Investment Appraisal is a typical management/managerial accounting examination topic for intermediate to higher level accounting. It normally involves making long term decision on capital investment .
These topics are tested in the LCCI Management Accounting And A-Level Accounting GCE level.(click here for more details).
Before we can understand Investment Appraisal, we need to apprehend the following:
STAGE A: EVEN BEFORE MAKING CAPITAL INVESTMENT DECISIONS STAGE
Why Capital Investment Decisions are so important
The types of capital project and the process
What is Capital budgeting
Understand the basic concepts of value of money in terms of:
What is Future Value Of Money concept
What is Time Value of Money concept
What is Present Value Of Money concept
Things to do or Factors to Consider before embarking on an investment appraisal exercise
What should be the criteria Of Good Investment Appraisal method.
STAGE B: DURING THE CAPITAL INVESTMENT APPRAISAL STAGE
What relevant data or salient points to look for
Understand what is Terminal Cash Flows of a project
Understand the different investment appraisal methodologies and the advantages & disadvantages of each method:-
Accounting Rate of Return (ARR) Investment Appraisal methodl
Payback Investment Appraisal method
Internal Rate of Return (IRR) Investment Appraisal method (Part 1)
Internal Rate Of Return (IRR) Investment Appraisal method (Part 2)
Net Present Value(NPV) Investment Appraisal Method
The need to understand what is Profitability Index in Investment Appraisal
Which investment appraisal method should we choose
Stage C:
Understand the need or importance or objectives of a Post Audit of Capital Investment project
Showing posts with label investment appraisal. Show all posts
Showing posts with label investment appraisal. Show all posts
6/20/09
Objectives of Post-Audit of Capital Investment Decision
In earlier article we saw the importance of capital investment decisions. As these decisions made relate to several years and can erode or increase shareholder value, it's important to periodically do post-audit of such capital investment decisions.
Some of the objectives of performing post audit on capital investment decisions are:
Some of the objectives of performing post audit on capital investment decisions are:
- To ensure that the capital spending does not exceed the amount authorized;
- To ensure that the anticipated benefits are eventually obtained and
- That implementation of the project is not being delayed.
Why Are Capital Investment Decisions So Important
Capital Investment Decisions cannot be underemphasized as they related to long term decisions. Examples of such decisions are:
- to introduce new products;
- drop existing products;
- purchase specialized machinery and
- invest in additional plant,machinery and factory
These decisions are very difficult ones as management need to look at a longer time horizon re: several years ahead and to forecast which might happen. Once decided, they are difficult to alter. Such capital investment decisions can increase or erode shareholder values in the long term.
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Understand What Is Terminal Cash Flows In Investment Appraisal
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Append below the explanation of terminal cash flows and a simple example as illustration:
Terminal Cash Flows:
- Is the last stage of a project’s cash flows re: the cash flows that will occur only at the project’s termination/ending.
- Examples are: salvage/scrap value of new machines less tax and net working capital recovered
Illustration:
Company XYZ intends to buy a new machine to increase its present sales. The machine costs $200,000 with five years of useful life and its salvage value is $25,000. By buying this machine, the company will incur additional yearly working capital requirements of $10,000. Calculate the terminal cash flows.
Solution:
Terminal cash flows= Salvage value = $25,000 + working capital recovered of $10,000 = $35,000
Salient Points or What Data To Look For When Performing Investment Appraisal
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As Investment Appraisal entails substantial initial capital outlay and years( at least more than one year) to reap the benefits, the analyst needs to ensure that he or she should pick up the relevant data when performing such appraisal otherwise the company will suffer. Hence, it is critically important to understand some of the cardinal principles or rules or guidelines when performing this Investment appraisal exercise.
