Introduction to investment

appraisal

Companies need to invest in wealth-creating assets in order to renew, extend or replace the
means by which they carry on their business. Investment can be divided into capital
expenditure (expenditure which results in the acquisition of non-current assets or an
improvement in their earning capacity) and revenue expenditure (regular spending on the
day-to-day running of the business where the benefit is expected to last for only one
specific period and to maintain the existing earning capacity of non-current assets) and can
be made in non-current assets or working capital.

When a business spends money on new noncurrent assets it is known as capital

investment. Spending may be for:
 Maintenance
 Profitability
 Expansion
 Indirect purposes.

Test your understanding 1

Identify the type of expenditure that each of the above represents. An enterprise spends
money on the following:
1. Annual rental payment for the warehouse
2. a new forklift truck to replace one damaged in an accident
3. Increased inventory to fulfil a newly work contract
4. An automatic moulding machine to streamline a production process.

Capital investment allows companies to continue to generate cash flows in the future or to
maintain the profitability of existing business activities. Typically, capital investment projects
will require:
 Significant cash outflows at the beginning and will then produce cash inflows over
several years.
 Careful evaluation because they require very large amounts of cash to be raised and
invested, and because they will determine whether the company is profitable in the
future.
 To choose most profitable investment projects so that it can maximise the return to its
shareholders.
 To avoid the negative strategic and financial consequences which could follow from
poor investment decisions.

Since capital investment decisions affect a company over a long period of time, it is
possible to view a company and its balance sheet as the sum of the previous investment
and financing decisions taken by its directors and managers.

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CAPITAL BUDGETING PROCESS

A capital budget:

 Is a programme of capital expenditure covering several years

 Includes authorised future projects and projects currently under consideration.

One stage in the capital budgeting process is investment appraisal. This appraisal has the
following features:

• Assessment of the level of expected returns earned for the level of expenditure made
• Estimates of future costs and benefits over the project’s life.

The capital budget will normally be prepared to cover a longer period than sales, production
and resource budget, say from three to five years, although it should be broken down into
periods matching those of other budgets. It should indicate the expenditure required to
cover capital projects already underway and those it is anticipated will start in the three to
five year period of the capital budget.

Investment opportunities do not just appear out of thin air. They must be created. An
organisation therefore set up a mechanism of future problems. The overriding feature of
any proposal is that it should be consistent with the organisation’s overall strategy to
achieve its objectives.

Each proposal must be subject to detailed screening. So that a qualitative evaluation of a

proposal can be made, a number of key questions as those below might be asked before
any financial analysis is undertaken. Only if the project passes this initial screening will
more detailed financial analysis begin.
• What is the purpose of the project?
• Does it fit with the organisation’s long-term objective?
• Is it a mandatory investment?
• What resources are required and are they available?
• Do we have a necessary management expertise to guide the project to
completion?
• Does the project expose the organisation to unnecessary risk?
• How long will the project last and what factors are key to its success?
• Have all possible alternatives been considered?

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Forecast capital requirements
1

Identify suitable projects

2

Appraise potential projects/project screening

3

Select and approve the best alternative/analysis and acceptance

4

Make capital expenditure

5

Compare actual and planned spending., investigate devisations and monitor benefits
6 from project over time

Budget limits or constraints:

• The imposition of internal constraints, which are often imposed when managerial
resources are limited, is known as soft capital rationing.
• Hard capital rationing occurs when external limits are set; perhaps because of
scarcity of financing, high financing costs or restriction on the amount of external
financing an organisation can seek.

METHODS OF INVESTMENT APPRAISAL

There are four methods of evaluating a proposed capital expenditure project. Any or all of
the methods can be used, but some methods are preferable to others, because they
provide a more accurate and meaningful assessment.
The four methods of appraisal are:
Non-discounting techniques: ‘ Discounted cash flow (DCF) methods:
 Accounting rate of return (ARR)  Net present value (NPV) method
method  Internal rate of return (IRR) method
 Payback method
Each method of appraisal considers a different financial aspect of the proposed capital
investment.

