Investment Appraisal

Introduction

core topic of afm and most likely one question either from sec A or B will be from this topic.
 Capital Budgeting Cycle

 Idea Generation
 Project Screening
 Financial & Non-financial Evaluation Accept Or Reject Decision
 Approval
 Implementation
 Ongoing Monitoring--is to ensure project is stil financially viable and it is generating benefits expected of it and if not there is variation to expected instead
we can take necessary options accordingly.
 Post Completion Audit --the objective is to note lessons learned so when in next project same mistakes can be avoided.
 Financial Evaluation Methods
Basic Methods Advanced Methods

 Payback Period  Net Present Value NPV

 Accounting Rate of Return (ARR)  Internal Rate of Return (IRR)
 Discounted Payback Period

difference b/w two methods are basis method do not inorporate time value of money but advance methods does.
Investment Appraisal
Cashflows
 Cash flows
following 3 characteristics that found in any cost or revenue or capital expenditure
we termed them as cash flows.
Relevant Cash flows Irrelevant Cash flows
if a transaction is lacking
• Future Oriented --to be incurred in future
any one of these 3 principles • Sunk Cost/ Historical Cost
it can not be classified as
cash flow. • Cashflows-transaction settlement or event is expected in • Non-cash cost Depreciation
resulting receipt or payment of cash

• Incremental---due to change in decisions or change • General Overheads

in nature of options the value of that event
(cost or revenue) is different.
• Central Office Overheads

Assumptions of Cashflows --relating to its timing

 If Cash flows arise during the period, then it is assumed as it arises at the end of that period.
 If cash flow arise at the start of the period then it is assumed as if it arises at the end of the
preceding period
 Period ‘0’ is not a period, instead it represents start of period ‘1’.--also called as present . Project years are written as
y1,y2 etc.
Investment Appraisal
Payback Period -- is a method based on cashflows
 Payback Period
It is the time period required to recover the initial investment.

For Inconsistent Cashflows

Prepare Cumulative cashflows and see estimate the time period before the cumulated cashflows

become positive.

For Consistent Cashflows

consistent cashflows= same cashflows for a series of period

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Payback Period =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠

Decision rule

If Payback Period < Target Payback, Accept the Project. Else Reject the Project
 Example (Payback Period)
Rough Ltd has the opportunity to invest in an investment with the following initial costs and returns:
A
($000S)
Initial Investment (100)
Cash Flows
Year 1 50
Year 2 40
Year 3 30
Year 4 25
Year 5 20
Residual Value – Year 5 5

The cost of capital is 10%. And the target payback period is 3 Years

Company uses the straight line method for depreciation.

Required: Calculate the payback period?

 Advantages & Disadvantages
Advantages Disadvantages
1. It is simple to use (calculate) and easy to understand 1. It does not give a measure of return, as

2. It is a particularly useful approach for ranking projects where such it can only be used in addition to

a company faces liquidity constraints and requires a fast other investment appraisal methods.

repayment of investment. 2. It does not normally consider the impact of

3. It is appropriate in situations where risky investments are discounted cash flow although a

made in uncertain market that are subject to fast design discounted payback may be calculated

and product changes or where future cash flows are (see later).

particularly difficult to predict. 3. It only considers cash flow up to the

4. The method is often used as the first screening device to payback, any cash flows beyond that

identify projects which are worthy of further investigation. point are ignored.

5. Unlike the other traditional methods payback uses cash 4. There is no objective measure of what is an

flows, rather than accounting profits, and so is less likely to acceptable payback period, any target

produce an unduly optimistic figure distorted by assorted payback is necessarily subjective

accounting conventions
Investment Appraisal
Time Value of Money
 Time Value of Money
Money received today will have more worth than the same amount received at some
point in the future.--today investment value can not be compared with future cashflows this will be unfair in accordance with time value of money.

the concept of compounding and discounting describes time value of money.

