CAPITAL INVESTMENT
APPRAISAL
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Investment Appraisal
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
As investments involve large resources, wrong investment
decisions are very expensive to correct
Managers are responsible for comparing and evaluating
alternative projects so as to allocate limited resources and
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maximize the firms wealth
Payback period
Accounting rate of return
Payback period
Payback period
Payback period is the period of time it takes
for a company to recover its initial
investment in a project
The method measures the time required for
a projects cash flow to equalize the initial
investment
Acceptance criterion
< predetermined cutoff period Accept the project
> Predetermined cutoff period Reject the project
Example
Project B
$
1000000
Initial investment
Cash inflow at the end of year
Year 1
700000
600000
Year 2
100000
400000
Year 3
100000
400000
Year 4
1300000
400000
Project A : 3 years
Project B: 2 years
Project B takes only two years to recover its initial investment. With
The shortest payback period, the company will accept project B
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Example
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Project B
900000
1000000
Year 1
700000
600000
Year 2
100000
400000
Year 3
100000
400000
Year 4
1300000
400000
Initial investment
Cash inflow at the end of year
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Project A
$
900000
Project B
$
1000000
Initial investment
Discounted cash flow
Year 1
700000 = 583333
400000 = 500000
1.21
1.21
Year 2
100000 = 69444
400000 = 277778
1.22
1.22
Year 3
100000 = 57870
400000
= 231481
3
3
1.2
1.2
Year 4
100000 = 626929 400000 = 192901
1.24
1.24
Discount payback period
Project A
3+ 900000-710647 = 3.3 years
626929
Project B
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15
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Calculation procedures
Average net profit per year (over the life of the project)
ARR =
Average investment cost
Total profit
Average net profit per year = No. of life of the project
Initial investment
Average investment cost =
2
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Acceptance criterion
In evaluating an investment project, the ARR of the project is
compared with a predetermined minimum acceptable accounting
Rate of return:
ARRs
< minimum acceptable rate
= minimum acceptable rate
> minimum acceptable rate
Highest
Comments
Reject project
Accept project
Accept project
Choose highest ARR
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Example
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51000+68000+59500+76500 = $63750
Average net income =
4
400000+0
= $200000
Average investment =
2
The cost of machinery is $400000 at the beginning
The cost of machinery is $0 at the end as depreciation is provided
On straight line method and there is no scrap value
$63750
ARR = $200000 = 31.875%
Since the ARR is 31.875%, which is higher than the minimum
Acceptable rate of 20%, the company should invest in the new
machinery.
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Advantages of ARR
It is easy to understand and compute
It avoids using gross figures. Therefore, it
enables comparisons to be made between
projects with different useful lives
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Disadvantages of ARR
It ignores the time value of money
ARR method seems to be less reliable than
the NPV method. It adopts the accounting
profit instead of cash flows calculation. The
change of depreciation method may also
alter the accounting profit
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Calculation procedures
Determining the discount rate
2. Calculating the NPV:
1.
FV1
FV2
+
NPV = (1+r)1
(1+r)2
FV3
(1+r)3
FVn
(1+r)n - I0
<0
=0
Indifferent to accept
or reject the project
>0
Example
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Required:
(a) Calculate the NPV of each investment and determine whether
to accept it or not (assuming the company has unlimited
resources)
(b) If the company has limited resources, determine which
investment should be accepted by referring to the highest NPV
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(a)
Project A
120000
250000
400000
1300000
+
+
+
NPV = 1.12
2
3
1.12
1.12
1.124 - 900000
= $517327 (accepting)
Project B
40000
NPV = 1.12
400000
+
1.122
400000
400000
+
+
3
1.12
1.124 - 1000000
= $214920(accepting)
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(a)
Project C
100000
100000
100000
100000
+
+
+
NPV = 1.12
2
3
1.12
1.12
1.124 - 303730
= $0 (indifferent to accept or reject)
Project D
10000
NPV = 1.12
10000
+
1.122
1000000
1000000
+
+
3
1.12
1.124 - 1500000
= -$135801(rejecting)
(b) With limited resources, the company should only accept project A
because it generates the highest NPV
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Advantages of NPV
Consistency with the time value of money
concept
Consideration of all cash flows
Adoption of cash flows instead of
accounting profit
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Calculation procedures
1.
2.
FVn
(1+r)n - I0 = 0
3.
4.
IRRs
Comments Reasons
NPV<0
NPV=0
Accept
NPV>0
Highest
Accept
Example
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$200
+
(1+r)3
- $400 = 0
- $400 = 8.4
- $400 = -3.8
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P
IRR = L +
(H L)
PN
Where L = Discount rate of the low trial
H = Discount rate of the high trial
P = NPV of cash flows of the low trial
N = NPV of cash flows of the high trial
IRR = 22% +
8.4
(24 22)%
8.4 (-3.8)
= 23.38%
Since the IRR (23.38%) is higher than the minimum rate of return (15%),
The project should be accepted
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