Chapter 11

Investment appraisal
techniques
Phuong Thao NGUYEN
SAA - NEU
Chapter 11
Making investment appraisal
01 decisions

02 The payback method

03 The accounting rate of return
04 The net present value method
05 The internal rate of return method
06 Environmental costing
1. Making investment
appraisal decisions
 Investment decision – making process

1 Origination of proposals Analysis and acceptance 3

Financial analysis
• Reject Đưa ý kiến thảo luận

➔Using investment appraisal techniques

• More thoroughly evaluated
Qualitative issues: also considered
Project screening 2
Qualitative evaluation Monitoring and review 4
• Fit long term objectives • Ensure: capital spending does not
• Possible alternative exceed the amount authorised
• Project is not delayed
• The anticipated benefits are
eventually obtained
 Investment decision – making process

The payback period

Non-discounting
techniques
The accounting rate of
Investment return method (ARR)
appraisal
techniques The net present value
method (NPV)
Discounting
methods
The internal rate of return
method (IRR)
2. The payback method
 2.1. The payback period

Payback:
Time required: cash inflows = cash outflows

Accept project Reject project

Payback period < target period Payback period > target period

Payback calculation:
• Use Profits before depreciation

Using payback alone: ➔ inadequate project appraisal technique

 2.1. The payback period
NOTES:
Initial payment
Even annual cashflows: Payback period = (in year) (*12 ➔ in month)
Annual cash flow (evenly)

Unven annual cashflows:

Payback period ➔ calculate cumulative cash flow over the life of project

Mutually exclusive: 2 events cannot both occur at the same time

➔ Only one of them can be undertaken Không thể làm 2 cái vì tiền k đủ

Residual value: the disposal value of equipment at the end of its life (disposal cost)

Scrap: Discarded material having some value

 2.1. The payback period
Disadvantages of payback period:

• Ignore: Timing of cash flows

Cash flows after end of the payback period ➔ total project return

Time value of money Overtrading

• Unable to distinguish: projects with the same PBP

• Choice of any Cut-off payback period (target period): arbitrary

• Lead to excessive investment in short-term projects

• NOT take account the variability of cash flows

 2.1. The payback period
Advantages of payback period: especially in screening

• A long payback: capital is tied up

• Early payback: enhance liquidity

• Investment risk is increased if payback is longer

• Shor-term forecasts are likely to be more reliable

• Calculation: quick and simple

• Payback: easily understood concept

3. The accounting rate
of return
 3.1. Calculating the accounting rate of return

Accounting rate of return: (ARR, or ROI, or ROCE)

• Expected average annual accounting profits from an investment
Decision Rule

ARR > Target rate

1. 2. Compare mutually
Accept
Appraise exclusive project
a project ➔ Select the project with
ARR < Target rate
Reject highest ARR
3.1. Calculating the accounting rate of return

Cash ìnlflow - Depre

𝐀𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭
ARR = x 100%
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Bỏ tiền ra mua

Select project
𝐀𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭 with highest ARR
ARR = x 100%
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Initial investment + Final (Scarp value)/2

(expected ARR > target ARR)

Average investment = (initial investment + final or scrap value)/2

 3.2. Advantages of ARR
• Calculation: quick and simple

• Involve: familiar concept of percentage return

• Accounting profits: easily calculated from financial statements

• Look at the entire project life

• Employ profit ➔ easily understood

• Allow to compare more than 1 project

 3.3. Disadvantages of ARR
• NOT take account of the timing of the profits from a project

• Based on accounting profits: subject to accounting policies

• Relative measure (NOT absolute measure) ➔ NOT consider the size of

the investment

• NOT take into account: length of the project

• Ignore: time value of money

4. The net present
value method
 4.1. Compounding: calculating the terminal value
y1 y2 y3

£10,000 £10,000 £11,000 £12,100

£10,000*10%=1000 £11,000*10%=1100 £12,100*10%=1210

Compounding: a future value (terminal value) of a given sum invested

today for a number of year

V = X(1 + r)n
V: future value/ terminal value r: compound rate of return (annual rate)
X: initial/ present value n: number of time periods (years)
4.1. Compounding: calculating the terminal value

