Project appraisal

Project appraisal tài liệu, giáo án, bài giảng , luận văn, luận án, đồ án, bài tập lớn về tất cả các lĩnh vực kinh tế, k...

under-of the time value under-of money and the opportunity cost under-of capital More cally the student should be able to:

specifi- calculate net present value and internal rate of return;

 show an appreciation of the relationship between net present value and internal rate of return;

 describe and explain at least three potential problems that can arise with internal rate of return in specific circumstances.

Shareholders supply funds to a firm for a reason That reason, generally, is to receive a return on their preciousresources The return is generated by management using the finance provided to invest in real assets It is vitalfor the health of the firm and the economic welfare of the finance providers that management employ the besttechniques available when analysing which of all the possible investment opportunities will give the best return.Someone (or a group) within the organisation may have to take the bold decision on whether it is better tobuild a new factory or extend the old; whether it is wiser to use an empty piece of land for a multi-storey carpark or to invest a larger sum and build a shopping centre; whether shareholders would be better off if the firmreturned their money in the form of dividends because shareholders can obtain a better return elsewhere, orwhether the firm should pursue its expansion plan and invest in that new chain of hotels, or that large car show-room, or the new football stand.

These sorts of decisions require not only brave people, but informed people; individuals of the required bre need to be informed about a range of issues: for example, the market environment and level of demand forthe proposed activity, the internal environment, culture and capabilities of the firm, the types and levels of costelements in the proposed area of activity, and, of course, an understanding of the risk and uncertainty apper-taining to the project

cali-Tesco presumably considered all these factors before making its multi-million pound investments – see

Exhibit 2.1

Bravery, information, knowledge and a sense of proportion are all essential ingredients when undertaking theonerous task of investing other people’s money, but there is another element which is also of crucial importance,that is, the employment of an investment appraisal technique which leads to the ‘correct’ decision, a techniquewhich takes into account the fundamental considerations

This chapter examines two approaches to evaluating investments within the firm Both emphasise the centralimportance of the concept of the time value of money and are thus described as discounted cash flow (DCF)techniques Net present value (NPV) and internal rate of return (IRR) are in common usage in most large com-mercial organisations and are regarded as more complete than the traditional techniques of payback andaccounting rate of return (e.g return on capital employed – ROCE) The relative merits and demerits of thesealternative methods are discussed in Chapter 3 alongside a consideration of some of the practical issues of proj-ect implementation In this chapter we concentrate on gaining an understanding of how net present value andinternal rate of return are calculated, as well as their theoretical underpinnings

Introduction

Tesco has turned up the heat on its rivals with surprise plans to invest an extra £1.7bn in the supermarket business, the major- ity to be spent strengthening its dominant position at home Sir Terry Leahy, chief executive, said

yesterday he wanted to build more hypermarkets to allow for

a jump in sales of non-food items, expand his convenience chain and services such as bank- ing He challenged international rivals with plans for extra invest-

ment in overseas expansion and

a change of strategy by ing to add convenience stores and smaller superstores to its hypermarket operations.

promis-Source: Financial Times, 14 January

2004, p 1 Reprinted with permission.

Exhibit 2.1

Tesco to raise £1.7bn for further growth

By Susanna Voyle, Retail Correspondent

FT

Value creation and corporate investment

If we accept that the objective of investment within the firm is to create value for its ownersthen the purpose of allocating money to a particular division or project is to generate cashinflows in the future significantly greater than the amount invested Put most simply, the proj-ect appraisal decision is one involving the comparison of the amount of cash put into aninvestment with the amount of cash returned The key phrase and the tricky issue is ‘signifi-cantly greater than’ For instance, would you, as part-owner of a firm, be content if that firmasked you to swap £10,000 of your hard-earned money for some new shares so that the man-agement team could invest it in order to hand back to you, in five years, the £10,000 plus

£1,000? Is this a significant return? Would you feel that your wealth had been enhanced if youwere aware that by investing the £10,000 yourself, by, for instance, lending to the govern-ment, you could have received a 5 per cent return per year? Or that you could obtain a return

of 10 per cent per annum by investing in other shares on the stock market? Naturally, youwould feel let down by a management team that offered a return of less than 2 per cent peryear when you had alternative courses of action that would have produced much more

This line of thought is leading us to a central concept in finance and, indeed, in businessgenerally – the time value of money Investors have alternative uses for their funds and theytherefore have an opportunity costif money is invested in a corporate project The investor’s opportunity cost is the sacrifice of the return available on the best forgone alternative.