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THE BASIS FOR MAKING AN INVESTMENT DECISION

When deciding whether or not to make a capital investment, management must decide on a
basis for decision-making. The decision to invest or not invest will be made for financial
reasons in most cases, although non-financial considerations could be important as well.
There are different financial reasons that might be used to make a capital investment
decision. Management could consider:
 The effect the investment will have on the accounting return on capital employed, as
measured by financial accounting methods. If so, they might use accounting rate of
return (ARR) /return on investment (ROI) as the basis for making the decision
 The time it will take to recover the cash invested in the project. If so, they might use the
payback period as the basis for the investment decision
 The expected investment returns from the project. If so, they should use discounted
cash flow (DCF) as a basis for their decision. DCF considers both the size of expected
future returns and the length of time before they are earned.

There are two different ways of using DCF as a basis for making an investment decision:
 Net present value (NPV) approach. With this approach, a present value is given to the
expected costs of the project and the expected benefits. The value of the project is
measured as the net present value (the present value of income or benefits minus the
present value of costs). The project should be undertaken if it adds value. It adds value
if the net present value is positive (greater than 0).
 Internal rate of return (IRR) approach. With this approach, the expected return on
investment over the life of the project is calculated, and compared with the minimum
required investment return. The project should be undertaken if its expected return (as
an average percentage annual amount) exceeds the required return.

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The remainder of this chapter considers the accounting rate of return (ARR) method and
the payback method of appraisal.

RETURN ON CAPITAL EMPLOYED (ROCE) or ACCOUNTING RATE OF RETURN (ARR)

The accounting rate of return (ARR) from an investment project is the accounting
profit, usually before interest and tax, as a percentage of the capital invested. It is similar to
return on capital employed (ROCE), except that whereas ROCE is a measure of financial
return for a company or business as a whole, ARR measures the financial return from
specific capital project.

Estimated average annual accounting profits before interest ∧tax

ROCE=
Estimated intial capital cost
Or alternatively:

Average annual accounting profits before interest ∧tax

ROCE=
A verage capital investment

Initial investment + Scrap value

Average capital investment=
2

In the exam you should use the initial capital cost unless you are told otherwise. However,
the ROCE calculation based on the average capital investment is the method most
commonly asked for in the exam. This will be made clear in the question.
The initial capital cost could comprise any or all of the following:
• Cost of new assets bought
• Net book value (NBV) of existing assets to be used in the project
• Investment in working capital
• Capitalised R&D expenditure (NB ensure this is amortised against profit).

It is important to remember that return on capital employed is calculated using

accounting profits, which are operating cash flows adjusted to take account of depreciation.
Accounting profits are not cash flows, since depreciation is an accounting adjustment,
which does not correspond to an annual movement of cash.

DECISION RULE: 

If the expected ROCE for the investment is greater than the target or hurdle rate (as
decided by management) then the project should be accepted. If only one of two
investment projects can be undertaken (i.e. if the projects are mutually exclusive), the
project with the higher return on capital employed should be accepted.

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Example: the ROCE and mutually exclusive projects

Arrow wants to buy a new item of equipment, which will be used to provide a service to
customers of the company. Two models of equipment are available, one with a slightly
higher capacity and greater reliability than other. The expected costs and profits of each
item are as follows.
Equipment item X Equipment item Y
Capital cost $80,000 $150,000
Life 5 years 5 years
Profits before depreciation $ $
Year 1 50,000 50,000
Year 2 50,000 50,000
Year 3 30,000 60,000
Year 4 20,000 60,000
Year 5 10,000 60,000
Disposal value 0 0

ROCE is measured as the average annual profit after depreciation, divided by the average
net book value of the asset. You are required to decide which item of equipment should be
selected, is any, if the company’s target rate ROCE is 30%.

Equipment item X Equipment item Y

Total profit over life of equipment
Before depreciation 160,000 280,000
After depreciation 80,000 130,000
Average annual profit after depreciation 16,000 26,000
Avg. investment= (capital cost + disposal value)/2 40,000 75,000
ROCE 40% 34.7%
Both projects would earn a return in excess of 30%, but since item X would earn a bigger
ROCE, it would be preferred to item Y, even though the profits from Y would be higher by
an average of $10,000 a year.

