Capital Investment Appraisal (1)

Capital Investment Appraisal

This represents the various methods by which we make long term investment decisions in items of capital expenditure.

It is based on the premise that we never have sufficient capital to do all we want therefore we have to invest what we have in order to do the best we can.


All the methods are based on the calculation of projected returns over the life time of the capital item we are considering and the rule is to invest in whichever capital project gives us the best return or best meets the criteria we have established for making that judgement.

Capital Investment AppraisalLet us take three potential projects;

X – initial cost £20,000 with a projected total return of £30,000

Y – initial cost £20,000 with a projected total return of £26,000

Z – initial cost £20,000 with a projected total return of £25,000

We only have £20,000 to invest – which project?

Capital Investment Appraisalproject X Y Z

Cost £20000 £20000 £20000

year

1 2,000 5,000 4,000

2 2,000 5,000 4,000

3 2,000 5,000 4,000

4 2,000 2,000 4,000

5 4,000 2,000 4,000

6 4,000 2,000 1,000

7 4,000 2,000 1,000

8 4,000 1,000 1,000

9 3,000 1,000 1,000

10 3,000 1,000 1,000

TOTAL 30,000 26,000 25,000


Method OnePAYBACK PERIOD

With this method we use the time taken to recover our initial investment back as the criteria to select the “right project”.

Project X takes 7 years to earn it’s money back.Project Y takes 5.5 yearsProject Z takes 5 yearsWe pick project Z as it has the fastest payback.


Advantages• Easy to compute and understand

• Uses cash flow not profit• A “play safe” option not likely to fail

Disadvantages• Ignores all income after payback point• Prefers tried and tested technologies

• Ignores the declining value of money over time• Poor for long term decision making


Method TwoReturn On Investment (ROI)

This methods uses the concept of “profit” and compares the annualised profit of each project compared to the initial investment to give a percentage Return on Investment.

In practical terms this means we include depreciation and thus profit is less than cash flow.


Thus in our original example;

Project X Y Z

Total profit £26000 £20000 £15000

Duration of Project (years)

10 10 10

Annualised Profit

£2600 £2000 £1500

Initial Investment

£20000 £20000 £20000

ROI%

13% 10% 7.5%


AdvantagesTakes in the total income of the project

Gives a good comparative measureEasy to understand and compute

Can be used to compare to a cost of borrowingDisadvantages

Uses profit which can be unreliableIgnores declining value of money over timeAmbiguity over what is the correct “initial

investment” figure


Method ThreeNet Present Value

This method tries to remove the problem of the falling value of money over time by reducing future cash flows into “today’s terms” by discounting them by some appropriate factor.

This is usually a discount factor based on the Cost of Capital of the company and is based on the opportunity cost idea.

Capital Investment AppraisalLets look at our former Project X; 8% C of C

Year Net cash flow£

Discount Factor

NPV£

0 -20000 1.000 -20000

1 2000 0.943 1886

2 2000 0.890 1790

3 2000 0.840 1680

4 2000 0.792 1584

5 4000 0.747 2988

6 4000 0.705 2820

7 4000 0.665 2660

8 4000 0.627 2508

9 3000 0.592 1776

10 3000 0.558 1674

Total +10000 +1366


Advantages• Takes in total income of project• Uses cash flow• Gives good comparative measure• Reflects falling value of money• Allows for risk • Reflects issues over the timing of cash flow


Disadvantages• Complicated to understand• Problems over the choice of discount rate as not

all companies know their cost of capital and those that do could want it to be kept secret to prevent giving the competition an advantage.

Most commercial organisations will use this method.


Method FourInternal Rate of Return (IRR)

This methodology is used when we don’t know or don’t want to use the Cost Of Capital and so we work out the discount rate at which the cash flow of the project is neutral –neither a surplus or a deficit. A principle very akin to Break Even.


Again let’s use Project X as an example, we already know that at 8% we get a NPV of +£1366. So this means we must look for a discount rate higher than 8% and one which will gives us a negative (-) NPV.

Let us try 10% and see what the result is.........

Capital Investment Appraisalyear NCF (£) Discount Factor NPV (£)

0 -20000 1.000 -20000

1 2000 0.909 1818

2 2000 0.826 1652

3 2000 0.751 1502

4 2000 0.683 1366

5 4000 0.621 2484

6 4000 0.564 2256

7 4000 0.513 2052

8 4000 0.467 1868

9 3000 0.424 1272

10 3000 0.386 1158

Total +10000 -2572


We know therefore that the Zero NPV must lie somewhere between the 8% and 10% discount rate.

We must therefore “interpolate” the discount rate for the Zero NPV.

We do this by applying a formula;


A + ((C/(C-D)) * (B-A))

A = the Positive NPV discount rateB= the Negative NPV discount rateC = the Positive NPV value in £’sD= the Negative NPV value in £’s


In our example

8% + (1366/(1366-(-2572))) * (10%-8%)

8% + ((1366/3938)* 2%)8% + (.3469 * 2%)

8% + 0.6937%8.69% = IRR


Advantages• Takes in total income of the project• Uses cash flow• Gives a good comparative measure• Reflects falling value of money over time• Allows for risk to be considered• Reflects timing issues of cash flow• Does not require a knowledge of Cost of Capital


Disadvantages• Complicated to understand and compute• Managers often have difficulty with the

principles of this method• Managers prefer Payback


VariationsDiscounted Payback uses the technique of NPV

but then goes for a payback approach. Not very satisfactory but managers think it removes all the problems of payback which sadly it does not.

Capital Investment Appraisal (1)

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