Investments must generate at least enough cash for all investors to obtain their requiredreturns If they produce less than the investor’s opportunity cost then the wealth of sharehold-ers will decline

Exhibit 2.2summarises the process of good investment appraisal The achievement of value

or wealth creation is determined not only by the future cash flows to be derived from a projectbut also by the timing of those cash flows and by making an allowance for the fact that timehas value

The time value of money

When people undertake to set aside money for investment something has to be given up now.For instance, if someone buys shares in a firm or lends to a business there is a sacrifice of con-sumption One of the incentives to save is the possibility of gaining a higher level of future

Is a proposed course of action (e.g investing

in a project) wealth creating?

Time value of moneyCash flow

Discounted cash flow project appraisal techniques

NoYes

Objective or fundamentalquestion

consumption by sacrificing some present consumption Therefore, it is apparent that sation is required to induce people to make a consumption sacrifice Compensation will berequired for at least three things:

compen- Impatience to consume Individuals generally prefer to have £1.00 today than £1.00 in five

years’ time To put this formally: the utility of £1.00 now is greater than £1.00 received fiveyears hence Individuals are predisposed towards impatience to consume, thus they need

an appropriate reward to begin the saving process The rate of exchange between certainfuture consumption and certain current consumption is the pure rate of interest– thisoccurs even in a world of no inflation and no risk If you lived in such a world you might

be willing to sacrifice £100 of consumption now if you were compensated with £102 to bereceived in one year This would mean that your pure rate of interest is 2 per cent

 Inflation The price of time (or the discount rate needed to compensate for time preference)

exists even when there is no inflation, simply because people generally prefer consumptionnow to consumption later If there is inflation then the providers of finance will have to becompensated for that loss in purchasing power as well as for time

 Risk The promise of the receipt of a sum of money some years hence generally carries with

it an element of risk; the payout may not take place or the amount may be less thanexpected Risk simply means that the future return has a variety of possible values Thus,the issuer of a security, whether it be a share, a bond or a bank account, must be prepared

to compensate the investor for impatience to consume, inflation and risk involved, wise no one will be willing to buy the security

other-Take the case of Mrs Ann Investor who is considering a £1,000 one-year investment andrequires compensation for three elements of time value First, a return of 2 per cent is requiredfor the pure time value of money Second, inflation is anticipated to be 3 per cent over theyear At time zero (t0) £1,000 buys one basket of goods and services To buy the same basket

of goods and services at time t1(one year later) £1,030 is needed To compensate the investorfor impatience to consume and inflation the investment needs to generate a return of 5.06 percent, that is:

(1 + 0.02)(1+ 0.03) – 1 = 0.0506 The figure of 5.06 per cent may be regarded here as the risk-free return (RFR), the interest ratethat is sufficient to induce investment assuming no uncertainty about cash flows Investorstend to view lending to reputable governments through the purchase of bonds or bills as thenearest they are going to get to risk-free investing, because these institutions have unlimitedability to raise income from taxes or to create money The RFR forms the bedrock for timevalue of money calculations as the pure time value and the expected inflation rate affect allinvestments equally Whether the investment is in property, bonds, shares or a factory, ifexpected inflation rises from 3 per cent to 5 per cent then the investor’s required return on allinvestments will increase by 2 per cent

However, different investment categories carry different degrees of uncertainty about theoutcome of the investment For instance, an investment on the Russian stock market, with itshigh volatility, may be regarded as more risky than the purchase of a share in BP with itssteady growth prospects Investors require different risk premiumson top of the RFR toreflect the perceived level of extra risk Thus:

Required return (Time value of money) = RFR + Risk premium

In the case of Mrs Ann Investor, the risk premium pushes up the total return required to, say,

10 per cent, thus giving full compensation for all three elements of the time value of money