Test your understanding 2

A project involves the immediate purchase of an item of plant costing $110,000. It would
generate annual cash flows of $24,400 for five years, starting in Year 1. The plant
purchased would have a scrap value of $10,000 in five years, when the project terminates.
Depreciation is on a straight-line basis.
Determine the project’s ROCE using:
(a) initial capital costs
(b) average capital investment

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Test your understanding 3

A project requires an initial investment of $800,000 and then earns net cash inflows as
follows:
In addition, at the end of the seven-year project the assets initially purchased will be sold for
$100,000.
Determine the project’s ROCE using:

Year 1 2 3 4 5 6 7
Cash inflows ($000) 100 200 400 400 300 200 150
(a) Initial capital costs
(b) Average capital investment.

Test your understanding 4

Carbon plc. is considering the purchase of a new machine and has found two which meet
its specification. Each machine has an expected life of five years. Machine 1 would
generate annual cash flows (receipts less payments) of $210,000 and would cost $570,000.
Its scrap value at the end of five years would be $70,000. Machine 2 would generate annual
cash flows of $510,000 and would cost $1,616,000. The scrap value of this machine at the
end of five years would be $301,000. Carbon plc. uses the straight-line method of
depreciation and has a target return on capital employed of 20 per cent.

Calculate the return on capital employed for both Machine 1 and Machine 2 on an average
investment basis and state which machine you would recommend, giving reasons.

Test your understanding 5 December 2012 question 1 (b)

BQK Co, a house-building company, plans to build 100 houses on a development site over
the next four years. The purchase cost of the development site is $4,000,000, payable at
the start of the first year of construction. Two types of house will be built, with annual sales
of each house expected to be as follows:
Year 1 2 3 4
Number of small houses sold: 15 20 15 5
Number of large houses sold: 7 8 15 15
Houses are built in the year of sale. Each customer finances the purchase of a home by
taking out a long-term personal loan from their bank. Financial information relating to each
type of house is as follows:
Small house large house
Selling price: $200,000 $350,000
Variable cost of construction: $100,000 $200,000

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Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred.
These would not relate to any specific house, but would be for the provision of new roads,
gardens, drainage and utilities.
The company can claim capital allowances on the purchase cost of the development site on
a straight-line basis over the four years of construction. New investments are required by
the company to have a before-tax return on capital employed (accounting rate of return) on
an average investment basis of 20% per year.

Required:
(b) Calculate the before-tax return on capital employed (accounting rate of return) of
the proposed investment on an average investment basis and discuss briefly its
financial acceptability.

ADVANTAGES OF THE RETURN ON CAPITAL EMPLOYED METHOD

• It is a quick and simple to calculate

• It involves the familiar concept of percentage, which can be compared with the existing
ROCE of a company, the primary accounting ratio used by financial analysts in
assessing company performance.
• It looks at the entire project life

DISADVANTAGES OF THE RETURN ON CAPITAL EMPLOYED METHOD

• It is based on accounting profits and not cash flows. Accounting profits are subject to a
number of different accounting treatments.
• It is a relative measure rather than an absolute measure and hence takes no account of
the size of the investment
• It takes no account on the length of the project
• Like the payback method, it ignores the time value of money

Though there may be many weaknesses associated with this method, it is still one of the
most commonly used methods due to its utilisation of the balance sheet and P/L account
magnitudes familiar to managers, namely profit and capital employed. It is not surprising
that some managers may be happiest in expressing project attractiveness in the same
terms in which their performance will be reported to shareholders, and according to which
they will be evaluated and rewarded. After all, most company’s bonus payment is based on
the ROCE achieved.

RELEVANT COST IN DECISION MAKING

In capital investment appraisal it is more appropriate to evaluate future cash flows than
accounting profits, because:

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 Profits cannot be spent
 Profits are subjective
 Cash is required to pay dividends.
For all methods of investment appraisal, with the exception of ROCE, only relevant cash
flows should be considered.