Terminal value ➔ difficult to compare or choose

between projects:
• Projects: end at different date
• Decision maker: interested in wealth now rather
than in the future
➔ Common to look at present value
➔ Reverse of compounding
 4.2. Discounting
y1 y2 y3

£10,000 £10,000 £11,000 £12,100

£10,000*10%=1000 £11,000*10%=1100 £12,100*10%=1210

Discounted cash flow: converts the future value to a present value ➔ cash
equivalent now of future sums
𝑽
𝑿 =
(𝟏 + 𝒓)𝒏

Timing of cash flows is taken into account by discounting them

 4.2. Discounting

Present value:
𝑽 Discount factor - fomular:
𝑿 =
(𝟏 + 𝒓)𝒏 𝟏
(𝟏 + 𝒓)𝒏
Discount factor - tables:
Example:
Spender expects the cash inflow from an investment to be £40,000 after 2
years and another £30,000 after 3 years
It target rate of return is 12%
Calculate the present value of these future returns
 4.3. Net present value (NPV)

NPV = present value of cash inflow – present value of cash outflows

Cash inflow: +
Cash outflow: -

NPV > 0: undertaken

NPV < 0: NOT undertaken
NPV = 0: not worth undertaking
(inherent risk)
 4.4. Timing of cash flows: conventions used in DCF

• A cash outlay (initial investment) ➔ occur now (T0) ➔ DF =1

• Cash flows occur at the end of each year (unless told otherwise)

• Later cash flows occur at annual intervals: T1, T2….

➔ A cash flow occurring at the beginning of a time period: take to occur at

the end of the previous time period

-10,000 2,000 4,000 4,500

T0 T1 T2 T3
31/12/2010 31/12/2011 31/12/2012 31/12/2013
 4.4. Timing of cash flows: conventions used in DCF
Outlay R = 10% Cash outflows:
£10,000 £10,000

2018
2015 2016 2017
Cash inflows Cash inflows Cash inflows
£10,000 £15,000 £35,000

year cash flow present value

0
1
2
3
 4.5. Cash flows, not accounting profits

DCF techniques:

• Based on: cash flows

(NOT accounting profits)

• Concerned with liquidity

(NOT profitability)
 4.6. Annuities

1. Annuity:

• A constant annual cash flow

• For a number of year

➔ Same cash flow per annum

➔ Annuity factor (cumulative

present value factors)

➔ Annuity table
 4.6. Annuities
2. Delayed annuities:

-10,000 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Year 0

PV 1,000 1,000 1,000 1,000 1,000

2

➔ 1. Applying the appropriate factor to the cash flow as normal

➔ 2. Further discounting back to Year 0
 4.6. Annuities
3. Annuities in advance

Outlay
£10,000 Year 1 Year 2 Year 3

Year 0

1st Cash inflows Cash inflows Cash inflows Cash inflows

£15,000 £15,000 £15,000 £15,000

1. Calculate the PV of a normal annuity (starting at Year 1 ➔ ignore Y0)

2. Add back the first cash flow
 4.6. Annuities
4. Annuities cash flows in perpetuity
Perpetuity:
• Constant annual cash flow
• Continue forever
𝒂
PV of perpetuity =
𝒓
1 year before the first cash flow
 4.7. Net terminal value

Net terminal value (NTV): cash surplus remaining at the end of a project
after taking account of interest and capital repayments
• NPV = discounted NTV (at the cost of capital)

• Or: calculate the cash surplus at the end of the project:

(Loan outstanding + interest ) – repaid

 4.8. Advantages of NPV

• Link to maximizing shareholder wealth in absolute terms at year 0

• Consider the time value of money

• Consider all relevant cash flows – unaffected by the accounting

policies

• Risk can be incorporated into decision making (adjust discount rate)

• Clear, unambiguous decision

 4.9. The time value of money

Present
> Future

Uncertainty Money invested

Inflation Current pleasures ➔Profit
 4.9. The time value of money

Notes
• No inflation: discounted cash flow techniques
would still used for investment appraisal

• Inflation: for the moment, has been completely

ignored

• Obviously necessary to allow for inflation

 4.9. The time value of money

• Individual: attaches more weight to current pleasures

than to future ones

• Discounted cash flow techniques: measure

• What alternative uses of the money would earn
(NPV method)
• What the money is expected to earn (IRR method)
4.10. Advantages of DCF methods of appraisal

