FM – Investment Appraisal

Contents
Introduction and Accounting Rate of Return ......................................................................... 3
INTRODUCTION .................................................................................................................. 3
INVESTMENT DECISION ...................................................................................................... 3
ACCOUNTING RATE OF RETURN ......................................................................................... 3
SIMILARITIES OF ARR AND ROCE ........................................................................................ 5
ADVANTAGES AND DISADVANTAGES OF ARR Advantages ................................................ 5
Relevant cash flows and Payback period ............................................................................... 6
RELEVANT CASH FLOW ....................................................................................................... 6
PAYBACK PERIOD ................................................................................................................ 7
The Time Value of Money ...................................................................................................... 9
COMPOUNDING.................................................................................................................. 9
DISCOUNTING ..................................................................................................................... 9
DISCOUNT FACTOR ........................................................................................................... 10
ANNUITY FACTOR ............................................................................................................. 10
DELAYED ANNUITY............................................................................................................ 10
PERPETUITY....................................................................................................................... 10
DELAYED PERPETUITY ....................................................................................................... 11
Net Present Value (NPV), Internal Rate of Return (IRR) and Discounted Payback Period .. 14
NET PRESENT VALUE (NPV) .............................................................................................. 14
DISCOUNTED PAYBACK PERIOD ....................................................................................... 19
INTERNAL RATE OF RETURN (IRR) .................................................................................... 21
Investment Appraisal ........................................................................................................... 28
ADVANCED NPV ................................................................................................................ 28
NPV PRO FORMA .............................................................................................................. 28
CAPITAL (WRITING DOWN) ALLOWANCES ....................................................................... 29
WORKING CAPITAL ........................................................................................................... 29
SOLUTION 1 ...................................................................................................................... 30
INFLATION......................................................................................................................... 31

1
FISHER EFFECT .................................................................................................................. 32
SOLUTION 2 ...................................................................................................................... 32

2
Introduction and Accounting Rate of Return
INTRODUCTION

The three key decisions in financial strategy are:

− Finance decision - where do we get our money from?

− Investment decision - what do we spend it on?

− Dividend decision - do we return money to our investors or do we retain it?

INVESTMENT DECISION

The objective of investment decisions is to maximise the wealth of shareholders.

There are four main investment appraisal techniques examinable in FM. Two of these
consider time value of money (through discounting), whereas the other two do not.

The two techniques that do not involve discounting are:

− The accounting rate of return (or ARR)

− Payback period (or PBP)

The two techniques that do involve discounting are:

− Net present value (or NPV)

− Internal rate of return (IRR)

ACCOUNTING RATE OF RETURN

The accounting rate of return (ARR) is the percentage return a profit generates on average
per year. It is also known as ‘return on investment’.

The formula is as follows:

ARR = (Average annual profit from investment / Initial

investment) x 100
OR
ARR = (Average annual profit from investment / Average
investment) x 100
Where, average investment = (Initial outlay + Scrap value) / 2

Note: In the exam, use the average investment formula where applicable.

3
Example 1

A potential project involves an initial investment in machinery of $1,700,000 and has these
operating annual cash inflows:

Year 1 - $300,000

Year 2 - $550,000

Year 3 - $600,000

Year 4 - $440,000

The machinery will be sold for scrap at the end of year 4 for $200,000.

Calculate the accounting rate of return based on average investment.

Solution 1

Total cash profits over four years = $300,000 + $550,000 + $600,000 + $440,000 =
$1,890,000

Total depreciation = $1,700,000 - $200,000 = $1,500,000

Total profit after depreciation = 1,890,000 - $1,500,000 depreciation = $390,000

Annual profit = $390,000 / 4 = $95,500

Average investment = ($1,700,000 + $200,000) / 2 = $950,000

ARR = 95,500 / 950,000 = 0.10 or 10%

Example 2

A potential project involves an initial investment in machinery of $1,000,000 and has the
following cash inflows:

ear 1 - $250,000

Year 2 - $350,000

Year 3 - $200,000

Year 4 - $200,000

At the end of year 4, the machinery will be sold for $400,000.

Calculate the accounting rate of return based on average investment.

