Chapter 6

Investment appraisal

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 1
 How to assess the worth
of an investment
• Companies often need to decide between a
number of investment opportunities.

• Methods can be used to help determine the

‘worth’ of an investment.

• Need to consider
– Profit
– Patterns of cash flow
– Risk

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 2
 Example
Table 1
Cash flows for 3 shopping centre
developments

Year Andover Bristol Carlisle

0 -4.0 -4.0 -5.0
1 1.0 1.5 0.0
2 1.0 2.5 0.5
3 1.0 0.5 1.5
4 1.0 0.5 2.0
5 1.0 0.0 3.0

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 3
 Traditional methods
These do not take into account the time value of money
Profit
Calculate and compare overall profit.
Choose C as will give a bigger profit.
Payback
Calculate how long to pay back the original investment.
Choose B as it takes less time to pay back the
original outlay.
NB This method favours projects which generate large
cash flows early.

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 4
 Accounting Rate of Return (ARR)

ARR
This method looks at the ratio of average annual return,
to investment.
ARR = average annual return x 100%
initial capital
For example: average return for A
= (1+1+1+1+1)/5 = 1
ARR = 1/4 x 100% = 25%

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 5
 Continued
Average return for B
= (1.5 + 2.5 + 0.5 + 0.5 + 0.0) / 5 = 1
ARR = 1/4 x 100% = 25%

Average return for C

= (0.0 + 0.5 + 1.5 + 2.0 + 3.0) /5 = 1.4
ARR = 1.4 /5 x 100% = 28%
Choose C
NB There are many different variations on the
formula for ARR
Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 6
 Discounted cash flow techniques

Traditional methods do not take into

account the time value of money.
For example, £1000 now is worth more
than £1000 in one year’s time.
£1000 in one year’s time can be
discounted back to the present, to give its
Net Present Value (NPV)
NPVs for different investments can then
be compared.

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 7
 Net Present Value (NPV)

Calculation of NPV is the converse of

calculating compound interest.
Compound interest formula
n
 r 
P n  P 0 1  
 100 
where P0 is the initial value of investment in
year 0, Pn is the value in year n
NPV formula
Discount
1
P0  P n  n
factor
 r 
1  
 100 
NPV
Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 8
 Calculation of NPV
Example: You will receive £1000 in 3 years’
time. Using 5% discount (or interest) rate, the
NPV of this is
= 1000 x _1___
1.053 Discount
factor
= 1000 x 0.8638
= £863

Thus, £1000 in 3 years’ time at an interest rate

of 5% is worth £863 now.

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 9
 Example
Andover Bristol Carlisle
Year Discount Cash Present Cash Present Cash Present
factor flow value flow value flow value
0 -4.0 -4.0 -5.0
1 0.9259 1.0 0.9259 1.5 1.3889 0.0 0.0
2 0.8573 1.0 0.8573 2.5 2.1435 0.5 0.4287
3 0.7938 1.0 0.7938 0.5 0.3969 1.5 1.1907
4 0.7350 1.0 0.7350 0.5 0.3675 2.0 1.4700
5 0.6806 1.0 0.6806 0.0 0.0 3.0 2.0418
3.9926 4.2968 5.1312

NPV

NPV is found by subtracting the initial investment from

the total present value.
Project A, NPV = 3.9926 - 4 = -£0.0074m
Project B, NPV = 4.2968 - 4 = £0.2968m
Project C, NPV = 5.1312 - 5 = £0.1312m
Choose B
Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 10
 Comparison of NPVs

If NPV is negative – this represents a

loss. Do not invest.
If NPV is positive – this represents a
profit.
Choose the investment with the highest
NPV

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 11
 Internal Rate of Return (IRR)
IRR is the value of r for an NPV of zero.
It is a measure of the rate of return for the project.
It is the value of interest rate which just matches
the return of the investment.
For example, IRR = 7%. This would give the
same return as investing the money at 7%.
If the IRR for a project is less than the prevailing
interest rate, don’t go for it.
Useful to compare IRRs for different projects.
Choose the highest one.

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 12
 Calculation of IRR

This is approximated by linear interpolation. A positive

and negative value of NPV (N1 and N2) must be found,
for different values of r (r1 and r2).
Formula

N 1r2  N 2 r1
IRR 
N1  N 2
Graph
Alternatively a graphical method may be used.

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 13
 Use of formula
N 1r2  N 2 r1
IRR 
N1  N 2
Example: Project A. It has been calculated that a
discount rate of 7.5% gave an NPV of £0.0459m. The
rate of 8% gave NPV £-0.0074m.
IRR = 0.0459 x 8 - (-0.0074) x 7.5
0.0459 - (-0.0074)
= 0.42195 = 7.93%
0.0532

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 14
 Graphical method
Plot of NPVs agaonst Discount Rate for Andover project

0.05

0.04

0.03
NP V (£m )

0.02

0.01

0
7.40% 7.50% 7.60% 7.70% 7.80% 7.90% 8.00% 8.10%

-0.01
Discount Rate

The line cuts the x-axis at 7.93%

This is the IRR

Essential Quantitative Methods 2nd edn © Les Oakshott 2001 Palgrave Publishers Ltd 15