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Investment Appraisal

a. Introduction. Profit and Cash Flow.


b. Methods of Investment Appraisal:
1. Return on Capital Employed/Accounting Rate of Return (ARR)
2. Payback period.
3. Net Present Value.
4. Internal Rate of Return.
c. Cost of capital.
d. Uncertainty and risk
After studying this chapter you should be able to

Understand the difference between using cash flow and profit in


making investment appraisals

Calculate and interpret the Accounting Rate of Return/Return on


Capital Employed of a project and appreciate its uses and limitations

Calculate and interpret the Payback Period of a project and appreciate


its uses and limitations

Understand the principles of discounting and calculate a projects Net


Present Value and Internal Rate of Return

Evaluate the strengths and weaknesses of Discounted Cash Flow


(DCF) approaches to investment appraisal

Understand which cash flows are relevant and should be included in


a DCF calculation, and which are not

Appreciate the importance of cost of capital in investment appraisal,


and evaluate the relevance of cost of capital calculations

Understand that there is always uncertainty and risk in investment


appraisal and appreciate various ways of dealing with this
1. Introduction
Financial accounting is concerned with reporting to shareholders on the success of
management in achieving what shareholders want. It may be assumed that the objective
is to maximise shareholder value, and this value depends on the future profits and cash
flows that a company is expected to generate. Actual results are reported regularly and
can be compared with expectations. There is always the risk that expectations are
exaggerated; that actual results will disappoint; and that companies share prices will
reflect this. A companys share price will suffer if they are known to produce fine
sounding plans which fail to deliver the promised results. Companies which plan
effectively how their shareholders funds are to be utilised in financing fixed assets and
current assets are most likely to maximise shareholder value. To achieve this they should
use proper investment appraisal techniques to ensure that shareholders funds are used
only to finance activities which will produce an adequate return. They must allow for risk
and uncertainty; strike a balance between high risk projects which seem to promise a high

return, and safer projects producing a lower return; and they should try to manage
investors expectations. They should also be aware of a companys cost of capital. A
company with a low cost of capital should be able to find many investment opportunities
which will generate substantial returns. A company with a cost of capital of 10% per
annum will find that projects yielding 12% per annum are attractive. A company with a
higher cost of capital (e.g. 15%) will find that fewer projects are attractive, and it is more
difficult to generate good returns for shareholders.
Investment
Individuals and companies invest money in the short term with the idea of getting back
more, in the longer term, than the initial cost of the investment. This is a straightforward
enough idea, but there are a number of issues that have to be addressed if we are to
appraise our investments properly.
1. How much do you need to get back to justify the amount invested?
2. How quickly does the money need to come back? If you can invest 1 today, and
get back 10 after 50 years, the return might look brilliant, but the timing is
terrible!
3. Risk. How sure are you that we will get back the amount suggested? There are
various ways of allowing for risk and uncertainty in investment appraisal, but
there is still a need for judgement, and to recognise that some uncertainty is
inevitable in most businesses and projects.
Before considering the various approaches that are used in investment appraisal, it is
necessary to be clear whether the returns that we expect an investment to make will be
measured as
(a) Profit; or
(b) Cash flow.
Profit and Cash Flow
Profits are measured in accordance with all the usual rules that apply to Income
Statements. Profit, by definition, should always mean after depreciation has been
charged as an expense. But as depreciation is not paid (no cash goes out of the
business), the annual cash flows from a project are usually much higher than the annual
profits. This is clearly illustrated by Elizabeths proposed project below
Elizabeth was made redundant recently and was given a severance payment of
55,000 which she uses to buy a special purpose delivery vehicle, and she
employs a driver. Each year she receives money from customers for delivering
goods; each year she pays all of her expenses in cash (wages, petrol, repairs,
insurance etc); and each year she pockets what is left: this amounts to 15,500 a
year, which she reckons is a pretty good return on her initial capital of 55,000.

Unfortunately, Elizabeth forgot to allow for depreciation. After five years the
vehicle is worn out, and she manages to sell it for 5,000. She should have
allowed 10,000 a year for depreciation.
In terms of cash flow, Elizabeth made 15,500 a year. In terms of profit she made
only 5,500 a year.
In this simple business we can see that
PROFIT
+
DEPRECIATION
5,500
+
10,000

=
=

CASH FLOW
15,500

2. Methods of Investment Appraisal


2.1 Return on Capital Employed/Accounting rate of return
One way of appraising an investment is to calculate its return on capital employed, also
known as its return on investment (ARR). This assesses a project on the basis of future
profits, which means that depreciation is charged as an expense (or deducted from cash
flows), before calculating the return.
It can be expressed as follows:
Average Annual Profits
Amount Initially Invested