• Use all cash flows relating to the project

• Allow timing of the cash flows

• Universally accepted methods of

calculating the NPV and IRR
 4.11. A comparison of the ROI and NPV methods

ROI and NPV: may not correspond

ROI NPV

• Measure the efficiency of an • Measure the cash flow of an

investment investment

• Calculate the return • Calculate future cash flow

• Can be easily manipulated • Cannot determine the dedicated

(using accounting profit) investment
 4.12. Discounted payback

Discounted payback method:

• How long it will take to payback the capital outlay

➔ Amount of time: Project’s cumulative NPV turn from (-) to (+)

➔ Discounted cash flow basis

 4.12. Discounted payback

Advantages:

• All advantages of the payback period method

• Take into account the time value of money

• Produce a longer payback period ➔ take into account more of the

project’s cash flow

• Clear accept or reject criterion:

Disadvantage: ignore cash flows which occur after the PP

 4.13. The discount rate

• Assumption: cost of capital ➔ constant

• Inflation and interest rate fluctuate ➔ different discount rates at

different points over the life of a project
• NPV and DPP: possible to use different rates
• IRR and ARR: impossible to use different rates

• Problem: difficult to decide on the correct rate in the first place

 4.13. The discount rate

Changing discount rates

𝐢𝐧𝐟𝐥𝐨𝐰 𝐢𝐧𝐟𝐥𝐨𝐰
NPV = out flow y0 + + +…
𝟏+𝐫𝟏 (𝟏+𝐫𝟏)(𝟏+𝒓𝟐)

R1: interest rate for Year 1

R2: interest rate for Year 2
5. The internal rate
of return
 5.1. The internal rate of return

Get back $10 Rate of return

Invest
Year 0 every year forever 10% p.a.
£100
Internal

Hidden rate of return

Get back y1 y2 y3 y4
Invest
£100 £20 £30 £90 £50
NOT forever
 5.1. The internal rate of return

𝟐𝟎 𝟑𝟎 𝟗𝟎 𝟓𝟎
NPV = -100 + + + + +
𝟏+𝐫 𝟏+𝐫 𝟐 𝟏+𝐫 𝟑 𝟏+𝐫 𝟒
Hidden

Expect: NPV ≥ 0
➔ Find the r where NPV = 0
➔ IRR
 5.1. The internal rate of return

Internal rate of return: the discount rate at which a project has

NPV = 0

➔ IRR: relative measure (%)

Discount rate < IRR
Accept
Decision
rule
Discount rate > IRR
Reject
 5.2. Graphical approach

Estimate the IRR:

• Find the project’s NPV: r1, r2….

• Sketch a graph

• IRR: where NPV = 0

 5.2. Graphical approach

Example:

A project might have the following NPVs at

the following discount rate:

R 5% 10% 15% 20%

NPV 5,300 700 (1,500) (3,200) IRR = 13%
 5.3. Interpolation method

Typical capital project

• Negative cash flow at the start
• Positive cash flow afterward

Determine cost of capital:

• Slightly positive NPV
• Slightly negative NPV
Drawing straight line between 2 point ➔ IRR
Interpolation:
assumes that NPV rises in linear fashion between the two NPVs close to 0
 5.3. Interpolation method

IRR interpolation formula:

𝐍𝐏𝐕 𝐚
IRR = a + x (b – a)
𝐍𝐏𝐕 𝐚 −𝐍𝐏𝐕 𝐛

a: the first discount rate giving NPVa

b: the second discount rate giving NPVb
 5.3. Interpolation method

Step 1: Calculate NPVs (close to 0) at 2 different costs of capital

(NPVa < 0 & NPVb > 0)

➔ Hit & miss: try r = 2/3 ARR or ¾ ARR

• If r1 give NPV < 0 ➔ IRR is higher than this

• If r2 give NPV > 0 ➔ IRR is smaller than this

•

Step 2: Use the formular to find IRR

𝐍𝐏𝐕 𝐚
IRR = a + x (b – a)
𝐍𝐏𝐕 𝐚 −𝐍𝐏𝐕 𝐛
 5.3. Interpolation method

Example:
A company is trying to decide whether to buy a machine for £80,000
which will save costs of £20,000 per annum for 5 years and which will
have a resale value of £10,000 at the end of year 5
Requirement
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 using the IRR method
whether this project should be undertaken?
 5.3. Interpolation method

