Chapter 46 Investment Appraisal
Chapter 46 Investment Appraisal
Chapter 46 Investment Appraisal
Investment Appraisal
To ensure the best decision is made when new capital investment projects are
considered, investment appraisal should be carried out
Accounting Rate of Return (ARR) is the expected return of the investment made in a project
expressed as a percentage of the average investment over the period.
Formula:
2. Payback Period
The payback period is the length of time it takes to recover the cost of an investment
by the cash flows generated from the investment.
Conceptually, the payback period can be viewed as the amount of time between the
date of the initial investment (cash outflow) and the date when the net cash inflow
produced by the project is equal to the initial investment.(Breakeven)
The shorter the payback period, the more attractive the investment and the better off
the company would be.
Formula:
Payback period = Years before breakeven + ( Unrecovered amount x 12 months)
Cash flow in recovery year
Example: Machine A
Years Cash flows Balance
0 (210 000) (210 000)
1 70000 (140 000)
2 80000 (60000)
3 90000
Net present value method (also known as discounted cash flow method) is a popular capital
appraisal technique that takes into account the time value of money. This is a method used to
determine the present value of all future cash flows generated by a project using cost of
capital.
Cost of capital:
The cost of capital is a discount rate which includes inflation, interest, taxes, dividends and any
other cost associated with the capital invested in a project.
Discount rate:
The discount rate refers to the interest rate used to determine the present value (Discounted
cash flows) of future cash flows.
p
Formula: IRR = X + d
p − n
X = Discount rate giving positive NPV
d = Difference between two discount rates
p = value of positive NPV
n = value of negative NPV
Example:
Discount rate 8% and NPV $14000
Discount rate 20% and NPV ($6000)
Calculate Internal Rate of Return.
IRR = 8 + (12 x 14000/20000)
= 16.4%
Note: Calculation of IRR when both net present values are positive
p
Formula: IRR = X + d
p − n
X = Discount rate giving Higher NPV
d = Difference between two discount rates
p = value of Higher NPV
n = value of lower NPV