INVESTMENT APPRAISAL

Methods 1. Payback period

2. 3. 4. ARR (Average rate of return / Accounting rate of return) NPV (Net Present Value) Discounted Cash flow The discounting method IRR (Internal rate of return)

NET PRESENT VALUE Years 0 1 2 3 4 5 Cash outflow / Discount Factor Cash inflow (1000 000) 1 500000 0.8929 500000 0.7972 500000 0.7118 500000 0.6355 500000 0.5674 Net Present Value Present Value (1000 000) 446450 398600 355900 317750 283700 802400

* interest rate = i = 12% PV =

A (1 + i ) n

where i = interest rate n = number of years A = amount PV = Present Value Exercise Pg. 367 Q.1. Years 0 1 2 3 4 5 Residual Value Q.2. Project A (000) (000) Years 0 Cash outflow / Cash inflow (100) Discount Rate 1 Present Value (100) Cash outflow / Cash inflow (20 000) 6000 6000 6000 6000 6000 5000 Net Present Value Discount Factor 1 0.91 0.82 0.74 0.67 0.61 0.61 Present Value (20 000) 5460 4920 4440 4020 3660 3050 5550

1 2 3 4 5

100 100 0 0 0 Net Present Value Project B (000)

0.92 0.86 0.79 0.73 0.68

92 86 0 0 0 78

(000) Years 0 1 2 3 4 5 Cash outflow / Cash inflow (100) 10 10 100 100 0 Net Present Value Project C (000) (000) Years 0 1 2 3 4 5 Cash outflow / Cash inflow (100) 0 10 100 100 150 Net Present Value Discount Rate 0.92 0.86 0.79 0.73 0.68 Present Value (100) 0 8.6 79 73 102 162.6 Discount Rate 1 0.92 0.86 0.79 0.73 0.68 Present Value (100) 9.2 8.6 79 73 0 69.8

Option C is the best choice since it gives the highest net present value as compared to other two. Q.3. (i) Payback period Year: 3 Months:-

50 12 = 3 200

Period: 3 years 3 months (ii) Accounting rate of return Profit = 1100 750 =

350 = 70 000 (Average profit) 5

ARR

70 000 100 750000

= 9.3%

Q.3.(b) @ 8% (000) (000) Years 0 1 2 3 4 5 R.V. Cash outflow (750) 200 250 250 200 150 50 Net Present Value Discount Rate 0.9259 0.8573 0.7938 0.7350 0.6806 0.6806 Present Value (750) 185.18 214.325 198.45 147.00 102.09 34.03 131.075

@ 10%
(000) (000) Years 0 1 2 3 4 5 R.V. Cash outflow (750) 200 250 250 200 150 50 Net Present Value Discount Rate 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.6209 Present Value (750) 181.82 206.6 187.825 136.6 93.135 31.045 87.025

@ 12%
(000) (000) Years 0 1 2 3 4 5 Cash outflow (750) 200 250 250 200 150 Discount Rate 0.8929 0.7972 0.7118 0.6355 0.5674 Present Value (750) 178.58 199.3 177.95 127.1 85.11

R.V. Q.4.

50 Net Present Value

0.5674

28.37 46.41

According to 3 year payback rule Project B can be discarded as it takes 3 years and 12 =- 0.6 months. So net present values of Project A & Project C have to be compared now. Years 0 1 2 3 4 5 R.V. Discount Factor 1 0.91 0.83 0.75 0.68 0.62 0.62 Net Present Value PVA (m) (10) 3.64 3.32 6.00 5.44 4.96 1.24 14.6 PVC (m) (10) 7.28 4.98 3.00 2.72 2.48 0.31 10.77

Project A should be chosen as the net present value from this is higher than that of Project C while Project B was already discarded at the screening stage. Q.5. a.(i)

Payback Period PROJECT A: PROJECT B:

4 years 4 years

and months = 4 years and 6 months (ii) Accounting rate of return PROJECT A Profit = 300 000 200 000 =

50 12 = 6 100

100 000 = 20 000 (average profit) 5

ARR

20 000 100 200 000

= 10% PROJECT B Profit = 350 000 250 000 =

100 000 = 20 000 (average profit) 5 20 000 100 250 000

ARR

= 8% Years 0 1 2 3 4 5 R.V. (b) Discount Factor 1 0.91 0.83 0.75 0.68 0.62 0.62 Net Present Value PVA (m) (200) 45.5 41.5 37.5 34.0 31.0 31.0 20.5 PVC (m) (250) 36.4 33.2 45.0 40.8 62.0 31.0 (1.6)

The company should opt for Project A since Project B should be immediately rejected for because the net present value of B is negative. Also the ARR of 10% is higher for Project A as compared to B and also its payback period is less than that of B at 4 years.

Q.6.(a) Years Cash @8% flow 1 500 .93 2 500 .86 3 500 .79 4 500 .74 5 500 .68 Total Present Value Present V 465 430 395 370 340 2000 @10% .91 .83 .75 .68 .62 Present V 455 415 375 340 310 1895 @12% .89 .80 .71 .64 .57 Present V 445 400 355 320 285 1805

(b)

Cash Outflow = 1890000 Net Present Values @8% 2000 000 1890 000 = 110 000 @10% 1895 000 1890 000 = 5000 @12% 1805 000 -= 1890 000 = ( 85000) The discount factor of 10% produces present value closest to that of cost of equipment.

(c)

Q.7.

