EPJ3760 Construction Investments Lecture 4: September 2013

4.1 Investment Appraisal Techniques 4.1 Investment Appraisal Techniques

Which techniques do (100 large UK) firms use? Which techniques do firms use – according to academic research?
Source: Pike (1992) Source: Taylor (1994)

1 2

4.1 Investment Appraisal Techniques 4.2 Future and Present Values

Which techniques do (Fortune 1000) firms use? Future Value (FV)
Source: Ryan and Ryan (2002) The value at a specific date in the future.

% of Fortune 1000 firms using each technique

Present Value (PV)
Technique Always Often Sometimes Rarely Never The current value (in today’s money) of a future sum of money or cash
flow.
Net Present Value 49,8% 35,3% 10,9% 3,0% 1,0%
Internal Rate of Return 44,6% 32,2% 15,3% 6,4% 1,5%
Discount rate (k)
Payback 19,4% 33,2% 21,9% 16,8% 8,7% The (interest) rate used to calculate the present value of future cash
Discounted Payback 15,5% 22,2% 19,1% 21,1% 22,2% flows. (Accounts for both time value of money and risk.)
Profitability Index 5,9% 15,5% 22,5% 21,9% 34,2%
Accounting Rate of Return 5,3% 9,5% 18,5% 16,4% 50,3% FVt = PV(1+k)t
Modified IRR 2,2% 7,1% 12,6% 27,9% 50,3% FVt
PV = (1+k)t

3 where t is time (usually the number of years) 4

4.3 Technique Definitions 4.3 Technique Definitions

Payback Period Profitability Index (PI)
The time taken to recover the initial investment cost from Benefit / cost ratio. The ratio of the present value of the
the net cash flows. future net cash flows to the initial investment.

Discounted Payback Net Present Value (NPV)

The time taken to recover the initial investment cost from
the discounted (i.e. the present values of the) net cash
flows.
Accounting Rate of Return (also called Average Rate of
Return, Average Return on Book Value & Simple
Rate of Return)
Various measures of profitability, typically the ratio of
average annual profit to either:
method 1: average investment
method 2: initial investment
5 (compounded at the MARR to the end of the project).
The present value of the future net cash flows less the
initial investment.
Internal Rate of Return (IRR)
The discount rate which equates the present value of the
future net cash flows with the initial investment.
Modified Internal Rate of Return (MIRR)
The discount rate which equates the present value of all
the cash outflows (discounted at the MARR to the start
of the project) to the future value of all the cash inflows
6

Emlyn Witt 1
EPJ3760 Construction Investments Lecture 4: September 2013

4.4 Payback Period 4.4 Payback Period

Calculation unrecovered cost at
Payback Period no. of years prior start of recovery year
Payback period = to full recovery of
(The time taken to recover the initial investment investment net cash flow during
cost from the net cash flows.) recovery year

Time Net cash flows Cumulative cash flow

Decision Rules Initial cash -10000 -10000
• Choose the project with the shortest payback outlay (time 0)
• Specify a maximum desired payback period Year 1 4000 -6000
(also called a cutoff period or target period): . Year 2 4000 -2000
– Specified cutoff period depends on project risk (higher Year 3 4000 2000
risk = shorter cutoff) Year 4 4000 6000
– Accept projects with payback less than the cutoff
period. Payback period = 2 years + (2000 / 4000) years
7 = 2,5 years 8

4.4 Payback Period 4.4 Payback Period

Illustration of concept Benefits of using Payback Period
• Formerly (up to about the year 2000) this was
cumulative cash the most popular method and it is still widely
used in business
net cash flow

flow curve
payback period • Simple to understand
• Quick to calculate

time Disadvantages
• Ignores the time value of money
• Ignores cash flows beyond the payback period

9 10

4.5 Discounted Payback Period 4.5 Discounted Payback Period

Calculation
Discounted Payback Period
(The time taken to recover the initial investment Same as for (simple) Payback Period but use Discounted
Cash Flows, e.g. with a discount rate of 10%:
cost from the discounted (i.e. the present values
of the) net cash flows.) Time Net cash Present values of net Discounted
flows cash flows cumulative cash flow
(discount rate = 10%)
Decision Rules Initial cash
-10000 -10000 -10000
• Specify a cutoff period: . outlay (time 0)

– Specified cutoff period depends on project risk (higher Year 1 4000 3636,4 -6363,6
risk = shorter cutoff) Year 2 4000 3305,8 -3057,9
– Accept projects with a discounted payback period Year 3 4000 3005,3 -52,6
less than the cutoff period. Year 4 4000 2732,1 2679,5

11 Payback period = 3 years + (52,6 / 2732,1) years 12

= 3,002 years

Emlyn Witt 2
EPJ3760 Construction Investments Lecture 4: September 2013

4.5 Discounted Payback Period 4.6 Accounting Rate of Return

Benefits of using Discounted Payback Period Accounting Rate of Return
• Considers the time value of money (Typically, the ratio of average annual profit to
• Useful metric to know either:
• Compatible with Net Present Value calculations method 1: average investment
OR
Disadvantages method 2: initial investment)
• Ignores cash flows beyond the payback period
• Difficult to set the cutoff period Decision Rules
• Validity of the chosen discount rate • Specify a required accounting rate of return: .
– Accept projects with an accounting rate of return
greater than the target rate of return.
13 14

4.6 Accounting Rate of Return 4.6 Accounting Rate of Return

Calculation (one variant)
n
Calculation (continued from previous slide)
Accounting rate
Σ
t=1
(Profit in year t ) / n
= Profit in each year is:
of return (Initial investment + salvage value) / 2 year 1 = 4000 – 2375 = 1625
year 2 = 4000 – 2375 = 1625
Annual average profit
= year 3 = 4000 – 2375 = 1625
Average investment year 4 = 4000 + 500 – 2375 = 2125
Example:
An initial investment of 10000 produces cash inflows of 4000 every Annual average profit = (1625+1625+1625+2125)/4 = 1750
year for 4 years. Assuming straight-line depreciation and a salvage
value of 500 (which is realised at the end of year 4), calculate the Average investment = (10000+500)/2 = 5250
Accounting Rate of Return using the formula above.
Accounting Rate of Return = 1750/5250
With straight-line depreciation, = 33,3%
annual depreciation = (Initial cost – salvage value) / useful life
= (10000 – 500)/4 = 2375 15 16

4.6 Accounting Rate of Return

Benefits of using Accounting Rate of Return
• Simple to calculate and based on readily available
accounting information which is familiar to business
managers
• Relates to the overall company accounts (Return on
Assets)

Disadvantages
• Ignores the time value of money
• Based on accounting profit rather than cash flows
• Is a ratio of 2 accounting measures (income to
investment) both of which may be measured in various
different ways causing confusion Several different
variations
17
It is NOT recommended for investment appraisal

Emlyn Witt 3