100

The calculation of Elizabeths return may be calculated as follows


5,500
x
100
=
10%
55,000
1
Using ARR is an appealing approach to investment appraisal in a number of ways. It is
in many ways consistent with conventional financial accounting. If the performance of a
company as a whole is judged on the basis of profitability, using Return on Capital
Employed, then it makes sense to judge the performance of each part of the business
using a return on capital employed. If a company wants to achieve a return on capital
employed of, say 15% per annum, they can be sure of achieving this if every part of the
business, and every project, achieves this return.
But calculating the return on the initial amount invested is likely to understate the returns
that a company subsequently achieves. If a project has no scrap value, i.e. the capital
employed at the end of its life is zero, then the average capital employed is exactly half of
the initial capital employed. The return on average capital employed will be double the
return on initial capital employed.
Illustration
The Trudo machine will cost 50,000, and will have a four year life with zero
scrap value at the end of five years. It will generate cash flows as follows
Year 1
10,000
Year 2
16,000

Year 3
Year 4
Total

20,000
20,000
66,000

To calculate average annual profit it is necessary to calculate average annual depreciation


charges.
The total amount to be written off, whatever method is used, is 50,000. The total
cash flows are 66,000. The total profits must therefore be 16,000. Averaged over four
years, the profits are 4,000 a year.
OR
We could work out average annual profits as follows
Average annual cash flows 66,000 4 =
16,500
Average annual depreciation 50,000 4 =
12,500
4,000
The return on initial amount of capital employed is
4,000
=
8%
50,000
The return on the average capital employed is
4,000
25,000

16%

If we think of Elizabeths project, the amount of capital invested in the project will reduce
each year as depreciation is charged. The amount invested is 55,000, initially. After one
years depreciation the amount of the investment will be reduced to 45,000. After two
years it will be 35,000. After three years it will be 25,000. After four years it will be
15,000. At the end of five years it will be down to 5,000. We can say that the average
amount invested in the project is the amount half way through its life, i.e. after 2 years.
The average amount invested is 30,000, and is calculated as follows:
Average Capital
Employed

30,000

Initial Capital Employed + Value at End


2
55,000 + 5,000
2

Return on average capital employed =

5,500
30,000

Elizabeth
Return on Initial Capital Employed
Return on Average Capital Employed

10%
18.3%

18.3%

In deciding whether or not a proposed project is acceptable it is probably better to use the
average amount invested, rather than the initial amount invested. This is a less prudent
approach: as we saw above, using the average amount invested shows a higher return.
The Trudo Machine should not be rejected on the grounds that its ARR is only 8%.
And Elizabeth should not reject what might be a perfectly good project on the basis that it
achieves a return on initial investment of only 10%.
It is difficult to relate the ARR of a project to the companys cost of capital. It would be
appealing to say that if a companys cost of capital is, say 12%, any project with an ARR
of greater than 12% should be accepted because it would increase the companys average
return on capital employed, and so increase the value of the company. There are several
important reasons why such a neat rule of thumb could lead to some very bad decisions.
1. There are many different ways of calculating ARR. As we have seen, choosing to
use the average amount of capital employed in a project produces a very different
answer from using the initial amount of capital employed. If the ARR achieved
by a project is to be compared with the companys cost of capital, then it is
incorrect to treat interest as an expense in calculating the ARR. But some users
and advocates of ARR do strange things with interest; some revalue assets and do
strange things with depreciation. Great care is needed in using ARR, to ensure
that like is compared with like.
2. ARR ignores the timing of future cash flows and profits. It simply averages
profits over the life of the project. It assumes that making 10,000 profit next
year is the same as making 10,000 profit after two years, or any number of
years. Shareholders want to see results within a relatively short period of time.
The problem can be illustrated by comparing two projects, one of which generates
cash flows and profits more quickly, and one which generates more profit and
cash flow, but over a longer period.
In the Illustration below the Jaggy project makes only 40 profit, but the Jaggy
project makes 45 profit. The ARR is therefore higher for the Lardy project than
it is for the Jaggy project. But the Jaggy project makes the money much more
quickly, and might be a better project.