At the rate of 12%, the business loses its profitability as the net present value is actually showing a loss of 85000. Therefore, if the expected rate is 12%, it would be better to not invest at all but rather leave the capital in the bank where it would at least care interest. ARR PROJECT X Total profit = 160 000 Average annual profit =

160 000 4

= 40 000

ARR

40 000 100 300 000

= 13.3% PROJECT Y Total profit = 160 000 Average annual profit =

160 000 4

= 40 000 ARR

40 000 = 100 300 000

= 13.3%

PROJECT Z Total profit = 200 000 Average annual profit =

200 000 4

= 50 000 ARR

50 000 = 100 300 000

= 16.7%

The company should select project Z. since the accounting rate of return is highest for it as compared to the other two projects. Also it is higher than the current rate of 12%. Q.8. Payback Period Years = 4 (370 (90 )) = 70

10 Months = 12 90
= 1.3 Q.9. Period = 4 years and 1.3 months Net Present Value Years 0 1 2 3 4 5 6 R.V. Cash flow (000) Discount actor (370) 1 90 0.8772 90 0.7695 90 0.6750 90 0.5921 90 0.5194 90 0.4556 20 0.4556 Net Present Value Present Value () (370000) 78948 69255 60750 53289 46746 41004 9112 (10,896)

Factors to be considered 1. Prevailing interest rate in the economy. 2. Techniques other than that already used in the question. 3. Economic situation of the company. boom risks can be taken revision think twice rate 4. Legal considerations government policies. 5. Social Environment, e.g. smuggling, making 6. Leadership attitude Q.10. Net Present Value PROJECT A Years 0 1 2 3 4 Cash flow () Discount actor (600000) 1 250000 0.909 250000 0.8260 250000 0.7513 250000 0.6830 Net Present Value Net Present Value PROJECT B Years 0 1 2 3 4 5 6 Cash flow () Discount actor (1500000) 1 400000 0.9259 400000 0.8573 400000 0.7938 400000 0.7350 400000 0.6806 400000 0.6302 Net Present Value Present Value () (1500000) 370360 342920 317520 294000 272240 252080 349120 Present Value () (600000) 227275 206600 187825 170750 192450

Q.11. Net Present Value PROJECT A Years 0 1 2 3 4 5 Cash flow () (700000) 200000 200000 200000 200000 200000 Discount actor 1 0.9091 0.8264 0.7513 0.6830 0.6209 Present Value () (700000) 181820 165280 150260 136600 124180

Net Present Value Years 0 1 2 3 4 Cash flow () Discount actor (1500000) 1 500000 0.9259 500000 0.8573 500000 0.7938 500000 0.7350 Net Present Value

58140 Present Value () (1500000) 462950 428650 396900 367500 156000

Q.12. Payback Period (i) PROJECT A: 3 years and months =

100 12 150

=8 Period = 3 years 8 months (ii) PROJECT B: 3 years ARR PROJECT A: profit = 560 250 =

310 = 51.67 (average profit) 6

= 20.7%

ARR =

51.67 100 250 270 = 45 (average profit) 6

= 22.5%

PROJECT B: profit = 470 200 =

ARR

45 = 100 200

Years 0 1 2 3

PROJECT A Discount Factor 1 0.9091 0.8264 0.7513

Cash Flow (250) 150

Present V (250) 112.695

PROJECT B Cash Flow (200) 60 50 90

Present V (200) 54.546 41.32 67.617

4 5 6

0.6830 0.6209 0.5645

150 160 100

102.45 99.344 120.939

90 90 NPV

61.47 55.881 131.639

Q.13. The factors that should be taken into consideration when deciding to proceed with the investment are: 1. The prevailing interest rate in the country. this would show whether it would be better to leave the capital in the bank to earn interest or to invest it E.g. if the interest rate was 10% while the ARR or the IRR earned was just 7%, then it would have been more profitable to leave the capital in bank. 2. The economic situation of the country. This means whether the country is in a boom or a recession. If the country is in a boom than risks can be taken i.e. longer investments spread over several years could be chosen. However, if the country is going into recession then it would not be good to invest in risky projects or equipment. E.g. the ones that generate revenue within a span of three to five years should be selected even if they are apparently less profitable than that of 10 years project. As in short term projects the revenue is more guaranteed and higher chances are there for its earning. 3. Legal considerations also need to be taken into account. This include government policies on different industries e.g. a firm may have a choice of investments including a foreign project. However, if there is a policy preventing investment in foreign project may have to be rejected despite its greater returns and favourable terms. 4. Social, environmental and ethical considerations. Certain projects despite their profitablility may be unethical or socially unacceptable E.g. a project may involve smuggling goods such as drugs approached animals and may thus be very profitable. However, it is socially wrong. Then there 5. Leadership attitude. If the leadership likes taking risks then it would take risky investments and invest in projects that give higher returns but after several years. If the leadership attitude is risk averse then the projects selected would be only moderately profitable and generating returns in a shorter time period. Ans. PAYBACK METHOD Advantages: Very simple and easy to calculate Quick screening device It places stress on early return, forecasts of which are likely to be more accurate than something long term. An early return is especially important when liquidity is more critical than profitability. Disadvantages: It ignores the timing of the return prior to payback. It ignores the earnings after payback. It discriminates against projects that involve a long payback period. NET PRESENT VALUE Advantages: It takes with account that interest rates affects the present value of future income. It shows that the future cash flow is discounted by the rate of interest.

It takes into account the length of time.

Disadvantage More complicated than other methods. Cost of capital is often difficult to ascertain. Complicate mathematically, but it is based on expectations.