INVESTMENT

AND PROJECT
APPRAISAL
Prepared by: Kha Pham
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CHAPTER OBJECTIVES
The methods of project appraisal: accounting rate
of return, payback and discounted cash flow
The concepts of time preference, the opportunity
cost of finance and the cost of capital
Relevant cash flows
Net present value and internal rate of return
methods
The implications of taxation and inflation in
discounted cash flow
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I. STEPS IN PROJECT APPRAISAL
Decision making and control cycle:

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GROUP DISCUSSION
Imagine you were Starbucks top managers. The
corporation planned to open the second Starbuck
store in Vietnam, following their successful operation
of the first one in Ho Chi Minh City.

Appraise the potentials of this project in Hanoi and
Danang City and make your conclusion!
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METHODS OF PROJECT
APPRAISAL
1. The accounting rate of return: calculates the
accounting profit (rather than cash flow) that will
be earned by a project and expresses this as a
percentage of the capital invested in the project

2. Payback period: Calculates the length of time a
project will take to recoup the initial investment,
based on cash flows

3. Discounted cash flow (DCF):
i. Net present value method (NPV)
ii. Internal rate of return (IRR)
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NON-FINANCIAL FACTORS
Legal
Ethical
Changes to regulations
Political
Quality implication
Personnel
Coherence
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II. ACCOUNTING RATE OF RETURN
=


100

Estimated average profits = Average annual cash flows

Estimated average investment =
+
2

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ARR EXAMPLE
ABC Limited is now choosing between two
alternatives of machine for the upcoming project:

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Machine A Machine B
Cost $15,000 $15,000
Estimated Scrap value $3,000 $4,000
Estimated life 3 years 3 years
Estimated future cash flows
Year 1 $4,000 $5,000
Year 2 $7,000 $7,000
Year 3 $7,000 $3,500
A ($) B ($)
Total Cash flows 18,000 15,500
Total depreciation 12,000 11,000
Total profit after depreciation 6,000 4,500

Average profit (3 years) 2,000 1,500

Value of investment initially 15,000 15,000
Eventual residual value 3,000 4,000
18,000 19,000
Average value of investment (/2) 9,000 9,500
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ARR for:
A 22%
B 16%
Machine A is preferred!
III. PAYBACK PERIOD
Gives greater weight to cash flows generated in
earlier years
The length of time required before the total cash
inflows are equal to the original cash outlay

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Machine P Machine Q
Cost $10,000 $10,000
Estimated future cash flows
Year 1 $3,000 $5,000
Year 2 $4,000 $7,000
Year 3 $4,000 $3,500
Year 4 $2,000 $2,000
IV. TIME VALUE OF MONEY
The value of money (purchasing power) today is
different from the value of money in the future!

For example, a $1,000 saving in a bank gives you
$1,100 in one year
The interest rate is 10%
The two amounts have the same purchasing power to
the owner who expects the 10% interest!
In other words, $1,100 is the future value of $1,000 in
one year!
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V. DISCOUNTING AND COMPOUND
INTEREST
Simple interest: = (1 +)

Compound interest: = (1 +)

Discounting: Compounding in reverse
=

(1 +)

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VI. DISCOUNTED CASH FLOW
A technique of evaluating capital investment
projects, using discounting arithmetic to determine
whether or not they will provide a satisfactory return
Ignore Depreciation
Only deal with Cash!

Can be used in two ways
Net Present Value (NPV)
Internal Rate of Return (IRR)
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NET PRESENT VALUE (NPV)
The sum of all present value of cash flows (both
outflow/ initial outlay and inflow) over the period of
the project

If NPV > 0: PV of benefits > PV of cost so the
project earns higher return than the cost of capital
should be accepted!

If NPV < 0: PV of benefits < PV of cost so the
project earns lower return than the cost of capital
should be rejected!

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NPV EXAMPLE
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Project A
Outlay cost $15,000
Estimated future cash flows
Year 1 $4,000
Year 2 $7,000
Year 3 $7,000
Discount rate/ Cost of capital/
Required rate of return
10%
Evaluate the following project
Year Cash
flow
Present value
factor
Present value
$ 10% $
0 (15,000) 1.000 (15,000)
1 4,000 0.909 3,636
2
7000 0.826 5782
3
7000 0.751 5257
NPV
(325)
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NPV < 0: Reject the project!
DISCOUNTED PAYBACK PERIOD
Reflect the time value of money!

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Year Cash flow Present
value
Cumulative
PV
$ $ $
0 (15,000) (15,000) (15,000)
1 4,000 3,636 (11,364)
2
7,000 5,782 (5,582)
3
7,000 5,257 (325)
4
6,000 4,098 3,773
DISCOUNTED PAYBACK PERIOD
Discounted payback period = 3 yrs + 325/4,098
= 3.079 years

This compares with a non-discounted payback period,
instead of occurring near the end of year 3, the
discounted payback period suggests that the initial
outlay can only be recouped at the beginning of year 4

If the project stops at year 3, it will not add value to the
company!
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COST OF CAPITAL
The appropriate discount rate to use in investment
appraisal is the companys cost of capital difficult
to determine

Both shareholders and debt holders expect some
sort of returns cost of financing to the company

Cost of capital = Weighted average cost of all the
sources of capital that a company uses
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ANNUITIES
In DCF, annuities are an annual cash payment/
receipt that is the same amount every year for a
number of year

Instead of using the normal DCF calculation, there
is a short-cut formula for annuities
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INTERNAL RATE OF RETURN (IRR)
IRR is the rate of return at which NPV = 0 (or the
total cash inflows are equal to the total cash
outflow)

There are two steps involved in IRR calculation
Calculating IRR expected from a project
Comparing IRR with cost of capital
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VII. ALLOWING FOR INFLATION
The inflation will influence the level of expected
returns of investors

Which rate to use? Money rate (Nominal rate) or
Real rate?
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VIII. TAXATION AND PROJECT
APPRAISAL
The incremental tax cash flows should be included
in the cash flows of the project for discounting to
arrive at the projects NPV

When taxation is ignored in the DCF calculation,
the discount rate is pre-tax rate of return

When taxation is included in the cash flows, a post-
tax rate is required!

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