Year
0
1
2
3
4
5
Total

Jaggy Project
Cash
Depn
Flow
(100)
45
20
40
20
35
20
10
20
10
20
140
100
Jaggy

Profit
25
20
15
(10)
(10)
40

Lardy Project
Cash
Depn
Flow
(100)
10
20
20
20
30
20
40
20
45
20
145
100
Lardy

Prof
it
(10)
10
20
25
45

Average annual profits 40 5 = 8


Average capital employed
50
Return on average investment
16%

45 5 = 9
50
18%

In deciding between Jaggy and Lardy we need a method of investment appraisal


which takes into account not just the amounts of cash flows or projects that a project
generates, but also the timing of them. It is better to get our money back quickly than
slowly.
In both of these projects there are years when no profit is being made. But as long as
a project is generating positive net cash flows it is usually worth continuing with it,
even if it makes no profit after depreciation has been charged.
3. Use of ARR can also be criticised because it depends on all of the usual
assumptions in financial accounting. ARR, and attempts to make consistent and
comparable decisions, are limited by the extent to which there are variations in
accounting policies, the use of creative accounting, and any questionable
assumptions in measuring profits or capital employed.
Accounting Rate of Return, or Return on Capital Employed, is the only method of
investment appraisal which uses profit figures as opposed to cash flow figures. The
Return means profit, and in calculating profit, depreciation has to be deducted.
Other methods of investment appraisal are based on cash flows, not profit. Depreciation
is not deducted from cash flows when calculating Payback Period, or Discounted Cash
Flow.
2.2 Payback Period
The easiest way to deal with the timing of future returns is to ask the simple question:
how quickly do we get our money back? A project which gives you your money back in
three years is likely to be better than one which takes 5 years to give you your money
back.
A quick look at Jaggy and Lardy shows that both require an initial investment of 100,
but Jaggy pays it back much more quickly. After only two years Jaggy has already
produced cash flows of 95, and will have paid back the full 100 just a couple of months
into the third year. But Lardy is much slower: it has not repaid the full 100 until the
end of the fourth year.
As a method of investment appraisal Payback Period has a number of clear advantages:
1. It is easy to calculate, easy to understand, and easy to present.
2. It is based on cash flow, not profit, and so is seen as being more objective with
less dependence on questionable accounting assumptions.
3. It emphasises the need for projects to repay quickly, which is important,
especially if we take into account the cost of the funds invested in a project.

4. Projects with shorter payback periods are likely to be less risky than projects
which take longer to pay back the initial investment. In forecasting the results of
a project we can be much more certain about costs and revenues in the first few
years than we can be about what might happen five or ten years into the future.
If we combine ARR with payback period we might make reasonable investment
decisions. ARR takes into account all the profits that a project makes throughout its life;
it ignores timing. Payback period considers only the length of time it takes for cash flows
to amount to the amount of the original investment; it ignores cash flows after the
payback period.
Using only the payback period as a method of investment appraisal could lead to really
silly decisions, as the following example shows.
Rudi pays 100,000 for a five year lease on an office building that will generate
cash flows of 50,000 a year for five years, and then have no residual value.
Duri pays 100,000 for the freehold of some shop premises which will bring him
cash flows of 12,500 a year for many years into the future. He assumes that he
will keep it for five years, and then sell it for 100,000.
Rudis payback period is two years.
Duris payback period is five years.
If the two investments were compared solely on the basis of payback period, Rudis is
clearly the better investment. But in this case it is worth waiting longer to get a lot more
money back. It is clear that Duris project is the better one.
The disadvantages of using the payback period are
1. It ignores cash flows after the initial amount has been paid back.
2. It does not consider the timing of cash flows in a systematic way.
Looking at the payback period may be a convenient way of screening out projects that
take far too long to pay back, but it does not indicate whether or not a project is
worthwhile. A project must produce enough total cash flows, as well as doing so within
a reasonable period.
It is also necessary to consider the timing of cash flows more precisely. This is done by
allowing for the fact that any delay in receiving money has a cost, which is like the cost
of interest for the period of the delay.
Methods of investment appraisal should take into account the amounts and timing of
future cash flows. This is best done using Discounted Cash Flow.