FV = PV × (1 + r)n Year 0 COMPOUNDING
Year 1
is the process of converting present cash flows into future.
Where
DISCOUNTING
PV - Present value. is the process of converting future cash flows in present value.

FV - Future value.
r- Rate of interest or cost of capital.
(which are usually)
n - Number of periods (years) ^

Revising the formula

𝐹𝑉
𝑃𝑣 = Or PV = FV × (1 + r)-n =discount factor(highlighted)
(
1+r n
Investment Appraisal
Net Present Value (NPV)
exam importance of this topic is enormous, is tested almost every time (in all exams) in one form ot the other.
 Net Present Value (NPV):

The NPV of the project is the sum of the PVs of all cash flows that arise as a result of

doing the project.

Decision Rule:-

If NPV of the project, discounted at cost of capital, is positive then Accept the

project, Else Reject the Project.

 Example (NPV)
Rough Ltd has the opportunity to invest in an investment with the following initial costs and returns:
A
($000S)
Initial Investment (100)
Cash Flows
Year 1 50
Year 2 40
Year 3 30
Year 4 25
Year 5 20
Residual Value – Year 5 5

The cost of capital is 10%. And the target ARR is 20%

Company uses the straight line method for depreciation.

Required: Calculate the NPV of the project and comment on acceptability?

 Advantages & Disadvantages
Advantages Disadvantages
1. A project with a positive NPV increases the 1. Determination of the correct discount rate
wealth of the company’s, thus maximise the can be difficult.
shareholders wealth.-objective of finance manager is to maximise 2. Non-financial managers may have difficulty
shareholder wealth so npv plays a major part to assist accomplish role of finance
manager.
2. Takes into account the time value of money. understanding the concept.

3. Discount rate can be adjusted to take 3. The speed of repayment of the original
account of different level of risk inherent in investment is not highlighted.
different projects. 4. The cash flow figures are estimates and may
4. Unlike the payback period, the NPV takes into turn out to be incorrect.-and if cash flows estimate incorrect risk
is project will not add value in shareholder wealth.
account events throughout the life of the 5. NPV assumes cash flows occur at the
project. beginning or end of the year, and is not a
5. Better than accounting rate of return technique that is easily used when
because it focuses on cash flows rather than complicated, mid-period cash flows are
profit. present --complicated mid term cash flows this method of npv will have
its own impacts and limitations.
Investment Appraisal
Internal Rate of Return (IRR)
 Internal Rate of Return (IRR):
how it is differentiated form ARR is (highlighted in green)

IRR is the total rate of return offered by an investment over its life, based on cashflows and time value
of money

Calculative, The rate of return at which the NPV equals zero. (at irr npv is =0 always) (remember)

𝐴
𝐼𝑅𝑅 = 𝑎% + 𝑋 𝑏−𝑎 %
𝐴−𝐵

Where:

a%- Small Disc. Rate at which NPV is Preferably positive

remember from exam perspective it is prefreential that these rates should be as big
and small to give +ve and -ve npvs but it is not necessary so if not
A NPV at a% provided with such big rate use whatever provided. The rule is to use to two discount
rate one small and other greater than small and can either be one positive and one negative or both positive or both negative

b%- Bigger Disc. Rate at which NPV is Preferably negative

B NPV at b%

Decision Rule

• If IRR of the project > Cost of capital, Accept the project. Else Reject the Project
 Example (IRR)
Rough Ltd has the opportunity to invest in an investment with the following initial costs and returns:
A
($000S)
Initial Investment (100)
Cash Flows
Year 1 50
Year 2 40
Year 3 30
Year 4 25
Year 5 20
Residual Value – Year 5 5

The cost of capital is 10%. And the target ARR is 20%

Company uses the straight line method for depreciation.