Discounted cash flow

The net present value and internal rate of return techniques, both being discounted cash flow

methods, take into account the time value of money Exhibit 2.3, which presents ProjectAlpha, suggests that, on a straightforward analysis, Project Alpha generates more cash inflowsthan outflows An outlay of £2,000 produces £2,400

However, we may be foolish to accept Project Alpha on the basis of this crude methodology.The £600 cash flows occur at different times and are therefore worth different amounts to aperson standing at time zero Quite naturally, such an individual would value the £600received after one year more highly than the £600 received after four years In other words,the present value of the pounds (at time zero) depends on when they are received

It would be useful to convert all these different ‘qualities’ of pounds to a common rency, to some sort of common denominator The conversion process is achieved by

cur-discountingall future cash flows by the time value of money, thereby expressing them as anequivalent amount received at time zero The process of discounting relies on a variant of the

compoundingformula:

F = P (1 + i) n

where F = future value P = present value

i = interest rate n = number of years over which compounding takes place

If a saver deposited £100 in a bank account paying interest at 8 per cent per annum, afterthree years the account will contain £125.97:

F = 100 (1 + 0.08)3= £125.97This formula can be changed so that we can answer the following question: ‘How much must

I deposit in the bank now to receive £125.97 in three years? We need to rearrange the formula

so that we are calculating for present value, P:

money is 10 per cent) – see Exhibit 2.4

We can see that, when these future pounds are converted to a common denominator, thisinvestment involves a larger outflow (£2,000) than inflow (£1,901.92) In other words thereturn on the £2,000 is less than 10 per cent

Net present value and internal rate of return

Net present value: examples and definitions

The conceptual justification for, and the mathematics of, the net present value and internalrate of return methods of project appraisal will be illustrated through an imaginary but realis-tic decision-making process at the firm of Hard Decisions plc This example, in addition todescribing techniques, demonstrates the centrality of some key concepts such as opportunitycost and time value of money and shows the wealth-destroying effect of ignoring these issues.Imagine you are the finance director of a large publicly quoted company called HardDecisions plc The board of directors agrees that the objective of the firm should be share-holder wealth maximisation Recently, the board appointed a new director, Mr Brightspark, as

an ‘ideas’ man He has a reputation as someone who can see opportunities where others seeonly problems He has been hired especially to seek out new avenues for expansion and make

If your calculator has a ‘powers’ function (usually represented by x y or y x) then compounding and counting can be accomplished relatively quickly Alternatively, you may obtain discount factors from thetable in Appendix II at the end of the book If we take the discounting of the fourth year’s cash flow forAlpha as an illustration:

dis-1––––––––––  600(1 + 0.10)4

Calculator: Input 1.10

Press y x (or x y)Input 4Press =Display 1.4641Press 1/xDisplay 0.6830Multiply by 600Answer 409.81

Using Appendix II, look down the column 10% and along the row 4 years to find discount factor of0.683: 0.683  £600 = £409.81

(Some calculators do not use x y or y x– check the instructions)

––––––––– = +495.87(1 + 0.1)2

––––––––– = +450.79(1 + 0.1)3

––––––––– = +409.81(1 + 0.1)4

Exhibit 2.4 Project Alpha, discounted cash flow

better use of existing assets In the past few weeks Mr Brightspark has been looking at someland that the company owns near the centre of Birmingham This is a ten-acre site on whichthe flagship factory of the firm once stood; but that was 30 years ago and the site is nowderelict Mr Brightspark announces to a board meeting that he has three alternative proposalsconcerning the ten-acre site.

Mr Brightspark stands up to speak: Proposal 1 is to spend £5m clearing the site, cleaning it

up, and decontaminating it [The factory that stood on the site was used for chemical tion.] It would then be possible to sell the ten acres to property developers for a sum of £12m

produc-in one year’s time Thus, we will make a profit of £7m over a one-year period

Clearing the site plus decontamination, payable t0 –£5m

This company is valued by the stock market at £100m because our investors are content thatthe rate of return they receive from us is consistent with the going rate for our risk class ofshares; that is, 15 per cent per annum In other words, the opportunity cost for our sharehold-ers of buying shares in this firm is 15 per cent (Hard Decisions is an all-equity firm; no debtcapital has been raised.) The alternative to investing their money with us is to invest it inanother firm with similar risk characteristics yielding 15 per cent per annum Thus, we maytake this opportunity cost of capitalas our minimum required return from any project (of thesame risk) we undertake This idea of opportunity cost can perhaps be better explained by the

use of a diagram (seeExhibit 2.5)

