H KUSPRCE

ti ~ ~ • 5 • ~ • • ~
HKU School of Professional and Continuing Education

Postgraduate Diploma in Professional Accounting

Module: Financial Management

Topic 5
Investment appraisal -
theory, practice and complications
Dr. Zenki Kwan, FRM, CPA (Aust.), CA/A, CB
zenkikwan@yahoo.com
 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

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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.
Tradfirm
Cash flows (fm)

Points in time (yearly intervals) 0 1 2 3 4 5 6

Project A -10 6 2 1 1 2 2
Project B -10 1 1 2 6 2 2
Project C -10 3 2 2 2 15 10

Note: Production ceases after six years, and all cash flows occur on anniversary dates.

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

• The decision rule is that if a project's payback period is less than

or equal to a predetermined threshold figure it is acceptable.

Page 3
 Tradfirm: Net Present Values (£m)
• Project A and B look indifferent if we consider the payback
period. In order to differentiate between the two projects, we
further apply NPV analysis.

6 2 1 1 2 2
Project A -10 + - + - + - + - + - + - = f0.913m
1.1 (1.1 )2 (1.1 ) 3 (1 .1)4 (1 .1)5 (1.1 ) 6

Project B -10 + -
1.1
1
+ -(1.11 )2 + -(1.12 )3 + -(1 .16 )4 + -(1.12 )5 + -(1.12 )6 = -£0.293m

Project C -10 + -
3
+ -2 + -2 + -2 + - 15 5 +
10
= f12.207m
1.1 (1.1 )2 (1.1 )3 (1 .1)4 (1.1 ) (1 .1)6

Note: The discount rate is 10 per cent.

Exhibit 4.4 Tradfirm: Net Present Values (£m)

Page4

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.
- no theoretical basis for setting the appropriate time period
and so guesswork, whim and manipulation take over

Pages
 Discounted payback: Tradfirm pie (£m)
• With discounted payback the future cash flows are discounted prior to
calculating the payback period. This is an improvement on the simple
payback method in that it takes into account the time value of money.
Points in time (yearly intervals) 0 1 2 3 4 5 6 Discounted payback

Project A
Undiscounted cash flow -10 6 2 1 1 2 2
Discounted cash flow -10 5.45 1.65 0.75 0.68 1.24 1.13 Year 6

Project B
Undiscounted cash flow -10 1 1 2 6 2 2 Outflow -1 Orn
Discounted cash flow -10 0.909 0.826 1.5 4.1 1.24 1.13 Inflow +£9.7m

Project C
Undiscounted cash flow -10 3 2 2 2 15 10
Discounted cash flow -10 2.73 1.65 1.5 1.37 9.3 5.64 Year 5

Note: The discount rate is JO per cent.

Drawbacks:
•Still necessary to make an arbitrary decision about the cut-off date
•Ignores cash flows beyond that date

Pages

Reasons for the continuing popularity of payback

• Not the primary investment appraisal technique, but rather a
supplement to the more sophisticated methods

• Pros:
An early stage filter for projects which have clearly unacceptable
risk and return characteristics. Identifying those projects at a
preliminary stage avoids the need for more detailed evaluation
Simple and easy to use (N PV is difficult to explain for non-
professionals)

• Projects which return their outlay quickly reduce the

exposure of the firm to risk (i.e. speed of returning capital deployed)
If funds are limited, there is an advantage in receiving a return on
projects earlier rather than later

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 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.

Pages

Timewarp pie
ARR can be calculated in a number of ways but the most popular
approach is to take profit after the deduction of depreciation. For the
investment figure we regard any increases in working capital as
adding to the investment required. Three alternative versions of ARR
are calculated for Timewarp pie which give markedly different results.

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

Accounting rate of return, version 1 (annual basis)
Profit for the year
ARR= x 100
Asset book value at start of year

Time (year) 1 2 3
£ £ £

Profit before depreciation 15,000 15,000 15,000

Less depreciation 10,000 10,000 10,000
Profit after depreciation 5,000 5,000 5,000
Value of asset (book value)
Start of year 30,000 20,000 10,000
End of year 20,000 10,000 0

Accounting rate of return 5,000 = 16.67% 5,000 = 25% 5,000 = 50%

30,000 20,000 10,000
On average the ARR is: 1/3 x (16.67 + 25 + 50)% = 30.56%.