Required: Calculate the IRR of the project assuming that the NPV at 10% is $34,000?
 Advantages & Disadvantages

Advantages Disadvantages
1. Like the NPV method, IRR recognises the time 1. Does not indicate the size of the investment,
value of money. thus the risk involve in the investment.--in fact this is the
drawback for any investment appraisal method in which we are estimating or computing
answer in %.
2. It is based on cash flows, not accounting 2. Assumes that earnings throughout the period
profits. of the investment are reinvested at the same

3. More easily understood than NPV by non- rate of return.--unreasonable assumption made by irr, this is not necessarily
possible.

accountant being a percentage return on 3. It can give conflicting signals with mutually
investment. exclusive project.

4. For accept/ reject decisions on individual 4. If a project has irregular cash flows there is
projects, the IRR method will reach the same more than one IRR for that project (multiple
decision as the NPV method IRRs).
Investment Appraisal
Discounted Payback Period
 Discounted Payback period
The time period in which initial investment is recovered in terms of present value is known

as payback period

It is same as simple payback period. The only difference is that the discounted cash flows

are used instead of simple cash flows for calculation.

• Decision Rule

(discounted)
If payback period is less than target payback period then ACCEPT the project, Else,
^

Reject the project

 Example (Discounted Payback Period)
Rough Ltd has the opportunity to invest in an investment with the following initial costs and returns:
A
($000S)
Initial Investment (100)
Cash Flows to the nearest year= last negative cumulative cashflow/cashflow of the next year

Year 1 50
Year 2 40
Year 3 30
Year 4 25
Year 5 20
Residual Value – Year 5 5

The cost of capital is 10%. And the target payback period is 3 Years

Company uses the straight line method for depreciation.

Required: Calculate the Discounted payback period?

 Advantages & Disadvantages

Advantages Disadvantages

1. It takes into account the time value of 1. It does not consider the whole life of

money and timings of cash flows. project.

2. It considers cash flows rather than 2. It requires knowledge of cost of capital

accounting profits. which is difficult to calculate.

3. Short payback period result in increased 3. Life expectancy of a project is ignored.

liquidity and enable business to grow 4. It ignores cash flows after the payback

more quickly period

Investment Appraisal
Taxation
 Effect of Taxation in investment appraisal

 Timing of Tax Cashflows: --in which year we have to consider/include tax receipts or payments
NOTE; In arrears if project life is 5 years than cash flows will be prepared for 6 years
Either in the same year or in arrears. the reason for this is because tax of 5th year will be settled in year 6.
in the same tax year= tax is charged in the year it will arise.
in arrears= tax recorded/included in immediate next tax year.

taxation
 Calculation of cashflows ^

o Tax on Operating Cashflows: Operational Cashflows X Rate of Tax

o Tax Savings on Capital Allowances: Calculate the capital Allowances/

Balancing Allowances and then multiply with Tax Rate.

Remember that capital allowances are a non cash cost, although tax relief on capital allowances which is a cash low and should be a part of our overall cashflows of the project.
 Example (Tax Savings)

Initial Investment = 2000

Capital Allowances = 25% reducing balance

Useful life = 4 years, Tax rate = 30% payable in arrears, Scrap Value = 500
Investment Appraisal
Inflation
 Effect of Inflation in investment appraisal:

Inflation may be defined as a general increase in prices, leading to general decline in

the real value of money, (decrease in purchasing power).

 Real Rate of Return=r difference b/w real rate of return and money or nominal rate of return is due to general rate of inflation.

 Money/ Nominal Rate of Return =n

 General Inflation =i

(1 + n) = (1 + r) (1 + i)
n=((1+r)(1+i))-1
 Effect of Inflation in investment appraisal:

Example

The Real rate of return is 6% and the rate of inflation is 3%.

Calculate the Nominal Rate of return

general rate of inflation= all cash flows have same rate of inflation. specific inflation rate= different cash flows have different

Inflating Cashflows
inflation rate than it is knows as specific inflation rate.

