Capital Investment Appraisal

• Capital Investment Decisions

  Capex decisions tend to involve significant sums of money being invested for long periods of time, hence the importance of appraisal methods to ensure the correct decision is taken
• Types of capital rationing

  • Soft capital rationing: self-imposed by the business itself
  • Hard capital rationing: external limitations imposed by lenders
• Accounting Rate of Return (ARR)

  • ARR=Average Profit (£) x100% / Average Investment (£)
  • Based on accounting principles, so average profit is measured after depreciation (i.e. after the potential project has paid for itself) and the average investment is the average Net Book Value(NBV) of the investment (i.e. after it has been depreciated each year)
  • The standard profit figure to use is Operating Profit (i.e. Profit before Interest and Taxation)
  • ARR is simple to calculate and a readily understandable percentage measure, which can provide a relative assessment between different projects
  • It takes account of the entire life of the project but takes no account of the time value of money, and is based on profits which are more subjective than cash flows
• Payback Period

  • The length of time for cash inflows from the project to cover the initial investment cash outflow
  • It is a simple to calculate and simple to understand measure of how long a project will take to recoup the initial investment
  • It is based on cash flow (and so is objective) and favours projects which repay quickly
  • However it totally ignores cash flows after the initial payback period and the time value of money
  • Payback gives no indication of project performance and is at best a rough measure of liquidity
• Time Value of Money

  • Reasons why it is preferable to receive money earlier rather than later:
  • i. Inflation - The buying power of money tends to lessen over time
  • ii. Returns Forgone - Cash received now could be invested to produce a return
  • iii. Risk - An expectation to receive money in the future is not certain
  • Discounting is the process of calculating an equivalent 'present value' of an anticipated future cash receipt
  • The further into the future cash receipts are expected the less their present value will be
  • Every business must estimate its own 'cost of capital' which takes into account all three reasons why it is preferable to receive money sooner rather than later
  • Discount tables are used to look-up a 'discount factor' which is then used to 'discount' every future anticipated cash flow back to today's 'present value'
• Net Present Value (NPV)

  • NPV takes into account all the cash flows from a project and discounts all future cash flows to their equivalent present value (at whatever discount factor represents that particular company's cost of capital)
  • A positive NPV means that at today's value of money the project is returning more money than it cost. It is therefore worthwhile as it increases shareholder value
  • A negative NPV means that at today's value of money the project is returning less money than it cost. It is therefore not worthwhile as it will decrease shareholder value
  • NPV is considered to be the most technically sound appraisal method. It is based on all of the project's cash flows, and takes into account the time value of money. However it is slower to calculate and harder to understand, and depends on knowing a 'cost of capital'. It provides an absolute £ result as opposed to a relative % measure
• Internal Rate of Return (IRR)

  • As the cost of capital increases, future cash flows are more heavily discounted and become worth less at today's value of money (i.e. the NPV will be less)
  • At a certain discount factor (i.e.cost of capital) the NPV will reduce to £nil
  • The cost of capital at which the NPV=0 is known as the 'Internal Rate of Return' (IRR)
  • IRR is based on discounted cash flows and so is an objective measure, but unfortunately can be technically flawed with irregular cash flows
  • It is slow to calculate and harder to understand, and it requires the cost of capital to be known in order to assess the relative risk of the project
  • It provides a relative % measure as opposed to an absolute £ result and so is a valuable complimentary measure to NPV