MBA Accounting & Finance Guide » Capital Appraisal Methods

True or False Question Test Paper on Capital Budget

slang — Wed, 20 Oct 2010 05:46:31 +0000

Below is a true or false question test paper (with answer) on simple capital budget to refresh your learning of the topic:

{click here for answer}

True or false question test on capital budget

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Capital Investment Appraisal Method:Payback Method

slang — Mon, 15 Oct 2007 12:32:14 +0000

Further to my earlier article on Accounting Rate of Return, let’s look at another simple investment appraisal method called Payback Period.This method seeks to determine how long it takes for the investment project to pay back its initial capital cost.

Illustration:

Let’s say we have two project A & B, having the following initial capital cost, cash inflows and timing

Project A:

Year	Investment	Cash Savings/Inflows	Cumulative Inflows
0	100,000
1		30,000	30,000
2		40,000	70,000
3		30,000	100,000
4

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Net Present Value Compared To Other Capital Investment Appraisal Methods

slang — Mon, 15 Oct 2007 12:29:46 +0000

We have reviewed the four methods of investment appraisal techniques:

Payback
Accounting rate of return
Net Present Value
Internal Rate of Return

The pros and cons of the payback, accounting rate of return and internal rate of return have been explained.

Fundamentally, the greatest disadvantage of the payback and accounting rate of return is that it ignores the time value or the present value of the inflows.

For accounting rate of return, besides ignoring the time value, it only refers to the accounting profit.As such, though they are simple to compute and understand, it’s not a true investment appraisal method as risk in the form of discount rate or cost of capital is completely not considered.

For Internal rate of return, the disadvantages have been outlined in my article.
Net Present Value method (NPV) has the following advantages:

It is the most logical method to enhance shareholder value as it considers the economic profit concept (excess return after deducting its cost of finance).

It’s also flexible, robust , simple to understand and able to cope with much complexity.

It’s takes into account the time value of money and compares today’s investment with the future cash flows in today’s money.

Furthermore, it’s take the risk of the investment into account through the choice of cost of capital or discount rate. The greater the risk so the cost of capital is getting higher.

It considers the whole of the economic life of the investment, not just an arbitrary number of years

It focuses on cash flow and not simply on accounting profit

When there is no budget constraints, Net present value (NPV) is particularly appropriate compared to other alternative investments method. The Internal rate of return cannot work well if it is comparing two mutually exclusive investment projects of different size or scope.

Even though, where we have budget constraints, we can also use the profitability index which is actually net present value reinstated ( present value of cash flows divide by investment outlay)

In view of the foregoing, the most appropriate or superior method should be the net present value or other method that uses discounted cash flow technique.

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The Profitability Index -Pros & Cons

slang — Mon, 15 Oct 2007 12:27:53 +0000

The profitability index is an alternative way of stating the net present value (NPV). It takes the present value of the cash-flows and divides them by the initial capital outlay.
i.e.: Profitability Index (PI) =Present value of cash flows / Initial cash outflow

Interpretation:
If the PI is more than one, then we should invest in the project as it represents a positive net present value.

Usefulness of Profitability Index:
The Profitability Index is useful tool for capital budget constraints and where the projects are divisible. This is true as you will have noticed that net present value (NPV) method tends to favor large investments over smaller one. However, in reality, a company is often operating under capital budget constraints, either fixed by the markets or by top management. This therefore makes NPV method as a less flexible tool.

Assuming the following scenario:
Budget constraints of $300,000
Total following investment cost of 5 projects more than $500,000

Project	Investment	Present Value	Profitability Index	NPV
A	100K	$141K	1.41 (141/100)	$41K
B	200K	$240K	1.20 (240/200)	$40K
C	82K	$120K	1.46 (120/82)	$38K
D	150K	$170K	1.13 (170/150)	$20K
E	50K	$85K	1.70 (85/50)	$35K

As we have the budget constraints of $300K, using the Profitability Index method, we should select the following projects to maximize our net present value:
Project E + Project C + Project A + part of Project B
Investment costs of $50K+$82K+$100K+$68K=$300K
NPV =$35K+$38K+$41K + pro-rate NPV of Project B=68/200×40K=$13.6=$127.6K

Limitation of Profitability Index:
As we have read above, the Profitability Index is merely another way of reinstating net present value. However, when coming to choose between two mutually exclusive projects which have a positive NPV and profitability indices of more than one, we see certain limitation of this index. This is similar to the situation mentioned in my earlier IRR’s article
Illustration:

Project	Investment	Present Value	Profitability Index	NPV
A	$10K	$16K	1.6	$6K
B	$30K	$42K	1.4	$12K

If we use the Profitability Index method, then we should select Project A which has a higher PI than Project B but then Project B actually has a very much higher net present value.