RELEVANT COSTS

 Relevant costs are cash flows. Any items of cost that are not cash flows must be
ignored for the purpose of decision. For example, depreciation expenses are not cash
flows and must always be ignored.

 Relevant costs are future cash flows. Costs that have already been incurred are not
relevant to a decision that is being made now. The cost has already been incurred,
whatever decision is made, and it should therefore not influence the decision. For
example, a company might incur initial investigation costs of $20,000 when looking into
the possibility of making a capital investment. When deciding later whether to undertake
the project, the investigation costs are irrelevant, because they have already been
spent.

 Incremental. Relevant costs are also costs that will arise as a direct consequence of
the decision, even if they are future cash flows. If the costs will be incurred whatever
decision is taken, they are not relevant to the decision.

 Opportunity costs. Opportunity costs are the benefits forgone by using assets or
resources for one purpose, instead of using them in the most profitable alternative way.
Opportunity costs are commonly measured as contribution forgone, but might also be
measured as a present value (in DCF analysis). When resources have more than one
alternative use, and are in limited supply, their opportunity cost is the contribution
forgone by using them for one purpose and so being unable to use them for another
purpose. For example a company is considering an investment in a major new
information system. The investment will require the use of six of the company’s IT
specialists for the first one year of the project. These IT specialists are each paid
$100,000 each per year. IT specialists are difficult to recruit. If the six specialists are not
used on this project, they will be employed on other projects that would earn a total
contribution of $500,000. The relevant cost of the IT specialist in Year 1 of the project
would be:
$
Basic salaries 600,000
Contribution forgone 500,000
Total relevant cost 1,100,000

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 Avoidable costs. Costs that could be avoided as a result of a particular decision. For
example the decision to close a factory will save variable costs and specific fixed costs
associated with the factory, i.e. factory manager’s salary, factory power, heating and
lighting costs etc.

Relevant costs of materials

When materials will have to be purchased for a project, because there are no existing
inventories of the materials, their relevant cost is their future purchase cost. However if the
materials required for a project are already held in inventory, their relevant cost depends on
circumstances. If the materials are in regular use, and quantities consumed for the
investment project would be replaced in the normal course of trading operations, the
relevant cost of the materials is their current replacement cost. If the materials will not be
replaced if they are used for the investment project, their relevant cost is the higher of:
 their net disposal value and
 the net contribution that could be earned using the materials for another available use.

Relevant cost of existing equipment

When new capital equipment will have to be purchased for a project, the purchase cost of
the equipment will be a part of the initial capital expenditure, and so a relevant cost.
However, if an investment project will also make use of equipment that the business
already owns, the relevant cost of the equipment will be the higher of:
 the current disposal value of the equipment, and
 the present value of the cash flows that could be earned by having an alternative use for
the equipment.

Relevant cost of investment in working capital

It is important that you should understand the relevance of investment in working capital for
cash flows. An investment in working capital is not a cash flow. However, it should be
treated as a cash flow, because:
 when capital investment projects are evaluated, it is usual to estimate the cash profits
for each year of the project
 however, actual cash flows will differ from cash profits by the amount of the increase or
decrease in working capital.

IRRELEVANT COSTS

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 Sunk costs. Costs that have already been incurred are not relevant to a current
decision. For example, suppose a company makes a nonreturnable deposit as a down
payment for an item of equipment, and then reconsiders whether it wants the equipment
after all. The money that has already been spent cannot be recovered and so is not
relevant to the current decision about obtaining the equipment.
 Committed costs. Costs that will be incurred anyway, whether or not a capital project
goes ahead, cannot be relevant to a decision about investing in the project. Fixed cost
expenditures are an example of ‘committed costs’. For the purpose of investment
appraisal, a project should not be charged with an amount for a share of fixed costs that
will be incurred in any event.
 Noncash items. Noncash items of cost can never be relevant to investment appraisal.
In particular, the depreciation charges on a noncurrent asset are not relevant costs for
analysis because depreciation is not cash expenditure.
 Allocated costs. Accounting treatment of costs is often irrelevant (e.g. depreciation,
inventory valuation, methods of allocating overheads) because it has no bearing on
cash flows, except to the extent that it may affect taxation payable. Overheads attributed
to projects should, in the examination, be taken as absorbed figures unless specified
otherwise. It should be assumed there is no change to actual overhead paid, and thus
no relevant cash flow.