Point 1

Proposal 1: Clean up and sell – Mr Brightspark’s figures

Firm with project funds

Shareholders investfor themselves

Investment opportunity in real assets – tangible

or intangible

Investment opportunity in financial assets, e.g.

shares or bonds

Alternatively handthe money back toshareholders

Invest withinthe firm

Exhibit 2.5 The investment decision: alternative uses of firm’s funds

If we give a return of less than 15 per cent then shareholders will lose out because they canobtain 15 per cent elsewhere and will, thus, suffer an opportunity cost We, as managers ofshareholders’ money, need to use a discount rate of 15 per cent for any project of the samerisk class that we analyse The discount rate is the opportunity cost of investing in the projectrather than the capital markets, for example, buying shares in other firms giving a 15 per centreturn Instead of accepting this project the firm can always give the cash to the shareholdersand let them invest it in financial assets.

I believe I am right in saying that we have received numerous offers for the ten-acre site overthe past year A reasonable estimate of its immediate sale value would be £6m That is, I couldcall up one of the firms keen to get its hands on the site and squeeze out a price of about £6m.This £6m is an opportunity cost of the project, in that it is the value of the best alternativecourse of action Thus, we should add to Mr Brightspark’s £5m of clean-up costs the £6m ofopportunity cost because we are truly sacrificing £11m to put this proposal into operation If

we did not go ahead with Mr Brightspark’s proposal, but sold the site as it is, we could raiseour bank balance by £6m, plus the £5m saved by not paying clean-up costs

Immediate sale value (opportunity cost) £6m

comparing the initial outlay directly with the final cash flow on a simple nominal sum basis.

The £12m is to be received in one year’s time, whereas the £5m is to be handed over to theclean-up firm immediately, and the £6m opportunity cost sacrifice, by not selling the site, isbeing made immediately

If we were to take the £11m initial cost of the project and invest it in financial assets of thesame risk class as this firm, giving a return of 15 per cent, then the value of that investment atthe end of one year would be £12.65m The calculation for this:

F = P (1 + k) where k = the opportunity cost of capital (in this case 15% per year):

11 (1 + 0.15) = £12.65mThis is more than the return promised by Mr Brightspark

Another way of looking at this problem is to calculate the net present valueof the project

We start with the classic formula for net present value:

CF1NPV = CF0+ ––––––––

(1 + k) n

where CF0= cash flow at time zero (t0), and

CF1= cash flow at time one (t1), one year after time zero:

12NPV = –11 + –––––––– = –11 + 10.435 = –0.565m

1 + 0.15

Finally

Proposal 1: Clean up and sell – sacrifice at t0

Point 2

All cash flows are expressed in the common currency of pounds at time zero Thus, everything

is in present value terms When the positives and negatives are netted out we have the netpresent value The decision rules for net present value are:

NPV  0 Accept NPV  0 Reject

Project proposal 1’s negative NPV indicates that a return of less than 15 per cent per annumwill be achieved

An investment proposal’s net present value is derived by discounting the future net cash receipts at a rate which reflects the value of the alternative use of the funds, summing them over the life of the proposal and deducting the initial outlay.

In conclusion, Ladies and Gentlemen, given the choice between:

(a) selling the site immediately, raising £6m and saving £5m of expenditure – a total of £11m,or

(b) developing the site along the lines of Mr Brightspark’s proposal,

I would choose to sell it immediately, because £11m would get a better return elsewhere

The chairman thanks you and asks Mr Brightspark to explain Project proposal 2

Mr Brightspark: Proposal 2 consists of paying £5m immediately for a clean-up Then, over thenext two years, spending another £14m building an office complex Tenants would not befound immediately on completion of the building The office units would be let gradually overthe following three years Finally, when the office complex is fully let, in six years’ time, it

would be sold to an institution, such as a pension fund, for the sum of £40m (seeExhibit 2.6)

Mr Brightspark claims an almost doubling of the money invested (£25m invested over the firsttwo years leads to an inflow of £47m)

Proposal 2: Office complex – Mr Brightspark’s figures

Points in time (yearly intervals) Cash flows (£m) Event

Outflow £25m

Exhibit 2.6 Cash flows for office project

Note: Mr Brightspark has accepted the validity of your argument about the opportunity cost of the alternative ‘project’ of selling the land immediately and has quickly added this –£6m to the figures.

