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Investment Appraisal: The decision making process. Corporate Finance 7. The decision-making process for investment appraisal. Empirical evidence on project appraisal techniques used The calculation of payback, discounted payback and accounting rate of return (ARR)

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slide2

The decision-making process for investment appraisal

  • Empirical evidence on project appraisal techniques used
  • The calculation of payback, discounted payback and accounting rate of return (ARR)
  • The drawbacks and attractions of payback and ARR
  • The balance to be struck between mathematical precision and imprecise reality
  • The capital-allocation planning process
slide4

Payback

The payback period for a capital investment is the length of time before the cumulated stream of forecasted cash flows equals the initial investment.

  • Payback
  • Project A: 4 years, Project B: 4 years, Project C: 5 years.
slide5

Tradfirm: Net Present Values (£m)

Exhibit 4.4 Tradfirm: Net Present Values (£m)

slide6

Drawbacks of payback

  • It makes no allowance for the time value of money
  • Receipts beyond the payback period are ignored
  • Arbitrary selection of the cut-off point
slide7

Discounted payback: Tradfirm plc (£m)

Exhibit 4.5 Discounted payback: Tradfirm plc (£m)

slide8

Reasons for the continuing popularity of payback

  • Supplements the more sophisticated methods
  • E.g. an early stage filter
  • It is simple and easy to use
  • Projects which return their outlay quickly reduce the exposure of the firm to risk
  • If funds are limited, there is an advantage in receiving a return on projects earlier rather than later
  • It is often claimed that the cash flows in the first few years of a project provide some indication of the cash flows in later years
slide9

Accounting rate of return

  • The accounting rate of return (ARR) method may be known by other names such as the return on capital employed (ROCE) or return on investment (ROI)
  • ARR is a ratio of the accounting profit to the investment in the project, expressed as a percentage
  • The decision rule is that if the ARR is greater than, or equal to, a hurdle rate then accept the project
slide10

Timewarp plc

  • Invest £30,000 in machinery: life of three years
slide11

Time warp plc (continued)

(5,000 + 5,000 + 5,000)/3 ARR = –––––––––––––––––––––– × 100 = 33.33% 15,000

slide12

Drawbacks of accounting rate of return

  • Wide-open field for selecting profit and asset definitions
  • Profit figures are very poor substitutes for cash flow
  • Fails to take account of the time value of money
  • High degree of arbitrariness in defining the cut-off or hurdle rate
slide13

Drawbacks of accounting rate of return (continued)

  • Accounting rate of return can lead to some perverse decisions
  • Suppose that Timewarp uses the second version, the total investment ARR, with a hurdle rate of 15 per cent
  • The appraisal team discover that the machinery will in fact generate an additional profit of £1,000 in a fourth year
  • Original situation
  • New situation

(5,000 + 5,000 + 5,000)/3 ARR = –––––––––––––––––––––– = 16.67%. Accepted 30,000

(5,000 + 5,000 + 5,000 + 1,000)/4 ARR = ––––––––––––––––––––––––––– = 13.33%. Rejected 30,000

slide14

Reasons for the continued use of accounting rate of returns

  • Managers are familiar with this ancient and extensively used profitability measure
  • Divisional performance and the entire firm is often judged on a profit-to-assets employed ratio
slide15

Internal rate of return: reasons for continued popularity

  • Psychological
  • IRR can be calculated without knowledge of the required rate of return
  • Ranking
slide16

The ‘science’ and the ‘art’ of investment appraisal

  • Strategy
  • Social context
  • Expense
  • Stifling the entrepreneurial spirit
  • Intangible benefits
slide19

Post-completion audit

  • Post-completion auditing is the monitoring and evaluation of the progress of a capital investment project through a comparison of the actual cash flows and other costs and benefits with those forecasted
  • Reasons for carrying out a post-completion audit:
    • 1 Financial control mechanism
    • 2 Insight gained may be useful for future capital investment decisions
    • 3 The psychological effect
slide20

Lecture review

  • Payback and ARR are widely used methods of project appraisal, but discounted cash flow methods are the most popular
  • Most large firms use more than one appraisal method
  • Payback
      • Drawbacks
      • Attractions
  • Accounting rate of return
      • Drawbacks
      • Attractions
  • Internal rate of return
  • Mathematical technique is only one element needed for successful project appraisal
  • The investment process is more than appraisal. It has many stages