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Chapter 14

Capital Investment Appraisal

Capital investment appraisal

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

Investment in capital projects involves large initial financial outlays, with long waiting periods before these funds are repaid from future cash flows or profits

Features of capital investments

Capital investment involves 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

Capital investment decisions

The decision to charter or purchase an aircraft.

The decision to lease or buy property to open a retail outlet, restaurant, leisure centre or other such business.

The decision to install an energy saving control system within a

The decision to employ a computerised point of sales stock control

system in a retail chain.

The decision to purchase new fun activities equipment within a leisure park.

The decision by a catering firm to purchase more equipment in order to tender for a school meals contract

Features of capital investment

decisions

The sums involved are relatively large

The timescale over which the benefits will be received is

relatively long, with greater risks and uncertainty in forecasting future revenues and costs.

The nature of a business, its direction and rate of growth is

ultimately governed by its overall investment programme.

The irreversibility of some projects due to the specialised nature

of certain assets for example, some plant and machinery bought with a specific project in mind could have little or no scrap value.

In order to complete projects on time and within budget,

adequate continuous control information is required

Capital investment is long-term and the recoupment of

investment may involve a significant period of time

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

Payback method

Net present value

Internal rate of return

Capital appraisal methods

Payback

Net Present Value (NPV)

Internal Rate of Return (IRR)

Accounting Rate of Return (ARR) Profits

Cash flows

Cash flows

Cash flows

Capital appraisal methods

The accounting rate of return is based on the use of operating

profit The operating profit of a project is the difference

between revenues earned by the project, less all the operating costs associated with the project, including depreciation

All other appraisal methods use net cash flows as the basis for appraising capital projects This is due to the nature of

assessing capital investment projects where one must spend cash now and reap the cash rewards later

The calculation of accounting profit is not concerned with the timing of cash flows This is due to its adherence to the

accruals concept whereby profits are calculated by deducting expenses charged from revenues earned.

Net cash flow

Net cash flow =

operating cash flows + / - capital cash flows

Net cash flow =

operating cash flows + / - capital cash flows

Net profit and net cash flow

Net profit Net cash flow

Related revenue earned

less Related cash inflows (operating + capital)

Accounting rate of return (ARR)

The accounting rate of return method calculates the

estimated overall profit or loss on an investment project and relates that profit to the amount of capital invested and to the period for which it is required

A business will have a required minimum rate of return for any investment This is related to the cost of capital of the business

If an investment yields a return greater than the cost of capital, then the investment would be considered suitable and profitable

The accounting rate of return is an average rate of return calculated by expressing average annual profit as a

percentage of the average value of the investment

Accounting rate of return (ARR)

ARR = Average annual profit

Average investment

Average annual profit

Total project profit after

depreciation and before interest,

tax and dividends, divided by the

estimated life of the project.

Average investment

Initial investment, plus value of investment at project-end, divided

by two.

Example 14.1: Accounting rate of

return

Example 14.1: Accounting rate of

return

Accept or reject criteria for ARR

method

Accept the project Reject the project

Project ARR greater

than the minimum

required return.

Project ARR less than the minimum required

return.

Advantages of ARR

It takes account of the overall profitability of the

project

It is simple to understand and easy to use

Its end result is expressed as a percentage, allowing projects of differing sizes to be compared

waiting to recoup the investment

The ARR takes no account of the size of the initial

investment

The payback method

This method of investment appraisal simply asks

the question ‘how long before I get my money

back?’

How quickly will the cash flows arising from the project exactly equal the amount of the

investment

It is a simple method, widely used in industry and

is based on management’s concern to be

reimbursed on the initial outlay as soon as

possible

It is not concerned with overall profitability or the level of profitability.

Example 14.2: Payback

Example 14.2: Payback

Accept or reject criteria for

payback method

Accept the project Reject the project

Payback period is less than

that required by investors Payback period is greater than that required by

investors

Advantages of payback

It is simple to understand and apply

It promotes a policy of caution in investment

Disadvantages of payback

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

Time value of money

The time value of money concept plays an important role in appraising capital projects because the time lag between the initial investment and payback can

be quite long

€1 earned or spent sooner, is worth more than €1

earned or spent later

To evaluate any project taking into account the time value of money, the cash flows received in the future must be reduced or discounted to a present value, so that all relevant cash flows are denominated in todays value (present value)

The cost of capital

All investment projects require funding Generally,

funding can be classified into:

Equity funding, where investors buy an equity or ownership share in a project This is done through the issue of shares or

by retaining profits in the business.

Debt, where the company can borrow or issue its own

debentures.

Each source of finance has a cost The cost of debt is the interest rate that applies to the debt The costs of equity finance are the dividends and increases in share price expected by shareholders

This cost of capital becomes the benchmark or

minimum required return on a project

A project is only truly profitable when its actual return

on assets is greater than the company’s cost of capital

Example 14.3: Cost of capital

Weighed average cost of capital

If a project is funded by more than one method of

financing, the weighted average cost of capital (WACC) should be calculated

Discounted cash flow (DCF)

DCF is the investment appraisal technique that takes account of the time value of money

DCF looks at the cash flows of a project, not the

accounting profits It is concerned with liquidity not profitability

The timing of cash flows is taken into account by

discounting all future cash flows to present value

The effect of discounting is to give a bigger value per euro for cash flows that occur earlier

The discount factor to use is the cost of capital to the business

Net present value (NPV)