Test your understanding 6

A manufacturing company is considering the production of a new type of widget. Each

widget will take two hours to make. Fixed overheads are apportioned on the basis of $1 per
labour hour. If the new widgets are produced, the company will have to employ an
additional supervisor at a salary of $15,000 pa. The company will produce 10,000 widgets
pa. What are the relevant cash flows?

Test your understanding 7

A company is evaluating a proposed expenditure on an item of equipment that would cost

$160,000. A technical feasibility study has been carried out by consultants, at a cost of
$15,000, into benefits from investing in the equipment. It has been estimated that the
equipment would have a life of four years, and annual profits would be $8,000, after
deducting annual depreciation of $40,000 and an annual charge of $25,000 for a share of
the existing fixed cost of the company. What are the relevant cash flows for this?

PAYBACK PERIOD

The payback period is the number of years it is expected to take to recover the original
investment from the net cash flows resulting from a capital investment project. The decision
rule when using the payback method to appraise investments is to accept a project if its’
payback period is equal to or less than a predetermined target value. It is possible to obtain

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an estimate of the payback period to several decimal places if cash flows are assumed to
occur evenly throughout each year, but a high degree of accuracy in estimating the
payback period is not desirable since it does not offer information, which is especially
useful. A figure to the nearest year or half-year is usually sufficient.

The decision rule:

If a payback period < target ACCEPT
If a payback period > target REJECT
The time value of money is ignored, and the total return on investment is not considered.

Test your understanding 8: Payback with constant annual cash:

An expenditure of $2 million is expected to generate net cash inflows of $500,000 each 
year for the next seven years. What is the payback period for the project?

Test your understanding 9: Payback with uneven cash flows:

In practice, cash flows from a project are unlikely to be constant. Where cash flows are une
ven, payback is calculated by working out the cumulative cash flow over the life of the 
project.
Simple investment project, showing a significant initial investment followed by a series of
cash inflows over the life of the project.

Year 0 1 2 3 4 5
Cash flow ($) (450) 100 200 100 100 80

ADVANTAGES
 Simple to calculate
 Easy to understand
 Concentrate on earlier flows, which are more certain and more important
 The method analyses cash flows, not accounting profits. Investments are about
investing cash to earn cash returns. In this respect, the payback method is better than
the ARR method.
 Payback is often used together with a DCF method, particularly by companies that have
liquidity problems and do not want to tie up cash for long periods. Payback can be used
to eliminate projects that will take too long to pay back. Investments that pass the
payback test can then be evaluated using one of the DCF methods.

DISADVANTAGES
 It ignores time value of money

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 It ignores all cash flows after the payback period, and so ignores the total cash returns
from the project. This is a significant weakness with the payback method.

The general conclusion that can be drawn from this discussion is that the payback method
does not give any real indication of whether an investment project increases the value of a
company. For this reason, it has been argued that, despite its well-documented popularity,
the payback method is not really an investment appraisal method at all, but rather a means
of assessing the effect of accepting an investment project on a company’s liquidity position.

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Test your understanding 10

A company must choose between two investments, Project A and Project B. It cannot
undertake both investments. The expected cash flows for each project are:
Year Project A Project B
$ $ $
0 (80,000) (80,000)
1 20,000 60,000
2 36,000 24,000
3 36,000 2,000
4 17,000 -

The company has a policy that:

The maximum permissible payback period for an investment is three years. If a choice has
to be made between two projects, the project with the earlier payback will be chosen.
Required
Calculate the payback period for each project:
(a) assuming that cash flows occur at that year end
(b) assuming that cash flows after Year 0 occur at a constant rate throughout each year

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Discounted cash flow

Discounted cash flow, or DCF for short, is an investment appraisal technique, which takes
into account both the timings of cash flows and total profitability of whole project's life.

Three important points about DCF are as follows.