If General inflation rate is given If Specific inflation rate is given

Money Method Real Method Money Method

Inflate all Cash flows Do not inflate Cash Inflate each variable cash
with general inflation flows. flow with its specific inflation
rate. Discount all Cash rate.
Discount these cash flows with real Discount with money cost of
flows with money discount rate. capital (calculated through
discount rate. real rate and general inflation
rate.

If Real Cashflows in Current price terms

Nominal Cashflow = Real cashflows ( 1+ i)n where i = general rate of inflation and n= number of period or years.

If Real Cashflows in Year 1 price terms

Nominal Cashflow = Real cashflows ( 1+ i)n-1 (subtract 1 from number of periods).
 Example (Nominal Cashflows)
Rough Ltd has the opportunity to invest in an investment with the following initial costs and returns:
A
(000S)
Year 1 50
Year 2 40
Year 3 30
Year 4 25
Year 5 20

The selling price is $5 in real price terms and the rate of inflation is 3%

Required:

Calculate the Nominal Sales Value

 Investment Appraisal
Working Capital & Finance Cost
 Working Capital --day to day funds required for business to run its operations.

Every business requires working capital for its operations.

Calculation of working capital will be done in the following steps.

generally
1. Calculate working capital requirement one year in advance e.g. working capital is
^

10% of sales at the start of each year

2. Calculate incremental working capital by taking change of each year working

capital--decrease in incremental working capital from one year to another is inflow and increase in incremental in working from on year to another is outflow.

3. In last year, there will be an assumption that all working capital will be recovered
applicable
(Only^ for project and not for ongoing business)
 Example (Working Capital)

A company is considering to invest in a project with its life of 4 years. Total working capital

required at the beginning of each year is as follows:

Year Cashflows

$’000
1 500
2 700
3 1000
4 600
Required:

Calculate the working capital cashflows of each year to be included in NPV calculation?
 Finance Cost

The Finance Cost will be a relevant cashflow. --- so if for a project we take a loan and on the loan we have to pay interest cost, so interest/
finance cost incurred is directly associated with project and hence it is a relevant cashflow.

although being a relevant cashflow

However, it will NOT become the part of cashflows. This is because it is part of cost of capital.
^
 Investment Appraisal
Annuity and Perpetuity Cashflows
&
Performa
 Consistent Cashflows
If Cashflows arises in a series of equal cashflows then it is called Consistent Cashflows.

These are of two Types:

Annuity: If Consistent cashflow for a certain Period. e.g Y1-5 or Y3-7

Perpetuity: If Consistent cashflow for infinite period e.g. Y1-∞ or Y3-∞

• Present Values of Consistent Cashflows

𝟏− 1 + r −n
• The Annuity Factor =
𝒓

• The Perpetuity Factor = 1/r

 Consistent Cashflows Present Value
Annuity Perpetuity
If Cashflows Start from Period 1.

Annual Cashflow X Annuity Factor Annual Cashflow X Perpetuity Factor

e.g. Y1-5 $10,000 at Disc. Rate of 10% e.g. Y1-∞ $10,000 at Disc. Rate of 10%
$10,000 X 3.791(from annuity table) =$37,910 $10,000 X (1/10%) = $100,000
If Cashflows Start from Period 0.
Annual Cashflow X (Annuity Factor + 1) Annual Cashflow X (Perpetuity Factor + 1)
e.g. Y0-5 $10,000 at Disc. Rate of 10% e.g. Y0-∞ $10,000 at Disc. Rate of 10%
$10,000 X (3.791+1) =$47,910 $10,000 X ((1/10%)+1) = $110,000
If Cashflows Start from Subsequent Period e.g. Year 3.
Annual Cashflow X Annuity Factor of No. of Annual Cashflow X Perpetuity Factor X Discount
periods X Discount factor of preceding period factor of preceding period from Start
from Start e.g. Y4-∞ $10,000 at Disc. Rate of 10%
e.g. Y4-8 $10,000 at Disc. Rate of 10% $10,000 X (1/10%) X 0.751 = $75,100
$10,000 X 3.791 X 0.751 =$28,470
Performa for Net Present Value
Specific Investment decision
Capital Rationing
 Capital Rationing --there are number of projects availabe to company with +ve
npvs but due to limited funds we can not undertake all projects
such situation is termed as capital ratiioning.