The chairman turns to you and asks: Is this project really so beneficial to our shareholders?You reply: The message rammed home to me by my finance textbook was that the bestmethod of assessing whether a project is shareholder wealth enhancing is to discount all itscash flows at the opportunity cost of capital This will enable a calculation of the net presentvalue of those cash flows.

NPV = CF0+ ––––– + ––––––– + ––––––– + –––––––

1 + k (1 + k)2 (1 + k)3 (1 + k) n

So, given that Mr Brightspark’s figures are true cash flows, I can calculate the NPV of

Proposal 2 – seeExhibit 2.7 Note that we again use a discount rate of 15 per cent, whichimplies that this project is at the same level of risk as Proposal 1 and the average of the exist-ing set of projects of the firm If it is subject to higher risk, an increased rate of return would

be demanded (Chapter 8 discusses the calculation of the required rate of return)

Because the NPV is less than 0, we would serve our shareholders better by selling the site andsaving the money spent on clearing and building and putting that money into financial assetsyielding 15 per cent per annum Shareholders would end up with more in Year 6

The chairman thanks you and asks Mr Brightspark for his third proposal

Mr Brightspark: Proposal 3 involves the use of the site for a factory to manufacture the uct ‘Worldbeater’ We have been producing ‘Worldbeater’ from our Liverpool factory for the

prod-Proposal 3: Worldbeater manufacturing plant

Exhibit 2.7 Office project: discounted cash

AN EXCEL SPREADSHEET VERSION OF THIS CALCULATION IS SHOWN AT

www.pearsoned.co.uk/arnold

past ten years Despite its name, we have confined the selling of it to the UK market I proposethe setting up of a second ‘Worldbeater’ factory that will serve the European market The fig-

ures are as follows (seeExhibit 2.8)

The chairman turns to you and asks your advice

You reply: Worldbeater is a well-established product and has been very successful I amhappy to take the cash flow figures given by Mr Brightspark as the basis for my calculations,which are set out in Exhibit 2.9 Note that the annual cash flow for year 3 of £5m is to bereceived every year thereafter as well as in year 3, and is therefore a ‘perpetuity’ (see page 64for perpetuity calculations)

AN EXCEL SPREADSHEET VERSION OF THIS CALCULATION IS SHOWN AT

Exhibit 2.8 Worldbeater factory cash flow

Note: Revenue is gained in Year 2 from sales but this is exactly offset by the cash flows created by the costs of production and distribution The figures for Year 3 and all subsequent years are net cash flows, that is, cash outflows are subtracted from cash inflows generated by sales.

33.33

(1 + 0.15)2

Exhibit 2.9 Discounted cash flows for Worldbeater

This project gives an NPV that is positive and, therefore, is shareholder wealth enhancing Thethird project provides a rate of return that is greater than 15 per cent per annum It produces areturn of 15 per cent plus a present value of £5.5m Based on these figures I would recom-mend that the board looks into Proposal 3 in more detail.

The chairman thanks you and suggests that this proposal be put to the vote

Mr Brightspark (interrupts): Just a minute, are we not taking a lot on trust here? Ourfinance expert has stated that the way to evaluate these proposals is by using the NPVmethod, but in the firms where I have worked in the past, the internal rate of return (IRR)

method of investment appraisal was used I would like to see how these three proposals shape

up when the IRR calculations are done

The chairman turns to you and asks you to explain the IRR method, and to apply it to thefigures provided by Mr Brightspark

Before continuing this boardroom drama it might be useful at this point to broaden standing of NPV by considering two worked examples

under-Note If these calculations are confusing you, now might be a good time to read the mathematical

tool Appendix 2.1 at the end of this chapter Also try the questions set as ‘Mathematical toolexercises’ Answers are given at the back of the book, in Appendix VI