1.DCF looks at the cash flows of a project, not the accounting profits.
2.Only future incremental cash inflows and outflows are considered.
3. The timing of cash flows is taken into account by discounting them.

The time value of money

When people undertake to set aside money for investment something has to be given up
now. For instance, if someone buys shares in a firm or lends to a business there is a
sacrifice of consumption. One of the incentives to save is the possibility of gaining a higher
level of future consumption by sacrificing some present consumption. Therefore, it is
apparent that compensation is required to induce people to make a consumption sacrifice.
Compensation will be required for at least three things:

This occurs for three reasons:

Impatience to consume That is, individuals generally prefer to have $1.00 today than
$1.00 in five years’ time. To put this formally: the utility of $1.00 now is greater than $1.00
received five years hence. Individuals are predisposed towards impatience to consume;
thus, they need an appropriate reward to begin the saving process.

Inflation The price of time (or the interest rate needed to compensate for impatience to
consume) exists even when there is no inflation, simply because people generally prefer
consumption now to consumption later. If there is inflation then the providers of finance will
have to be compensated for that loss in purchasing power as well as for time.

Risk The promise of the receipt of a sum of money some years hence generally carries
with it an element of risk; the payout may not take place or the amount may be less than
expected. Risk simply means that the future return has a variety of possible values. Thus,
the issuer of a security, whether it be a share, a bond or a bank account, must be prepared
to compensate the investor for impatience to consume, inflation and risk involved, otherwise
no one will be willing to buy the security.

Required return = Risk free rate + Risk premium

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(Time value of money)

Compounding
A sum invested today will earn interest. Compounding calculates the future or terminal
value of a given sum invested today for a number of years.

FV = P (1 + r)n

Where FV = Future value after n periods

P = Present or Initial value

r = Rate of interest per period

n = Number of periods

Discounting
Present value is the cash equivalent now of a sum of money receivable or payable at a
stated future date, discounted at a specified rate of return.

Discounting starts with the future value, and converts a future value to a present value.
Discounting tells us how much an investment will be worth in today's terms.

Formula to learn
Present value of 1 = (1+r)-n

The discount factors

In the compounding and discounting examples above, we used the company's required rate
of return as the discount factor.

The rate of interest used for discounting reflects the cost of the finance that will be tied up in
the investment.

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The Net Present Value

Net present value or NPV is the value obtained by discounting all cash outflows and inflows
of a capital investment project by a chosen target rate of return or cost of capital.

The NPV represents the surplus funds (after funding the investment) earned on the project,
therefore:

 If the NPV is positive – the project is financially viable

 If the NPV is zero – the project breaks even
 If the NPV is negative – the project is not financially viable
 If the company has two or more mutually exclusive projects under consideration it should
choose the one with the highest NPV
 The NPV gives the impact of the project on shareholder wealth.

Assumptions used in discounting

Unless the examiner tells you otherwise, the following assumptions are made about cash
flows when calculating the net present value:

 All cash flows occur at the start or end of a year

 Initial investments occur (T0)
 Other cash flows start one year after that (T1).

Note:

A cash outlay or receipt, which occurs at the beginning of a time period (say, at the
beginning of one year) is taken to occur at the end of the previous year. Therefore, a
cash outlay of $15,000 at the beginning of year 2 is taken to occur at the end of year

Test your understanding 11

LCH manufactures product X, which it sells for $5 per unit. Variable costs of production are
currently $3 per unit, and fixed costs 50c per unit. A new machine is available which would
cost $90,000 but which could be used to make product X for a variable cost of only $2.50
per unit. Fixed costs, however, would increase by $7,500 per annum as a direct result of
purchasing the machine. The machine would have an expected life of four years and a
resale value after that time of $10,000. Sales of product X are estimated to be 75,000 units
per annum. LCH expects to earn at least 12% per annum from its investments. Ignore
taxation.

You are required to decide whether LCH should purchase the machine.

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Discounting annuities

An annuity is simply an investment that pays a constant sum each year over a period of
time. Thus, fixed payments made in respect of a loan or mortgage or a fixed amount of
income received from an investment bond would be examples of annuities.