Solution 2

4
Total cash profits over four years = $250,000 + $350,000 + $200,000 + $200,000 =
$1,000,000

Total depreciation = $1,000,000 - $400,000 = $600,000

Total profit after depreciation = 1,000,000 - $600,000 depreciation = $400,000

Annual profit = $400,000 / 4 = $100,000

Average investment = ($1,000,000 + $400,000) / 2 = $700,000

ARR = 100,000 / 700,000 = 0.143 or 14.3%

SIMILARITIES OF ARR AND ROCE

Accounting rate of return is often compared to the company’s overall Return on capital
employed (ROCE), which is a similar measure, just for the whole business. The owners of the
business often look at return on capital employed to help them understand how well the
business is doing.

ROCE = Profit before interest and tax / Capital employed

The rationale is that if a project has a potentially higher return than the current return on
capital employed, taking it on will increase the return on capital employed.

ADVANTAGES AND DISADVANTAGES OF ARR

Advantages

− Percentage measure and easy to understand

− In tune with return on capital employed

− Unlike payback method, considers entire project life

Disadvantages

− Does not provide direct measure of impact on shareholder wealth

− Does not consider time value of money

− Small cash flows at the end of project life can reduce overall ARR

5
Relevant cash flows and Payback period
RELEVANT CASH FLOW

When we are making a decision about whether or not to invest, the amount to include in
the appraisal should be: future, incremental, cash. The reason for this is as follows:

1. Firstly let’s consider the significance of the word ‘future’ When we are making
decisions, we are concerned about how that decision will affect the future.
Anything that happened in the past cannot be changed and so should not be
considered further in the decision itself.

For example, suppose I commission an investigation into a project, and that investigation
cost me $1 million. When I read the report, it says ‘if you invest $1,000 today you’ll get
$2,000 back tomorrow’. Am I upset that I’ve paid $1 million for this advice? You bet I am!
But, does that mean I don’t invest $1000 today to get $2,000 back tomorrow? I can’t change
the fact that report has cost me $1 million so the cost of the report is irrelevant to the
decision. The only decision we face is whether or not to invest $1,000 today to get $2000
back tomorrow. A 100% return in 24 hours sounds pretty good to me!

2. Next, let’s consider the significance of the word incremental. We are only
interested in understanding how a decision will change the future. Financial
accountants often struggle with this concept.

For example, if you are paid $50,000 a year and your manager says to you ‘I need to work on
this project for a year – it will take up one day of your five day week each week’. When
you’re considering the relevant cost of your time, it’s very tempting to say something like
$50,000 / 5 = $10,000, so $10,000 is the relevant cost of my time on this project. However,
in actual fact you were paid $50,000 before and you continue to be paid $50,000, so the
incremental cost of your time is zero.

Opportunity costs and benefits are also relevant. Suppose we have some material in the
warehouse that we bought for a project a while ago that didn’t go ahead. Suppose it cost
$1,000 to buy, and we have no further use for this material other than for a project we are
considering. If we don’t get on with the project we could sell the material for scrap for $100.
Let us consider the relevant cost of using this material on the project. Firstly, the $1,000 is
irrelevant as it’s a historic and therefore sunk cost. If we don’t go ahead with the project we
could sell this material for $100, so if we do go ahead we will be choosing to forego an
income of $100. In effect, using the material on the project has cost us $100 as we are $100
worse off as a result of going ahead.

3. Finally, let’s consider the significance of the word cash. In short, you can’t spend
profits. We make shareholders wealthier by giving them cash. So, when the
company spends cash, it is at that point that it has

6
cost the shareholder as we can no longer give it to them. Equally, when cash flows into the
business, this makes shareholders wealthier. Hence, we focus on cash flows.

NOTE: A good mental image to maintain when trying to decide on the size and relevance of
a future incremental cash flow is as follows: imagine a cash flow forecast of the business if
you don’t go ahead with the decision you are considering, and then next to it imagine a cash
flow forecast of the business if you do go ahead with the decision. Anywhere there is a
difference between those two cash flow forecasts and the size of that difference is the
relevant cash flow.

PAYBACK PERIOD

The payback period for a project is the time it takes to recover its initial investment, it’s the
time it takes for the project to pay for itself. Let us have a look at an example to improve
your understanding around this topic.

A potential project involves an initial investment in machinery of $1,700,000 and has these
operating annual cash inflows:

Year 1 - $300,000
Year 2 - $550,000
Year 3 - $600,000
Year 4 - $440,000

The machinery will be sold for scrap at the end of year 4 for $200,000.

