Ce316 03

CAPITAL INVESTMENT
AND APPRAISAL
METHODS
1
CE316
CAPITAL BUDGETING /
2 INVESTMENT APPRAISAL
´ Detailed analysis which entails the planning process to

ensure that projects pursued are viable
´ Budget for major investment / expenditure such as:
´ New machinery
´ Replacement of machinery
´ Launch of new products
´ Research development projects
3 CAPITAL BUDGETING OBJECTIVE
´ Assist managers to make informed decisions on
acquiring & disposing of assets
´ Detailed analysis examples: new machinery, new

vehicles & land
´ Capital investment decisions have direct effect on:

- future profitability
- increase in efficiency and
- reduction in costs
CAPITAL INVESTMENT
´ Capital investment basis
´ Capital investment involves the sacrifice of current
funds in order to obtain the benefit of future wealth.
´ It involves investing now in the hope of generating

future cash flows which will exceed the initial
investment.
´ Capital investment features:

´ the use of significant levels of finance to acquire assets
for long-term use in an organisation with the desire to
increase future revenues and profits.
FACTORS TO CONSIDER IN
ASSESSING CAPITAL PROJECTS
´ The size of the investment.
´ The phasing of the investment expenditure.
´ The period between the initial investment and the
asset actually generating revenues and profits for
the business.
´ The economic life of the project.
´ The level of certainty regarding the projected
cash flows.
´ The working capital required.
´ The degree of risk involved in the project.
CAPITAL APPRAISAL METHODS
´ As capital investment decisions usually involve
significant amounts of finance, it is important to fully
evaluate each decision using sound appraisal
techniques.
´ The main methods used to evaluate investment in
capital projects are:
Accounting Rate of Return (ARR) Profits
Payback Cash flows
Net Present Value (NPV) Cash flows
Internal Rate of Return (IRR) Cash flows

1 - PAY BACK METHOD
´ The payback is defined as the time it takes the cash

inflow from a capital investment project to equal the
initial cash outflows, usually expressed in years.
´ When deciding between 2 or more competing

projects, the usual decision is to accept the one with
the shortest payback.
´ How long does it take for incoming returns to cover

costs or break even?
´ Project should be rejected if its payback period is

more than the company’s target payback period.
1 - PAY BACK METHOD EXAMPLE
Project P Project Q
Capital expenditure $60,000 $60,000
Cash Inflows
Year 1 $20,000 $50,000
Year 2 $30,000 $20,000
Year 3 $40,000 $5,000
Year 4 $50,000 $5,000
Year 5 $60,000 $5,000
Project P: Year 0 (60,000)
Year 1 20,000
Year 2 30,000
Year 3 40,000 (only 10,000 more required in 3rd year)
Project P’s pay back period about ¼ through year 3 i.e, ( 2.25 years).
Project Q: Year 0 (60,000)

Year 1 50,000
Year 2 20,000 (only 10,000 more required in 2nd year)
Project Q’s pay back period is about ½ through year 2 i.e, ( 1.5 years).
Using pay back period alone to judge the capital investment projects,
project Q would be preferred. But the returns from project P over its life
are much higher than the returns from project Q
1 - PAY BACK METHOD
´ The pay back period provides a rough measure of
liquidity and not profitability.
´ Project P will earn total profits after depreciation of

$140,000, on an investment of $60,000.
´ Project Q will earn total profits after depreciation of

only $25,000, on an investment of $60,000.
´ Pay back can be important and long payback

periods mean capital tied up and also high
investment risk, but total project return ought to be
taken into consideration as well.
ACCEPT OR REJECT CRITERIA FOR
PAYBACK METHOD
Accept the project Reject the project
Payback period is less than Payback period is greater than

that required by investors. that required by investors.
´ Payback period = Y + ( A / B)
where Y = number of years before final payback year

A = total remaining to be paid at the start of payback year
B = total (net) paid back in the entire payback year
´ Advantages of Pay Back Method
´ It is simple to understand and apply.
´ It promotes a policy of caution in investment.
´ Disadvantages of Pay Back Method

´ It takes no account of the timing of cash flows ($100 received
today is worth more than $100 received in 12 months time).
´ It is only concerned with how quickly the initial investment is
recovered and thus it ignores the overall profitability and
return on capital for the whole project.
´ It ignores the time value of money
13 1 - PAY BACK METHOD
A project yields the following cash flows over its five year life. Calculate
the payback period.
YEAR CASH FLOW
0 $1,000
1 $500
2 $400
3 $200
4 $200
5 $100
2 - NET PRESENT VALUE (NPV)
´ Takes into account the fact that money values
change with time (time value of money)
´ How much would you need to invest today to

earn x amount in x years time?
´ Value of money is affected by interest rates
´ NPV helps to take these factors into

consideration
´ Shows you what your investment would have

earned in an alternative investment regime
2 - NET PRESENT VALUE (NPV)
´ The principle:
´ How much would you have to invest now to earn $100 in one
year’s time if the interest rate was 5%?
´ Allows comparison of an investment by valuing cash
payments on the project and cash receipts expected
to be earned over the lifetime of the investment at
the same point in time, i.e. the present.
$%&%'( )*+%(
!" = Where i = interest rate,n = no of yrs
(-./)1
´ The PV of $1 @ 10% in 1 years time is $0.9090

´ If you invested $0.9090 today and the interest rate was
10% you would have $1 in a year’s time
´ Process referred to as ‘Discounting Cash Flow’

NET PRESENT VALUE
´Cash flow x discount factor = present value
´e.g. PV of $500 in 10 years time at a rate of

interest of 4.25% = 500 x 0.6595373 = $329.77
´$329.77 is what you would have to invest

today at a rate of interest of 4.25% to earn
$500 in 10 years time
´PVs can be found through valuation tables

(e.g. Parry’s Valuation Tables)
Discounted Cash Flow
´ An example:
´ A firm is deciding on investing in an energy

efficiency system. Two possible systems are under
investigation
´ One yields quicker results in terms of energy savings

than the other but the second may be more
efficient later
´ Which should the firm invest in?

