisition Costs 100,000 € 50,000 €
2. Useful Life (years) 5 5
3. Residual Value 10,000 € 0
4. Utilisation (units/year) 10,000 10,000
5. Depreciation (€/year) 18,000 € 10,000 €
6. Cost of Capital (interest rate of 10%) 5,500 € 2,500 €
7. Other Fixed Costs 1,000 € 700 €
8. Total Fixed Costs 24,500 € 13,200 €
9. Labour Costs 4,700 € 12,000 €
10. Material Costs (€/year) 1,500 € 1,500 €
11. Energy and other costs 800 € 2,000 €
12. Total Variable Costs 7,000 € 15,500 €
13. Variable costs per unit 0.70 € 1.55 €
13. Total Costs 31,500 € 28,700 €
Illustration 7: Example for an Equivalent Annual Cost Method
Source: Own Illustration
We can see that machine 2 has smaller total costs. Therefore, according to this method,
machine 2 has to be chosen as an investment.

1.2.4. Assessment
Advantages:
− Simple application
− Relatively easy data collection
Disadvantages:
− Possible accrual of costs at different times is not considered
− Only period is assessed, which leads to inaccuracies
− At comparing alternatives, different useful lives are not considered, because only the costs
of one period are taken into account
− Future differences in quality and capacity are not considered
− In practice, it is often difficult to separate the costs in variable and fixed
− The extent of capital expenditure is not considered adequately

1.3. Profit Comparison Method

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

1.3.1. Character
The profit comparison method is an extension of the equivalent annual cost method. Here,
besides the costs, the revenues are also included into the calculation. If the possible revenues
of the alternatives are different, the profit comparison method has to be carried out, because
the equivalent annual cost method would lead to wrong conclusions.
Reasons for different profits could be:7
a) The investment alternatives have different performance features (e.g. maximum output)
b) The investment alternatives have different qualitative characteristics, so it could be
possible that the output quantity is the same, but the products of one alternative are
qualitatively superior and could be sold at a higher price
However, some authors are of the opinion that the profit comparison method should not be
used, because in all cases, in which different revenues occur, a comparison of the rate of
return should be executed.8

1.3.2. Example
We will use the same example, as in the previous section. For example the products of
machine 1 can be sold at 4 € per unit and the products of machine 2 for 3.50 € per unit. So we
receive the following results:
Machine 1 Machine 2
Revenues 40,000 € 35,000 €
Costs 31,500 € 28,700 €
Profit 8,500 € 6,300 €
Illustration 8: Example for a Profit Comparison Method
Source: Own Illustration
In this case, machine 1 is more favourable than machine 2.

1.3.3. Assessment
Advantages:
− Besides the costs, the revenues are taken into account, so investment objects with different
revenues can be compared
− Simple application
− Relatively easy data collection

Disadvantages:
− Short-term, static method
− Different extent of profits in the single periods are not considered
− Assignment of the revenues to the single investment objects is usually very difficult

7
Schulte, S., Script Finanzierung und Investition, p. 22
8
Boegelspacher, K., Script Investition & Finanzierung, p. 26

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

− Already realised profits are compared with future possible ones

− This method only compares absolute profits, but does not compare the rates of return

1.4. Accounting Rate of Return

1.4.1. Character
One of the essential disadvantages of the equivalent annual cost method and profit
comparison method is that they assess investment opportunities without consideration of the
necessary employment of capital. Therefore the accounting rate of return determines the
relative advantage of an investment.
For the calculation of the rate of return, this method uses the results of the annual cost and
profit comparison method. Here the corrected profit of a period is related to capital employed
on average. The corrected profit contains, besides the actual profits, the costs of capital. In
that way this method wants to consider greater differences in the acquisition costs.9
Corrected Profit
Accounting Rate of Return = * 100
Average Capital Em ployed

According to this method, an investment is advantageous, when the rate of return is greater
than the minimum rate of return or the investment with the greatest rate of return is the most
favourable.

1.4.2. Example
Machine 1 Machine 2
Revenues 40,000 € 35,000 €
Costs 31,500 € 28,700 €
Profit 8,500 € 6,300 €
Cost of Capital 5,500 € 2,500 €
Corrected Profit 14,000 € 8,800 €
Average Capital Employed10 55,000 € 25,000 €
Accounting Rate of Return 25.5 % 35.2 %
Illustration 9: Example for an Accounting Rate of Return Method
Source: Own Illustration
It is interesting that according to this method, machine 2 is more favourable, while the
profit comparison method proposed machine 1. The reason for this is that machine 1, despite
its greater absolute profits, has much a greater average capital employed. Therefore, in
relative terms, machine 2 is more favourable.

