Capital investment:

investment appraisal
Managing financial resources & decisions
(H/601/0548)

1
Nurul Afza Binti Abd Rashid
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
2
Investment Appraisal
Why do companies invest?
Importance of remembering investment as the purchase of productive
capacity NOT buying stocks and shares or investing in a bank!

Buy equipment/machinery or build new plant to:
Increase capacity (amount that can be produced) which means:
Demand can be met and this generates sales revenue
Increased efficiency and productivity


3
METHODS OF CAPITAL INVESTMENT
APPRAISAL
Proposed
Capital
Project
Payback
Discounted
payback
Accounting
Rate of
Return
Internal
Rate of
Return
Net
Present
Value
4
5
1. The PAYBACK method
The payback method is an attempt to estimate how long it would take
before a project begins to pay for itself.
Example : If a company was going to spend RM 300,000 on purchasing some
new plant, the accountant would calculate how many years it would take
before RM 300,000 had been received back in cash.
The recovery of an investments in a project is usually measured in terms of
net cash flow.
Net cash flow is the difference between cash received and cash paid during a
defined period of time.
6
The PAYBACK method
The Newland City Council has investigated the possibility of investing in a new
project, and the following information has been obtained.

RM RM
Total cost project 500,000
Expected net cash flows:
Year 1 20,000
2 50,000
3 100,000
4 200,000
5 300,000
6 30,000 (700,000)
Net Return 200,000
7
The PAYBACK method
Year Net cash flow Cumulative net cash
flow
Year 0 (500,000) (500,000)
1 20,000 (480,000)
2 50,000 (430,000)
3 100,000 (330,000)
4 200,000 (130,000)
5 300,000 170,000
6 30,000 200,000
8
The PAYBACK method
By the year end of fifth year, the original investment of RM 500,000 will
have been covered.

However, the exact years that investments will be covered is 4 years and 5
months [(RM 130,00 / RM 300,000) x 12 months].
9
2. The DISCOUNTED PAYBACK method
Year

(1)
Net Cash Flow

(2)
Discount
factors
(3)
Present Value at 8 %
[Column (2) x Column (3)]
(4)
Cumulative
present value
(5)
0 (500,000) 1.0 (500,000) (500,000)
1 20,000 0.9259 18,518 (481,482)
2 50,000 0.8573 42,865 (438,617)
3 100,000 0.7938 79,380 (359,237)
4 200,000 0.7350 147,000 (212,237)
5 300,000 0.6806 204,180 (8,057)
6 30,000 0.6302 18,906 10,849
10
The DISCOUNTED PAYBACK method
By the year end of sixth year, the original investment of RM 500,000 will
have been covered.

However, the exact years that investments will be covered is 5 years and 5
months [(RM 8,000 / RM 19,000) x 12 months].

11
Accounting Rate of Return
The accounting rate of return(ARR) method attempts to compare the profit
of a project with the capital invested in it.
Using the formula :
ARR = Average annual net profit before interest and taxation x 100
Initial capital employed on the project
12
3. Accounting Rate of Return
RM RM
Total cost project (5 years) 50,000
Estimated net profit:
Year 1 12,000
2 18,000
3 30,000
4 25,000
5 5,000
Total Net Profit 90,000
Bridge Limited is considering investing in a new project, the
details of which are as follows:
13
Accounting Rate of Return
The accounting rate of return would be calculated as follows :
Average annual net profits x 100
Cost of the investment

Average annual net profits = RM 18,000 (RM 90,000/5)
Accounting Rate of Return = RM 18,000 x 100 = 36 %
RM 50,000
14
Accounting Rate of Return
In evaluating an investment project, the ARR of the project is
compared with a predetermined minimum acceptable accounting
Rate of return:
ARRs Comments
< minimum acceptable rate Reject project
= minimum acceptable rate Accept project
> minimum acceptable rate Accept project
Highest Choose highest ARR
15
4. Net Present Value
The NPV method recognizes that cash received today is preferable to cash
receivables sometimes in the future.
When facing different investment proposals, the management should
choose the project that can generate the greatest addition of value to the
company.
Net present value (NPV) method is a process that uses the discounted cash
flow of a project to determine whether the rate of return on that project is
equal to, higher than, or lower than the desired rate of return
With the NPV method, we can compare the return on investment in capital
projects with the return on an alternative equal risk investment in securities
traded in financial market


