CORPORATE FINANCE AND

INVESTMENT
GHANA TECHNOLOGY UNIVERSITY
COLLEGE/ANHALT UNIVERSITY

CORPORATE FINANCE AND INVESTMENT

LECTURE 6– INVESTMENT APPRAISAL TOOLS AND

APPLICATIONS.
1
Paul Kwame Awuah 1
At the end of this session, you should be able
to:
Explain investment appraisal and outline the
motives for capital expenditure

Outline the processes involved in capital budgeting.

Discuss the main project evaluation tools such as

NPV and IRR and understand how they work in
practice.

Paul Kwame Awuah 2

 Investment appraisal is
the process of evaluating and selecting long-term
investments that are consistent with the firm’s goal of
maximizing owners’ wealth.
That is, a management task involving analysis of capital
expenditure proposals selection of "optimum" proposal.
 Motivesfor capital expenditure include the
following:
to expand operations
to replace or renew fixed assets, or
to obtain some other, less tangible benefit over a long
period

Paul Kwame Awuah 3

 The capital budgeting process consists of five
distinct but interrelated steps:
Proposal generation
Review and analysis
Decision making
Implementation
Follow-up.

Paul Kwame Awuah 4

Paul Kwame Awuah 5
 There are several tools, but focus is on:

Accounting rate of returns (ARR)

Payback period

Discounted payback period

Net present value (discounted cash flow)

Profitability index

Internal rate of return

Paul Kwame Awuah 6

 The accounting rate of return (ARR) model
expresses a project’s return as the increase
in expected average annual operating income
divided by the required initial investment.

ARR

*Average annual incremental cash inflow from operations

minus incremental average annual depreciation.

Paul Kwame Awuah 7

EXAMPLE
Assume the following:
Investment is ¢5,827.

Useful life is four years.

Estimated disposal value is zero.

Expected annual cash inflow

from operations is ¢2,000.

Annual depreciation = (cost – disposal value)/useful life

Annual depreciation = (5,827 – 0)/4 = 1,456.75

Paul Kwame Awuah 8
 ARR =

Average annual incremental

cash inflow –
Incremental annual depreciation

ARR = (2,000 – 1,457) ÷ 5,827 = 9.3%

Paul Kwame Awuah 9

Some companies use the “average” investment
(often assumed to be the average book value
over the useful life) instead of original
investment in the denominator

Average annual incremental

cash inflow –
Incremental annual depreciation

ARR = ($2,000 – $1457) ÷ $2,913.50 = 18.6%

Paul Kwame Awuah 10

Decision Rule
Accept the project only if its ARR is equal
to or greater than the required accounting
rate of return.
In case of mutually exclusive projects,
accept the one with highest ARR where
both have ARR’s greater than the required
accounting rate of return.

Paul Kwame Awuah 11

 Thepayback method simply measures how
long (in years and/or months) it takes to
recover the initial investment.
The maximum acceptable payback period is
determined by management.

 Decision Rule
If the payback period is less than the maximum
acceptable payback period, accept the project.
If the payback period is greater than the maximum
acceptable payback period, reject the project.

Paul Kwame Awuah 12

 Project A Project B
Initial Investment 42,000 45,000
Year Operating Cash Flows
1 14,000 28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000

Payback period for Project A

Year 1: 42,000 - 14,000 = 28,000
Year 2: 28,000 – 14,000 = 14,000
Year 3: 14,000 – 14,000 = 0.
PBP = 3 years
Paul Kwame Awuah 13
 Project A Project B
Initial Investment 42,000 45,000
Year Operating Cash Flows
1 14,000 28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000

Payback period for Project B

Year 1: 45,000 – 28,000 = 17,000
Year 2: 17,000 – 12,000 = 5,000
PBP = 2 years + (5,000/10,000)
= 2.5 years
Paul Kwame Awuah 14
Pros
It is simple, intuitive, and considers cash
flows rather than accounting profits.
It also gives implicit consideration to the
timing of cash flows and is widely used as a
supplement to other methods such as Net
Present Value and Internal Rate of Return .