1.4.3. Assessment

9
Wöhe, G., Einführung in die Allgemeine Betriebswirtschaftslehre, p. 631
10
For the calculation of the average capital employed see section 1.2.2.1

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

The greatest advantage of the accounting rate of return method is that it determines the
relative advantage of an investment. Furthermore, this method has the same advantages as the
profit comparison and equivalent annual cost method.
This method has the same disadvantages as the profit comparison method. Furthermore,
this method does not take into account the time value of money in determining the rate of
return. So, it supposes that the differences in the acquisition costs can be invested at the
respective accounting rate of return (i.e. practically at every interest rate).11 However, this
assumption is not very realistic.

1.5. Simple (Static) Payback Method

1.5.1. Character
The static payback method is the only static method, which uses data of several periods.
This method calculates the period, which is necessary to compensate the acquisition costs by
the annual cash flows of the investment. An investment is advantageous when it has a short
payback period. The payback period is the period in which the acquisition costs of the
investment are “paid back”, i.e. returned to the company.
The methods, discussed so far, use costs and revenues. However, in order to calculate the
cash flow, the profits have to be corrected by the depreciation. The depreciation is subtracted
from the revenues at calculation of the profit, but the depreciation is not affecting payment, so
it has to be added to the profits. So the approximate cash flow can be determined.
In this method it is assumed that the whole cash flow is used exclusively for the payback of
the investment.

1.5.2. Example
Machine 1 Machine 2
Acquisition Costs 100,000 € 50,000 €
Useful Life (years) 5 5
Cash Flow Year 1 (cumulative) 26,500 € (26,500 €) 16,300 € (16,300 €)
Cash Flow Year 2 27,500 € (54,000 €) 16,700 € (33,000 €)
Cash Flow Year 3 25,000 € (79,000 €) 15,000 € (48,000 €)
Cash Flow Year 4 21,000 € (100,000 €) 12,000 € (60,000 €)
Payback Period 4 years 3.17 years
Illustration 10: Example for Simple Payback Method
Source: Own Illustration
According to this method, machine 2 has to be chosen.

1.5.3. Assessment

11
Knapps Enzyklopädisches Lexikon des Geld-, Bank- und Börsenwesens, p. 1028

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

Advantages:
− Simple application
− Shows how fast the acquisition costs return to the company
− Relatively easy data collection

Disadvantages:
− Simple payback does not take into account the time value of money
− It ignores cash flows received after the end of the payback period
− It does not take into account the overall profitability of the project.

1.6. Value Benefit Analysis

The value benefit analysis is not a classical method for investment appraisal. It is a method
to assess alternatives according to non-monetary criteria, e.g. technical, psychological or
social criteria. Therefore this method should complete every investment appraisal.
The single criteria are weighted and every investment alternative receives certain points
according to its fulfilment of the criteria. The alternative with the most points is chosen.
Illustration 11 shows some examples for such criteria.

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL
Market Criteria
Labour- and Procurement Criteria
Labour Physiological Criteria
Infrastructure Criteria
Technical Criteria
Environmental Criteria
Illustration 11: Example for Non-Monetary Criteria in the Value Benefit Analysis
Source: Bögelspacher, K., Script Investition & Finanzierung, p. 29/30
• Market Share
• Saturation of the Market
• Product Range
• Market Strategy
• Availability of Qualified Labour
• Availability of Raw Material
• Service
• Delivery Time
• Accident Prevention
• Dust, Noise and Other
Annoyances
• Intellectual Capability
• Manual Capability
• Handling
• Internal and external transport
possibilities
• Energy Supply
• Pre- and Post-Capacity
• Waste Disposal
• Universal Availability
• Capacity Reserves
• Degree of Automation
• Maturity of Construction
• Disturbances during Installation
• Accordance with Magisterial
Planning
• Environmental Impact due to
Emissions
• Image Improvement in the market
• Meeting Socio-Political Needs
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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