2.3 Discounted Cash Flow: Net Present Value


It is obviously better to receive 100 today than to receive 100 in one years time. We
might prefer to receive the 100 today because we fear that it might not be on offer in a
years time there is always an element of risk. We might prefer to receive the 100
today because we fear that inflation will erode its value: in one years time it might be
able to buy less than today. But even if we assume that there is no risk, and that there is
no inflation, we would still prefer to receive 100 today rather than wait a year for it. If
we receive 100 today we can invest it, and after a year it might be worth 104, or more,
depending how successful the investment is. In waiting for the money we lose the
opportunity of using it to generate a return even if the return is only 4% interest.
We could say that if we have to wait to receive money, we need to receive more to
compensate for the waiting, and the fact that we were unable to make use of the money
whilst waiting. Companies ought to be able to invest money more profitably than
putting it in a bank to earn 4%. People invest in companies for that very reason:
companies should have better investment opportunities than individuals.
If we have the choice of receiving 100 today, or 120 in a years time, the decision is a
little more difficult, but it is always worth waiting to receive money, if we are going to
receive extra money to compensate for the delay. Indeed, that is the whole nature of
investment: we pay out money in the short term in order to receive more back in the
future. If a companys cost of capital1 is 10%, it is well worth waiting a year to receive
120 than having only 100 today. .
If we assume that a companys cost of capital is 10% per annum, then we can calculate
the cost of waiting to receive money. If we know the cost of an investment, and we know
what cash flows it will generate in the future, and when, then it is a matter of arithmetic
to determine whether or not an investment is worthwhile. We apply a 10% interest rate to
discount future cash flows. If we have to wait one year to receive 100, that is the
equivalent of receiving 90.91 today. This is because, if we received 90.91 today, we
could invest it at 10% for a year, and then it would give us exactly 100 in a years time.
If we have to wait 2 years for it, then the present value is 82.64. If we have to wait 3
years for it, then the net present value is 75.13. If we have to wait 4 years for it, then the
net present value is 68.30 and so on.
It is easy to check this. If we had 68.30 today, and it earned 10% a year interest, at the
end of 4 years it would amount to 68.30 x 1.1 x 1.1 x 1.1 x 1.1, which comes to 100.
A companys opportunity cost of capital might be 10% because they have opportunities
to invest in projects which give a positive net present value when discounted at 10%. If
they have 100 today, they expect it to become 110 after one year. If this is the case, we
can make the following statements:
1

The calculation of a companys cost of capital is not a part of the Managerial Accounting module syllabus.
Modern Finance students will cover the calculation. Simply put the Cost of Capital is the weighted average
cost of debt and shareholders funds.

1. Receiving 100 today is equivalent to receiving 110 after one year.


2. Waiting one year to receive 110 is equivalent to receiving 100 today.
3. Waiting one year to receive 100 is equivalent to receiving 90.91 today. This is
because if we have 90.91 today, and we invest it at 10%, we will make 9.09
interest in one year which will give us (90.91 + 9.09 = ) 100 after one year.
4. Waiting two years to receive 100 is equivalent to receiving 82.64 today. This is
because if we have 82.64 today, and we invest it at 10%, we will make 8.26
interest in the first year, giving us (82.64 + 8.26 =) about 90.902, which, after
another year at 10% will give us 100.
5. We can look at any future cash flows and discount them in this way.
This is all very important in investment appraisal. The nature of investment is that we
pay out money now, and expect to get returns in the future. To start with we need to work
out what those future returns are likely to be, and to assess the timing of them. Then we
need to discount the future cash flows to take into account the cost of having to wait for
them. We will continue to assume that the cost is 10% per annum, but equivalent
calculations can be made for any discount rate.
We have already established that receiving 100 after
1 year is equivalent to receiving
90.91 today
2 years is equivalent to receiving
82.64 today
We can continue as follows:
3 years
4 years

75.13
68.30 and so on

The easiest way of finding these discount factors is to look them up in a Present Value
table, where they appear as follows:
Year Present Value
0
1.0
1
0.9091
2
0.8264
3
0.7513
4
0.6830
5
0.6209
6
0.5645
7
0.5132
8
0.4665
9
0.4241
10
0.3855
Most discount tables round up to 3 decimal places.
We can then apply these discount factors to the cash flows of a particular project to find
the present value of the future cash flows, assuming a cost of capital of 10%. This is
applied to Jaggy and Lardy as follows:
2

There are usually some rounding errors with discounting, so the figures may not be exact.

Jaggy Project

Lardy Project

Yea Cash
Discount
Present
Cash
Discount
Present
r
Flow
Factor
Value
Flow
Factor
Value
0
(100)
inflows
(100)
inflows
After
1
45
0.9091
40.91
10
0.9091
9.09
2
40
0.8264
33.06
20
0.8264
16.53
3
35
0.7513
26.30
30
0.7513
22.54
4
10
0.6830
6.83
40
0.6830
27.32
5
10
0.6209
6.21
45
0.6209
27.94
Tota 140
PV of
145
PV of
l
inflows = 113.31
inflows = 103.42
reducing all future cash flows using a 10% discount factor, we can see that the total Net
Present Value each of the projects is as follows:
Jaggy (113.31 - 100 =)
Lardy (103.42 - 100 =)