Key to calculating payback period is to calculate a cumulative cash flow column over time as
follows:

Year Cash flow Cumulative cash flow

0 -1,700,000 -1,700,000
1 300,000 -1,400,000
2 550,000 -850,000
3 600,000 -250,000
4 440,000 190,000
The scrap proceeds from selling the machinery are only received right at the end of the
project, at the end of year four. The project pays for itself before the scrap proceeds are
received hence we don’t need to include them in this analysis.

The project pays for itself in the final year. At the start of that final year the project still
owes us $250,000. During that final year $440,000 flows in over the year. Assuming that
money flows in evenly, we could work out how far into that year we have to go in order to
reach payback. We would need to go 250,000 / 440,000, or 57% of the way through that
year. In other words, 57% x 12 months = 6.8 months into that year. The payback period is
therefore three years and 6.8 months.

7
In order to decide whether or not to proceed, the payback period calculated needs to be
compared to some relatively arbitrary benchmark. For example, the company may say ‘we
only accept projects that pay back within three years’, in which case we would reject this
project as it takes longer than three years to payback.

Advantges

Payback period has several advantages as an investment appraisal technique:

− It is cash flow based as opposed to accounting rate of return which is based on

accounting profits– Accounting profits can be manipulated and cash flow more directly
relates to the fundamental objective of maximising shareholder wealth.

− It also gives the decision maker a feel for how risky the project is– A project that pays
back quickly is likely to be less risky as the near future is simply more knowable than the
distant future.

− Payback period is also useful if the company is facing cash flow difficulties as it shows
how long the project has to be financed for.

Disadvantages

However, payback period also has several disadvantages:

− It takes no account of the time value of money.

− It ignores all cash flows after the payback period has been reached. For example, a
project may have a really fast payback but then soon after the payback period has been
reached there could be an enormous outflow to decommission the site. Overall, the
project could be very poor in terms of its financial performance even though it has paid
back quickly.

8
The Time Value of Money
WHAT IS TIME VALUE OF MONEY?

$1 today is worth more than $1 in three years’ time. There are three reasons for this:

− Inflation - You can buy more with a dollar today than you could with a dollar in three
years’ time as prices tend to increase periodically.

− Interest - You could put one dollar into a bank account today and over three years it
would accumulate interest to grow into something bigger than $1 in three years’ time.

− Risk - A dollar today is a definite dollar, whereas the promise of a dollar in three years’
time is never going to be quite as certain. This is sometimes known as the ‘bird in hand’
principle – from the old expression ‘a Bird in the hand is worth two in the bush.’

COMPOUNDING

This can be illustrated as interest accumulating on a deposit in the bank. Suppose we put
$1,000 on deposit today into an account that will earn us 10% a year. In one years’ time, it
will be worth $1,000 x 1.1 = $1,100. By the end of the second year, the balance would be
$1,100 x 1.1 = $1,210. By the end of the third year the balance would be $1,210 x 1.1 =
$1,331.

This calculation can be done in one go as follows:

$1,000 x (1.1)3= $1,331,

Or, in general terms: Present value x (1+r)n = Future value

Where ‘r’ is the annual rate of interest and ‘n’ is the number of years.

DISCOUNTING

In investment appraisal, we are interested in finding the present value of future cash flows.
This can be achieved via discounting. In other words, we can find out how much we need to
put into the bank today for it to grow into that future value.

For example, the present value of $1,331 received in three years’ time at an annual rate of
10% would be: $1,331 / (1.13) = $1,000.

In general terms, the present value = the future value / (1+r)n Where r is the annual rate of
interest and n is the number of years. This can also be written as follows:

Present value = Future value x 1 / (1+r)n

9
DISCOUNT FACTOR

The term 1 / (1+r) n is called a discount factor. The discount factor tables are provided in the
exam so make sure you know how to use them.

ANNUITY FACTOR

A constant cash flow received each period for a fixed number of periods is called an annuity.
An annuity factor is basically a sum of all discount factors. For example, the discount factors
for year 1, 2 and 3 at 10% are 0.909, 0.826 and 0.751 respectively. Their sum is 2.486 and it
is the annuity factor for 3 years.

The annuity factors can be found from the annuity factor tables. The formula for annuity
factor is also provided in the table.

DELAYED ANNUITY

The annuity tables assume that the first payment under the annuity will be in one year’s
time. This may not be the case. For example, the first payment may start from year four. The
same table can be used as long as you remember that annuity factor is simply the sum of
discount factors.