2. Dynamic Methods
The dynamic methods are said to be more superior to the static methods, because they take
into account the time value of money. These methods assume that one Euro today is worth
more than one Euro this time next year. Because today’s one Euro can be invested and receive
income from it. Therefore, the dynamic methods stress that future cash flows should be
expressed in terms of what they are worth now when cash is expended on the project. The
present values of these future cash flows can then be compared with what we are spending
now on the project. In other words, the net present value is saying that one should compare
like with like, which of course is a fair statement. By setting the future cash inflows from the
project without discounting them against the initial capital cost, one is not being realistic and
fair.12
The following example will show the differences between the dynamic and static methods:
Project Profits in the years Average
1 2 3
A 10 20 30 20
B 27 20 10 19
Illustration 12: Example of Two Competing Investments
Source: Knapps Enzyklopädisches Lexikon des Geld-, Bank- und Börsenwesens, p. 1027
In this case, if we want to conduct an investment appraisal according to the static methods,
we will choose Project A. Because the static methods only use one period and calculate with
average values, project A will be chosen. However, the dynamic methods try to consider all
periods, in which the investment object is used. We can see that project A has on the one hand
a greater average profit, but has small profits at the beginning of its use. Contrary to this,
project B has a smaller average profit, but greater profits at the beginning of the period.
Therefore it has to be investigated, whether the combination of profits of project B are
probably more favourable than of project A. The dynamic methods give an answer to this
question, as we will see in the following sections.

2.1. Net Present Value Method

2.1.1. Character
This method compares the present values of cash outflows and inflows. If the result gives a
positive net present value, then the project is favourable. An investment is more
advantageous, the greater the net present value is.
The net present value is calculated according to this formula:
n
It - Ot
NPV = -A 0 + ∑
i =1 qt

NPV = net present value

I = cash inflows in the years1 to n
O = cash outflows in the years1 to n
t = period (t = 0, 1, 2, ..., n)
n = useful life of the investment object

12
O Idowu, S., Capital investment appraisal - part 1

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

q = interest rate13
A0 = Acquisition Costs in period 0
A positive net present value can be interpreted as follows: The internal interest rate of the
investment is higher than the interest rate, which was used in the calculation. So the net
present value shows the profit of the investment. If the net present value is zero, the
investment only produces the minimum rate of return. In this case the cash flow can only
cover the acquisition costs and the cost of capital for the capital employed. This is especially
important, when the investment is financed with loan capital.

2.1.2. Example
In the following example, we will calculate the net present value of an investment, with
acquisition costs of 100,000 € and a residual value of 10,000 € in period 5. Furthermore we
will calculate with an interest rate of 10% and with the following cash inflows and outflows:
Year Cash Inflows Cash Outflows Difference Present Value
0 100,000 -100,000 -100,000
1 55,000 15,000 40,000 36,364
2 50,000 20,000 30,000 24,793
3 45,000 20,000 25,000 18,783
4 40,000 22,000 18,000 12,294
5 38,000 28,000 10,000 6,209
Residual Value 10,000 0 10,000 6,209
Net Present Value 4,653
Illustration 13: Example for a Net Present Value calculation
Source: Own Illustration
We can see that the investment has a net present value of 4,653 €. Therefore the internal
rate of the investment is higher than the interest rate of 10 %.
The net present value method can also be used in comparing two competing investments.
This shows the following example:
Year Machine 1 Machine 2
0 -100,000 -100,000 -50,000 -50,000
1 40,000 36,364 20,000 18,182
2 30,000 24,793 15,000 12,397
3 25,000 18,783 15,000 11,270
4 18,000 12,294 10,000 6,830
5 10,000 6,209 5,000 3,105
Residual Value 10,000 6,209 0 0
Net Present Value 4,653 1,783
Illustration 14: Example for Using the Net Present Value Method in Comparing Two Alternatives
Source: Own Illustration
This example shows that machine 1 is more favourable than machine 2. It has to be
mentioned that the residual value at the end of the period is treated as a cash inflow and
therefore has to be discounted.

13
Instead of the interest rate, the inflation rate can be used, in order to make the cash flows of different years
comparable

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2.1.3. Assessment
Advantages:
− Considers the time value of money
− Shareholder wealth is maximised
− It is based on cash flows, which are less subjective than profits.