Present value can be defined as the cash equivalent now of a sum of money to be received or paid at a stated future date, discounted at a specified cost of capital

The net present value is the value obtained by

discounting all the cash outflows and inflows of a

capital investment project, at a chosen target rate of return or cost of capital

The present value of the cash inflows, minus the

present value of the cash outflows, is the net present value

Net present value (NPV)

If the NPV is positive, it means that the cash inflows

from the investment will yield a return in excess of the cost of capital and thus the project should be

undertaken, as long as there are no other projects

offering a higher NPV

If the NPV is negative, it means that the cash inflows

from the investment yield a return below the cost of capital and so the project should not be undertaken

If the NPV is exactly zero, the cash inflows from the

investment will yield a return which is exactly the

same as the cost of capital and thus the project may

or may not be worth undertaking depending on other investment opportunities available

Example 14.4: Net present value

Accept or reject criteria for NPV

method

Accept the project Reject the project

NPV is positive

In choosing between

mutually exclusive projects,

accept the project with the

highest NPV.

NPV is negative

Advantages of NPV

It takes into account the time value of money

Profit and the difficulties of profit measurement are excluded

Using cash flows emphasises the importance of liquidity

It is easy to compare the NPV of different projects

The internal rate of return (IRR)

The IRR method calculates the exact rate of

return which the project is expected to achieve, based on the projected cash flows It is the

discount rate which, when applied to the

projected cash flows, ensures they are equal to the initial capital outlay The IRR is the discount factor which will give a NPV of zero It is the

actual return from the project, taking into

account the time value of money.

The internal rate of return (IRR)

Example 14.5: Internal rate of return

Accept or reject criteria for IRR

method

Accept the project Reject the project

IRR greater than the

Disadvantages of IRR

The trial and error process of calculating the IRR can be time consuming, however this disadvantage can easily be overcome with the use of computer software.

It is possible to calculate more than two different IRR’s for a

project This occurs where the cash flows over the life of the

project are a combination of positive and negative values Under these circumstances it is not easy to identify the real IRR and the method should be avoided.

In certain circumstances the IRR and the NPV can give

conflicting results This occurs because the IRR ignores the

relative size of investments as it is based on a percentage return rather than the cash value of the return

The NPV approach is considered superior to the IRR because of the disadvantages associated with the

IRR method

However it is clear that there is a place for all four

methods, which inform judgement, not replace it

Appraisal methods

Newport Leisure Park Ltd investment appraisal summary

Comparing mutually exclusive

projects with unequal lives

When comparing mutually exclusive projects, the

appraisal method to use is the net present value

approach

However businesses often have to decide on two or

more competing projects that have unequal or different life spans To simply compare the net present values of each project without looking at the unequal lifespan

would not be comparing like with like

The net present value of both projects needs to be

expressed in equal terms

The ‘equivalent annual annuity method’ to compare the

net present values on an annualised basis

Comparing mutually exclusive

projects with unequal lives

1 Calculate the NPV of each project.

2 Divide the NPV of each project by the annuity

factor for the period of the project This

calculates what is called the ‘equivalent annual annuity’ or EAA.

3 Compare the EAA of each project, accepting the project with the highest equivalent annual

annuity.

Example 14.6: Project appraisal

with unequal lives

Example 14.6: Project appraisal

with unequal lives

The calculation of cash flows

Operating cash flows represent sales revenues, less variable cost attributed to the project or investment Fixed costs are also included but only if they relate to the new investment and are incremental

All costs that would occur irrespective of the

investment decision should be ignored

The cash flows that are to be considered are those that would not arise without the investment

The calculation of cash flows

Sunk costs are past costs that have already been paid and should be

ignored.

Incremental costs that relate to the decision should be taken into

account.

Opportunity gains or costs should be taken into account

Replacement costs of using that resource or asset should be used, not

its original cost.

Loan interest and dividend payments should not be taken into account in

calculating the operating cash flows (for DCF) as the discount factor

already takes into account the cost of financing.

Incremental working capital should be treated as part of the initial

expenditure or capital investment At the end of the project's life, the total investment in working capital is assumed to be liquidated (turned into cash) at original cost and is treated as a cash inflow in the final year of the life of the project.

Depreciation: is a non-cash item and must be ignored in calculating

operating cash flows

Year-end assumption: in calculating the cash flows of a project, it is

assumed that they arise at the end of the relevant year

Taxation: will usually be an important consideration as investors are

interested in the after tax returns generated from the business

Example 14.7: Calculation of cash

flows

Example 14.7: Calculation of cash

flows

Example 14.7: Calculation of cash

flows

Project appraisal and risk

Operating risk: This occurs where a business has a high fixed

operating cost structure and hence it must ensure it generates sufficient revenues and contribution to cover fixed costs In

general, the hospitality and tourism sectors suffer from a high level of operating risk

Financial risk: This arises from the methods chosen to finance

an operation High financial risk implies that a business is highly financed through borrowings and hence must ensure operating profit and cash flows are sufficient to meet the interest costs of these financial instruments

Business risk: This occurs as a result of changes to the

economic and business environment that can be caused by a range of factors such as hurricanes, terrorism, tsunamis,

technological advances, consumer confidence, inflation and

fluctuations in national and global economies All businesses are subject to this type of risk and it is this type of risk that is

associated with investment appraisal

All future projects are subject to some element of uncertainty and risk.