Example

Suppose we are going to receive $1,000 for three consecutive years, starting from year four.
In other words, we are going to receive $1,000 for year 4, 5 and 6. To find out the present
value, simply take the annuity factor of all six years and then deduct the annuity factor of
first three years to get the annuity factor of year 4, 5 and 6.

Annuity factor for 6 years = 4.355

Annuity factor for 3 years = 2.487

Annuity factor for year 4, 5 and 6 = 4.355 - 2.487 = 1.868

Present value of $1,000 = 1,000 x 1.868 = $1,868

PERPETUITY

Perpetuity is a type of annuity that lasts forever. The present value of perpetuity is
calculated as 1 / r.

For example, the present value of $1,000 each year starting next year and continuing
forever with a 10% discount rate would be: $1,000 x (1/0.1) = $10,000.

10
DELAYED PERPETUITY

Again, it is assumed that perpetuity starts from year 1. If it is delayed, we follow a similar
approach as we followed with delayed annuity.

Example

Suppose we are going to receive $1,000 forever starting from year 4. The discount rate is
10%.

Again, we will deduct the annuity factor for first three years. Therefore, the present value
will be:

$1,000 x (10 - 2.487)

$1,000 x 7.513 = $7,513

11
DISCOUNT FACTOR TABLE

Present Value Table

Present value of an annuity of 1 i.e. 1 – (1 + r)–n
Where r = discount rate
n = number of periods

Discount rate (r)

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
(n)
1 0-990 0-980 0-971 0-962 0-952 0-943 0-935 0-926 0-917 0-909 1
2 0-980 0-961 0-943 0-925 0-907 0-890 0-873 0-857 0-842 0-826 2
3 0-971 0-942 0-915 0-889 0-864 0-840 0-816 0-794 0-772 0-751 3
4 0-961 0-924 0-888 0-855 0-823 0-792 0-763 0-735 0-708 0-683 4
5 0-951 0-906 0-863 0-822 0-784 0-747 0-713 0-681 0-650 0-621 5
6 0-942 0-888 0-837 0-790 0-746 0-705 0-666 0-630 0-596 0-564 6
7 0-933 0-871 0-813 0-760 0-711 0-665 0-623 0-583 0-547 0-513 7
8 0-923 0-853 0-789 0-731 0-677 0-627 0-582 0-540 0-502 0-467 8
9 0-914 0-837 0-766 0-703 0-645 0-592 0-544 0-500 0-460 0-424 9
10 0-905 0-820 0-744 0-676 0-614 0-558 0-508 0-463 0-422 0-386 10
11 0-896 0-804 0-722 0-650 0-585 0-527 0-475 0-429 0-388 0-350 11
12 0-887 0-788 0-701 0-625 0-557 0-497 0-444 0-397 0-356 0-319 12
13 0-879 0-773 0-681 0-601 0-530 0-469 0-415 0-368 0-326 0-290 13
14 0-870 0-758 0-661 0-577 0-505 0-442 0-388 0-340 0-299 0-263 14
15 0-861 0-743 0-642 0-555 0-481 0-417 0-362 0-315 0-275 0-239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0-901 0-893 0-885 0-877 0-870 0-862 0-855 0-847 0-840 0-833 1
2 0-812 0-797 0-783 0-769 0-756 0-743 0-731 0-718 0-706 0-694 2
3 0-731 0-712 0-693 0-675 0-658 0-641 0-624 0-609 0-593 0-579 3
4 0-659 0-636 0-613 0-592 0-572 0-552 0-534 0-516 0-499 0-482 4
5 0-593 0-567 0-543 0-519 0-497 0-476 0-456 0-437 0-419 0-402 5
6 0-535 0-507 0-480 0-456 0-432 0-410 0-390 0-370 0-352 0-335 6
7 0-482 0-452 0-425 0-400 0-376 0-354 0-333 0-314 0-296 0-279 7
8 0-434 0-404 0-376 0-351 0-327 0-305 0-285 0-266 0-249 0-233 8
9 0-391 0-361 0-333 0-308 0-284 0-263 0-243 0-225 0-209 0-194 9
10 0-352 0-322 0-295 0-270 0-247 0-227 0-208 0-191 0-176 0-162 10
11 0-317 0-287 0-261 0-237 0-215 0-195 178 0-162 0-148 0-135 11
12 0-286 0-257 0-231 0-208 187 0-168 152 0-137 0-124 0-112 12
13 0-258 0-229 0-204 0-182 163 0-145 130 0-116 0-104 0-093 13
14 0-232 0-205 181 0-160 141 0-125 111 0-099 88 0-078 14
15 0-209 0-183 160 0-140 123 0-108 95 0-084 0-074 0-065 15

