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Lecture 2- Capital Investment Appraisal: Appraisal process and methods. Objectives: Describe the nature of capital investment appraisal Apply the main investment appraisal techniques Recognise the limitations of investment appraisal technique. Definition of Investment .

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lecture 2 capital investment appraisal appraisal process and methods
Lecture 2- Capital Investment Appraisal: Appraisal process and methods

Objectives:

  • Describe the nature of capital investment appraisal
  • Apply the main investment appraisal techniques
  • Recognise the limitations of investment

appraisal technique

definition of investment
Definition of Investment
  • Any act which involves the sacrifice of an immediate and certain level of consumption in exchange for the expectation of an increase in future consumption.
  • forgo the present consumption in order to increase resources in future
types of capital investment
Types of capital investment
  • Replacement of obsolete assets
  • Cost reduction e.g. IT system
  • Expansion e.g new building & equipment
  • Strategic proposal: improve delivery service, staff training.
  • Diversification for risk reduction
need for investment appraisal
Need for Investment Appraisal
  • Large amount of resources are involved and wrong decisions could be costly
  • Difficult and expensive to reverse
  • Investment decisions can have a direct impact on the ability of the organisation to meet its objectives
investment appraisal process
Investment Appraisal Process

Stages:

  • identify objectives. What is it? Within the corporate objectives?
  • Identify alternatives. Use CAD, CAM or use external service.
  • Collect and analyse data. Examine the technical and economic feasibility of the project, cash flows etc.
investment appraisal process6
Investment Appraisal Process

Stages:

  • decide which one to undertake
  • authorisation and implementation
  • review and monitor: learn from its experience and try to improve future decision - making.
appraisal methods
Appraisal Methods

Payback method - length of time it takes to repay the cost of initial investment

payback period
Payback Period

Lecture Example 2.1

LBS Ltd uses the payback period as its sole investment appraisal method. LBS invests £30,000 to replace its computers and this investment returns £9,000 annually for the five years. From the information above evaluate the investment using the payback. Assume that £9,000 accrues evenly throughout the year.

payback period9
Payback Period

Solution 2.1

Year Yearly cash flow cumulative net cash flow

£ £

0 (30,000) (30,000)

  • 1 9,000 (21,000
  • 2 9,000 (12,000)
  • 3 9,000 (3,000)
  • 4 9,000 6,000
  • 5 9,000 15,000

Therefore 3years = 27,000 then 3000/9000 x 12 = 4

Payback period = 3 years 4months

example 2 2 solution
Example 2.2 solution
  • Undiscounted pay back

For A = 4 years

For B = 5 years

example 2 2 solution13
Example 2.2 solution

For A, payback is outside the project’s life

For B payback is 6.25 yeas (how?)

example 2 3 solution
Example 2.3 - solution

Average Accounting Profit

(- 250 +1000 + 1000 + 20,750) / 4 = 5625

Average investment = 45,000 / 2 = 22500

ARR = (5625/22,500 x 100 = 25%

slide18
ARR

Read on:

Advantages and disadvantages (page 14)

appraisal methods19
Appraisal Methods
  • Net Present Value (NPV) - the difference between the present values of cash inflows and outflows of an investment
  • Opportunity cost of undertaking the investment is the alternative of earning interest rate in the financial market.
definitions
Definitions
  • Present value:- the amount of money you must invest or lend at the present time so as to end up with a particular amount of money in the future.
  • Discounting: -finding the present value of a future cash flow
example 2 4
Example 2.4

A company can purchase a machine at the price of £2200. The machine has a productive life of three years and the net additions to cash inflows at the end of each of the three years are £770, £968 and £1331. The company can buy the machine without having to borrow and the best alternative is investment elsewhere at an interest rate of 10%.

Evaluate the project using the

  • Net present value method.
  • Internal rate of return
net present value
Net Present Value

Lecture Example 2.5

A firm invest £180,000 in a project that will give a net cash inflow of 50,000 in real terms in each of the next six years. Its real pre-tax cost of capital is 13%.

Required:

Calculate NPV

net present value26
Net Present Value

Solution 2.5

  • Year Cash Flow PV factor 13% Present value
  • 0 (180,000) 1.00 (180,000)
  • 1 50,000 0.885 44,250
  • 2 50,000 0.783 39,150
  • 3 50,000 0.693 34,650
  • 4 50,000 0.613 30,650
  • 5 50,000 0.543 27,150
  • 6 50,000 0.480 24,000
  • NPV 19,850
  • Positive NPV indicates viability of the project.
  • Negative NPV indicates non-viability of the project.
alternative solution to 2 5
Alternative solution to 2.5

Use the annuity table

Year Cash flow DF @13% PV

0 (180,000) 1 (180,000)

1-6 50,000 3.998 199,900

NPV 19,900

appraisal methods28
Appraisal Methods
  • Internal Rate of Return - is the discount rate that equates the present values of an investment’s cash inflows and outflows.
  • Internal Rate of Return (IRR) - is the discount rate that causes an investment’s NPV to be zero
example 2 6
Example 2.6

Using Lecture example 2.4 (above), calculate the internal rate of return for the project.

internal rate of return
Internal Rate of Return

Solution to 2.6

  • IRR Try 15%
  • Year Cash flow Discount Factor (15%) PV
  • 0 (2200) 1.000 (2200)
  • 1 770 0.8696 669.59
  • 2 968 0.7561 731.90
  • 3 1331 0.6575 875.13
  • NPV 76.62
internal rate of return32
Internal Rate of Return
  • Year Cash flow DC (16%) PV
  • 0 (2200) 1.000 (2200)
  • 1 770 0.8621 663.83
  • 2 968 0.7432 719.42
  • 3 1331 0.6407 852.77
  • NPV 36.01
slide33
IRR
  • Year Cash flow DCF (17%) PV
  • 0 (2200) 1.000 (2200)
  • 1 770 0.8475 652.58
  • 2 968 0.7305 711.48
  • 3 1331 0.6244 831.08
  • NPV (4.86)
  • Interpolation
  • 16 + 36.01 / 40.87 = 16.88%
appraisal methods34
Appraisal Methods

Please read more on the advantages and disadvantages of these techniques

Why is the NPV considered superior over the other methods, even the IRR?

end of lecture 2
End of Lecture 2

Any question please?