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 Time warp pie (Continued)
Accounting rate of return, version 2 (total investment basis)
Average annual profit
ARR= - - - - - - x 100
Initial capital invested

ARR = (5,000 + 5,000 + 5,000)/3 x 100 = 16 _6?%

30,000
Accounting rate of return, version 3 (average investment basis)
Average annual profit
A R R = - - - - - - x 100
Average capital invested

30,000
Average capital invested:--= 15,000
2
(5,000 + 5,000 + 5,000)/3
A R R = - - - - - - - - - x 1 0 0 = 33.33%
15,000

• Note: these are just three of all the possible ways of calculating ARR - there
are many more.
Page 10

Drawbacks of accounting rate of return

• Wide-open field for selecting profit and asset definitions
- No clear definition for profit and asset numbers to be applied

• Profit figures are very poor substitutes for cash flow

- The inflow and outflow of cash should be the focus of investment
analysis appraisals.

• Fails to take account of the time value of money

- No allowance for the fact that cash received in year 1 is more valuable
than an identical sum received in year 3.

• High degree of arbitrariness in defining the cut-off or

hurdle rate
- No reason for selecting 10, 15 or 20 per cent as an acceptable ARR.
This arbitrariness contrasts with NPV, which has a sound theoretical
base to its decision rule: accept if the project's cash flows deliver more
than the finance provider's opportunity cost of capital.
Page 11
 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
(5,000 + 5,000 + 5,000)/3
ARR = - - - - - - - - = 16.67%. Accepted
• New situation 3o,ooo

(5,000 + 5,000 + 5,000 + 1,000)/4

A R R = - - - - - - - - - - = 13.33%. Rejected
30,000

Common sense suggests that if all other factors remain constant this new
situation is better than the old one, and yet the ARR declines to below the
threshold level (15 per cent) because the profits are averaged over four years
rather than three and the project is therefore rejected.
Page 12

Reasons for the continued use of accounting rate of returns

• Managers are familiar with this ancient and

extensively used profitability measure.
- The financial press regularly report accounting rates of return.

• Divisional performance and the entire firm is often

judged on a profit-to-assets employed ratio.
- Indeed, the entire firm is often analysed and management
evaluated on this ratio. Because performance is measured in
this way, managers have a natural bias towards using it in
appraising future projects.

Page 13
 Internal rate of return: Reasons for continued popularity

• Psychological
- Managers are familiar with expressing financial data in the
form of a percentage.

• IRR can be calculated without knowledge of the

required rate of return
- Do you know your firm's required rate of return?

• Ranking
- Some managers are not familiar with the drawbacks of IRR
and believe that ranking projects to select between them is
most accurately and most easily carried out using the
percentage-based IRR method

Page 14

TB: CH5
Project appraisal: capital rationing, taxation and inflation

• Coping with investment appraisal in an environment of

capital rationing, taxation and inflation.
• More specifically:
- Explain why capital rationing exists and be able to use the
profitability ratio in one-period rationing situations
- Show awareness of the influence of taxation on cash flows
- Discount nominal cash flows with a nominal discount rate, and
real cash flows with a real discount rate

Page 15
 Capital rationing
• Capital rationing occurs when funds are not available to finance all
wealth-enhancing projects
• Soft rationing
- Internal management-imposed limits on investment expenditure. Financial
policy control
• Hard rationing
- Relates to capital from external sources. Agencies (e.g. shareholders)
external to the firm will not supply unlimited amounts of investment capital,
even though positive NPV projects are identified.
- In a perfect capital market hard rationing should never occur, because if a
firm has positive NPV projects it will be able to raise any finance it needs.
Hard rationing, therefore, implies market imperfections
• One-period capital rationing
- Divisible projects (undertake a fraction of a total project)
- Indivisible projects

Page 16

One-period capital rationing with divisible projects

Example:
•Bigtasks has four positive NPV projects to consider. Capital at time zero
has been rationed to £4.Sm because of head office planning and control
policies, and because the holding company has been subtly warned that
another major round of fresh borrowing this year would not be welcomed.
•The four projects under consideration can each be undertaken once
only and the acceptance of one of the projects does not exclude the
possibility of accepting another one.