12
 Annuity Table
Present value of an annuity of 1 i.e. 1 – (1 + r)–n/r
Where r = discount rate
n = number of periods

Discount rate (r)

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
(n)
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

13
Net Present Value (NPV), Internal Rate of Return (IRR) and
Discounted Payback Period
NET PRESENT VALUE (NPV)

With NPV, the basic approach is to estimate the future incremental cash flows associated
with an investment opportunity and restate all those future amounts to present value
equivalents by discounting them. If we then add them all up and if the answer is positive,
then the project has a positive value in today’s terms.

Example

A potential project involves an initial investment in machinery of $1,700,000 and has these
operating annual cash

inflows:

Year 1 - $300,000
Year 2 - $550,000
Year 3 - $600,000
Year 4 - $440,000

The machinery will be sold for scrap at the end of year 4 for $200,000.
Now let’s work out the NPV for this project.

14
Let us set up a table and fill in the cash flows:

NPV Computation
Cash flows
Point in time Description
($’000)
T0 Initial investment (1,700)
T1 Operational cash inflow 300
T2 Operational cash inflow 550
T3 Operational cash inflow 600
T4 Operational cash inflow 440
T4 Disposal proceeds 200

Next we add discount factors from tables as follows. Let us assume we have a time value of
money of 10% per year:

15
 NPV Computation
Cash flows Discount factor – 10%
Point in time Description (Table)
($’000)

T0 Initial investment (1,700) 1

T1 Operational cash inflow 300 0.909
T2 Operational cash inflow 550 0.826
T3 Operational cash inflow 600 0.751
T4 Operational cash inflow 440 0.683
T4 Disposal proceeds 200 0.683

NOTE: The T0 discount factor is always ‘1’ - no need to discount this value as it’s a cash flow
happening today, in effect it is already stated at its present value.

To enable us to do discounting calculations, we have to make a simplifying assumption

about the timing of cash flows. We need to assume that cash flows that arise over a period
of time arrives at the end of that period. So for example, the year one cash flows of
$300,000 may well arise evenly over that first year. We will assume that it all arrives in one
go all the end of that year, at T1.

16
Then, multiply the discount factor by the cashflow to work out the present value of each
cash flow:

NPV Computation
Cash flows Discount factor – 10% Present value – 10%
Point in time Description (Table)
($’000) ($’000)
T0 Initial investment (1,700) 1 (1,700.0)
T1 Operational cash inflow 300 0.909 272.7
T2 Operational cash inflow 550 0.826 454.3
T3 Operational cash inflow 600 0.751 450.6
T4 Operational cash inflow 440 0.683 300.5
T4 Disposal proceeds 200 0.683 136.6

17
Finally, add up all the present values to get the NPV:

NPV Computation
Cash flows Discount factor – 10% Present value – 10%
Point in time Description (Table)
($’000) ($’000)

T0 Initial investment (1,700) 1 (1,700.0)

T1 Operational cash inflow 300 0.909 272.7
T2 Operational cash inflow 550 0.826 454.3
T3 Operational cash inflow 600 0.751 450.6
T4 Operational cash inflow 440 0.683 300.5
T4 Disposal proceeds 200 0.683 136.6
NPV (85.3)

We picked on 10% as the discount rate here for an example. The discount rate that should
be used for investment appraisal is the investors required rate of return, also known as the
cost of capital.

The basic decision rule for an NPV assessment is that if the answer is positive the project
should be accepted. This is because the value of all the cash flows restated to present
values is net positive, in other words, accepting the project will add to shareholder wealth.

In this case, the NPV is negative and this would suggest the project should not be
undertaken because to do so will reduce the value of the business by $85,300.

Advantages:

NPV has much to commend it as a technique:

1. First and foremost, it gives a direct answer to the question ‘what will be the impact on
shareholder wealth if I take this project on?’. For example, an NPV of +$100,000 means if
that project is taken on, shareholder wealth will be increased by $100,000 in today’s terms.
The value of the company’s shares logically should increase by this amount in total.