Paul Kwame Awuah 15

Cons
The appropriate payback period is a subjectively
determined number.
It provides no indication as to whether a project
adds to firm value
Payback fails to fully consider the time value of
money.
Ignores cash flows beyond the cut-off point
Biased against long-term projects, such as R&D
and new products

Paul Kwame Awuah 16

Definition:
How long does it take to get the initial cost back
after you bring all of the cash flows to the present
value.

Computation:
Estimate the present value of the cash flows
Subtract the future cash flows from the initial cost
until the initial investment has been recovered

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 Findthe discounted payback period of Project
A with the following cash flows using a
discount rate of 10%?

YEAR CASH FLOW

0 -20,000
1 12,000
2 7,000
3 15,000
4 5,000

Paul Kwame Awuah 18

 YEAR CASH PVF@10% DCF
FLOW
0 -20,000 1 -20,000
1 12,000 0.9091 10,909
2 7,000 0.8264 5,785
3 15,000 0.7513 11,270
4 20,000-10,909=9,091;
Year 1: 5,000 continue
0.6830 3415
Year 2: 9,091-5,785=3,306; continue
DPBP: 2+(3,306/11270) = 2.29 years

Paul Kwame Awuah 19

 Pros
It is simple, intuitive, and considers cash flows
rather than accounting profits.

It also gives implicit consideration to the timing of

cash flows and is widely used as a supplement to
other methods such as Net Present Value and
Internal Rate of Return.

It considers time value of money

Paul Kwame Awuah 20

 Cons
The appropriate payback period is a subjectively
determined number.

It provides no indication as to whether a project

adds to firm value

Ignores cash flows beyond the cut-off point

Biased against long-term projects, such as R&D

and new products

Paul Kwame Awuah 21

 The NPV is found by subtracting a project’s
initial investment from the present value of
its net cash flow
NPV = Present value of net cash flow - Initial
investment

 Decision rule
If the NPV is greater than 0, accept the project.
If the NPV is less than 0, reject the project.

Paul Kwame Awuah 22

 Project A Project B

Initial ¢42,000 ¢45,000

Investment
Year Operating Cash Flow PVF@10% DCF A DCF B

1 14,000 28,000 0.9091 12,727 25,455

2 14,000 12,000 0.8264 11,570 9,917

3 14,000 10,000 0.7513 10,518 7,513

4 14,000 10,000 0.6830 9,562 6,830

5 14,000 10,000 0.6209 8,693 6,209

Sum of Discounted Cash Paul
FlowsKwame Awuah 53,071 23
 NetPresent Value for project A
53,071 – 42,000 = ¢ 11,071

 Net
Present Value for project B
55,924 – 45,000 = ¢ 10,924

Paul Kwame Awuah 24

 PROS

Considers all of the cash flows in the computation

Uses the time value of money

Provides the answer in dollar terms, which is easy

to understand

Usually provides a similar answer to the IRR

computation

Paul Kwame Awuah 25

 CONS

Requires the use of the time value of money, thus a

bit more difficult to compute

Projects that differ by orders of magnitude in cost

are not obvious in the NPV final figure

Paul Kwame Awuah 26

 The Profitability Index (PI) is the sum of the present value
of net cash flow divided by the Initial investment
 The decision rule
Invest in the project when the index is greater than 1.0.
 PI for project A = 53,071/42,000 = 1.26
 PI for Project B = 55,924/45,000 = 1.24

 A Profitability Index of 1.26 implies that for every ¢1 of

investment, we create an additional ¢0.26 in value.
 A PI>1 means the firm is increasing in value.

Paul Kwame Awuah 27

 Theinternal rate of return (IRR) is the
discount rate at which the NPV of an
investment opportunity is equal to 0.

 Decision Rule
If the IRR is greater than the cost of capital, accept
the project.
If the IRR is less than the cost of capital, reject the
project.