13.31
3.42

Although Lardy brings in more money than Jaggy, it is not worth waiting for. Jaggy
earns enough to cover the cost of capital, and an extra 13.31. Lardy does cover its cost
of capital, and have a positive net present value. But Jaggy has a greater net present
value, and so is the better investment.
Discount rates can be applied in this way to most projects. Once the discount rate, or cost
of capital has been decided, the best project is the one that produces the highest net
present value.
When we have identified all of the future cash flows, and then allowed for the delay in
receiving them by discounting them, we know the net present value of the future cash
inflows. This can be compared with the amount of the initial outflow to see if the project
has earned us the 10% which we specified as the cost of capital. Investment decisions
should be based on choosing those projects which give the maximum cash flows, after
applying the appropriate discount rate. This is called the net present value.
2.4 Discounted Cash Flow: Internal Rate of Return
With the Net Present Value approach to investment appraisal we need to select a discount
rate; then the net present value of the project is calculated. With Jaggy, the NPV was
13.31. With Lardy the NPV was 3.42. The answer will always be a sum of money (it
could happen to be zero).
If we do not know what discount rate to use, we could put the question the other way
around: what discount rate would make future cash flows exactly equal to the amount of

10

the initial investment? In other words, at what discount rate does the project break even,
or give a zero net present value?
With the Internal Rate of Return we do not assume a discount rate. Instead we try to find
a discount rate at which the net present value of the project is zero. The answer will
always be a percentage. A quick glance at Jaggy and Lardy suggests that the IRR of
Jaggy is well above 10%. As Lardy has a much smaller NPV its IRR is likely to be not
much above 10%. In the following calculations 20% is chosen as a guess for Jaggy, and
15% for Lardy.

Year Cash
Flow
0
1
2
3
4
5
Tota
l

(100)
45
40
35
10
10
140

Jaggy Project
Discount
Present
Factor
Value
20%
0.8333
0.6944
0.5787
0.4823
0.4019

Lardy Project
Cash
Discount
Flow
Factor
15%
(100)
10
0.8696
20
0.7561
30
0.6575
40
0.5718
45
0.4972
145

37.50
27.78
20.25
4.82
4.02
94.37

Present
Value
8.70
15.12
19.72
22.87
22.37
88.78

When the cash flows of Jaggy and Lardy are discounted using higher discount rates we
can see that the totals amount to less than the 100 originally invested. Comparing these
results with those shown using a 10% discount rate we can say that
Jaggy earns more than 10% : it has a positive NPV of 13.31 when discounted at
10%
Jaggy earns less than 20% : it has a negative NPV of (100 - 94.37 =) 5.63
when discounted at 20%
Jaggys IRR is between 10% and 20%; but it is closer to 20%
Lardy earns more than 10% : it has a positive NPV of 3.62 when discounted at
10%
Lardy earns less than 15%: it has a negative NPV of (100 - 88.78 =) 11.22
when discounted at 15%
Lardys IRR is between 10% and 15%; but it is closer to 10%
A better estimate of IRR can be made using interpolation. See the formula in the lecture
notes.
We know that Jaggy's IRR is between 10% and 20%. It is 10% plus a part of 10%.
IRR =
10% +
13.31____
x 10%
(13.31 + 5.63)

11

10%

17%

0.7 x 10%

We know that Lardys IRR is between 10% and 15%. It is 10% plus a part of 5%
IRR =
10% +
3.62____
x 5%
(3.62 + 11.12)
=

10%

11.2%

0.24 x 5%

We can now compare the two investments, Jaggy and Lardy, using different approaches
to investment appraisal.
Jaggy
Lardy
Return on Average Investment
16%
18%
Payback Period
2.14 years
4 years
Net Present Value at 10%
13.31
3.62
Internal Rate of Return
17%
11.2%
Jaggy is clearly the better project. Lardy showed a better Return on Investment because it
produces slightly more profits. But because Jaggy produces cash flows more quickly it
shows a shorter payback period, and it is better using DCF.
Advantages of using Internal Rate of Return are
1. It deals properly with the timing of all cash flows
2. Seeing an answer as a percentage appears to be easy to understand and can be
compared with a companys cost of capital
3. It is difficult to know what a companys cost of capital is, and so what discount
rate should be used to calculate NPV. Using IRR sidesteps this. A company
could simply rank all projects according to the IRR that each achieves; it would
select the projects with the highest IRRs, and reject those with the lowest.
Assuming that the company has only limited funds for investment, those funds
would be allocated to the projects which have the highest IRR.
The main disadvantages of using Internal Rate of Return are
1. It involves more calculations than other methods; and
2. It is technically flawed and can lead to incorrect decisions. This is particularly
true where there are irregular patterns of cash flows (perhaps with inflows coming
before outflows), and high discount rates.
A variety of different techniques for investment appraisal may be used. Sometimes the
use of one technique rather than another can lead to a different, and perhaps a poor,

