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Investment Appraisal: The decision making process

Investment Appraisal: The decision making process. Corporate Finance 7. The decision-making process for investment appraisal. Empirical evidence on project appraisal techniques used The calculation of payback, discounted payback and accounting rate of return (ARR)

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Investment Appraisal: The decision making process

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  1. Investment Appraisal: The decision making process Corporate Finance 7

  2. The decision-making process for investment appraisal • Empirical evidence on project appraisal techniques used • The calculation of payback, discounted payback and accounting rate of return (ARR) • The drawbacks and attractions of payback and ARR • The balance to be struck between mathematical precision and imprecise reality • The capital-allocation planning process

  3. Appraisal techniques

  4. Payback The payback period for a capital investment is the length of time before the cumulated stream of forecasted cash flows equals the initial investment. • Payback • Project A: 4 years, Project B: 4 years, Project C: 5 years.

  5. Tradfirm: Net Present Values (£m) Exhibit 4.4 Tradfirm: Net Present Values (£m)

  6. Drawbacks of payback • It makes no allowance for the time value of money • Receipts beyond the payback period are ignored • Arbitrary selection of the cut-off point

  7. Discounted payback: Tradfirm plc (£m) Exhibit 4.5 Discounted payback: Tradfirm plc (£m)

  8. Reasons for the continuing popularity of payback • Supplements the more sophisticated methods • E.g. an early stage filter • It is simple and easy to use • Projects which return their outlay quickly reduce the exposure of the firm to risk • If funds are limited, there is an advantage in receiving a return on projects earlier rather than later • It is often claimed that the cash flows in the first few years of a project provide some indication of the cash flows in later years

  9. Accounting rate of return • The accounting rate of return (ARR) method may be known by other names such as the return on capital employed (ROCE) or return on investment (ROI) • ARR is a ratio of the accounting profit to the investment in the project, expressed as a percentage • The decision rule is that if the ARR is greater than, or equal to, a hurdle rate then accept the project

  10. Timewarp plc • Invest £30,000 in machinery: life of three years

  11. Time warp plc (continued) (5,000 + 5,000 + 5,000)/3 ARR = –––––––––––––––––––––– × 100 = 33.33% 15,000

  12. Drawbacks of accounting rate of return • Wide-open field for selecting profit and asset definitions • Profit figures are very poor substitutes for cash flow • Fails to take account of the time value of money • High degree of arbitrariness in defining the cut-off or hurdle rate

  13. Drawbacks of accounting rate of return (continued) • Accounting rate of return can lead to some perverse decisions • Suppose that Timewarp uses the second version, the total investment ARR, with a hurdle rate of 15 per cent • The appraisal team discover that the machinery will in fact generate an additional profit of £1,000 in a fourth year • Original situation • New situation (5,000 + 5,000 + 5,000)/3 ARR = –––––––––––––––––––––– = 16.67%. Accepted 30,000 (5,000 + 5,000 + 5,000 + 1,000)/4 ARR = ––––––––––––––––––––––––––– = 13.33%. Rejected 30,000

  14. Reasons for the continued use of accounting rate of returns • Managers are familiar with this ancient and extensively used profitability measure • Divisional performance and the entire firm is often judged on a profit-to-assets employed ratio

  15. Internal rate of return: reasons for continued popularity • Psychological • IRR can be calculated without knowledge of the required rate of return • Ranking

  16. The ‘science’ and the ‘art’ of investment appraisal • Strategy • Social context • Expense • Stifling the entrepreneurial spirit • Intangible benefits

  17. The investment process – pre-appraisal

  18. The investment process – post-appraisal

  19. Post-completion audit • Post-completion auditing is the monitoring and evaluation of the progress of a capital investment project through a comparison of the actual cash flows and other costs and benefits with those forecasted • Reasons for carrying out a post-completion audit: • 1 Financial control mechanism • 2 Insight gained may be useful for future capital investment decisions • 3 The psychological effect

  20. Lecture review • Payback and ARR are widely used methods of project appraisal, but discounted cash flow methods are the most popular • Most large firms use more than one appraisal method • Payback • Drawbacks • Attractions • Accounting rate of return • Drawbacks • Attractions • Internal rate of return • Mathematical technique is only one element needed for successful project appraisal • The investment process is more than appraisal. It has many stages

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