Disadvantages:
− It assumes that there is no difference between the interest rate for equity capital and for
loan capital.
− It assumes that money can be invested on the same interest rate during the whole period14
− it can be difficult to identify an appropriate discount rate
− Cash flows are usually assumed to occur at the end of a year, but in practice this is over
simplistic
− It is assumed that the cash flows can be assigned directly to the investment object
− It is difficult to compare alternatives with different useful lives with this method

2.2. Internal Rate of Return Method

2.2.1. Character
This method allows determining the real rate of return of an investment. So in such a case
the net present value of an investment would be zero. The internal rate of return therefore is
the maximum rate of discount that will be used to finance a project without making a loss
from it. This is especially an important question, when the project is financed by loan capital.
So the investor knows what the maximum possible interest rate of the loan could be.
In order to calculate the internal rate of return, the equation for determining the net present
value has to be solved for qt. This is a very complicated mathematic operation. Therefore
there are two possibilities to solve this problem. First, software (e.g. MS Excel) can be used to
calculate the internal rate of return or an approximation method can be used.
In the approximation method two net present values (NPV 1 and NPV2) for two arbitrarily
determined interest rates. However, these interest rates should not be too far from another (< 5
%). The first net present value has to be negative (NPV1), while the second one must be
positive (NPV2).15 The calculated values are inserted into the formula below:
q 2 - q1
q int = q1 - NPV1 *
NPV2 - NPV1

The investment is advantageous, when the internal rate of return is not below the expected
minimum interest rate.

14
Knapps Enzyklopädisches Lexikon des Geld-, Bank- und Börsenwesens, p. 1030
15
Bögelspacher, K., Script Investition & Finanzierung, p. 32

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

2.2.2. Example
For this example, we will use the same data as in the example of the previous section. As
second interest rate, we will use an interest rate of 13%, which results in a negative net
present value.
Year i = 10% i = 13 %
0 -100,000 -100,000 -100,000 -100,000
1 40,000 36,364 40,000 35,398
2 30,000 24,793 30,000 23,494
3 25,000 18,783 25,000 17,326
4 18,000 12,294 18,000 11,040
5 10,000 6,209 10,000 5,428
Residual Value 10,000 6,209 10,000 5,428
Net Present Value 4,653 -1,886

Illustration 15: Example for Determining the Internal Rate of Return with the Approximation Method
Source: Own Illustration
When we insert the data into the formula, mentioned above, we receive the following
result:
1.10 - 1.13
q int =1,13 - (-1886) * =1,121
4653 - (-1886)

So machine 1 has an internal rate of return of 12.1 %.

2.2.3. Assessment
Advantages:
− It takes into account the time value of money, which is a good basis for decision-making
− Results are expressed as a simple percentage and therefore are more easily understood than
some other methods
− It indicates how sensitive decisions are to a change in interest rates.

Disadvantages:
− Projects with unconventional cash flows can have either negative or multiple IRRs. For
example, a project has the following cash flows: A0 = 1, CF1 = 6, CF2 = -11 und CF3 = 6. If
we use the simple payback method, we would refuse this investment, because the payback
period is at the end of the useful life. If we use the internal rate of return method, we would
6 11 6
also receive an IRR of 0 %. Because − 1 + 1 − 2 + 3 = 0 . However, this project has two
1 1 1
(!) further IRRs, qint = 100 % and qint = 200 %, because the equations
6 11 6 6 11 6
− 1 + 1 − 2 + 3 = 0 and − 1 + 1 − 2 + 3 = 0 are also solved. Such results make no
2 2 2 3 3 3
sense, especially when we calculate the maximum possible interest rate for loans and
moreover the question, which IRR of this example is the correct one, is not answered.16

16
Knapps Enzyklopädisches Lexikon des Geld-, Bank- und Börsenwesens, p. 1031

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

− IRR cannot accommodate changes in interest rates over the life of a project
− It assumes funds are re-invested at a rate equivalent to the IRR itself, which may be
unrealistically high.
− It may give conflicting recommendations to net present value
The question arises, what to do, when the internal rate of return method and net present
value method calculate different results? Then the net present value method should be used.
Because the internal rate of return method leads to inexpedient results, as the example
mentioned above shows. The NPV method assumes that the cash flows can be invested on the
calculated interest rate. However, the IRR method assumes that funds are re-invested at a rate
equivalent to the IRR itself. This assumption is very unrealistic, especially for non-monetary
investments.17

2.3. Annuity Method

2.3.1. Character
The annuity method distributes the net present value into commensurate annuities.
Therefore, an investment is advantageous, when the annuity is not negative. The annuity
method leads to the same results, like the net present value method. Therefore, it can be called
a version of the net present value method.
The annuity can be calculated with the following formula:
q n (q - 1)
a = NPV *
q n −1

2.3.2. Example
Year Cash Flow Present Value
0 -100,000 -100,000
1 40,000 36,364
2 30,000 24,793
3 25,000 18,783
4 18,000 12,294
5 10,000 6,209
Residual Value 10,000 6,209
Net Present Value 4,653
Annuity 1,227
Illustration 16: Example for Calculating an Annuity
Source: Own Illustration
This investment has an annuity of 1,227 €. Therefore the investor is able to take annually
1,227 € and the investment has still an internal rate of return of 10%.