Test your understanding 12

a) What is the present value of $1,000 in contribution earned each year from years 1-10,
when the required return on investment is 11%?
b) What is the present value of $2,000 costs incurring each year from years 3-6 when the
cost of capital is 5%?
c) Calculate the present value of $2,000 receivable for each of 10 years commencing three
years from now. Assume interest at 7%.

Discounting perpetuities
A perpetuity is an annual cash flow that occurs forever.It is o9ikften described by examiners
as a cash flow continuing ‘for the foreseeable future’.

Test your understanding 13

An organisation with a cost of capital of 14% is considering investing in a project costing

$500,000. The project would yield nothing in Year 1, but from Year 2 would yield cash
inflows of $100,000 per annum in perpetuity.

Required

Assess whether the project should be undertaken.

Test your understanding 14

Find the present value of the following cash flows:

a) A fifteen-year annuity of $300 starting at once/immediately. Interest rates are 6%.

b) Perpetuity of $33,000 commencing immediately/at once. Interest rates are 22%

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c) A fifteen-year annuity of $300 starting at T3. Interest rates is 6%.

d) A perpetuity of $2,000 starting in six years’ time, growing at 3% per annum. Interest
rates are 10%

e) Calculate the present value of $2,000 receivable in perpetuity commencing in 10

years' time. Assume interest at 7%.

The internal rate of return method

The internal rate of return (IRR) of an investment is the cost of capital at which its NPV
would be exactly $0.

The IRR method of investment appraisal is an alternative to the NPV method for investment
appraisal. This method is to accept investment projects whose IRR exceeds a target
rate of return. The IRR is calculated approximately using a technique called interpolation.

Two step approach

1. Calculate two NPV’s at two different discount rates, preferably one +ve and another –ve
NPV

2. Input the numbers calculated in step 1 into the formula, this is known as interpolation

a = the lower rate of return used

b = the higher rate of return used

NPVa = the NPV obtained using rate a

NPVb = the NPV obtained using rate b

Test your understanding 15

A company is trying to decide whether to buy a machine for $80,000 which will save costs

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appraisal
of $20,000 per annum for five years and which will have a resale value of $10,000 at the
end of year 5. If it is the company's policy to undertake projects only if they are expected to
yield a DCF return of 10% or more, ascertain whether this project should be undertaken.

Reinvestment assumptions

An assumption underlying the NPV method is that any net cash inflows generated during
the life of the project will be reinvested at the cost of capital (that is, the discount rate). The
IRR method, on the other hand, assumes these cash flows can be reinvested to earn a
return equal to the IRR of the original project.

Summary of NPV and IRR comparison

1. When cash flow patterns are conventional both methods give the same accept or
reject decision.
2. The IRR method is more easily understood.
3. NPV is technically superior to IRR
4. IRR and accounting ROCE can be confused.
5. IRR ignores the relative sizes of investments.
6. Where cash flow patterns are non-conventional, there may be several IRRs which
decision-makers must be aware of to avoid making the wrong decision.
7. The NPV method is superior for ranking mutually exclusive projects in order of
attractiveness.
8. The reinvestment assumption underlying the IRR method cannot be substantiated.
9. When discount rates are expected to differ over the life of the project, such variations
can be incorporated easily into NPV calculations, but not into IRR calculations.
10. Despite the advantages of the NPV method over the IRR method, the IRR method is
widely used in practice.

DCF methods of appraisal have a number of advantages over other appraisal methods.

1. The time value of money is taken into account.

2. The method takes account of all a project's cash flows.
3. It allows for the timing of cash flows.
4. There are universally accepted methods of calculating the NPV and IRR.

Disadvantages of DCF methods are

1. DCF methods use future cash flows that may be difficult to forecast. Although other
methods use these as well, arguably the problem is greater with DCF methods that
take cash flows into the longer term.

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2. The basic decision rule, accept all projects with a positive NPV, will not apply when
the capital available for investment is rationed.
3. The cost of capital used in DCF calculations may be difficult to estimate.
4. The cost of capital may change over the life of the investment.

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