2. NPV is based on cash flows, and considers the whole life of the project.

18
Disadvantages:

However, it also has its disadvantages:

1. It is not used that’s often in practice because it is not well understood by non-finance
professionals. Alternative measures like accounting rate of return and payback period
on more immediately accessible to understand.

2. It needs a cost of capital to be able to calculate it, this is the discount rate that is used.
This is relatively subjective and difficult to calculate.

3. It assumes that cash flows arise at the end of the period. Operating cash flows often
arise throughout the period.

DISCOUNTED PAYBACK PERIOD

One of the downsides associated with payback period was, we said, that it does not take
account of the time value money. We can modify this technique slightly to include
discounting, by discounting the cash flows first before working out when the cumulative
cash flow returns to 0. This is known as the discounted payback period, or adjusted
payback period.

Example

For example, suppose a project required $1,000 investment today, and will generate $390
each year for 5 years.

19
The discounted payback period would be calculated as follows:

Discounted Payback Computation

Cash Discount factor – Present value – Cumulative present
Time Description flows
10% 10% value
($) (Table)
($) ($)
T0 Initial investment (1,000) 1 (1,000.00) (1,000.00)
Operational cash
T1 390 0.909 354.51 (645.49)
inflow

Operational cash
T2 390 0.826 322.14 (323.35)
inflow

Operational cash
T3 390 0.751 292.89 (30.46)
inflow
Operational cash
T4 390 0.683 266.37 235.91
inflow
Operational cash
T5 390 0.621 136.6 N/A
inflow

NOTE: Multiply the discount factor by the cashflow to give present value. Work out the
cumulative present value as it builds up over time.

We can see in this example that the discounted payback period is approximately (a little
over) 3 years.

20
INTERNAL RATE OF RETURN (IRR)

IRR is closely related to NPV, it is the discount rate that yields an NPV equal to 0. If we took
the cash flows associated with a project and did several different NPV calculations at
different discount rates, and plotted the results on a graph, it might look something like this:

The more heavily we discount future flows, the less they are worth in present value terms,
And the lower the NPV becomes. The IRR is where this curve crosses the x-axis, this is the
discount rate where NPV equals zero.

The way we interpret the IRR is as follows:

If the IRR is greater than the cost of capital, then we would accept the project because this
implies that at the cost of capital the project has got a positive NPV. Let’s see why that’s the
case on the graph:

With similar reasoning, f the IRR is less than the cost of capital we would reject the project
as this implies that at the cost of capital the project has got a negative NPV:

21
IRR is sometimes known as the ‘breakeven cost of capital’ because that is the discount rate
at which the project breaks even – in other words when it has zero NPV.

So, to recap, compare the IRR with the cost of capital. If the IRR is greater than the cost of
capital then accept the project. If the IRR is less than the cost of capital then reject.

Let’s have a look now at how we actually calculate the IRR. We actually estimate the IRR
using a process known as linear interpolation. The process is as follows:

Calculate the NPV at two different discount rates. It doesn’t really matter what the rates
are, just use ones off tables like 5% and 10%. What we will have done then is find two points
on the curve as follows:

Mathematically we will draw a straight line between these two points. Approximately,
where the straight line crosses the x-axis is more or less where the curve crosses the x-axis.
We can work out exactly where the straight line crosses the x-axis. Let us label graph the
first:

22
− A is always the lower percentage.

− B is the higher percentage

− Na is the NPV at A%

− Nb is the NPV at B%

Combine them together in this formula:

(B − A)Na

IRR = A + Na − Nb

NOTE: You have to learn this formula for the exam, it’s not given to you on the formula
sheet. However it may help you to remember it if you do the following; Starting with the A
and read across: the formula spells out ‘A Banana NB’!

Example

Let’s calculate the IRR of our earlier example. Here’s the project in question:

A potential project involves an initial investment in machinery of $1,700,000 and has these
operating annual cash inflows:

Year 1 - $300,000
Year 2 - $550,000
Year 3 - $600,000
Year 4 - $440,000

The machinery will be sold for scrap at the end of year 4 for $200,000.