16
Steps to be considered in calculating NPV
1. Calculate the annual net cash flows expected to arise from the projects.
2. Select an appropriate rate of interest, or required rate of return.
3. Compare the total net present value with the initial outlay.
4. Accept the project if the total NPV is positive.
17
Net Present Value
Project ALPHA BETA
Estimated life 3 years 5 years
Commencement date 1.1.2001 1.1.2001
Project cost at year 1 100,000 100,000
Estimated net cash flows:
Year 1 20,000 10,000
2 80,000 40,000
3 40,000 40,000
4 0 40,000
5 0 20,000
140,000 150,000
18
Net Present Value
Year ALPHA BETA
Net Cash
Flow
RM
Discount
Factor
10 %
Present
Value
RM
Net Cash Flow
RM
Discount
Factor
10%
Present
Value
RM
(1) (2) (3) (4) (5) (6) (7)
1 20,000 0.9091 18,182 10,000 0.9091 9,091
2 80,000 0.8264 66,112 40,000 0.8264 33,056
3 40,000 0.7513 30,052 40,000 0.7513 30,052
4 - 0 - 40,000 0.6830 27,320
5 - 0 - 20,000 0.6209 12,418
Total present value 114,346 111,937
Less : Initial cost (100,000) (100,000)
Net present value 14,346 11,937
19
Interpreting the NPV derived as follows:

NPVs Comments Reasons
<0 Reject the project
The rate of return from the project is
small than the rate of return from an
equivalent risk investment
=0 Indifferent to accept
or reject the project
The rate of return from the project is
equal to the rate of return from an
equivalent risk investment
>0 Accept the project
The rate of return from the project is
greater than the rate of return from an
equivalent risk investment
Highest Accept the project
If various project are considered, the
project with highest positive NPV
should be chosen
20
Internal Rate of Return
The internal rate of return is the annual percentage return achieved by a
project, of which the sum of discounted cash inflow over the life of the
project is equal to the sum of discounted cash outflows
If the IRR is used to determine the NPV of a project, the NPV will be zero.
The company will accept this project only if the IRR is equal to or higher than
the minimum rate of return or the cost of capital

21
Internal Rate of Return
Example :
Bruce Limited is considering whether to invest RM 50,000 in a new project. The
projects expected net cash flows would be as follows:

Year RM
1 7,000
2 25,000
3 30,000
4 5,000
22
Internal Rate of Return
Year Net Cash Flow Discount Factors Present Value
(1) (2) (3) (4) (5) (6)
10 % 15% 10% 15%
RM RM RM
1 7,000 0.9091 0.8696 6,364 6,087
2 25,000 0.8264 0.7561 20,660 18,903
3 30,000 0.7513 0.6575 22,539 19,725
4 5,000 0.6830 0.5718 3,415 2,859
Total present values 52,978 47,574
Initial cost (50,000) (50,000)
Net Present Value 2,978 (2,426)
23
Internal Rate of Return
Break-Even Rate of Return

IRR = Positive Rate + Positive NPV x Range of rates
Positive NPV + Negative NPV*

So, solution : IRR = 10% + 2,978 x (15% - 10 %)
(2,978 + 2,426)
= 10 % + (0.5511 x 5%)
= 10% + 2.76%
= 12.76%
24
INVESTMENT APPRAISAL
ADVANTAGES AND DISADVANTAGES OF
METHODS OF CAPITAL INVESTMENTS APPRAISAL
25
The PAYBACK Method
Advantages Disadvantages
1. Payback can be important: long payback
means capital tied up and high investment
risk.
1. It ignores the timing of cash flows within
the payback period, the cash flows after the
end of payback period and therefore the total
project return.
2. The method also has the advantage that it
involves a quick, simple calculation and an
easily understood concept.
2. It ignores the time value of money. Only
suitable for short-term only.
3. Can be used as a supplementary. It focuses
on the cash recovery of an investment.
3. It is unable to distinguish between projects
with the same payback period.
4. It may lead to excessive investment in
short-term projects.
26
Accounting Rate of Return
Advantages Disadvantages
1. The method is compatible with a similar
accounting ratio used in financial accounting.
1. Does not take account of the time value of
money

2. It is relatively easy to understand and not
difficult to compute.
2. 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

3. It draws attention to the notion of overall
profit.
27
Net Present Value
Advantages Disadvantages
1. Consistency with the time value of money
concept

1. It is difficult to estimate accurately the net
cash flow for each year of the projects life.
2. Consideration of all cash flows

2. Some difficulties may incurred in
estimating the initial cost of the project and
the time periods in which instalments must be
paid back.
3. Adoption of cash flows instead of
accounting profit

3. It is not easy to select an appropriate rate of
interest.
4. It is easy to compare the NPV of different
projects and to reject projects that do not
have an acceptable NPV.
28
Internal Rate of Return
Advantages Disadvantages
1. Attention is given to the timing of
net cash flows.
1. It is not easy to understand.
2. An appropriate rate of return does
not have to be calculated.
2. It is difficult to determine which two
suitable rates to adopt.
3. The method gives a clear
percentages return on a investments.
3. The method gives an approximate
rate of return.
29
Conclusion
NPV is considered to be a highly acceptable method of Capital Investment
Appraisal. It takes into the timing of net cash flows, the projects
profitability, and the return of the original investment.
However, an entity would not necessarily accept a project just because it
had an acceptable NPV, because there are many non-financial factors that
must be allowed for.
Furthermore, other less profitable projects (or even projects with a negative
NPV) may ahead, perhaps because they are concerned with employee
safety or welfare.
30