Append below in brief pertaining to:
GUIDELINES/PRINCIPLES ON THE CAPITAL BUDGETING ANALYSIS Guideline No1: Use Cash Flows And Not Accounting Profit. Remember that profit is not equating to cash. You need to adjust accounting profit to arrive at the relevant cash flows Guideline No 2: Focus on Incremental Cash flows. Simply it means that you should compare the total cash flows of the company with and without the project. After determining the incremental cash flows, you need to consider the tax implication on these cash flows viz focus only on “after-tax incremental cash flows” in the capital budgeting analysis. Guideline No.3: Consider any synergistic effect on the project for example when this new product the firm is going to introduce, will the sales of the existing products also increase- are they complementary to each other. In financial terms therefore we need to consider the sales of the new products Plus the increase in sales of the existing products Guideline No.4: Consider the opposite of rule no 3 re: the existing sales might reduce with the introduction of the new products. Factored the loss of revenue from such existing products into the capital budgeting analysis Guideline No.5: Ignore sunk costs and consider only those costs which are relevant to the projects. Guideline No.6: Incorporate any NET additional working capital requirements into the capital budgeting analysis for example the need to have additional inventories, accounts receivables and or cash (increase in current assets) minus additional financing from accounts payable, bank borrowings(current liabilities) Guideline No.7: Excludes Interest Payments as this is already reflected in the discount rate ( this rate implicitly accounts for the cost of raising the financing ) |
The Process, Types of Capital Projects And Types of Decision
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Earlier article explain what’s capital budgeting and its importance.
Append below explains the process, types of capital projects and capital budgeting decisions a firm needs to embark on:
Capital Budgeting Process Involves :
Types Of Capital Budgeting Projects:
Types Of Capital Budgeting Decisions:
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What Is Capital Budget & Its Importance or Benefits
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Below explain the meaning of capital budget and its importance:
Capital Budgeting:
- Is a decision making process of selecting and evaluating long term investments viz investing in fixed assets or capital expenditure(capex)
- This will require a substantial initial outlay and expect to produce benefits/results over a period of more than one year
Importance of Capital Budget:
- Proper decision on capital budget will increase a firm’s value as well as shareholders’ wealth
- Capital budgeting is critical to a firm as it helps the firm to stay competitive as it is expanding its business like proposing to purchase equipments to produce additional or new products, renting or owning premises for opening new branches, etc
Which Investment Appraisal Methods Are The Best Or Which to Choose
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We have reviewed the four methods of investment appraisal techniques:
The pros and cons of the payback, accounting rate of return and internal rate of return have been explained.
Fundamentally, the greatest disadvantage of the payback and accounting rate of return is that it ignores the time value or the present value of the inflows.
For accounting rate of return, besides ignoring the time value, it only refers to the accounting profit.As such, though they are simple to compute and understand, it’s not a true investment appraisal method as risk in the form of discount rate or cost of capital is completely not considered.
For Internal rate of return, the disadvantages have been outlined in my article.
Net Present Value method (NPV) has the following advantages:
- It is the most logical method to enhance shareholder value as it considers the economic profit concept (excess return after deducting its cost of finance).
- It’s also flexible, robust , simple to understand and able to cope with much complexity.
- It’s takes into account the time value of money and compares today’s investment with the future cash flows in today’s money.
- Furthermore, it’s take the risk of the investment into account through the choice of cost of capital or discount rate. The greater the risk so the cost of capital is getting higher.
- It considers the whole of the economic life of the investment, not just an arbitrary number of years
- It focuses on cash flow and not simply on accounting profit
When there is no budget constraints, Net present value (NPV) is particularly appropriate compared to other alternative investments method. The Internal rate of return cannot work well if it is comparing two mutually exclusive investment projects of different size or scope.
Even though, where we have budget constraints, we can also use the profitability index which is actually net present value reinstated ( present value of cash flows divide by investment outlay)
In view of the foregoing, the most appropriate or superior method should be the net present value or other method that uses discounted cash flow technique.
Understand The Profitability Index
The profitability index is an alternative way of stating the net present value (NPV).
It takes the present value of the cash-flows and divides them by the initial capital outlay.
i.e.: Profitability Index (PI) =Present value of cash flows / Initial cash outflow
Interpretation:
If the PI is more than one, then we should invest in the project as it represents a positive net present value.
Usefulness of Profitability Index:
The Profitability Index is useful tool for capital budget constraints and where the projects are divisible. This is true as you will have noticed that net present value (NPV) method tends to favor large investments over smaller one. However, in reality, a company is often operating under capital budget constraints, either fixed by the markets or by top management. This therefore makes NPV method as a less flexible tool.
