### INVESTMENT APPRAISAL

```INVESTMENT APPRAISAL
INVESTMENT
Refers to the purchasing of capital goods such as
equipment, vehicles and new buildings; and
improving fixed assets
INVESTMENT APPRAISAL
Evaluating the profitability or desirability of an
investment project. It assesses the economic
viability of potential investment options so as to
arrive at the most acceptable alternative
depending on the criteria used for comparing
these projects
INVESTMENT APPRAISAL TECHNIQUES
• Payback Period - Uses Cash Flows
• Average Accounting Rate of Return (ARR /
AARR)- Uses Net Profit
• Net Present Value (NPV) - Uses Cash Flows
• Internal Rate of Return (IRR) - Uses Cash Flows
PAYBACK PERIOD
This is the length of time necessary to recover
the entire cost of an investment from the
resulting annual net cash flows.
Payback Period = (Number of years before
recovery of initial investment) + ([Amount of
investment remaining to be recaptured / Total
cash flow during year of payback] x 12)
EXAMPLE
The following refers to information relating to
the investment in two projects:
YEAR
0 (Initial
Investment)
PROJECT A
PROJECT B
(\$500,000)
(\$500,000)
1
\$300,000
\$10,000
2
\$200,000
\$20,000
3
\$50,000
\$200,000
4
\$10,000
\$135,000
5
\$5,000
\$200,000
CALCULATING PAYBACK PERIOD
• Calculate cumulative cash flow
YEAR
PROJECT A PROJECT A
CUMULATIVE
CASH FLOW
PROJECT B
PROJECT B
CUMULATIVE
CASH FLOW
0
(\$500,000)
(\$500,000)
(\$500,000)
(\$500,000)
1
\$300,000
(\$200,000)
\$10,000
(\$490,000)
2
\$200,000
\$0
\$20,000
(\$470,000)
3
\$50,000
\$50,000
\$200,000
(\$270,000)
4
\$10,000
\$60,000
\$135,000
(\$135,000)
5
\$5,000
\$65,000
\$200,000
\$65,000
CALCULATING PAYBACK PERIOD cont’d
• Payback will occur where the cumulative cash flow is
equal to zero (0).
• Project A – Payback period is 2 years. (Straightforward)
• Project B – Payback Period = 4yrs and ? (To Calculate)
? = (Amount of investment remaining to be
recaptured / Total cash flow during year of payback) x 12
= (\$135,000/ \$200,000) x 12
= 8.1 months
Final Answer is 4yrs and 8.1mths
• It is easy to calculate and understand
• It focuses on risk and therefore promotes
prudence and caution
• By focusing on liquidity (cash flow) rather than
profitability, this method is looked upon
favorably by lenders of capital
METHOD
• It fails to take into account cash flows after the
payback period
• It does not take into consideration the time
value of money
• It only looks at cash flows and does not
consider overall profitability
Average Accounting Rate of Return
(AARR / ARR)
Unlike other appraisal methods, the ARR uses
profit instead of cash flows. This method
therefore give profitability of the investment as
a percentage of the initial investment. The usual
difference in a question between cash flow and
profitability is depreciation. In order to arrive at
profit when given cash flows, you need to minus
depreciation per year from the cash flows.
AARR / ARR EQUATION
ARR = (Average Annual Profit /Initial Investment)
x 100
CALCULATING ARR /AARR
• Calculate profit if depreciation per year is
\$10,000 for Project A and \$15,000 Project B
YEAR
CASH
PROFIT
FLOW
PROJECT A
PROJECT A
CASH
FLOW
PROJECT B
0
(\$500,000)
(\$500,000)
1
\$300,000
\$290,000
\$10,000
(\$5,000)
2
\$200,000
\$190,000
\$20,000
\$5,000
3
\$50,000
\$40,000
\$200,000
\$185,000
4
\$10,000
\$0
\$135,000
\$120,000
5
\$5,000
(\$5,000)
\$200,000
\$185,000
Total
\$515,000
PROFIT
PROJECT B
\$490,000
CALCULATING ARR /AARR cont’d
• Project A = [(\$515,000/5) / \$500,000] x 100
= (\$103,000 / \$500,000) x 100
= 20.6%
• Project B = [(\$490,000/5) / \$500,000] x 100
= (\$98,000 / \$500,000) x 100
= 19.6%
• It focuses on profitability in all years unlike
payback
• It focuses on profitability, which is the central
• The result is easy to understand and compare
with other projects
• It ignores the timing of profit flows. This could
result in two projects having the same ARR
but with different paybacks
• The time value of money is ignored
NET PRESENT VALUE (NPV)
This method takes into consideration the fact
that future cash flows will lose value over time.
This method therefore discounts all future cash
flows and brings them to present values. (Using
a Present Value Interest Factor [PVIF] table) This
summed total of all of the Present Values is then
subtracted from the initial investment in order
to calculate the Net Present Value. The project
with the highest positive NPV would be chosen.
CALCULATING NPV
PROJECT A
YEAR
CASH FLOW
10%
DISCOUNT
FACTOR
PRESENT
VALUE
0
(\$500,000)
1
1
\$300,000
0.9091
\$272,730
2
\$200,000
0.8264
\$165,280
3
\$50,000
0.7513
\$37,565
4
\$10,000
0.6830
\$6,830
5
\$5,000
0.6209
\$3,104.50
NPV
(\$500,000)
(\$14,490.50)
CALCULATING NPV
PROJECT B
YEAR
CASH FLOW
10%
DISCOUNT
FACTOR
0
(\$500,000)
1
\$10,000
0.9091
\$9,091
2
\$20,000
0.8264
\$16,528
3
\$200,000
0.7513
\$150,260
4
\$135,000
0.6830
\$92,205
5
\$200,000
0.6209
\$124,180
NPV
1
PRESENT
VALUE
(\$500,000)
(\$107,736)
• It takes into account the time value of money
• It considers the cash flows for the entire
project
• It is more complicated to calculate
• The discount rate is only an estimate, this
could change at any moment
INTERNAL RATE OF RETURN (IRR)
Attempts to find the discount rate where NPV is
equal to zero.(ie. When the cost or initial
investment = discounted cash flows). This rate is
then compared to the interest rate which is charged
when borrowing to invest (Cost of Capital)If that
rate is more than the cost of capital then the
project should be profitable. The IRR is therefore
the rate at which the company internally generates
profit on its investment. (Not required to work it
out for exams)
```