Paul Kwame Awuah 28

 Project A Project B
Initial Investment - 42,000 - 45,000

Year Operating Cash Flow

1 14,000 28,000

2 14,000 12,000

3 14,000 10,000

4 14,000 10,000

5 14,000 10,000

IRR 19.86% 21.65%

Paul Kwame Awuah 29
 Ona purely theoretical basis, NPV is the better
approach because:
the NPV measures how much wealth a project creates (or
destroys if the NPV is negative) for shareholders, which
is in line with managers’ objective to maximize
shareholders’ wealth.
Certain mathematical properties may cause a project
with non-conventional cash flows to have multiple IRRs.

 Despite its theoretical superiority, however,

financial managers prefer to use the IRR because of the
preference for rates of return.

9-30 Paul Kwame Awuah

The above indicates which cash flow to include and exclude from the
analysis

1) Accounting Adjustment

Adjustment such as depreciation which does not involve movement

of
cash should be excluded. But its associate tax should be added as
tax
savings which reduces cash outflow of tax payment

2) All Relevant cash inflow should be after tax

3) Financing Decisions should not be part of the Investment appraisal

cash flows. Hence financing charges should be excluded

4) Any attributes cost of undertaking the project should be taking

into consideration
 4) Any attributes cost of undertaking the project should be
taking into consideration
 5) Working Capital Movement need to be taken care in the
analysis at the end of the period it should be reversed as
inflows.
 6) Sunk cost which has already been incurred should be
excluded since they do not involve new cash out flows.

 7) Opportunity cost could be defined as the value of a benefit

forgone or sacrificed in favour of an alternative cause of action

 8) Residual value should be included at their disposed value.

This should be stated at Net of disposal cost.

 NPV only recognize cash flow representing future incremental

cash flow only as a result of the project.
 1. Discuss the accounting rate of return and
payback period approaches to investment
appraisal paying particular attention to the
limitations of each approach.

2. Substantiate the statement that NPV is the

king of capital budgeting.
Discuss and compare it with other capital
budgeting techniques.

Paul Kwame Awuah 33

 3. An investment of an item of equipment
would cost GHS75,000. It is estimated that
sales in the first year would be GHS60,000
rising by 5 % a year for the next 4 years.
Variable cost would be 50% of sales . Annual
fixed cost would be GHS20,000 in the first
three years , rising to GHS30,000 in years 4
and 5. Fixed cost of 40% would be avoided if
the project did not go ahead. The scrap value
of the equipment at the end of year 5 would
be GHS5,000.

Awuah 34
 The project would also required an investment
in working capital of GHS20,000 at the start of
the year 2 and rise to GHS25,000 at the start of
year 4. The company cost of capital is 9 %.
  
 Required.
 Calculate the NPV of the project and suggest
whether it should be undertaken.

  

Paul Kwame Awuah 35

4 .Kumasi United Football club is considering
acquiring the service of John Taylor, a popular
footballer now playing for Accra United.
Kumasi United will make an immediate cash
payment of GH¢200,000 to Accra United as the
transfer fee of John Taylor. Kumasi United will
also make an immediate cash payment of GH
¢50,000 to John Taylor as his signing on fee
and will sign a three year contract with the
player.

Paul Kwame Awuah 36

 At the end of the contract, Kumasi United
will sell John Taylor to another club for GH
¢40,000. During his three year stay in the
club, John Taylor will receive an annual salary
of GH¢175,000 and yearly bonus of GH
¢20,000.00. Due to the popularity of John
Taylor, Kumasi United club gate proceeds
will increase by GH¢300,000 yearly for the
three year period the player will play for the
club.

Paul Kwame Awuah 37

 As a financial consultant to Kumasi United
advise whether the team should purchase
John Taylor. The cost of capital of Kumasi
united is15%

Paul Kwame Awuah 38

END OF LECTURE.
QUESTIONS???

1-
Paul Kwame Awuah 39