Bigtasks pie

Point in time (yearly intervals) 0 1 2 NPVat 10%

£m £m £m £m

Project A -2 6 1 4 .281
Project B -1 1 4 3.215
Project C -1 1 3 2.388
Project D -3 10 10 14.355

Page 17
 Bigtasks pie (Continued)
Ranking according to absolute NPV

Initial outlay NPV (£m)

All of Project D 3 14.355

3/4 of Project A 1.5 3.211
4.5 Total NPV 17.566

To achieve an optimum allocation of the £4.Sm we need to make use of

either the profitability index (PI) or the benefit-cost ratio

Gross present value

Profitability index = - - - - - - -
Initial outlay
Net present value
Benefit-cost ratio = - - - - - -
Initial outlay

Page 18

Bigtasks pie: Profitability indices and benefit-cost ratios

Project NPV GPV Profitability index Benefit-cost ratio

(@ 10%) (@ 10%)

6.281 4.281
A 4.281 6.281 -- = 3.14 -- =2.14
2 2

4 .215 3.215
B 3.215 4.215 -- =4.215 -- = 3.215
1 1

3.388 2.388
C 2.388 3.388 -- = 3.388 -- = 2.388
1 1

17.355 14.355
D 14.355 17.355 = 5.785 =4.785
3 3

Exhibit 5.1 Bigtasks pie: Profitability indices and benefit-cost ratios

Page 19
Bigtasks pie: Ranking according to the highest profitability index

The use of profitability indices or benefit-cost ratios is a matter of personal

choice. Whichever is used, the next stage is to arrange the projects in order of
the highest profitability index or benefit-cost ratio.

Profit Profitability index Initial outlay fm NPVfm

D 5.785 3 14.355
B 4.215 1 3.215
1/2 of C 3.388 0.5 1.194
Nothing of A 3.14 0 0
Total investment 4.5 18.764

With the profitability index, Project D gives the highest return and so is the best
project in terms of return per £ of outlay.
However, Project A no longer ranks second because this provides the lowest
return per unit of initial investment.

Page 20

Indivisible projects
Individual project with capital constraint of £3m
capital constraint of f3m

Feasible combination 1 NPV(£m)

£2m invested in Project A 4.281

£1 m invested in Project B 3.215
Total NPV 7.496

Feasible combination 2 NPV(£m)

£2m invested in Project A 4.281

£1 m invested in Project C 2.388
Total NPV 6.669

Feasible combination 3 NPV(£m)

£1 m invested in Project B 3.215

£1 m invested in Project C 2.388
Total NPV 5.603

Feasible combination 4 NPV(£m)

£3m invested in Project D Total NPV 14.355

• Multi-period capital rationing

Page 21
 Taxation and investment appraisal
• Taxation can have an important impact on project viability. If managers
are implementing decisions that are shareholder wealth enhancing, they
will focus on the cash flows generated which are available for
shareholders.

• Rule 1: If acceptance of a project changes the tax liabilities of the firm

then incremental tax effects need to be accommodated in the analysis
• Rule 2: Get the timing right. Incorporate the cash outflow of tax into
the analysis at the correct time

• Specific projects are not taxed separately, but if a project

produces additional profits in a year, then this will generally increase
the tax bill

Page 22

Snaffle pie
• Purchase of a machine for €1,000,000 at time zero
• Scrap value at the end of its four-year life: this will be equal to its
written-down value
• The tax authorities permit a 25 per cent declining balance writing-
down allowance on the machine each year
• Corporation tax, at a rate of 30 per cent of taxable income, is payable
• Snaffle's required rate of return is 12 per cent
• Operating cash flows, excluding depreciation, and before taxation, are
forecast to be:

Time (year) 1 2 3 4
€ € € €

Cash flows before tax 400,000 400,000 220,000 240,000

Note: All cash flows occur at year ends.

