Capital Investment Appraisal

• Capital investment appraisal is the process of planning expenditure on long-term assets with cash flows extending beyond one year.
• When making capital investment decisions, management’s objective is to select investments that will ultimately add to the organisation’s value while taking cognizance of the social, environmental and governance impact of the decision.
• Methods of investment appraisal include Payback and discounted payback, Net present value, and Internal rate of return.
• The payback period determines the number of years it takes to recover the original investment cost.
• An example of a payback period is Sierra Limited selling appliances and considering a R100 000 investment with the following cash flows: Year Cash flows Cumulative cash flows 1 R25 000 R25 000 2 R38 000 R63 000 3 R45 000 R108 000 4 R56 000 R164 000.
• The investment cost is recovered during Year 3.
• Uncertainty in capital investment appraisal cannot be measured as there is not enough information to assigned a probability.
• An example of sensitivity analysis is: if the initial cost increases by R 1 378 972 today, the Net Present Value (NPV) equals 0.
• Risk can be measured as there is enough information available to assign probabilities to cash flows and use expected values instead of single values.
• This is a 5.5% increase (R 1 378 972 / R 2 500 000).
• Risk in capital investment appraisal requires an enormous amount of estimation.
• Methods to allow for uncertainty in capital investment appraisal include comparing payback periods, increasing the discount rate above the target WACC for riskier investments, and ignoring investment cash flows beyond a certain period.
• Sensitivity analysis, simulation, and Monte Carlo analysis are methods to allow for uncertainty in capital investment appraisal.
• Tax losses can be created if taxable losses arising from an investment can be offset against profits made by the company’s other activities.
• If the company does not have any other taxable profits, the tax loss before and after the investment are the same.
• Sustainable value creation involves considering other issues beyond economic factors with the ultimate goal of creating sustainable value.
• A 170% increase in the discount rate can cause the investment to have a net present value (NPV) of zero.
• Due diligence is the detailed examination of an investment before the acquisition to ensure that the company makes an informed decision.
• A 37.9% decrease in annual cash flows can cause the investment to have a net present value (NPV) of zero.
• A good decision relies on the understanding of the business and should be considered and interpreted in relation to an organisation's strategy and its economic, social and competitive position.
• Post investment audit is when the company compares the actual results of the investment to the original estimates and provides explanations for any differences.
• The aim of a post investment audit is to improve the capital investment appraisal process.
• If the proceeds on sale decrease by R2, the net present value (NPV) will equal zero.
• The internal rate of return (IRR) is the point where the net present value (NPV) is 0.
• The payback period is calculated as follows: R25 000 (Year 1) + R38 000 (Year 2) + R37 000 (Year 3) = R100 000.
• The payback period is 2.82 years.
• Advantages of the payback period include its ease of calculation and understanding, and it gives a measure of risk exposure, with a lower payback period indicating a lower risk.
• When comparing investments with different lifespans, an annual equivalent needs to be calculated and the investment with the higher annual equivalent should be accepted.
• An investment with a negative net present value should always be rejected.
• The investment with the higher net present value should be accepted where investments are mutually exclusive.
• All investments with a positive net present value should be accepted when capital rationing exists.
• The NPV method is superior to all other methods as it takes into account time value of money, assumes that all cash flows received from the investment will be reinvested at the WACC, and selects investments which maximise shareholder value.
• Sierra Limited sells appliances and is considering a R100 000 investment with the following cash flows, discounted at 8%: Year 0, R25 000; Year 1, R38 000; Year 2, R45 000; Year 3, R56 000.
• The payback period is calculated as follows: R23 150 (Year 1) + R32 566 (Year 2) + R35 730 (Year 3) + R8 554 (Year 4) = R100 000.
• All investments with a positive net present value should be accepted where investments are independent.
• The investment cost is recovered during Year 4.
• The payback period is longer when time value of money is taken into account.
• The net present value (NPV) of future cash flows is the present value of future cash flows discounted at the target weighted average cost of capital (WACC) less the cost of the investment.
• Disadvantages of the payback period include ignoring time value of money and inflation, and the allowable payback term is subjective.
• Discounted payback period incorporates time value of money by calculating the present value of the future cash flows prior to identifying the payback period.