Week 1 investment appraisal

FINANCIAL MANAGEMENT
Prepared by Tishta Bachoo
1

Lecture 1 - overview
2
• Introduction to financial management
• Investment Appraisal & its techniques
• Payback period
• Net Present Value (NPV)
• Accounting Rate of Return (ARR)
• Profitability Index (PI)

What is Financial Management?
 Financial management means to plan
and control the finance of the company. It is
done to achieve the objectives of the company.
 Financial management is concerned with raising
financial resources and their effective
utilization towards achieving the organizational
goals.
3

 One of the duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return.
 Therefore, a financial manager must be able to decide
whether an investment is worth undertaking and be able to
choose intelligently between two or more alternatives.
 To do this, a sound procedure to evaluate, compare, and
select projects is needed. This procedure is called
Investment Appraisal.
4

 As investments involve large resources, wrong investment
decisions are very expensive to correct
 Managers are responsible for comparing and evaluating
alternative projects so as to allocate limited resources and
maximize the firm’s wealth
 Some basic techniques of making capital investment
appraisal for evaluating proposed capital investment
projects
5

Payback period
6

Payback period
 The payback period is the most basic and simple
decision tool.
 Payback period is the period of time it takes for a
company to recover its initial investment in a
project
 The method measures the time required for a
project’s cash flow to equalize the initial
investment
7

Acceptance criterion
8
< Number of years Accept the project
> Number of years Reject the project

Advantages of payback period
 Easy to adopt
 Simple to compute
 Provides some information on the risk of the
investment.
9

Disadvantages of Payback
period
 Ignore the cash flows after payback period
 Ignores the time value of money.
10

Example
11

12
A company is considering making the following mutually exclusive
investments in the production facilities for the new products with an
estimated useful life of four years. The cash inflow and outflows are
listed as follows:
Project A Project B
Initial investment 1000000 1000000
Cash inflow at the end of year
Year 1 700000 600000
Year 2 200000 400000
Year 3 300000 400000
Year 4 1300000 400000

13
Project A Project B
$ $
Initial investment 1000000 1000000
Discounted cash flow
Year 1 700000 600000
Year 2 200000 400000
Year 3 300000 400000
Year 4 1300000 400000
Payback period:
Project A 2 years and 4 months (100000/300000*12)
Project B = 2 years

Net Present Value
Method
14

 NPV is used in investment appraisal to analyze
the profitability of an INVESTMENT or project
 A Net Present Value (NPV) that is positive is
good (and negative is bad).
 But your choice of interest rate can change
things!
15

Calculation procedures
1. Determining the discount rate
2. Calculating the NPV:
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NPV =
FV1 FV2 FV3 FVn
(1+r)1
(1+r)2
(1+r)3
(1+r)n
+ + + - I0
where FV = future value of an investment
n = no. of years
r = Rate of return available on an equivalent risk
security in the financial market
I 0= initial investment

3. Interpreting the NPV derived as follows:
17
NPVs Comments Reasons
<0 Reject the project The rate of return from the project is
small than the rate of return from an
equivalent risk investment
=0 Indifferent to accept
or reject the project
The rate of return from the project is
equal to the rate of return from an
>0 Accept the project The rate of return from the project is
greater than the rate of return from an
Highest Accept the project If various project are considered, the
project with highest positive NPV
should be chosen

Example
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19
A company is considering making several investments in the
Production facilities for the new products with an estimated useful
Life of four years. The cash inflows and outflows are listed as follows:
Project
A B C D
$ $ $ $
Initial investment 900000 1000000 303730 1500000
Cash inflow
Year 1 120000 400000 100000 10000
Year 2 250000 400000 100000 10000
Year 3 400000 400000 100000 1000000
Year 4 1300000 400000 100000 1000000
The appropriate discount rate of these investment is 12%