Discounted Cash Flow – System A
Year Cash Flow Discount Present

(£) Factor Value (£)
(4.75%) (CF x DF)
0 - 600,000 1.00 -600,000
1 +75,000 0.9546539 71,599.04
2 +100,000 0.9113641 91,136.41
3 +150,000 0.8700374 130,505.61
4 +200,000 0.8305846 166,116.92
5 +210,000 0.7929209 166,513.39
6 +150,000 0.7569650 113,544.75
Total 285,000 NPV
=139,416
Discounted Cash Flow – System
B
Year Cash Flow (£) Discount Present Value
Factor (£)
(4.75%) (CF x DF)
0 - 600,000 1.00 -600,000
1 +25,000 0.9546539 23,866.35
2 +75,000 0.9113641 68,352.31
3 +85,000 0.8700374 73,953.18
4 +100,000 0.8305846 83,058.46
5 +150,000 0.7929209 118,938.10
6 +450,000 0.7569650 340,634.30
Total 285,000 NPV
=108,802.70
Discounted Cash Flow
´System A represents the better investment
´System B yields the same return after six years

but the returns of System A occur faster and
are worth more to the firm than returns
occurring in future years even though those
returns are greater
3 - INTERNAL RATE OF RETURN
´ Allows the risk associated with an investment project to be
assessed
´ The IRR is the rate of interest (or discount rate) that makes the
net present value equal to zero
´ Helps measure the worth of an investment
´ Allows the firm to assess whether an investment in the
machine, etc. would yield a better return based on
internal standards of return
´ Allows comparison of projects with different initial outlays
´ Set the cash flows to different discount rates
´ Software or simple graphing allows the IRR to be found
22 3 - INTERNAL RATE OF RETURN
´ IRR is the rate of return on an investment
´ IRR is the discount rate that gives NPV of zero
´ Decision to accept or reject the purchase
depends on whether IRR is higher or lower than the
discount rate
´ Start with a guess at IRR, r.
´ NPV is calculated using discount rate r.
´ When NPV is close to zero then r is the IRR.
´ When NPV is positive r is increased
´ When NPV is negative r is decreased
3 - INTERNAL RATE OF RETURN
ACCEPT OR REJECT CRITERIA FOR IRR
METHOD
Accept the project Reject the project
IRR greater than IRR less than the

the cost of capital. cost of capital.
Appraisal methods
Accounting Rate of Return (ARR) Profits

Non time based
Payback Cash flows
Net Present Value (NPV) Cash flows

Time based (DCF)
Internal Rate of Return (IRR) Cash flows
CONCLUSION ON CAPITAL BUDGETING
METHODS
´ Companies normally employ more than capital
budgeting method as each method will provide
somewhat different piece of information to the decision
maker.
´ Pay back and discounted pay back provide indication
of both risk and liquidity of the project.
´ NPV method gives a direct measure of the dollar
benefit of the project to the share holders. Therefore it is
regarded as the best single measure of profitability.
´ IRR is also a measure of profitability but it also contains a
projects safety margin
27 QUESTIONS???
Investment in capital projects involves large
initial financial outlays. Briefly explain three
appraisal methods used in capital investment
projects and the importance of doing so. (25
marks)
END!!!!!

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CAPITAL INVESTMENT

´ Detailed analysis which entails the planning process to

´ Detailed analysis examples: new machinery, new

´ Capital investment decisions have direct effect on:

´ It involves investing now in the hope of generating

´ Capital investment features:

Accounting Rate of Return (ARR) Profits

Payback Cash flows

Net Present Value (NPV) Cash flows

Internal Rate of Return (IRR) Cash flows

´ The payback is defined as the time it takes the cash

´ When deciding between 2 or more competing

´ How long does it take for incoming returns to cover

´ Project should be rejected if its payback period is

Project Q: Year 0 (60,000)

´ Project P will earn total profits after depreciation of

´ Project Q will earn total profits after depreciation of

´ Pay back can be important and long payback

Accept the project Reject the project

Payback period is less than Payback period is greater than

where Y = number of years before final payback year

´ Disadvantages of Pay Back Method

´ How much would you need to invest today to

´ NPV helps to take these factors into

´ Shows you what your investment would have

´ The PV of $1 @ 10% in 1 years time is $0.9090

´ Process referred to as ‘Discounting Cash Flow’

´e.g. PV of $500 in 10 years time at a rate of

´$329.77 is what you would have to invest

´PVs can be found through valuation tables

´ A firm is deciding on investing in an energy

´ One yields quicker results in terms of energy savings

´ Which should the firm invest in?

Year Cash Flow Discount Present

´System B yields the same return after six years

Accept the project Reject the project

IRR greater than IRR less than the

Accounting Rate of Return (ARR) Profits

Net Present Value (NPV) Cash flows

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