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 ADM 658: Chapter 4 - Investment Appraisal
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ADM 658: Chapter 4 - Investment Appraisal

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  • 1. ADM658 – CHAPTER 4: INVESTMENT APPRAISAL WHAT IS CAPITAL BUDGETTING: • A decision that involves broad strategic aspects of the company, in which managers analyze alternative long term investment. EXAMPLES: • Launch a new plant or plant expansion • Purchase new machinery • Equipment placement • Equipment selection NATURE OF CAPITAL BUDGETTING DECISION. • Outlays of large amount of resources • Non-reversible • Strategic and risky STEPS OF EVALUATING CAPITAL BUDGETTING. • Identify potential capital investments • Forecast future net cash flow • Analyse potential investment • Choose among alternative investments when the resources are not sufficient to fund all profitable projects • Perform post audit after making capital investment. 2 TYPES OF CAPITAL BUDGETTING DECISION • Screening • Pertain to whether or not some proposed investment is acceptable; these decision come first. • Preference • Attempt to rank acceptable alternaives from the most to least appealling. METHODS USED TO EVALUATE CP DECISION. • Accounting rate of return • Net present value • Payback period • Internal rate of return
  • 2. ADM658 – CHAPTER 4: INVESTMENT APPRAISAL Accounting rate of return •Formula: •Average annual net income/initial investment •Average CF/average investment •Average CF: project A1+A2+A3 •Decision rule: •Accept the project if its ARR is greater than the company's target rate of return. PROS Simple Intuitive CONS Time value of money ignored ARR = Net Income. Not cash flow Other accounting method may impact the net income. Typical cash outflow •Initial investment •Additional amount of working capital •Repair and maintenance •Additional operating cost Typical cash inflows •Incremental revenues •Reduction in cost •Salvage value •Release of working capital Payback period. •Length of time takes for an investment project to recoup its own initial cost out of the cash receipts it generates. •More quickly the cost recovered, more desirable the invesment. •Decision rule: accept the project f payback period is shorter than the company's target payback period. •Formula: •Initial investmet/annual cash flow •(Yn-1)+(IO-CCF)/CF yn PROS Provides simple and intuitive tool for roughly screening investment For some firms, it’s an essential to recoup its initial cash outflow ASAP. CONS Fails to consider time value for money Does not consider a project’s cash flows beyond the payback period. Net pesent value •Analysis emphasize on discounted cash flows •Reason: net income is based on accruals that ignore the timing of the cash flows into and out of the organization •PV factor.