We can further verify this by using the incremental cash flow and seeing whether they fulfil the profitability index decision rule:

	Investment	Present Value	Profitability Index	NPV
Differential between A & B	$20K	$26K	1.3	$6K

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Capital Investment Appraisal Method:Net Present Value(NPV) Method

slang — Mon, 15 Oct 2007 12:23:55 +0000

In basic term, net present value (NPV) of an investment is the difference between:
The present value of future cash flows and the present value of the initial capital expenditure required to implement the project.
Say for example the following project having the follow details:

	Year O	Year 1	Year 2	Year 3	Year 4
Initial Outlay (a)	$100K

Net cash-flows (b)		$20.00K	$30.00K	$40.00K	$50.00K

Using NPV:
PV Factor ©	1.000	0.909	0.826	0.751	0.683
Present Value (ac) or (bc)	- $100K	+$18.18K	+$24.78K	+$30.04K	+$34.15K
Net Present Value	+$7.15K

Interpretation of NPV:
If the project has a positive NPV, it should be accepted. By acceptance, it will increase the shareholders value as it gives a higher return compared to its cost of capital ( in this case is the PV factor or discount factor which we assume is 10%)
It’s important to understand that normally, a positive NPV implies excess returns over its cost of capital. But in economic theory, it will not happens in an efficient and competitive market as competitiveness will remove the opportunities to make excess returns from capital expenditures.
Of course in the real world, we have imperfection, however it’s interesting to note and rationalize the source of the positive NPV or the excess return. Is it from any superior technological expertise, R&D, trademarks and patents, market knowledge & skill, quality control, distribution network, after sales service and client relations or the caliber of management and employees? By identify the competitive factors that generate positive NPV , we are able to understand better the reasons for the project’s profitability.

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Pros & Cons Of Internal Rate Of Return (IRR)

slang — Mon, 15 Oct 2007 12:19:38 +0000

In the earlier articles, we have looked at how we compute NPV and IRR and also understand how to interpret the individual result.
One very good point is that both NPV and IRR are able to eliminate the greatest disadvantage of ignoring the time value of money or present value unlike the other two methods -Payback and ARR.

We now focus on the advantages of using IRR:

IRR is useful for the following reasons:

If a company had specified it’s “hurdle rate” or a required cost of capital that new projects must achieved in order to be accepted. By just calculating the IRR, it is then compared to the hurdle rate to see whether the IRR is above the rate and the project can be accepted. Incidentally, even without the hurdle rate, if the IRR rate is very high say 32%, this can some sort warrant further analysis as this high IRR rate seems to be much more than the probable opportunity cost of capital.

IRR is a “true” return (using present value concept) on the investment compared to the other accounting rate of return.

However IRR also has its critique which is as follows:

IRR does not tell us anything about the size or scope of a potential investment. This is especially important when we are choosing between two mutually exclusive investments, where only one of the investment projects can be chosen.

Say for example, if we are choosing two investment projects with capital outlays of $1,000 and $10,000 and the IRR of the $1,000 is higher. If we use the IRR method than the IRR which is higher will be more attractive. However, the Net Present Value of the other investment could be much high and so we make have made a less than perfect decision. Therefore, the IRR method is not suitable for making comparisons between two investment projects of different scope or differing time horizons.
For illustration purpose that IRR is not suitable to be used when we need to choose between two mutually exclusive investments:

Year	Project A Investment	Cash-flows	Project B Investment	Cash- flows
0	-$100K		-$40K
1		$40K		$20K
2		$50K		$20K
3		$70K		$30K
	NPV @10%	$20K(say)		$10K(say)
	IRR	15%		22%

Project A should be chosen if the NPV method was used whilst Project B should be chosen according to its IRR. But, by taking the differential/remaining cash-flows and calculating the NPV and IRR, we can see that this would have been a less than perfect decision.
Differential Balance of Cash-flow

Year	Investment Project A – B	Cash-flows
0	-$60K
1		$20K
2		$30K
3		$40K
	NPV @10%	$6K(say)
	IRR	14%

The differential table shows that there is still value to be gained to enhance shareholder value by investing the differential.

