PROJECT APPRAISAL AND FINANCE Bolaji Akinyemi (MBA, MSC) (a.

) Investment Appraisal: This is the assessment of the attractiveness of an investment, it is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. (b.) Payback Period: In capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because it is easy to use. (c.) Accounting Rate of Return: also known as the Average rate of return or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

(d.) Net Present Value: net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows of the same entity. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting and widely used throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. (e.) Internal Rate of Return (IRR): Or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or the rate of return (ROR). In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).

Question 2

A Banker

Payback Period The Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred Year 0 1 2 3 4 5 Cash flow -800,000 50,000 120,000 350,000 80,000 800,000 Net cash flow -800,000 -750,000 -630,000 -280,000 -200,000

The Payback Period, or breakeven point, occurs sometime during the fifth year. If we assume that the cash flows occur regularly over the course of the year in year 5, the Payback Period can be computed using the following equation:

Thus, the Payback Period for the project can be computed as follows: Payback period = 4

200 ,000 4.25 years 800 ,000

Since it will take 4.25 years to payback on the investment, the project is not acceptable since board of directors are used to evaluating project proposals on the basis of a payback rule which requires that all investments achieve payback in four years. Accounting Rate of Return (ARR) Accounting rate of return or simple rate of return is the ratio of the estimated accounting profit of a project to its average investment. It is an investment appraisal technique. ARR ignores the time value of money. Accounting Rate of Return =
Average Accounting Profit Initial Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Initial investment is sometimes replaced by average investment due to the reason that the book value of the project usually declines over

its life time. Average investment is calculated as the sum of the beginning and ending book value of the project divided by 2. Annual Depreciation =
Initial Investment - Scrap Value Useful life in years

Hence, Annual Depreciation =

800,000 0 160,000 5

Year Cash Inflow Salvage value Depreciation Accounting Income

1 50,000 -160,000 -110,000

2 120,000 -160,000 -40,000

3 350,000 -160,000 190,000

4 80,000 -160,000 -80,000

5 800,000 0 -160,000 64,000

Average Accounting Income =

Average Accounting Profit Initial Investment

Hence,

110,000 40,000 190,000 80,000 640,000 120,000 5

Average Accounting Income =

Average Accounting Profit Initial Investment

Therefore, ARR =

120 ,000 0.15 100 % 15 % 800 ,000

Net Present Value Net present value is one of the most reliable measure used in capital budgeting. It is the present value of net cash inflows generated by a project less the initial investment on the project. The use of discounted cash inflows (DCF) means that net present value accounts for time value of money. The major component of NPV is the present value of net cash inflows which may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in different periods). Where net cash inflows are even, present value can be easily calculated by using the

present value formula of annuity. However if net cash inflows are uneven we need to calculate the present value of each individual cash inflow separately as below: Year 0 1 2 3 4 5 Cash flow -800,000 50,000 120,000 350,000 80,000 800,000 DCF @ 10% 0.9091 0.8264 0.7513 0.6830 0.6209 Net Present Value = Present Values -800,000+ 45,455+ 99,168+ 262,955+ 54,640+ 496,720+ 158,938

To determine the DCF @ 10% For year 1=

1 0.9091 (1 10 %) 1

For year 2 =

1 = 0.8264 (1 10 %) 2 1 0.7513 and so on. (1 10 %) 3

For year 3 =

The NPV for the project is 158,938.00 Internal Rate of Return Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, IRR is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. It is one of the several measures used for investment appraisal. Decision Rule A project should only be accepted if its IRR is NOT less than the target internal rate of return. When comparing two or more mutually exclusive projects, the project having highest value of IRR should be accepted. To Calculate IRR The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR, Net Present Value (NPV) is zero, thus: NPV = 0; or PV of future cash flows Initial Investment = 0; or

CF1 (1+r)
1

CF2 (1+r)
2

CF3 ( 1 + r )3

+ ...

Initial Investment = 0

Where, r is the internal rate of return; CF1 is the period one net cash inflow; CF2 is the period two net cash inflow, CF3 is the period three net cash inflow, and so on ... But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above equation. However, there are alternative procedures which can be followed to find IRR. The simplest of them is described below: 1. 2. 3. 4. 5. Guess the value of r and calculate the NPV of the project at that value. If NPV is close to zero then IRR is equal to r. If NPV is greater than 0 then increase r and jump to step 5. If NPV is smaller than 0 then decrease r and jump to step 5. Recalculate NPV using the new value of r and go back to step 2.

To calculate NPV that will be negative, we need to select a higher DCF. Therefore, for the project, we guess r to be 20% So the DCF @ 20% is as follows: For year 1=
1 0.8333 (1 20 %) 1
1 = 0.6944 (1 20 %) 2

For year 2 =

For year 3 =

1 0.5787 and so on. (1 20 %) 3

So, calculating NPV @ 20% below: Year 0 1 2 3 4 5 Cash flow -800,000 50,000 120,000 350,000 80,000 800,000 DCF @ 20% 0.8333 0.6944 0.5787 0.4822 0.4018 Net Present Value = Present Values -800,000+ 41,665+ 83,328+ 202,545+ 38,576+ 321,440+ -112,446

Therefore at DCF of 20%, NPV = -112,446

This means that the DCF that will result in zero NPV is between 10% and 20%, So we can use the formula for IRR to interpolate as follows:
IRR r1 NPV1 (r2 r1 ) NPV1 NPV 2
158 ,938 (20 10 ) 158 ,938 112 ,446

Therefore, IRR for the project = 10

= 10+0.5856 (10) = 15.85% Hence the DCF that will make NPV for the project = to zero is 15.85% and this is the IRR too.