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Required:
(a) Calculate the NPV of each investment and determine whether
to accept it or not (assuming the company has unlimited
resources)
(b) If the company has limited resources, determine which
investment should be accepted by referring to the highest NPV

21
Project A
NPV =
120000 250000 400000 1300000
1.12 1.122
1.123
1.124
+ + + - 900000
= $517327 (accepting)
Project B
NPV =
40000 400000 400000 400000
1.12 1.122
1.123
1.124
+ + + - 1000000
= $214920(accepting)
(a)

22
Project C
NPV =
100000 100000 100000 100000
1.12 1.122
1.123
1.124
+ + + - 303730
= $0 (indifferent to accept or reject)
Project D
NPV =
10000 10000 1000000 1000000
1.12 1.122
1.123
1.124
+ + + - 1500000
= -$135801(rejecting)
(a)
(b) With limited resources, the company should only accept project A
because it generates the highest NPV

Advantages of NPV
 Consistency with the time value of
money concept
 Consideration of all cash flows
 Tells whether the investment will
increase the firm’s value.
23

Disadvantages of NPV
 Requires an estimate of the cost of capital in
order to calculate the NPV
 It is quite lengthy to calculate.
24

Accounting Rate of
Return
25

Accounting rate of return
 The accounting rate of return compares the
average accounting profit with the average
investment cost of project
 The accounting profit can be expressed either
before tax or after tax
26

Calculation procedures
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ARR =
Average net profit per year (over the life of the project)
Average investment cost
Average net profit per year =
Total profit
No. of life of the project
Average investment cost =
Initial investment+ cost at end
2

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In evaluating an investment project, the ARR of the project is
compared with a predetermined minimum acceptable accounting
Rate of return:
ARRs Comments
< minimum acceptable rate Reject project
= minimum acceptable rate Accept project
> minimum acceptable rate Accept project
Highest Choose highest ARR
Acceptance criterion

Example
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A company is considering whether to buy specialized machines
For a new production line. The purchase price of machinery is
$400000 and its estimated useful life is four years. There is no scrap
Value after four years
The project income statements:
Year1 Year 2 Year 3 Year 4
$ $ $ $
Revenue 310000 280000 280000 310000
Depreciation 100000 100000 100000 100000
Other expenses150000 100000 110000
120000
Profit before tax 60000 80000 70000 90000
Taxation (15%) 9000 12000 10500 13500
51000 68000 59500 76500
Should the company buy the new machinery if the minimum acceptable
Rate of return is 20%?

31
Average net income =
51000+68000+59500+76500
4
= $63750
Average investment =
400000+0
2
= $200000
The cost of machinery is $400000 at the beginning
The cost of machinery is $0 at the end as depreciation is provided
On straight line method and there is no scrap value
ARR =
$63750
$200000 = 31.875%
Since the ARR is 31.875%, which is higher than the minimum
Acceptable rate of 20%, the company should invest in the new
machinery.

Advantages of ARR
 It is easy to understand and compute
 It avoids using gross figures. Therefore, it
enables comparisons to be made between
projects with different useful lives
32

Disadvantages of ARR
 It ignores the time value of money
 ARR method seems to be less reliable than the
NPV method. It adopts the accounting profit
instead of cash flows calculation. The change of
depreciation method may also alter the
accounting profit
33

34
Profitability Index
(PI)

Profitability index
• Although a project may show the highest positive NPV
compared to other alternatives, it might not be efficient in the
profitable use of funds invested.
• To identify if the project uses the capital invested most
efficiently, an index is calculated by comparing the present
values of all net operating cash flows with the capital outlay,
that is the profitability index.
35

Advantages of Profitability
index
 PI considers the time value of money.
 PI considers analysis all cash flows of the
project.
36

Disadvantages of Profitability
index
 It is difficult to understand interest rate or
discount rate.
 It is difficult to calculate profitability index if
two projects having different useful life.
37