12

investment decision. The best approach is to use DCF to calculate the NPV. In order to do
this it is necessary to know what discount rate to use, or the cost of capital.
Which cash flows to include
It is easy to get lost in the technicalities and complications of DCF and overlook the fact
that the calculations can be no better than the basic data on which they are based.
Estimates have to be made of the cost of the project, of the future cash inflows and
outflows that it will generate, and of the cost of capital, and there is always an element of
risk and uncertainty.
The appraisal should take into account all cash flows that would result from the project
being undertaken, and exclude all cash flows that would arise whether or not the project
is undertaken. There are a number of problem areas, including the following as shown
below. It is important not only to have the best estimates of the amounts of the cash
flows, but also to be clear about the timing of them.
1. Working capital. Where a project involves expansion, there is usually a requirement
for additional working capital (financing stocks and debtors) at the beginning, which is
treated as a cash outflow. It is usually assumed that at the end of the projects life the
additional working capital will no longer be required, and so becomes a cash inflow.
2. Installation. Where a new piece of equipment is being bought, the cash outflow for it
should include any payments for installation and setting it up.
3. Scrap values. If a new machine is being bought there is often a cash inflow from the
sale of the old machine. If this scrapping is a direct result of buying the new machine,
then the cash inflow from the scrap value should be included in the appraisal.
When the new machine comes to the end of its life, perhaps after 5 or 10 years, we
usually assume that there will be a cash inflow from selling it.
4. Taxation. If a new project is going to make more money for the company (that is
usually the intention), more corporation tax will be payable on the profits, and the
appraisal should include these additional payments. They usually take place in the year
after the profit has been earned. The tax computations can be rather complicated. The
Inland Revenue allows profits to be reduced for tax purposes by substantial allowances
for depreciation (usually more generous) than the amounts that the company charges in
their financial accounts). There may also be additional payments in respect of any profit
on sale of the old machinery; or a reduction in payments if there is a loss.
5. Relevant costs. Some costs will be incurred, and the payments made, whether or not
the project is undertaken. A project may be charged its share of fixed overheads (such as
the costs of providing a factory and its administration), but as those costs will be incurred
whether or not the project is undertaken, the cash flows for fixed overheads are usually
excluded.
6. Sunk costs. There are often significant payments for market research and feasibility
studies which are undertaken before a decision is made on whether or not to go ahead.
As those costs have already been incurred or paid (they are sunk), they are irrelevant in
deciding whether or not to go ahead, and should not be included in the appraisal.
7. Opportunity costs. The cost of using an asset for a particular project is often the
opportunity cost and the best alternative use.

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Cost of Capital
Some organisations establish a cut off cost of capital figure almost arbitrarily. Any
project which gives a positive net present value when discounted at, say, 10% is
acceptable. One advantage of this is that everyone knows where they are, and which
projects are going to be acceptable, and which are not. In the unlikely event that a
company has unlimited funds available at a cost of 10%, then the more projects they take
on, provided they clear the hurdle rate of 10%, the better.
If the amount of finance available is limited, the company chooses those projects which
give the greatest net present value when discounted at 10%.
One way of establishing the cost of capital is to look at the opportunity cost of capital.
If there are limited funds available, and more than enough projects that show a net
present value when discounted at, say, 14%, then the cut off rate for projects should be
14%. No projects should be undertaken unless they show a positive net present value
when discounted at 14%. If there are plenty of projects that can do better than 17%, then
the company should undertake only those projects which show a positive net present
value at 17%. There is no point in tying up limited funds on projects that achieve only,
say 11%, if there is the opportunity to invest in projects that achieve 14% or more.
Shareholders are not likely to be impressed when companies start investing in projects
that have lower returns than previously. If management are trying to maximise
shareholder wealth, they must aim to increase profitability and cash flows, and so
(hopefully) share prices. They should not undertake projects which are likely to lower
the companys returns, and share price. When companies cannot find sufficiently
profitable opportunities for investing funds that they have available, they should return
those funds to shareholders as dividends, or use them to buy up the companys shares.
There are plenty of examples of companies that have invested surplus funds unwisely,
and so have reduced the value of the company.
Most companies have some idea of a hurdle rate which an investment should achieve,
otherwise the investment will be rejected. The hurdle rate should also be the companys
opportunity cost of capital: they should not invest in a Lardy if that would mean losing
the opportunity to invest in a Jaggy.
In practice it is usually difficult to know for sure what cash flows an investment will
produce, how many years the return will continue for, and what its value will be, if any, at
the end if indeed the proposal has an end in mind. Given these uncertainties, any
sophisticated attempts to calculate a companys cost of capital may be a waste of time
and effort. It is probably better to put the effort into forecasting the project itself, and
evaluating alternative scenarios, than trying to pretend that we can guess what discount
rate is required to meet shareholders expectations.
Most companies prepare some sort of business plan, perhaps looking 5 10 years into the
future. Often, particularly with smaller businesses, these are prepared mainly for their