A limit on the level of funding available to a business, there are two types--/reasons for capital rationing

 Hard capital rationing (External) --is due to factors beyond the control of management. For example bank restriction on lending is an example of hard
capital rationing.

 Soft capital rationing (Internal) ---capital rationing due to internal factor for example management policies and are under or with in reach or control of
management for example willingness of directors to raise debt due to increase financial risk.

Divisible and indivisible projects

Divisible – An entire project or any fraction of that project may be undertaken. Projects

displaying the highest profitability indices (i.e. NPV/Initial Investment) will be preferred.

Indivisible – An entire project must be undertaken, since it is impossible to accept part of a

project only. In this event different combination of projects are assessed with their NPV and the

combination with the highest NPV is chosen.

 Capital Rationing (Solving Divisible)
Steps for divisible project

1. Calculate the NPV of each Investment

2. Calculate the Profitability indices --by formula pi =npv/initial investment or (npv/initial investment) +1

3. Ranking

4. Investment Plan

Note: In case of Mutually exclusive Projects, the project with the Higher Profitability Indices will

be ranked and lower will be ignored.

 Example (Divisible Projects)
Following are the divisible projects that the company is considering along with the respective

investment and it’s NPV.

Project Investment NPV

A 1,000 500
B 1,200 700
C 800 300
D 700 450

The Company only has $2,500/- Funds.

Required

Prepare Investment Plan and the total NPV

 Capital Rationing (Solving Indivisble)
Non-divisible project

We will make possible combinations and see which has better NPV

Example

Following are the indivisible projects that the company is considering along with the respective

investment and it’s NPV.

Project Investment NPV we make the best combination based on investment required in each project and amount of
funds available.
A 1,000 500
B 1,200 700
C 800 300
D 700 450

The Company only has $2,500/- Funds.

Required
Prepare Investment Plan and the total NPV
Investment Appraisal Risk
 RISK

The Possibility of change in expected outcome is known as risk or Uncertainty.

If the variation in outcome can be measured or probabilities can be assigned then it’s a Risk

If the variation in outcome cannot measured reliability then it’s called Uncertainty

Techniques available:

Sensitivity analysis

Expected values

Adjusted discount rates

 Sensitivity Analysis
Sensitivity Analysis

A technique that considers a single variable at a time and identifies by how much that variable

has to change for the decision to change (from accept to reject).

Formula to calculate sensitivity of a particular cashflow: -

𝑁𝑃𝑉
𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 % = 𝑋 100%
𝑃𝑉 𝑜𝑓 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑠𝑒𝑛𝑠𝑡𝑖𝑣𝑖𝑡𝑦

Formula to calculate sensitivity of a particular variable:-

sensitivity of discount rate of sensitivity of cost of capital.

𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 % = 𝑋 100%
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
 Example

Following are the Present Values of the project:

PV ($’000)
Sales 55
Variable cost 25
Fixed cost 10
Investment 10

Required:

Calculate the sensitivity of Fixed cost and Sales Volume

 Adjusted Discount Rate

The discount rate we have assumed so far is that reflecting the cost of capital of the business. In

simple terms this means that the rate reflects either the cost of borrowing funds in the form of a

loan rate or it may reflect the underlying return of the business (i.e. the return required by the

shareholder), or a mix of both.

An individual investment or project may be perceived to be more risky than existing investments.

In this situation, the increased risk could be used as a reason to adjust the discount rate up to

reflect the additional risk.