Decision Rule
38
Accept a project if the profitability index is greater than 1, stay
indifferent if the profitability index is zero and don't accept a project if
the profitability index is below 1.
Profitability index is sometimes called benefit-cost ratio too and is
useful in capital rationing since it helps in ranking projects based on
their per dollar return.
Profitability Index = Present Value of future cash flows
Initial investment

Example
39

40
A company is considering making several investments in the
Production facilities for the new products with an estimated useful
Life of four years. The cash inflows and outflows are listed as follows:
Project
A B C D
$ $ $ $
Initial investment 900000 1000000 303730 1500000
Cash inflow
Year 1 120000 400000 100000 10000
Year 2 250000 400000 100000 10000
Year 3 400000 400000 100000 1000000
Year 4 1300000 400000 100000 1000000
The appropriate discount rate of these investment is 12%

41
Project A
NPV =
120000 250000 400000 1300000
1.12 1.122
1.123
1.124
+ + + - 900000
= $517327 (accepting)
Project B
NPV =
40000 400000 400000 400000
1.12 1.122
1.123
1.124
+ + + - 1000000
= $214920(accepting)
(a)

42
Project C
NPV =
100000 100000 100000 100000
1.12 1.122
1.123
1.124
+ + + - 303730
= $0 (indifferent to accept or reject)
Project D
NPV =
10000 10000 1000000 1000000
1.12 1.122
1.123
1.124
+ + + - 1500000
= -$135801(rejecting)
(a)

 Taking into accounting the previous NPV example, the
project which was chosen was A with an PV of $ 1417327.
 To calculate the Profitability index now, we apply the
formula.
 Profitability Index = Present Value of future cash flows
Initial investment
= $1417327. = 1.57 (>1) therefore accept the project.
$900000
43

END OF LECTURE 
44

45
TUTORIAL QUESTIONS & ANSWERS

Q1. Net Present Value
Deciding on a new machine
A small industrial machine costs $100 000 and is
expected to earn annual net cash inflows of $44 000,
$40 000, $36 000 and $32 000, before it wears out
sufficiently to be unreliable and must be sold for an
estimated $10 000.
Required:
a. If funds earn 10 per cent, what is its NPV?
b. If funds earn 15 per cent, what is its NPV?
46

A1. Net Present Value (a)
NPV = Present Value of Net Cash Flows – Initial Cost
Discount rate is 10%
Present Value of Net Cash Flows using factors from the Present
Value table for $1 at the end of N periods:
PV1 = $44 000 x 0.909 = $39 996
PV2 = $40 000 x 0.826 = $33 040
PV3 = $36 000 x 0.751 = $27 036
PV4 = ($10 000 + $32 000) x 0.683 = $28 686
$128 758
NPV = $128 758 - $100 000 = $28 758
47

A1. Net Present Value (b)
Present Value of Net Cash Flows using factors from the Present
Value table for $1 at the end of N periods:
PV1 = $44 000 x 0.870 = $38 280
PV2 = $40 000 x 0.756 = $30 240
PV3 = $36 000 x 0.658 = $23 688
PV4 = ($10 000 + $32 000) x 0.572= $24 024
$116 232
NPV = $116 232 - $100 000 = $16 232
48

Q2. Payback Period (PP)
A machine costing $102 700 is estimated to have a useful life
of 5 years and is estimated to produce the following annual
net cash inflows: Year Annual Net Cash Inflow
1 $21 600
2 $28 200
3 $31 600
4 $38 200
5 $42 000
Required:
Calculate the payback period for the investment.
49

A2. Payback Period (PP)
Year Net Cash Flow Cumulative
Net Cash Flow
0 ($102 700) ($102 700)
1 $21 600 ($81 100)
2 $28 200 ($52 900)
3 $31 600 ($21 300)
4 $38 200 $16 900
5 $42 000 $58 900
50
Payback occurs between years 3 and 4. Calculating the exact payback period
in years and months:
At the end of year 3 there is $21 300 of the initial investment left to be paid
back and during year 4 the net cash inflow is $38 200.
Payback period = 3 years + (21 300 ÷ 38 200 x 12 months)
= 3 years 6.69 months
= 3 years 7 months

