Investment Appraisal

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1 Introduction

In this chapter we will apply the discounting techniques covered in the previous chapter to the appraisal of capital investments.

2 Net Present Value

Under this approach to investment appraisal we look at all the expected cash flows that will arise from an investment.

If overall the investment generates a cash surplus then we will accept and invest; if however there is an overall cash deficit then we will reject the investment.

However, we also need to take into account interest on the investment in the project. This is either because we have needed to borrow money and therefore be paying interest, or because we are using money that could otherwise have been invested and be earning interest.

In either case, we account for the interest by discounting the future cash flows to get the present value. The overall surplus or deficit is known as the Net Present Value.

A new project will cost $80,000 and is expected to last 4 years. At the end of 4 years it is expected to have a scrap value of $10,000.

The project is expected to generate operating cash flows each year as follows:

Year 1	20,000
Year 2	30,000
Year 3	40,000
Year 4	10,000

Assume that all operating cash flows occur at the ends of years.

If interest is 10% p.a., calculate the Net Present Value of the project and state your decision as to whether or not we should invest.

		d.f. @ 10%		P.V.
	(80,000)	1.000		(80,000)
1	20,000	0.909		18,180
2	30,000	0.826		24,780
3	40,000	0.751		30,040
4	20,000	0.683		13,660
			N.P.V.	6,660

The net present value is positive and therefore we should invest in the project.

3 Internal Rate of Return

One problem in practice with basing our decision on the Net Present Value is that it will usually be impossible for a company to determine their cost of capital (or interest cost) accurately.

In these circumstances, it is therefore often useful to calculate a ‘breakeven’ interest rate of the project.

This is known as the Internal Rate of Return (IRR) and is the rate of interest at which the project gives a NPV of zero.

For the project detailed in Example 1.

Calculate the net present value at interest of 15% and hence estimate the Internal Rate of Return of the project.

		d.f. @ 15%		P.V.
	(80,000)	1.000		(80,000)
1	20,000	0.870		17,400
2	30,000	0.756		22,680
3	40,000	0.658		26,320
4	20,000	0.572		11,440
			N.P.V.	(2,160)

4 Payback Period

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One problem with basing decision on the net present value of a project is that the cash flows are only estimates, and if the estimate are wrong then the decision could be wrong.

It is likely to be the earlier cash flows that are the most certain whereas the further into the future that we are estimating the more uncertain the cash flows are likely to be.

The payback period is the number of years it takes to get back the original investment in cash terms. The shorter the payback period, the more certain we are that the project will actually pay for itself.

The discounted payback period is exactly the same except that it takes into account the time value of money by measuring how many years it takes to get back the original investment looking at the discounted cash flow each year.

A new project will cost $100,000 and will last for 5 years with no scrap value.

The project is expected to generate operating cash flows each year as follows:

Year 1 20,000

Year 2 30,000

Year 3 40,000

Year 4 50,000

Year 5 30,000

The cost of capital is 10%

(a) Calculate the payback period

(b) Calculate the discounted payback period

	Cash inflow	Cumulative Cash inflow	Discounted cash inflow	Cumulative discounted cash inflow
1	20,000	20,000	18,180	18,180
2	30,000	50,000	24,780	42,960
3	40,000	90,000	30,040	73,000
4	20,000	140,000	34,150	107,150
5	30,000	170,000	18,630	125,780

Answer the questions one at a time. Your progress is saved so you can leave and come back.

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