23
The NPV at 10% was (85.3):

NPV Computation
Cash flows Discount factor – 10% Present value – 10%
Point in time Description
(Table)
($’000) ($’000)
T0 Initial investment (1,700) 1 (1,700.0)
T1 Operational cash inflow 300 0.909 272.7
T2 Operational cash inflow 550 0.826 454.3
T3 Operational cash inflow 600 0.751 450.6
T4 Operational cash inflow 440 0.683 300.5
T4 Disposal proceeds 200 0.683 136.6
NPV (85.3)

If we rerun the NPV calculation from earlier on at 5%, we get the following:

NPV at 5%
Cash flows Discount factor – 5% Present value – 5%
Point in time Description (Table)
($’000) ($’000)
T0 Initial investment (1,700) 1 (1,700.00)
T1 Operational cash inflow 300 0.952 285.60
T2 Operational cash inflow 550 0.907 498.85
T3 Operational cash inflow 600 0.864 518.40
T4 Operational cash inflow 440 0.823 362.12
T4 Disposal proceeds 200 0.823 164.60
NPV 129.57

So the IRR must be somewhere between 5% and 10%. Let us apply the formula:

So the IRR is 8%. If the firm’s cost of capital was 10%, we should reject this project as its
return is less than the cost of its finance.

24
You don’t need to have a positive and a negative NPV for the formula to work. Suppose you
picked 5% and 10% as discount rates and they both came out with positive NPVs. The
formula will still work, all it is doing is the following:

This is known as extrapolation, it’s technically not quite as accurate as what we did before
but it’s still perfectly acceptable for our exam, you will notice that the black line is still pretty
close to the curve on the x-axis.

Advantages

IRR has several advantages:

1. It is a percentage and managers like percentages because they can be easily compared
to other alternatives

2. It is based on cash flows and includes the time value of money.

3. You don’t need to know the cost of capital precisely to use it. For example, if you feel
your cost of capital is somewhere between 5% and 10% and you calculate the IRR as
being 18% then you’d be safe in saying let’s go ahead as 18% is higher than the entire
range from 5 to 10%.

25
Disadvantages

However, there are some problems with IRR:

1. As a percentage measure it always begs the question ‘percentage of what?’. For this
reason, you cannot use it to compare two different projects. For example, suppose
project A has an IRR of 40% and project B has an IRR of 20%. It looks like project A is
preferable. However, suppose I now tell you that project A gives you a 40% return on $1
and project B gives you a20% return on $1 million. Clearly project B would make you
wealthier but IRR indicated project A.

2. We are assuming with the basic decision rule that the project involves an initial outflow
followed by years of inflows, this is known as a ‘traditional’ project. This is what gives
the curve on the IRR graph its downward slope from left to right. Other types of
projects will yield different shaped curves hence the decision rule would need to
change.

For example, if a project consisted of an initial outflow, several years of inflows and then a
big outflow at the end (such a site cleanup costs) then the IRR graph may look like the
following:

And that’s just one example! There are many possible graphs Depending on the pattern of
the cash flows of the project, which makes the basic decision rule of ‘if the IRR is greater
than the cost of capital then accept the project’ unreliable.

3. One final disadvantage of IRR (a technical point), the IRR calculation assumes the cash
flows that are generated early on in the project are reinvested at the internal rate of return.
This is known as the ‘reinvestment assumption’. There is no reason to assume that this will
be the case, cash flows that are earned early on in the project are generally extracted from
the project and something else is done with them.

26
NOTE: Investment appraisal, and especially NPV is a highly examinable topic, take time to
get to grips with it as a subject and work through plenty of question practice.

27
Investment Appraisal
ADVANCED NPV

Some of the advanced issues that need to be considered in the calculation of NPV are:

− Taxes (including capital allowances)

− Inflation

− Working capital

NPV PRO FORMA

In longer questions, a more orderly pro forma helps in dealing with the volume of information
and also helps the marker to allocate marks.

T0 T1 T2 T3 T4 T5

Sales 1 - - - - - -
Expense 1 - - - - - -
Expense 2 - - - - - -
Expense 3 - - - - - -
Tax- - - - - -
Investment / Scrap value - - - - - -
Capital allowances - - - - - -
Working capital - - - - - -
Net cash flow - - - - - -
Discount factor - - - - - -
Present values - - - - - -

28
CAPITAL (WRITING DOWN) ALLOWANCES

Writing down allowances, or capital allowances, is tax allowable depreciation. The capital
allowance itself is not cash flow. The cash flow is the saving in tax we benefit from it as a result
of having it. Remember, tax allowable expenses reduce our tax liability. As a result, less cash
has to be paid in form of taxes.

