Topic 2 - Investment appraisal techniques

Topic Overview

  • Lecture: AF3603 Financial Management by Dr. Marco Realdon

  • Focus: Investment Appraisal techniques

Essential Reading

  • Main Text: P. Atrill. Financial Management for Decision Makers. Pearson International, (9e, 2019).

  • Key Chapter: Chapter 4

Learning Objectives

  • Cash Flow: Define relevant cash flow and distinguish it from accounting profit.

  • Investment Appraisal: Identify and calculate relevant cash flows

  • ROCE/ARR: Calculate and discuss Return on Capital Employed (ROCE) / Accounting Rate of Return (ARR) to appraise investments.

  • Payback Period: Calculate and discuss the payback period for investment appraisal.

Investment Appraisal Process

  • Context: Investment appraisal is a step in the capital budgeting process.

  • Techniques Covered:

    • ROCE / ARR

    • Payback Period

Appraisal Techniques

  • Types:

    • ROCE/ARR: Evaluates accounting profit.

    • Payback Period (PP): Measures liquidity.

  • Other Techniques:

    • Net Present Value (NPV)

    • Profitability Index (PI)

    • Internal Rate of Return (IRR)

  • Key Differences:

    • Some methods ignore time value of money (e.g., ARR), while others like NPV use discounted cash flows.

ROCE/ARR

  • Definition: Evaluates investment based on accounting profit (revenues - expenses).

  • Calculation:

  • ROCE = Average annual profit before interest and tax / Average capital invested

  • ARR = Average annual profit / Average capital invested

  • Decision Rule: Accept projects with expected ARR greater than prescribed hurdle rate.

ARR Example 1

  • Scenario: Purchase of plant costing $110,000.

  • Cash Flows: Annual inflows of $24,400 for 5 years; scrap value of $10,000 at end.

  • Calculations:

    • Average annual depreciation = ($110,000 - $10,000) / 5 = $20,000

    • Average annual profit = $24,400 - $20,000 = $4,400

    • Average book value = ($110,000 + $10,000) / 2 = $60,000

    • ARR = $4,400 / $60,000 = 7.33%

ARR Example 2

  • Initial Investment: $800,000 with cash inflows over 7 years.

  • Cash Inflows: Totaling $1,750,000 with a salvage value of $100,000 at the project’s end.

  • Calculations:

    • Average annual inflows = $1,750,000 / 7 = $250,000

    • Average annual depreciation = ($800,000 - $100,000) / 7 = $100,000

    • Average annual profit = $250,000 - $100,000 = $150,000

    • Average capital invested = ($800,000 + $100,000) / 2 = $450,000

    • ARR = $150,000 / $450,000 = 33.33%

Initial Investment

  • Components of Initial Capital Cost:

    • Cost of new assets

    • Net Book Value (NBV) of existing assets

    • Working capital investment

    • Capitalised R&D expenditure (amortised against profit)

Advantages and Disadvantages of ARR

  • Advantages:

    • Simplicity of calculation

    • Aligns with other accounting measures

  • Disadvantages:

    • Ignores project duration and cash flow timing

    • Dependent on accounting policies

    • Does not measure value added by investment only profitability

    • Lacks definitive signal for investment decisions

Accounting Profits vs Cash Flows

  • More appropriate to focus on cash flows for investment appraisal due to:

    • Profit non-spendable

    • Subjectivity in profits

    • Cash is essential for dividends

  • Focus on Cash: All appraisal methods, except ARR, prioritize cash flows.

Relevant Cash Flows and Costs

  • Considerations:

    • Future incremental cash inflows/outflows

    • Opportunity costs

    • Ignore sunk costs, committed costs, non-cash revenues/expenses, allocated costs related to the investment

Relevant Costs Example

  • Scenario: New widget production with specific cash flows.

  • Relevancy: Only salary of $15,000 for supervisor is relevant; fixed overheads not incremental.

Payback Method of Appraisal

  • Definition: Time needed for a project to recover initial investment.

  • Key Formula: Payback period = Initial investment / Annual cash flow.

  • Decision Rule: Favor projects with shorter payback periods, indicating lesser risk.

Payback Period Examples

  • Example Calculation: Slideshow section providing payback periods for set cash flows over specified years.

  • Emphasis on quick recovery aiding liquidity and reducing failure risk.

Advantages and Disadvantages of Payback

  • Advantages:

    • Simplicity and ease of understanding

    • Favorable in rapidly changing technology contexts

  • Disadvantages:

    • Ignores returns post-payback

    • Timing of cash flows less considered

    • Subjective and not definitive in investment signaling.