Q3. Accounting Rate of Return
BlueMan, Inc. wants to purchase of a new ice cream truck
with a cost of $58,000. BlueMan has a cost of capital of 8.4%
and a required rate of return of 12.4%. The acquisition is
proposed for January 1, 2018. BlueMan expects it can sell
the new truck for $10,000 at end of its useful life of 4 years.
BlueMan predicts the new truck will generate net income of
$6,000 and operating cash flows of $18,000 during 2018,
with an increase of $500 each subsequent year. Calculate
the accounting rate of return.
51

A3. Accounting Rate of Return
 The accounting rate of return method uses
net income instead of cash flows. The net
income for the four years must be averaged.
The $500 increase applies as well.
 ARR=
=
52
Average net income
Average investment
($6,000 + $6,500 + $7,000 + $7,500) / 4 years
($58,000 + $10,000) / 2
= 19.85%

A3. Accounting Rate of Return
(Cont.)
 The denominator averages the book value at the acquisition
date with the book value at the end of the 4 year period. At the
acquisition date, the cost is $58,000 and accumulated
depreciation is zero, leaving a book value of $58,000. At the
end of the useful life, the cost is still $58,000 but with 4 years
of depreciation at $12,000 each, total accumulated depreciation
will be $48,000. The book value at the end of the life is $58,000
less $48,000, or $10,000. The book value at the end of the
useful life is always equal to the salvage value. The
denominator is divided by 2 because 2 numbers are being
averaged.
 This investment is expected to generate a return of profit of
almost 20% for each of the 4 years of the proposed asset's life.Prepared by Tishta Bachoo
53

Q4. Profitability Index
 (a) Company C is undertaking a project at a cost of $50
million which is expected to generate future net cash
flows with a present value of $65 million. Calculate the
profitability index.
 (b) A small industrial machine costs $100 000 and is
expected to earn annual net cash inflows of $44 000,
$40 000, $36 000 and $32 000, before it wears out
sufficiently to be unreliable and must be sold for an
estimated $10 000. [Same question as Q1 where you
have calculated the PV already]. Calculate the
profitability index for both cases that is funds earn is
10% and 15% respectively.Prepared by Tishta Bachoo
54

A4. Profitability Index (a)
 Profitability Index = PV of Future Net Cash Flows /
Initial Investment Required
 Profitability Index = $65M / $50M = 1.3
55

A4. Profitability Index (b)
NPV = Present Value of Net Cash Flows – Initial Cost
Present Value of Net Cash Flows using factors from the Present Value
table for $1 at the end of N periods:
PV1 = $44 000 x 0.909 = $39 996
PV2 = $40 000 x 0.826 = $33 040
PV3 = $36 000 x 0.751 = $27 036
PV4 = ($10 000 + $32 000) x 0.683 = $28 686
$128 758
PI= 128758/100000 = 1.28
56

A4. Profitability Index (b)
Present Value of Net Cash Flows using factors from the
Present Value table for $1 at the end of N periods:
PV1 = $44 000 x 0.870 = $38 280
PV2 = $40 000 x 0.756 = $30 240
PV3 = $36 000 x 0.658 = $23 688
PV4 = ($10 000 + $32 000) x 0.572= $24 024
$116 232
PI= 116232/100000 = 1.16Prepared by Tishta Bachoo
57

Rectifications:
 For NPV and PI, in class I asked you to use interest rate of
12%, However, in the tutorial solutions on PowerPoint, I
have used 15% as it was initially.
58

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END OF SESSION 

Next week …
Decision-Making techniques:
-To accept or reject special orders
-To make or to buy
-Decision when there is a limiting factor
60

Week 1 investment appraisal

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