Assuming the following scenario:
Budget constraints of $300,000
Total following investment cost of 5 projects more than $500,000
| Project | Investment | Present Value | Profitability Index | NPV |
| A | 100K | $141K | 1.41 (141/100) | $41K |
| B | 200K | $240K | 1.20 (240/200) | $40K |
| C | 82K | $120K | 1.46 (120/82) | $38K |
| D | 150K | $170K | 1.13 (170/150) | $20K |
| E | 50K | $85K | 1.70 (85/50) | $35K |
As we have the budget constraints of $300K, using the Profitability Index method, we should select the following projects to maximize our net present value:
Project E + Project C + Project A + part of Project B
Investment costs of $50K+$82K+$100K+$68K=$300K
NPV =$35K+$38K+$41K + pro-rate NPV of Project B=68/200×40K=$13.6=$127.6K
Limitation of Profitability Index:
As we have read above, the Profitability Index is merely another way of reinstating net present value. However, when coming to choose between two mutually exclusive projects which have a positive NPV and profitability indices of more than one, we see certain limitation of this index. This is similar to the situation mentioned in my earlier IRR’s article
Illustration:
| Project | Investment | Present Value | Profitability Index | NPV |
| A | $10K | $16K | 1.6 | $6K |
| B | $30K | $42K | 1.4 | $12K |
If we use the Profitability Index method, then we should select Project A which has a higher PI than Project B but then Project B actually has a very much higher net present value.
We can further verify this by using the incremental cash flow and seeing whether they fulfil the profitability index decision rule:
| Investment | Present Value | Profitability Index | NPV | |
| Differential between A & B | $20K | $26K | 1.3 | $6K |
Net Present Value Investment Appraisal Method
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In basic term, net present value (NPV) of an investment is the difference between:
The present value of future cash flows and the present value of the initial capital expenditure required to implement the project.
Say for example the following project having the follow details:
| Year O | Year 1 | Year 2 | Year 3 | Year 4 | |
| Initial Outlay (a) | $100K | ||||
| Net cash-flows (b) | $20.00K | $30.00K | $40.00K | $50.00K | |
| Using NPV: | |||||
| PV Factor © | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 |
| Present Value (a*c) or (b*c) | - $100K | +$18.18K | +$24.78K | +$30.04K | +$34.15K |
| Net Present Value | +$7.15K |
Interpretation of NPV:
If the project has a positive NPV, it should be accepted. By acceptance, it will increase the shareholders value as it gives a higher return compared to its cost of capital ( in this case is the PV factor or discount factor which we assume is 10%)
It’s important to understand that normally, a positive NPV implies excess returns over its cost of capital. But in economic theory, it will not happens in an efficient and competitive market as competitiveness will remove the opportunities to make excess returns from capital expenditures.
Of course in the real world, we have imperfection, however it’s interesting to note and rationalize the source of the positive NPV or the excess return. Is it from any superior technological expertise, R&D, trademarks and patents, market knowledge & skill, quality control, distribution network, after sales service and client relations or the caliber of management and employees? By identify the competitive factors that generate positive NPV , we are able to understand better the reasons for the project’s profitability.
Understand Internal Rate Of Return (IRR) (Part 2)
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We have looked at how we compute investment appraisal method using Net Present Value(NPV) and Internal Rate Of Return(IRR) and also understand how to interpret the individual result.
One very good point is that both NPV and IRR are able to eliminate the greatest disadvantage of ignoring the time value of money or present value unlike the other two methods -Payback and ARR.
We now focus on the advantages of using IRR:
IRR is useful for the following reasons:
- If a company had specified it’s “hurdle rate” or a required cost of capital that new projects must achieved in order to be accepted. By just calculating the IRR, it is then compared to the hurdle rate to see whether the IRR is above the rate and the project can be accepted. Incidentally, even without the hurdle rate, if the IRR rate is very high say 32%, this can some sort warrant further analysis as this high IRR rate seems to be much more than the probable opportunity cost of capital.
- IRR is a “true” return (using present value concept) on the investment compared to the other accounting rate of return.
However IRR also has its critique which is as follows:
- IRR does not tell us anything about the size or scope of a potential investment. This is especially important when we are choosing between two mutually exclusive investments, where only one of the investment projects can be chosen.
