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INVESTMENT APPRAISAL METHODS

CHAPTER 5. INVESTMENT APPRAISAL METHODS. Chapter outline. Introduction Importance of efficient investment appraisal Types of investment decisions Average return method Payback period method Discounted payback period method Net present value method Internal rate of return

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INVESTMENT APPRAISAL METHODS

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  1. CHAPTER 5 INVESTMENT APPRAISAL METHODS

  2. Chapter outline • Introduction • Importance of efficient investment appraisal • Types of investment decisions • Average return method • Payback period method • Discounted payback period method • Net present value method • Internal rate of return • Comparison between the net present value and internal rate of return methods • Modified internal rate of return • Profitability index • Conclusion

  3. Learning outcomes • By the end of this chapter, you should be able to: • understand the importance of the investment appraisal process • distinguish between the different types of investment decisions • calculate, interpret and evaluate the average return method • calculate, interpret and evaluate the payback period method • calculate, interpret and evaluate the discounted payback period method • calculate, interpret and evaluate the net present value method

  4. Learning outcomes (cont.) • By the end of this chapter, you should be able to: • calculate, interpret and evaluate the internal rate of return method • define, construct and interpret a net present value profile graph • calculate, interpret and evaluate the modified internal rate of return method • calculate, interpret and evaluate the profitability index method • understand why ranking investment proposals on the basis of the net present value and internal rate of return methods may lead to conflicting rankings.

  5. Introduction • Most investment decisions involve outflows of cash, which result in inflows of cash • Typically, an investment project involves a relatively large initial investment (outflow of cash) at the beginning of the project • After the initial investment, a stream of cash inflows and outflows spread over the project lifetime • Finally, provision may also have to be made for cash outflows resulting from additional investments made over the project lifetime. Large cash flows may also be required at the end of the project lifetime

  6. Introduction (cont.) • To evaluate the feasibility of investment projects investment appraisal methods (capital-budgeting techniques) are usually used • Selecting which investment opportunities to pursue and which to avoid is a vital matter to businesses • Focus is usually placed on evaluating expected cash outflows and resulting cash inflows in order to determine if project is profitable

  7. Importance of investment appraisal • Capital budgeting: • Process of identifying and analysing investment opportunities available • Deciding how scarce capital resources (land, labour and capital) will be allocated • Company should ensure that only value-creating investments are accepted

  8. Importance of investment appraisal • Importance of efficient capital budgeting • Investment decisions define company’s strategic direction • Require long-term investment – capital is locked into the project • Failure to conduct efficient capital budgeting: result in insufficient production facilities • Capital budgeting involves large amounts of capital: difficult to reverse incorrect investment decisions • Limited capital available: cannot invest in unprofitable investment opportunities • If efficient planning is not conducted: may not be able to find capital required to finance investments

  9. Importance of investment appraisal • Steps in the capital budgeting process: • Identify all possible investment alternatives • Determine relevant cash flows associated with investment alternatives • Determine company’s cost of capital: important to determine if return earned on projects will exceed company’s cost of capital • Evaluate the projects – appraisal of investment alternatives’ financial feasibility • Decide if acceptable projects are going to be implemented • Follow up and continuously re-evaluate investment projects

  10. Types of investment projects • Replacement projects • Most assets have finite lifespan – will have to be replaced when existing assets reach end of lifespan • Expansion projects • Company wants to expand its current level of operations by either internal or external expansion • Independent projects • Acceptance of project does not influence other projects under consideration • Mutually exclusive projects • Implementation of one project results in rejection of all other alternatives

  11. Types of investment projects • Complementary projects • Acceptance of one project has positive effect on company’s other projects • Substitute projects • Implementation of one project could have negative effect on cash flows of company’s other projects • Conventional projects • Initial cash outflow followed by cash inflows throughout project lifetime • Unconventional projects • Initial cash outflow at beginning of project lifetime followed by inconsistent cash flows • Other types of projects

  12. The average return method • Considers initial cash investment the project requires • Compares it to average annual cash flow generated by project over its lifetime  

  13. Example 5.1

  14. The payback period method • Calculates expected number of years after which initial investment amount (C0) is recovered from the project’s net cash flows (Ct) • Aim is to determine how long it will take to recover initial capital outlay  • PBP = Years before full recovery +

  15. Example 5.2 • Project A: Cash flow Year 1: R5 000 Year 2: R10 000 • End of Year 2: Accumulated cash flow equal to R15 000 (5 000 + 10 000). • This amount R10 000 less than initial investment • Only R10 000 of R15 000 cash flow Year 3 required. PBP therefore equal to: • PBPProject A = 2 + • = 2 + 0,67 • = 2,67 years