 Expected Values
Expected Values

Where there are a range of possible outcomes which can be identified and a probability

distribution can be attached to those values. The expected value is the arithmetic mean of the

outcomes as: EV = Σpx

Where P = the probability of an outcome

x = the value of an outcome

Example
Outcomes % EV
100,000 0.25 25,000
200,000 0.50 100,000
300,000 0.25 75,000
Expected Value 200,000
Investment Appraisal Risk
Monte Carlo Simulation --important technique of risk assessment in any
investment appraisal. Since this techinique is
extremly complex due to its complexity it is not
core part of our exam syllabus so only an
explanation in exam is expected.
 Monte Carlo Simulation

Monte Carlo simulation is a method of measuring an expected outcome by means of

generating multiple trials or iterations, in order to determine the expected value of the

outcome and also to measure the variability or risk.

for a human to do it manually is very difficult due to its complex nature and high level of calculation, so we can only perform this calculation by using computer software(especialy designed
software).

The use of Monte Carlo simulation modelling is made possible by computers, which can

produce a large number of iterations quickly, to produce a reliable expected value and

probability distribution of the outcome.

Steps Monte Carlo Simulation --steps to identify expected outcomes using monte carlo simulation.

 Specify major variable.---that major variable could be comprised of an investment appraisal of the following.

 Market size.

 Selling price.
all the variables which can effect investment appraisal identify them

 Market growth rate.

 Investment required.

 Residual value of investment.

 Specify the relationship b/w variables to calculate an NPV

 Sales revenue = market size x market share x selling price.

 Net cash flow = sales revenue (variable cost + fixed cost = taxation) etc

 Simulate the environment and computerized model will generate a range of NPV across all

probability levels
Advantages & Disadvantages
Advantages Disadvantages

 It includes all possible outcomes in  Models can become extremely complex

the decision making process. and the time and cost involved in their

 It is relatively easily understood construction can be more than is gained

from the improved decisions.

technique. --but for perfomance it is complex.
 Probability distributions may be difficult to
 It has a wide variety of applications
formulate ---because of nature of information.
for eg to manage inventory levels, where they can ascertain how much
inventory level should be maintained from each individual need of inventory.

 Accuracy of data output depends upon the

accuracy of data input

Investment Appraisal Risk
Project Value at Risk --important method to assess risk in investment
appraisal.
 Project VaR equals cap N open paren confidence level close paren times s times the square root of
cap T

Project value at risk (VAR)

Where:

N (confidence level) is the number of standard deviations from the mean for the given confidence
level (extracted from the normal distribution tables)
s is the annual standard deviation of the project's returns
T is the number of years of the project.

A project value at risk is the maximum amount, at a given confidence level, by which the

actual NPV from a project will be worse than the expected value of the NPV. It can therefore

be used to assess the risk in a capital investment project, which should help management to

decide whether or not to invest in the project, taking into consideration the risk as well as the

expected return (expected NPV).

s= volatility of pv of cash flows these values of confidence levels will not be provided in exam.
t = time (memorize)
confidence level = n 95% Confidence = 1.645
99% Confidence = 2.327
VAR = σS × √T X Confidence Value
S=volatility of pv of cashflows.

S= volatility of pv of cash flows.

 Example
A simulation model has been used to calculate the expected value of the NPV of a project.

This is $282,000. The project has an expected life of ten years, and the volatility of the PV of the

annual cash flows is $30,000.

Estimate the Project Value at risk at 95% confidence Level and also interoperate the Answer

Where:
solution var;
s=30.,000 N (confidence level) is the number of standard deviations from the mean for the given
t=10 confidence level (extracted from the normal distribution tables)
n=95% hence valued at 1.645 s is the annual standard deviation of the project's returns
var=30.000*(10)^1/2*1.645 T is the number of years of the project.
var=156,058
since npv = 282,000
difference between the two is 125,942

CONSLUSION;
if that risk exposes than our expected npv will fall to 125,942
156,058 states that (var value states that) we are 95% certain (since calculated on 95%
confidence level) total return pv or npv of variability in cash flow will not exceed 156,058
or we can say that we are 95% certain/confident that our minimum npv will be 125,942

THIS IS WHAT VAR TELLS US.