Say for example, if we are choosing two investment projects with capital outlays of $1,000 and $10,000 and the IRR of the $1,000 is higher. If we use the IRR method than the IRR which is higher will be more attractive. However, the Net Present Value of the other investment could be much high and so we make have made a less than perfect decision. Therefore, the IRR method is not suitable for making comparisons between two investment projects of different scope or differing time horizons.
For illustration purpose that IRR is not suitable to be used when we need to choose between two mutually exclusive investments:
| Year | Project A Investment | Cash-flows | Project B Investment | Cash- flows |
| 0 | -$100K | -$40K | ||
| 1 | $40K | $20K | ||
| 2 | $50K | $20K | ||
| 3 | $70K | $30K | ||
| NPV @10% | $20K(say) | $10K(say) | ||
| IRR | 15% | 22% |
Project A should be chosen if the NPV method was used whilst Project B should be chosen according to its IRR. But, by taking the differential/remaining cash-flows and calculating the NPV and IRR, we can see that this would have been a less than perfect decision.
Differential Balance of Cash-flow
| Year | Investment Project A – B | Cash-flows |
| 0 | -$60K | |
| 1 | $20K | |
| 2 | $30K | |
| 3 | $40K | |
| NPV @10% | $6K(say) | |
| IRR | 14% |
The differential table shows that there is still value to be gained to enhance shareholder value by investing the differential.
The other disadvantages of IRR are:
- There is technical disadvantages to using the IRR method when dealing with unconventional cash-flows.
- We can have more than one IRR depending on the flow of the cash-flows. As IRR is determined by mathematical iterations, it is possible to have two IRRs when there is more than one change in the direction of the cash-flows. In a normal investment, in the initial one to two years, there are negative cash-flow but subsequently followed by positive cash-flow. But if an investment has a negative cash flow at the end of its economiclife, the investment would actually have two IRR like in a company which is processing radioactive material materials, it will have to invest heavily at the end of the investment’s life to dispose of the radio-active waste products.
Understand Internal Rate Of Return (IRR) (Part 1)
In the previous article on NPV, we noted that a positive NPV denotes that a project can be accepted as it generates excess returns over its cost of finance. Hence, vice-versa, we cannot accept a negative NPV as it cannot generate a return above the cost of finance.
How do we then interpret a zero NPV
Zero NPV is actually the Internal Rate of Return which is therefore the discount rate that causes:
The present value of all the future cash flows – the present value of the initial outlay to yield an NPV of zero.
Using the same cash flow’s details from the NPV case, we shall try to get the IRR:
| Year O | Year 1 | Year 2 | Year 3 | Year 4 | |
| Initial Outlay (a) | $100K | ||||
| Net cash-flows (b) | $20.00K | $30.00K | $40.00K | $50.00K | |
| Using PV factor of 10% NPV= | +$7.15K | ||||
| Simulating it : | |||||
| Using PV factor of 15% NPV= | +$0.5K | ||||
| Using PV factor of 12% NPV= | $0.00K |
To calculate the Internal Rate of Return, we can either use the interpolation method which is to take two discount rates, one rate that gives a positive NPV and another discount rate that give a negative NPV and interpolate the IRR.
Or you can use a calculator or a computer model (excel formula for IRR).
Interpretation of IRR:
If the IRR for the project is12% and the cost of capital used to finance it is lesser than 12%,then the project should be accepted.
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Payback Investment Appraisal Method
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Earlier article was on the traditional Accounting Rate Of Return(ARR).
In this article, we look at the Payback Method which seeks to determine how long it takes for the investment project to pay back its initial capital cost.
Illustration:
Let’s say we have two project A & B, having the following initial capital cost, cash inflows and timing
Project A:
Year | Investment | Cash Savings/Inflows | Cumulative Inflows |
0 | 100,000 | ||
1 | 30,000 | 30,000 | |
2 | 40,000 | 70,000 | |
3 | 30,000 | 100,000 | |
4 |
Payback period = 3 years
Project B:
Year | Investment | Cash Savings/Inflows | Cumulative Inflows |
0 | 100,000 | ||
1 | 60,000 | 60,000 | |
2 | 40,000 | 100,000 | |
3 | 30,000 | 130,000 | |
4 |
Payback peiod=2 years
Using the payback period methodology, the analysts merely see how long or how fast the investment can be recouped.