Page 23
 Snaffle (Continued)

Point in time Annual writing-down allowance Written-down value

(yearly intervals) € €

0 0 1,000,000
1 1,000,000 X 0.25 = 250,000 750,000
2 750,000 X 0.25 = 187,500 562,500
3 562,500 X 0.25 = 140,625 421,875
4 421,875 X 0.25 = 105,469 316,406

Exhibit 5.5 Calculation of written-down allowances

Page 24

Snaffle: Calculation of corporation tax

Year 1 2 3 4
€ € € €

Net income before writing-down 400,000 400,000 220,000 240,000

allowance and tax
Less writing-down allowance 250,000 187,500 140,625 105,469
Incremental taxable income 150,000 212,500 79,375 134,531

Tax at 30% of incremental taxable income 45,000 63,750 23,813 40,359

Exhibit 5.6 Calculation of corporation tax

Page 25
 Snaffle: Calculation of flows

Year 1 2 3 4
€ € € €

Incremental cash flow -1,000,000 400,000 400,000 220,000 240,000

before tax
Sale of machine 316,406
Tax 0 -45,000 -63 ,750 -23 ,813 -40,359

Net cash flow -1,000,000 355,000 336,250 196,187 516,047

355,000 336,250 196,187 516,047

Discounted cash flow -1,000,000 + + --- + +
1.12 (1 .12)2 (1.12) 3 (1.12)4
-1,000,000 +316,964 +268,056 +139,642 +327,957

Net present value = + €52,619

Exhibit 5. 7 Calculation of cash flows

Note: tax is payable in the same year that the income was earned in this case, this case.

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Inflation
• Inflation alters the present value of future cash flows.
• Specific inflation refers to the price changes of an individual
good or service
• General inflation is the reduced purchasing power of money
and is measured by an overall price index which follows the
price changes of a 'basket' of goods and services through time
• Inflation creates two problems for project appraisal
- The estimation of future cash flows is made more troublesome. The
project appraiser will have to estimate the degree to which
future cash flows will be inflated.
- The rate of return required by the firm's security holders will rise if
inflation rises (using Fisher's equation in the next 2 slide).

Page 27
 'Real' and 'nominal' rates of return
• Discount rate takes account of three types of compensation:
- The pure time value of money or impatience to consume
- Risk
- Inflation

• Real rate of return: that which is required in the absence of inflation, say 8%

• If we change the assumption so that prices do rise then investors will

demand compensation for general inflation

• If inflation is 4% then the money value of one basket of commodities at Time 1

which would leave the investor indifferent when comparing it with one basket at
Time 0, is:1.08 x 1.04 = 1.1232

• Since the nominal cash flow of £1, 123.20 at Time 1 is financially equivalent to
£1,000 now, the nominal rate of return is 12.32 per cent

Page 28

Fisher's equation

The generalised relationship between real rates of return

and money (or market or nominal) rates of return and
inflation is expressed in Fisher's (1930) equation:
(1 + nominal rate of return) =
(1 + real rate of return) x (1 + anticipated rate of inflation)

(1 + m) = (1 + h) x (1 + 1)
(1 + 0.1232) = (1 + 0.08) X (1 + 0.04)

Page 29
 'Nominal' cash flows and 'real' cash flows

• Two possible discount rates:

- Nominal discount rate
- Real discount rate
• Two alternative ways of adjusting for the effect of future inflation
on cash flows:
- Estimate the likely specific inflation rates for each of the inflows
and outflows of cash and calculate the actual monetary amount
paid or received in the year that the flow occurs. This is the
money cash flow or the nominal cash flow.
• Use a nominal discount rate
- Measure the cash flows in terms of real prices. That is, all future
cash flows are expressed in terms of, say, Time O's prices.
• Use a real discount rate

Page 30

Amplify pie
• A project requires an outlay of £2.4m at the outset
• Nominal cash flows receivable from sales will depend on the
specific inflation rate for Amplify's product-anticipated to be
6 per cent per annum
• Labour costs are expected to increase at 9 per cent per year,
materials by 12 per cent and overheads by 8 per cent
• The discount rate of 12.32 per cent that Amplify uses is a
nominal discount rate, including an allowance for inflation