WORKING CAPITAL

Working capital is an investment that is required to have a project operating in the first place.
For example, without any inventory, there won’t be any raw materials to turn into the finish
product. We have to buy this inventory in advance, so it is a use of cash at the start of the
project.

The amount invested in the working capital each year is incremental. We consider the amount
of working capital invested in the previous year and adjust the working capital as required. For
example, if working capital invested last year was $1,000 and this year the total requirement is
$1,500, we only consider $500 (being incremental impact) in the NPV pro forma.

Usually, the investment in working capital is recovered at the end of project life.

EXAMPLE 1

Plant Co is undertaking a new project. The following forecasts have been prepared:

Year 1 Year 2 Year 3 Year 4

$000 $000 $000 $000
Sales 100 200 300 200
Material costs 20 40 60 40
Labour costs 20 20 20 20

In addition, the following information is relevant:

− The initial investment in plant and machinery will be $250,000. At the end of year 4, the
plant and machinery will be sold for $75,000. The investment is eligible for capital
allowances at the rate of 25%.

− Working capital equal to 10% of the sales revenue is required at the start of the year. The
working capital will be recovered at the end of project life.

− The cost of capital is 10%.

− The tax rate is 25% and tax is payable in the same year.

29
− All the cash flows as well as the cost of capital is
in nominal terms.

Required

Calculate the net present value of the project.

SOLUTION 1

The NPV of the project is:

T0 T1 T2 T3 T4 T5
$’000 $’000 $’000 $’000 $’000 $’000
Sales 100 200 300 200
Materials -20 -40 -60 -40
Labour -20 -20 -20 -20
60 140 220 140
Tax @ 25% -15 -35 -55 -35
Investment / Scrap -250 75
Capital allowances (W1) 16 12 9 8
Working capital (W2) -10 -10 -10 10 20
Net cash flow -260 51 107 184 208
Discount factor - 10% 1 0.909 0.826 0.751 0.683
Present values -260 46.4 88.4 138.2 142
Net present value 155

30
Working 1 – Capital allowances

Time WDV Tax Saved (25%) Timing

T0 - Investment 250,000

1st year – 25% -62,500 15,625 T1

187,500
2nd Year – 25% -46,875 11,719 T2

140,625
3rd Year – 25% -35,156 8,789 T3

105,469

Scrap value -75,000

Balancing allowance 30,469 7,617 T4

Working 2 – Working Capital

T0 T1 T2 T3 T4

Sales 100 200 300 200

Working Capital Required 10 20 30 20 0
Incremental cash flows -10 -10 -10 10 20

INFLATION

Inflation affects both the cash flows and the cost of capital. Inflating prices increases cash flows.
As explained earlier, the cost of capital is there to compensate the investors for three things –
interest, inflation and risk. Therefore, inflation also increases the cost of capital.

In principle, there are two possible approaches to deal with inflation:

− Leave inflation out of the cash flows and leave inflation out of the cost of capital

− Include inflation in the cash flows as well as the cost of capital.

In theory, both approaches provide the same answer. However, in most of the longer
questions, it is usual to include inflation in both cash flows and cost of capital.

31
FISHER EFFECT

The fisher equation can be used to illustrate the relationship between inflated (nominal) and
uninflated (real) cost of capital. The formula, provided in the exam sheet, is:

(1+i) = (1+r) x (1+h)

Where,

i = the inflated cost of capital, also known as the money or nominal cost of capital

r = the uninflated cost of capital, or the real rate

h = the inflation rate

EXAMPLE 2

A business is expecting the following (real) cash flows in the next three years:

Year 1 = 100

Year 2 = 150

Year 3 = 200

The inflation rate is 3% per annum and the real cost of capital is 7% per annum. Calculate the
NPV.

SOLUTION 2

T1 T2 T3
Cash flows (Real term) 100 150 200
Inflation factor x 1.03 x 1.032 x 1.033
Inflated cash flows 103 159 219
Discount factor @ 10% (W1) 0.909 0.826 0.751
Present values 93.6 131.3 164.5
NPV 389.4

32
Working 1 – Cost of capital

(1+i) = (1+r) x (1+h)

(1+i) = (1.07) x (1.03)

i = 1.1021 - 1

i = 0.1021, or 10.21%

33