In the aforesaid situation, we see that by investing in Project B, the company has a faster payback period of 2 years instead of Project A which takes a bit longer which is 3 years.
Like the accounting rate of return, payback method also has its advantages and disadvantages.
The advantages are:
- this method is very easy to understand and to explain to other people;
- it requires the proposer to consider and to collect only the forecasts of the initial capital outlay and estimated cash inflows in the next few yeras, typically no more than five years
- it gives a “result” very quickly without much analysis needed-there is no need to compute a discount rate)
- lastly, if forecasts into the future are unlikely to be accurate, due to technological changes for example, it is considered “less risky” because it is only taking into account those cashflows which are easier to forecast well.
However, its following disdvantages outweight the abovesaid advantages:
- this method ignores the time value of money. That is it assumes that if a company has an investment decision rule which sets payback on projects at, say four years, the company will be indifferent as to whether its investment is recouped in the first year of the project or the third year of the project;
- it ignores any cashflows which might occur outside the “Four-year rule”(say). Thus the company may reject a very lucrative project in favor of a less profitable one because the former recoups its investment over a six-year period whilst the latter recoups much less cash but within the four-year(say) payback period;
- this method automatically favors short-term over long-term investments[the company should preferably have a range of investment projects with differing time horizon thus retaining a flexible approach to new opportunities while capitalizing on long-term projects which ensures that the company keeps pace with technological or other research developments that affect its future viability;
- it does not have a clear decision criteria as to whether to accept or reject an investment project. The cut-off point is ambiguous. For example when is the investment stage of a project considered to be finishd? When the investment project begins to generate cash or automatically after the first year? This ambiguiy leads to subjective decision-making rather than clear-cut decision rules and
- thinking that Paybak is “less risk” can be misleading. The opportunity cost of capital takes into account the increased risks associated with forecasting in future years whereas Payback just ignores these cashflows altogehter. This therefore is really not “less risky” but just more inaccurate!
Accounting Rate Of Return(ARR) Method Of Appraising Investments
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One way of appraising capital investment is the traditional Accounting Rate of Return(ARR) Method or Accounting Return on Book Value.
In this article, there are two parts.
The first part illustrate how to compute Accounting Rate Of Return method and the next part is to discuss its advantages and disadvantages.
About Accounting Rate of Return(ARR):
- The Accounting rate of return is very commonly used as this concept is a very familiar concept to return on investment (ROI), return on capital employed(ROCE) or accounting rate of return(ARR).
- The formula for this method is Average Annual Income/Average Annual Investment
Worked Example:
Let’s say we are evaluating the below said project with the following Initial Outlay/Investment and Net Cash flow ( Revenue minus Costs)
Investment:
Year 0 | Year 1 | Year 2 | Year 3 | Average | |
Gross Book Value of Investment | 100,000 | 100,000 | 100,000 | 100,000 | |
Depreciation | 20,000 | 20,000 | 20,000 | ||
Accumulated Depreciation | 20,000 | 40,000 | 60,000 | ||
Net Book Value | 100,000 | 80,000 | 60,000 | 40,000 | 70,000 |
Returns/Net “Cash flow (Revenue-Costs)
Year 1 | Year 2 | Year 3 | Average | |
Revenue(a) | 50,000 | 70,000 | 100,000 | |
Costs (b) | 20,000 | 30,000 | 40,000 | |
Cashflow (a-b) | 30,000 | 40,000 | 60,000 | |
Depreciation | 20,000 | 20,000 | 20,000 | |
Net profit | 10,000 | 20,000 | 40,000 | 23,300 |
Accounting Rate of Return
=
Average annual returns
Average annual investments
= $23,300
$70,000
= 33.3%
This Part B looks at the advantages and disadvantages of applying the Accounting Rate Of Return (ARR) method.
Append below a snapshot of the Pro’s and Con’s of ARR:
Pro’s | Con’s |
It takes all the years into account when making an investment decision, | There is no account of time value of money. It does not take into account the fact that dollars to be received in the future is not worth as much as money in the hand today. |
It’s is easy to use and is familiar concept to managers which they refer to as “ return on investment” or “ return on Capital employed. | It is purely based on accounting figures and not on cash flow. Thus it
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Having calculated the return, we still do not know whether the return is acceptable or not?
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