NPV = M0 + - - - + - - -
1+ m (1 + m) 2 (1 + m)n
M = actual or nominal cash flow
m = actual or nominal rate of return

Page 31
 Amplify pie (Continued)

• Annual cash flows in present (Time 0) prices are as

follows:

fm Inflation

Sales 2 6%
Labour costs 0.3 9%
Material costs 0.6 12%
Overhead 0.06 8%

• All cash flows occur at year ends except for the initial
outflow

Page 32

Amplify pie: Money cash flow

Point in time Cash flow before Inflation Money cash flow
(yearly intervals) allowing for price rises adjustment
fm fm

0 Initial outflow -2.4 1 -2.4

1 Sales 2 1.06 2.12

Labour -0.3 1.09 -0.327
Materials -0.6 1.12 -0.672
Overheads -0.06 1.08 -0.065
Net money cash flow for Year 1 +1.056

2 Sales 2 (1 .06)2 2.247

Labour -0.3 (1.09)2 -0.356
Materials -0.6 (1.12)2 -0.753
Overheads -0.06 (1.08)2 -0.070
Net money cash flow for Year 2 +1.068

3 Sales 2 (1.06)3 2.382

Labour -0.3 (1.09)3 -0.389
Materials -0.6 (1.12)3 -0.843
Overheads -0.06 (1.08)3 -0.076
Net money cash flow for Year 3 +1.074

Exhibit 5.11 Amplify pie: Money cash flow

Page 33
Amplify pie: Nominal cash flows discounted at the nominal discount rate

Point in time 0 1 2 3
(yearly intervals) £m £m £m £m

Undiscounted cash flows -2.4 1.056 1.068 1.074

1.056 1.068 1.074

Discounting calculation -2.4
1 + 0.1232 (1 + 0.1232) 2 (1 + 0.1232)3

Discounted cash flows -2.4 0.9402 0.8466 0.7579

Net present value= +£0.1447 million.

Exhibit 5.12 Amplify pie: Nominal cash flows discounted at the nominal discount
rate

Page 34

Amplify: Cash flow in real terms and real discount rate

• Discounting real cash flow by the real discount rate

• A real cash flow is obtainable by discounting the money cash
flow by the general rate of inflation, thereby converting it to its
current purchasing power equivalent
• The general inflation rate is derived from Fisher's equation:

(1 + m) = (1 + h) x (1 + 1),
m is given as 0.1232, has 0.08, i as 0.04
(1 + m) 1 + 0.1232
/ = - - - - 1 = - - - - - 1 =0.04
(1 + h) 1 + 0.08

Page 35
 Real cash flows

Under this method net present value becomes:

NPV= R0 + - - - + - - - + - - - +
1+h (1 + h) 2 (1 + h) 3

The net present value is equal to the sum of the real

cash flows Rt discounted at a real rate of interest, h

Page 36

Amplify pie: Discounting nominal cash flows by the general inflation rate

Points in time Cash flow Calculation Real cash flow

(yearly intervals) £m £m

0 -2.4 -2.4

1.056
1 1.056 1.0154
1 + 0.04
1.068
2 1.068 0.9874
(1 + 0.04)2
1.074
3 1.074 0.9548
(1 + 0.04)3

Exhibit 5.13 Amplify pie: Discounting money cash flows by the general inflation
rate
Page 37
 Amplify pie: Real cash flows discounted at the real discount rate

Point in time 0 1 2 3
(yearly intervals) £m £m £m £m

Real cash flow -2.4 1.0154 0.9874 0.9548

1.0154 0.9874 0.9548

Discounting calculation -2.4
1 + 0.08 (1 + 0.08) 2 (1 + 0.08) 3

Discounted cash flow -2.4 0.9402 0.8465 0.7580

Net present value= +£0.1447 million.

Exhibit 5.14 Amplify pie: Real cash flows discounted at the real discount rate

Page 38

A warning

• Never do either of the following:

- 1) Discount nominal cash flows with the real discount rate
- 2) Discount real cash flows with the nominal discount rate

Page 39