2.4. Dynamic Payback Method

17
Wöhe, G., Einführung in die Allgemeine Betriebswirtschaftslehre, p. 644

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

2.4.1. Character
The dynamic payback method determines in which period the capital employed plus the
expected interest rate returned to the company. The payback period is in particular dependent
on the interest rate. A high interest rate leads to a long payback period, while a short interest
rate leads to a short payback period.

2.4.2. Example
We will calculate the payback period for machine 1.
Year Machine 1 Present Value Cumulative Value
Present Value
0 -100,000 -100,000 -100,000
1 40,000 36,364 -63,636
2 30,000 24,793 -38,843
3 25,000 18,783 -20,060
4 18,000 12,294 -7,766
5 10,000 6,209 -1,557
Residual Value 10,000 6,209 +4,653
Net Present Value 4,653
Illustration 17: Example for Dynamic Payback Method
Source: Own Illustration
We can see that the payback period of this investment is about 4 years.

2.4.3. Assessment
Advantages:
− Considers the time value of money
− It is based on cash flows, which are less subjective than profits
− Shows how fast the acquisition costs plus interest return to the company

Disadvantages:
− It ignores cash flows received after the end of the payback period
− It does not take into account the overall profitability of the project.

2.5. Conditions for Using the Dynamic Methods

For using the dynamic methods, the following conditions have to be fulfilled:18
- For every investment object it must be possible to assign the cash inflows and outflows,
which is not very easy in practice

18
Gabler Wirtschaftslexikon, p. 1645

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 DYNAMIC AND STATIC METHODS OF INVESTMENT APPRAISAL

- The cash flows have to be reinvested immediately and they must be able to produce a
yield at the calculated interest rate at minimum
- The liquidity of the company is assured in any case, i.e. no matter what kind of investment
will be undertaken
- The company is able to sell its products at a predetermined price, in unlimited quantity

3. Conclusion
We have shown in this study, what alternatives a company has, in order to determine the
possible success of an investment. The single methods have been investigated according to
their advantages and disadvantages. Due to their disadvantages, especially because they use
only one period and ignore the time value of money, the static methods are more and more
ousted by the dynamic methods. The most important advantage of the dynamic methods is
that they consider the time value of money. However, these methods are based on some
unrealistic assumptions:19
 The cash flows can be invested on the same interest rate during the whole useful life
of an investment object
 There is no difference between the interest rate for equity capital and for loan capital.
 It is difficult, sometimes impossible, to assign cash inflows and outflows to the
investment object
 Every investment contains risks. These risks have to be considered in the investment
appraisals
All these assumptions are not very realistic, but they are fundamental for the application of
the dynamic methods. Due to these constraints, new methods have been developing for
investment appraisals, which try to compensate the disadvantages of the traditional methods.
Examples for these new methods are the DEAN-model, methods of operations research and
approaches for a simultaneous investment and finance planning.

19
See also Wöhe, G., Einführung in die Allgemeine Betriebswirtschaftslehre, p. 654

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Bibliography
1. Bögelspacher, K., Script: „Investition & Finanzierung“
2. Gabler Wirtschaftslexikon, 15th edition, Wiesbaden, 2000.
3. Irons, A., Capital investment appraisal, article at
http://www.accaglobal.com/publications/studentaccountant/1105038
4. Knapps Enzyklopädisches Lexikon des Geld-, Bank- und Börsenwesens, 4th edition,
Frankfurt am Main, 1999.
5. O Idowu, S., Capital investment appraisal - part 1, article at
http://www.accaglobal.com/publications/studentaccountant/39869
6. Schulte, S., Script: „Finanzierung und Investition“
7. Wöhe, G., Einführung in die Allgemeine Betriebswirtschaftslehre, 20th edition, München,
2000.

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