14

bankers, or others who supply funds. If the bank is going to charge, say, 10% per annum
interest, this is probably a reasonable approximation of a companys cost of capital. If
budding entrepreneurs decide to accept all projects with a positive net present value when
discounted at 10%, and reject those that do not, they probably wont go far wrong. Their
hurdle rate would be the rate of interest to be charged3.
It is important that a company has a sensible hurdle discount rate for investment
appraisal. If it is set too low, perhaps at 7%, then the company is likely to invest in
projects that barely earn their keep; that disappoint the owners of the business; and that
result in the value of the business falling.
If the hurdle rate is set too high, perhaps at 22%, then the company is likely to reject
projects that more than earn their keep. If projects which earn a good return are rejected,
then the business loses opportunities to increase its value.
Companies are usually financed partly by borrowing, and partly by shareholders funds.
At first sight it is not difficult to establish the cost of borrowing: the interest rate on
borrowings is usually specified. The cost of shareholders funds is more difficult. As
there is no requirement for companies to pay dividends on ordinary shares, we might be
tempted to think that shareholders funds have no real cost. They are free, and provided
the company makes some profit, that is OK. But directors who do not meet
shareholders expectations in terms of profit will probably soon find themselves out of a
job. Low profits lead to low share prices; low share prices invite takeover bids; and
when another company acquires a company that is seen to be failing, they will soon get
rid of the previous managers.
The cost of ordinary shareholders funds depends on market expectations. The company
should aim to invest in ways which increase the value of the company, not in ways which
reduce the value of the company. Attempts to identify a companys cost of capital are
attempts to identify the discount rate that projects must achieve in order to at least
maintain the value of the company. There are widely used methods of indicating the cost
of capital for a company that is listed on the stock market. For unlisted companies,
comparisons can be made with listed companies, and common sense suggests a discount
rate of between 10% and 15% would usually be a reasonable approximation.

Conclusion
In theory managers use investment appraisal techniques to ensure that a companys funds
are used in ways which maximise shareholders wealth. In practice managers may have
their own agendas, favouring particular projects, seeking to impress their superiors,
enhancing their reputation, increasing their personal remuneration packages, and getting
3

After allowing for taxation, the cost of interest would be less; but the cost of shareholders funds would be
more; so 10% would be a reasonable approximation. A higher discount rate, up to say 15%, could be used
for more risky project.

15

promotion by claiming credit for all that goes well, and blaming others for all that goes
badly. It is easy to gain approval for a pet project by producing forecasts and appraisals
which meet the companys criteria and show it as being viable. It is important that
companies have post investment appraisal procedures in place that check if actual
results are in line with the figures that were included in the appraisal which the company
approved. Successful managers will have done some, or all, of the following
1. Made sure that actual results are in line with the original appraisals.
2. Been promoted and transferred so that they are no longer around to take the
blame.
3. Kept a careful record of all the forecasts that made up the appraisal, and made
sure that someone else is responsible for each element that made up the total
appraisal. If the project does not come up to expectations, it is Bills fault because
the sales forecasts were wrong; or Janes fault because she underestimated the
original cost; or Jos fault because actual costs were way out of line.
Successful investment projects are the key to the financial success of a company, and to
maximising shareholder value. Management cannot avoid the results of their investment
activities being assessed by the outside world through their published financial
statements. For individual managers, taking credit for successful investment projects is
important in success. All managers need to understand investment appraisals if they are
to be the ones who take the credit, and not the ones who end up taking the blame. Good
managers ensure that decisions are taken on the basis of information that is as honest as
possible, with risks and uncertainties specified and taken into account. Good decisions
are taken by responsible groups of managers who understand the limitations of the data,
and of the techniques used for appraising the data.
Review of key points

The ARR of a project is calculated using profits, not cash flow, and is
comparable with the return on capital employed for the company as a
whole
The Payback Period is calculated using cash flows, not profits, and
tells us how quickly a project is likely to pay for itself
To improve the advice provided by the payback period method it is
useful to use the cost of capital to discount future cash flows
(Discounted Payback)
DCF properly allows for the timing of cash flows
The Net Present Value method of DCF is the preferred method of
investment appraisal
It is necessary to know the companys cost of capital to use BPV
DCF calculations can be no better than the underlying data which are
based on estimates, and there is always some risk and uncertainty

APPENDIX
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1. Return on capital employed


