CHAPTER 5

INVESTMENT APPRAISAL METHODS

LECTURER:PROF O.A. ONI
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
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
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.
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
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
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
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
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
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
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
The average return method

• Considers initial cash investment the project

requires
• Compares it to average annual cash flow
generated by project over its lifetime
 n 

  C t  / n
100
AR   
t 1
x
C0 1
Example 5.1
Sizwe Limited is choosing between two investments.
Project A requires initial investment of R25 000;
Project B requires amount of R100 000. The relevant
annual cash inflows for each project are as follows:

Year Project A Project B

1 R5 000 R60 000
2 R10 000 R36 000
3 R15 000 R30 000
4 R20 000 R24 000

The AR for Project A can be determined as follows:

 4 
ARProject A =




t 1
C t  / 4
 100
x
C0 1
5 000  10 000  15 000  2 0 000  / 4 x 100
=
25 000 1
= 50%
The payback period method

• Calculates expected number of years after

which initial investment amount (C0) is
recovered from the project’s net cash flows (C t)
• Aim is to determine how long it will take to
recover initial capital outlay

PBP = Years before full recovery +

Unrecovere d cash flow beginning of the year
Cash flow during the year
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:

10 000
PBPProject A = 2+
15 000
= 2 + 0,67
= 2,67 years
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
Example 5.3
You are required to calculate the DPB for Project A if the cost of capital =
10%.
Year Project A
Cash flow Cash flow
discounted at
10%
1 R 5 000 R 4 545,45
2 R10 000 R 8 264,46
3 R15 000 R11 269,72
4 R20 000 R13 660,27

Project A: Accumulated discounted cash flows after three years =

R24 079,63 (4 545,45 + 8 264,64 + 11 269,72).
Only R920,37 of Year 4’s discounted cash flow required to recover initial
investment.
920,37
DPBProject A = 3 + 13 660,27
= 3 + 0,07
= 3,07 years
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

NPV = PV of expected cash flows − initial investment

n Ct
=
 1  i
t 1
t
 C0
Example 5.4

You are required to calculate the NPV for Project

A if the cost of capital = 10%.
n
Ct
NPVProject A =  1  i 
t 1
t
 C0

5 000 10 000 15 000 20 000

 
= 1,10 1 1,10 2 1,10 3 1,10 4   25 000

5 000 10 000 15 000 20 000

=     25 000
1,10 1,21 1,331 1,4641
= 4 545,46 + 8 264,46 + 11 269,72 + 13 660,27 − 25 000
= R12 739,91
Example 5.4

Using the financial calculator:

Input Function
−25 000 Cf0
5 000 Cf1
10 000 Cf2
15 000 Cf3
20 000 Cf4
10 i

NPV = R12 739,91

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.
IRR can be defined as discount rate that will ensure that:

n Ct
 1  IRR
t 1
t
- C0 = 0
Example 5.5
You are required to calculate the IRR for Project A.
Suppose that the cost of capital = 10%.

Based on the use of a financial calculator, the IRR

is determined as follows:

Input Function
−25 000 Cf0
5 000 Cf1
10 000 Cf2
15 000 Cf3
20 000 Cf4

IRR = 27,27%
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
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
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
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
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
Example 5.8
• Calculating MIRR for Project A:
The profitability index

• Investigates relationship between initial

investment amount and expected pay-off of
project
• Measure project’s profitability relative to each
rand invested
Example 5.9

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

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.
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.
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.
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.
Practice Question Ch 5
Design plus industries is a company involved in the
manufacture of furniture. The company is planning
investing in a new project, the details are as follows:
Project A Project B
Salvage value nil nil
Expected cash flow
Year 0 (100 000) (70 000)
Year 1 30 000 10 000
Year 2 40 000 15 000
Year 3 45 000 48 000
Practice Question Ch 5 cont..d
Design plus uses the straight line method of depreciation for all
fixed assets. The estimated cost of capital is 10%.

Required: Calculate for each project

The payback period (3)
The discounted payback period (5)
The Net present value (5)
The profitability index (4)
The internal rate of return (5)
Which project would be chosen and why? (3)