Solution:
• First step: calculate 2 NPV close to 0
(try starting at r = 2/3 ARR or 3/4 ARR)
Annual depreciation = (80,000 – 10,000)/5 = 14,000
ARR = (20,000 – 14,000)/ (80,000+10,000)/2 = 13.3%
Try: 2/3x13.3% = 8.9% ➔ 9%
NPV1 = -80,000 + 20,000* + 10,000 *(1/(1.09)^5
= 4,300
 5.3. Interpolation method

NPV1 = -80,000 + 20,000* + 10,000 *(1/(1.09)^5

= 4,300
NPV2: try 10%, 11%, 12%
(if 1st NPV > 0 ➔ choose higher rate for the next to get negative NPV)
Try r2 = 12% ➔ NPV 2 = (2,230)

𝟒,𝟑𝟎𝟎
IRR = 9+ x (12-9) = 10.98% ➔ 11%
𝟒,𝟑𝟎𝟎−(−𝟐,𝟐𝟑𝟎)
 5.4. NPV and IRR compared

IRR advantages
• Easily understood by managers – especially non-financial managers
• A discount rate does not have to be specified
Disadvantages
• ARR and IRR: mixed up
• Ignores: relative size of the investment
• Discount rates are expected to differ over the life of project: impossible
• Problems: project has non-conventional cash flow or deciding between mutually
exclusive projects
 5.5. Non – conventional cash flows

Normal cash flows: Initial cash flow followed by a series of inflows

➔ IRR and NPV: the same decision

Non - Conventional cash flows: Many IRR

vary outflow and inflow ➔ not recommended

Year Cash flow

0 (1,900)
1 4,590
2 (2,735)
 5.5. Non – conventional cash flows

Non - Conventional cash flows:

• Using IRR: lack of knowledge of multiple IRRs ➔ error in the
decision
➔ Not recommended in non-conventional cash flow patters
• NPV: clear, unambiguous results whatever the cash flow pattern
 5.5. Non – conventional cash flows

Sketching an NPV graph

• Start on the vertical axis (NPV at 0% = sum of cashflows)
• Various IRRs: cut horizontal axis where NPVs = 0
• NO IRR: does not cut horizontal axis
Example
Year 0 Year 1 Year 2 IRR
Project C (4,000) 25,000 (25,000) 25% & 400%
Project D 1,000 (1,600) 1,200 No
5.6. Mutually exclusive projects

The IRR and NPV methods can

give conflicting rankings

➔ Prefer: Higher NPV ➔ create

more wealth

“What do you think my NPV will be if I invest

12 years in your school at £20,000 p.a. at
8% floating interest rate?”
 5.7. Reinvestment assumption

Assumptions:
• NPV method: Net cash inflows will be reinvested elsewhere at the
cost of capital
• IRR method: cash flows can be reinvestment elsewhere to earn a
return = IRR of the original project

➔ If the assumption (under NPV method) is not valid: the IRR

method overestimates the real return
6. Environmental
costing
6.1. Importance of environmental costs

Briefly summaries
• Sustainability costs
• Impact ➔ Double materiality
• Dependencies

• Sustainability reporting: currently voluntary, change in future

• Good ESG policies ➔ lower risk (banks and investors)
• Financing decisions: based on ESG performance
6.1. Importance of environmental costs

Management accountants consider environmental cost for:

• Ethical reason
• Associate environmental costs with Product/ services ➔ Correct
product/ service pricing
• Poor environmental behaviour ➔ fines, increase taxes, damage
reputation
• Recording environmental cost: importance (regulatory compliance)
• Saving energy ➔ cost saving
6.1. Importance of environmental costs

List of dependencies that can lead to additional costs

• Extreme weather events
• Climate change
• Resource availability/ supply chain disruption
• Regulation
• Worker health
➔ Environmental costs, monitoring of resource usage, environmental
impacts: part of capital investment decisions
6.2. Environmental cost classification

Hansen and Mendoza (1999):

• Environmental prevention costs: eliminate environmental impacts
• Environmental appraisal costs: complying with environmental
standards and policies
• Environmental internal failure costs: not released contaminants/
waste into the environment
• Environmental external failure costs: release harmful waste into
environment
Practice