Investment Appraisal: The decision making process Corporate Finance 7

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
rate of return (ARR)
accounting
• The drawbacks and attractions of payback and ARR
• The balance to be struck between mathematical precision
imprecise reality
• The capital-allocation planning process
and
Appraisal techniques
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.
Tradfirm: Net Present Values (£m)
Exhibit 4.4 Tradfirm: Net Present Values (£m)
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
Discounted payback: Tradfirm plc (£m)
Exhibit 4.5 Discounted payback: Tradfirm plc (£m)
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
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
Timewarp plc
• Invest £30,000 in machinery: life of three years
Time warp plc (continued)
(5,000 + 5,000 + 5,000)/3
ARR = –––––––––––––––––––––– × 100 = 33.33%
15,000
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
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
(5,000 + 5,000 + 5,000)/3
ARR = –––––––––––––––––––––– = 16.67%. Accepted
30,000
• New situation
(5,000 + 5,000 + 5,000 + 1,000)/4
ARR = ––––––––––––––––––––––––––– = 13.33%. Rejected
30,000
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
Internal rate of return: reasons for continued popularity
• Psychological
• IRR can be calculated without knowledge of the
required rate of return
• Ranking
The ‘science’ and the ‘art’ of investment appraisal
• Strategy
• Social context
• Expense
• Stifling the entrepreneurial spirit
• Intangible benefits
The investment process – pre-appraisal
The investment process – post-appraisal
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
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