The perpetuity formula can be used on the assumption that the first payment arises one year from the time at which we are valuing So, if the first inflow arises at time 3 weare valuing the perpetuity as though we are standing at time 2 The objective of this exer-cise is not to convert all cash flows to time 2 values, but rather to time 0 value.Therefore, it is necessary to discount the perpetuity value by two years

Required

Given these cash flows, will this investment provide a 10 per cent return (per annum) over the life of theproject? Assume for simplicity that all cash flows arise on anniversary dates and the project has the samerisk level as the company’s existing set of projects

Second, discount these cash flows to their present value equivalents.

(1.1)2Third, net out the discounted cash flows to give the net present value

–1.0000+0.1818+0.2479+1.4876–––––––

Net present value +0.9173

–––––––

Conclusion

The positive NPV result demonstrates that this project gives not only a return of 10 per cent per annumbut a large surplus above and beyond a 10 per cent per annum return This is an extremely attractive proj-ect: on a £1m investment the surplus generated beyond the opportunity cost of the shareholders (theirtime value of money) is £917,300; thus by accepting this project we would increase shareholder wealth bythis amount

Worked example 2.1 Continued

AN EXCEL SPREADSHEET VERSION OF THIS CALCULATION IS SHOWN AT

Using discount rates of 8 per cent, and then 16 per cent, calculate the NPVs and state which project issuperior Why do you get a different preference depending on the discount rate used?

1 + 0.08 (1 + 0.08)2 (1 + 0.08)3–240,000 + 185,185 + 85,734 +15,877 = £46,796

Project B

20,000 120,000 220,000–240,000 + ––––––– + –––––––––– + –––––––––

1 + 0.08 (1 + 0.08)2 (1 + 0.08)3–240,000 + 18,519 + 102,881 + 174,643 = £56,043Using an 8 per cent discount rate both projects produce positive NPVs and therefore would enhanceshareholder wealth However, Project B is superior because it creates more value than Project A Thus, ifthe accepting of one project excludes the possibility of accepting the other then B is preferred

Using 16 per cent as the discount rate

Project A

200,000 100,000 20,000–240,000 + ––––––– + –––––––– + ––––––

1.16 (1.16)2 (1.16)3–240,000 + 172,414 + 74,316 + 12,813 = + £19,543

Project B

20,000 120,000 220,000–240,000 + –––––– + ––––––– + –––––––

1.16 (1.16)2 (1.16)3–240,000 + 17,241 + 89,180 +140,945 = + £7,366With a 16 per cent discount rate Project A generates more shareholder value and so would be preferred

to Project B This is despite the fact that Project B, in pure undiscounted cash flow terms, produces anadditional £40,000

The different ranking (order of superiority) occurs because Project B has the bulk of its cash flows ring towards the end of the project’s life These large distant cash flows, when discounted at a high discountrate, become relatively small compared with those of Project A, which has its high cash flows discounted byonly one year

occur-Worked example 2.2 Continued

AN EXCEL SPREADSHEET VERSION OF THIS CALCULATION IS SHOWN AT

www.pearsoned.co.uk/arnold

Internal rate of return

We now return to Hard Decisions plc The chairman has asked you to explain internal rate ofreturn (IRR)

You respond: The internal rate of return is a very popular method of project appraisal and

it has much to commend it In particular it takes into account the time value of money I amnot surprised to find that Mr Brightspark has encountered this appraisal technique in his pre-vious employment Basically, what the IRR tells you is the rate of return you will receive byputting your money into a project It describes by how much the cash inflows exceed the cashoutflows on an annualised percentage basis, taking account of the timing of those cash flows.The internal rate of return is the rate of return which equates the present value of futurecash flows with the outlay:

Outlay = Future cash flows discounted at rate r

Thus:

CF1 CF2 CF3 CF n

CF0= ––––– + ––––––– + –––––– … ––––––

1 + r (1 + r)2 (1 +r)3 (1 +r) n

IRR is also referred to as the ‘yield’ of a project

Alternatively, the internal rate of return, r, is the discount rate at which the net present value is zero It is the value for r which makes the following equation hold:

I apologise, Ladies and Gentlemen, if this all sounds like too much jargon Perhaps it would

be helpful if you could see the IRR calculation in action Let’s apply the formula to MrBrightspark’s Proposal 1

Using the second version of the formula, our objective is to find an r which makes the counted inflow at time 1 of £12m plus the initial £11m outflow equal to zero:

dis-CF1

CF0+ ––––– = 0

1 + r

12–11 + ––––– = 0

1 + r The method I would recommend for establishing r is trial and error (assuming we do not have

the relevant computer program available) So, to start with, simply pick an interest rate andplug it into the formula Let’s try 5 per cent:

12–11 + –––––––– = £0.42857m or £428,571

1 + 0.05(You can pick any (reasonable) discount rate to begin with in the trial and error approach.)

A 5 per cent rate is not correct because the discounted cash flows do not total to zero Thesurplus of approximately £0.43m suggests that a higher discount rate will be more suitable.This will reduce the present value of the future cash inflow Let’s try 10 per cent:

12–11 + ––––––– = –0.0909 or –£90,909

1 + 0.1

Proposal 1: Internal rate of return

Again, we have not hit on the correct discount rate Let’s try 9 per cent:

12–11 + –––––––– = 0.009174 or +£9,174

1 + 0.09The last two calculations tell us that the interest rate which causes the discounted future cashflow to equal the initial outflow lies somewhere between 9 per cent and 10 per cent The pre-cise rate can be found through interpolation

First, display all the facts so far established (seeExhibit 2.10)

Exhibit 2.10 illustrates that there is a yield rate (r) that lies between 9 per cent and 10 per cent

which will produce an NPV of zero The way to find that rate is to first find the distancebetween points A and B as a proportion of the entire distance between points A and C

A  B 9,174 – 0–––––– = ––––––––––––––– = 0.0917

A  C 9,174 + 90,909Thus the ? lies at a distance of 0.0917 away from the 9 per cent point

Thus, IRR:

9,174

= 9 + –––––––– (10 – 9) = 9.0917 per cent100,083

To check our result:

12–11 + ––––––––––––– = –11 + 11 = 0

1 + 0.090917

Internal rate of return decision rules

The rules for internal rate of return decisions are:

 If k  r reject If the opportunity cost of capital (k) is greater than the internal rate of return

(r) on a project then the investor is better served by not going ahead with the project and

applying the money to the best alternative use

 If k  r accept Here, the project under consideration produces the same or a higher yield

than investment elsewhere for a similar risk level

The IRR of Proposal 1 is 9.091 per cent, which is below the 15 per cent opportunity cost ofcapital used by Hard Decisions plc for projects of this risk class Therefore, using the IRRmethod as well as the NPV method, this project should be rejected

It might be enlightening to consider the relationship between NPV and IRR Exhibit 2.11

shows what happens to NPV as the discount rate is varied between zero and 10 per cent forProposal 1 At a zero discount rate the £12m received in one year is not discounted at all, sothe NPV of £1m is simply the difference between the two cash flows When the discount rate

is raised to 10 per cent the present value of the year 1 cash flow becomes less than the current

outlay Where the initial outflow equals the discounted future inflows, i.e when NPV is zero,

we can read off the internal rate of return

Net presentvaluePoint

+£9,174A

0B

–£90,909C

Exhibit 2.10 Interpolation for Proposal 1

To calculate the IRR for Proposal 2 we first lay out the cash flows in the discount formula:

–11 + –––––– + ––––––– + ––––––– + ––––––– + ––––––– + ––––––– = 0

(1 + r) (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 (1 + r)6

Then we try alternative discount rates to find a rate, r, that gives a zero NPV:

Try 14 per cent: NPV (approx.) = –£0.043m or –£43,000

At 13 per cent: NPV (approx.) = £932,000Interpolation is required to find an internal rate of return accurate to at least one decimal

place (seeExhibit 2.12)

sharehold-it is important to have only a small gap in trial and error discount rates prior to interpolation

Exhibit 2.12 Interpolation for Proposal 2

AN EXCEL SPREADSHEET VERSION OF THIS CALCULATION IS SHOWN AT

www.pearsoned.co.uk/arnold