  16. The discounted payback period method • Calculated based on cash flows that are discounted at company’s cost of capital • DPB calculates expected number of years required to recover initial investment by considering discounted net cash flows

  17. Example 5.3

  18. The net present value method • Difference between present value (PV) of all expected net cash inflows and PV of all expected net cash outflows calculated over expected life of project • With NPV method: net cash flows are discounted at cost of capital (i) to determine their PV, and compared with initial investment

  19. Example 5.4 You are required to calculate the NPV for Project A if the cost of capital = 10%.

  20. Example 5.4

  21. The internal rate of return method • IRR: Attempts to determine discount rate that equates PV of expected net cash inflows and PV of net cash outflows • Defined as discount rate that will result in NPV of zero.

  22. Example 5.5

  23. Multiple or no IRRs • Major weakness of IRR method: • Conventional projects – IRR method can usually be applied without calculation problems • Unconventional projects – calculation problems may occur • No IRR value – if there are no changes in signs of cash flows • Generate more than one IRR – if more than one change in the sign of the cash flows occurred

  24. Comparing the NPV and IRR • When mutually exclusive projects are evaluated by applying the two methods conflicting rankings may sometimes be obtained • Construct NPV profile graph to illustrate differences between the two methods

  25. Comparing the NPV and IRR IRR Project A = 27,27% IRR Project B = 22,47% Represented at the point where NPV profiles intercept horizontal axis. • Point where two projects intercept: crossover rate • At discount rates below crossover rate: NPV Project B larger than NPV Project A. • Discount rates beyond crossover rate: NPV Project A is largest. • In case of mutually exclusive projects: same results if cost of capital exceeds crossover rate. • Below crossover rate: contradictory results

  26. Evaluating mutually exclusive projects with the IRR method • When applying NPV method to evaluate mutually exclusive projects: project with higher NPV accepted • In case of IRR method: project with highest IRR not necessarily better alternative • To evaluate mutually exclusive projects with IRR – calculation of IRR values first round of evaluation • Also necessary to investigate IRR on incremental cash flows to determine if difference in initial investment required generates sufficient incremental cash flows to justify one investment alternative over another

  27. Modified internal rate of return method • MIRR: Attempts to improve on IRR method • Include more conservative view on reinvestment rate earned on cash flows generated during project’s lifespan. • Also solves problem with multiple IRR values • Cash stream converted into only cash inflow and cash outflow value

  28. Example 5.8 • Calculating MIRR for Project A:

  29. The profitability index • Investigates relationship between initial investment amount and expected pay-off of project • Measure project’s profitability relative to each rand invested

  30. Example 5.9 • Calculate PI of Project A. Cost of capital is 10%:

  31. Conclusion • Efficient investment appraisal is required to ensure that capital is invested in projects that will result in the creation of value. • Before a project is subjected to the various investment appraisal techniques, it is important to determine what type of project it is to decide what the most appropriate method will be. • A distinction can be made between those appraisal methods that take the time value of money into consideration, and those that ignore it.

  32. Conclusion (cont.) • The AR method is a relatively simple appraisal method that expresses the average annual cash inflow as percentage of the initial investment. • The PBP method calculates the time it takes to recover the initial investment amount from the cash inflows generated by a project. • The DPB is determined by discounting the future cash flows at the company’s cost of capital, and determining the period of time these discounted values will take to recover the initial investment required.

  33. Conclusion (cont.) • The NPV of a project is determined by calculating the present value of all future cash flows at the company’s cost of capital, and comparing it to the initial investment required. Projects yielding positive NPVs are accepted, while negative NPV projects are rejected. • The IRR method determines the discount rate that will ensure a zero net present value, and is compared to a company’s cost of capital to evaluate a project’s financial feasibility. • For mutually exclusive projects, the NPV and IRR methods may provide conflicting signals with regard to the acceptability of the projects. In these cases, the NPV is the more conservative measure to apply.

  34. Conclusion (cont.) • The MIRR is calculated by discounting all cash outflows to the beginning of the project lifetime, and accumulating all the cash inflows at the end. The measure is then calculated as the discount rate that will ensure that a zero net present value is obtained based on these two values. • The PI is calculated by dividing the present value of all future cash flows by the initial investment amount. Index values in excess of one indicate that a project is acceptable, while values of less than one indicate that the present value of the future cash flows are less than the initial investment required.

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