If a company has a return on capital employed of, say, 15%, then we can assume that
shareholders expect that this rate of return will continue in the future; and if the company
fails to achieve this, the share price is likely to fall. This does not, however, mean that
the companys cost of capital for DCF purposes is 15%. If the company rejected all
projects that did not show a net present value when discounted at 15%, they might be
rejecting good projects that would increase the value of the company. Return on capital
employed is based on profits, not cash flows; and the calculation ignores timing. There
are also different ways of calculating return on capital employed. If we are going to
compare ROCE for the company as a whole with ARR for particular projects, we should
look at the return on the average amount of capital employed over a projects life, not the
return on the initial amount of capital invested in the project4.
A company which accepts all projects that show a positive net present value when
discounted at 12%, might achieve a return on capital employed of 15%. It would be a
mistake to assume a 15% cost of capital for DCF purposes; and it would be a mistake to
reject all projects which failed to show positive net present value when discounted at
15%.
It could also be the other way round, particularly with projects that are very profitable,
but which take a long time to earn the profits. A company might be tempted to invest in
projects which show a return on average capital employed of more than 15%. But if those
projects are too slow to generate positive cash flows, they might fail a 12% cost of capital
hurdle.
There is no clear relationship between a companys return on capital employed and
their cost of capital to be used for DCF.

2.Uncertainty and Risk Use of Probabilities


All investment is based on assumptions about the future and there is usually some
uncertainty about our forecasts, and a degree of risk. There are some risk free
investments, such as lending money to the government by buying gilts. But managers
are more likely to be involved in evaluating projects where there is some uncertainty and
risk in estimating:

T his is because looking at the company as a whole, on average, projects are likely to be half way through
their lives

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1. The initial cost of the project. With major projects the initial capital expenditure
often turns out to be much higher than was originally planned.
2. The cash inflows that the project will generate. Forecasts may prove to be much
too high, or much too low.
3. The cash outflows, including costs, that will be involved.
4. The timing. A project may take longer to be completed and to generate cash flows
than was anticipated. And it is difficult to be sure how long a project will last. It
is easy to assume a five year life, but difficult to know how long it will really
continue.
There are various ways of dealing with risk and uncertainty, all of which involve a quite a
bit of subjectivity, but which help to give some credibility to forecasts and appraisals.
One approach is to use a higher discount rate for projects which are seen as involving
more risk than others. Such an approach may be theoretically sound; the problem is
knowing how much extra risk there is, and by how much the discount rate should be
increased.
A second approach, where there are several possible outcomes, is to apply probability
theory to arrive at an expected value. For example, if there is a 20% chance that a cash
flow will be 10,000, a 45% chance that it will be 20,000, and a 35% chance that it will
be 30,000, the expected cash flow can be calculated as follows:
20% x 10,000 = 2,000
45% x 20,000 = 9,000
35% x 30,000 = 10,500
Expected cash flow
21,500
The actual cash flow for a particular project is unlikely to be the expected figure
calculated in this way. But if probabilities can be applied in this way to a number of
different projects, on average the actual results are likely to be in line with what is
expected. The problem is, of course, knowing what the probability is for any particular
outcome.
A third approach is to recognise that a range of different outcomes is possible, and to
produce one appraisal based on rather pessimistic assumptions, one based on rather
optimistic assumptions, and one realistic appraisal between these two extremes. This
may be attractive in terms of saying (a) this is the worst that is likely to happen; this is the
downside risk; (b) this is what is most likely to happen; and (c) this is the best that is
likely to happen. If (a) looks pretty dreadful, then a pretty good (c) is likely to be needed
to make the risk look worthwhile. This may give a useful feel for a project, and
provide a basis for considering other likely outcomes. It may not be too difficult to get
agreement on a range of likely outcomes, which can help to get decisions made. But it is
all, of course, very subjective. There is no way of determining how dreadful the
pessimistic assumptions should be, or how brilliant the optimistic assumptions should be.

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A fourth approach is to use sensitivity analysis to consider a wide range of different


possible outcomes. The appraisal can be done again and again, using different
assumptions, to see how sensitive it is to particular changes. It may be unsure whether a
project will last for five years, or ten years, or somewhere in between. Sensitivity analysis
might show that it is brilliant if it lasts for ten years, but it is still viable if it lasts for only
five years. It may be unsure whether the initial project cost will be 1million, or
2million, or somewhere in between. Sensitivity analysis might show that it is a brilliant
project if it costs only 1 million; a waste of money if it costs 2million; and that,
provided it does not cost more than 1.6 million, it is viable. Wherever there is
uncertainty, the proposal can be recalculated to see how sensitive it is to a change in
assumptions. This approach does not remove subjectivity, but it enables the financial
effects of particular uncertainties to be quantified to provide a basis for judgement and
decision making.

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