The other disadvantages of IRR are:

There is technical disadvantages to using the IRR method when dealing with unconventional cash-flows.

We can have more than one IRR depending on the flow of the cash-flows. As IRR is determined by mathematical iterations, it is possible to have two IRRs when there is more than one change in the direction of the cash-flows. In a normal investment, in the initial one to two years, there are negative cash-flow but subsequently followed by positive cash-flow. But if an investment has a negative cash flow at the end of its economiclife, the investment would actually have two IRR like in a company which is processing radioactive material materials, it will have to invest heavily at the end of the investment’s life to dispose of the radio-active waste products.

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Capital Investment Appraisal Method:Internal Rate Of Return

slang — Mon, 15 Oct 2007 12:13:10 +0000

In the previous article on NPV, we noted that a positive NPV denotes that a project can be accepted as it generates excess returns over its cost of finance. Hence, vice-versa, we cannot accept a negative NPV as it cannot generate a return above the cost of finance.
How do we then interpret a zero NPV
Zero NPV is actually the Internal Rate of Return which is therefore the discount rate that causes:
The present value of all the future cash flows – the present value of the initial outlay to yield an NPV of zero.
Using the same cash flow’s details from the NPV case, we shall try to get the IRR:

	Year O	Year 1	Year 2	Year 3	Year 4
Initial Outlay (a)	$100K

Net cash-flows (b)		$20.00K	$30.00K	$40.00K	$50.00K

Using PV factor of 10% NPV=	+$7.15K

Simulating it :
Using PV factor of 15% NPV=	+$0.5K
Using PV factor of 12% NPV=	$0.00K

To calculate the Internal Rate of Return, we can either use the interpolation method which is to take two discount rates, one rate that gives a positive NPV and another discount rate that give a negative NPV and interpolate the IRR.
Or you can use a calculator or a computer model (excel formula for IRR).

Interpretation of IRR:
If the IRR for the project is12% and the cost of capital used to finance it is lesser than 12%,then the project should be accepted.

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Capital Investment Appraisal Method:Accounting Rate Of Return

slang — Mon, 15 Oct 2007 12:01:00 +0000

There are many investment appraisal techniques.

Today’s article is confined to the discussion of the Accounting Rate of Return Method or Accounting Return on Book Value. First, we shall go thro’ an illustration to demonstrate how it’s being calculated and then go on with the discussion on its advantages and disadvantages.

Incidentally, the Accounting rate of return is very commonly used as this concept is a very familiar concept to return on investment (ROI), return on capital employed(ROCE) or accounting rate of return(ARR).

The formula for this method is Average Annual Income/Average Annual Investment

Illustration:

Let’s say we are evaluating the below said project with the following Initial Outlay/Investment and Net Cash flow ( Revenue minus Costs)

Investment:

	Year 0	Year 1	Year 2	Year 3	Average
Gross Book Value of Investment	100,000	100,000	100,000	100,000
Depreciation		20,000	20,000	20,000
Accumulated Depreciation		20,000	40,000	60,000
Net Book Value	100,000	80,000	60,000	40,000	70,000

Returns/Net “Cash flow (Revenue-Costs)

	Year 1	Year 2	Year 3	Average
Revenue(a)	50,000	70,000	100,000
Costs (b)	20,000	30,000	40,000
Cashflow (a-b)	30,000	40,000	60,000
Depreciation	20,000	20,000	20,000
Net profit	10,000	20,000	40,000	23,300

Accounting Rate of Return = Average annual returns

Average annual investments

= $23,300

$70,000

= 33.3%

What are then the Pro’s and Con’s of ARR:

Pro’s	Con’s
It takes all the years into account when making an investment decision,	There is no account of *time value of money*. It does not take into account the fact that dollars to be received in the future is not worth as much as money in the hand today.
It’s is easy to use and is familiar concept to managers which they refer to as “ return on investment” or “ return on Capital employed.	It is purely based on *accounting figures* and not on cash flow. Thus it Does not take into account the *working capital requirements* that are needed for the investment as working capital is not captured in accounting profit, can be *manipulated by changing accounting methods like depreciation rates & methods* which have nothing to do with the underlying investment.
	Having calculated the return, we still do not know *whether the return is acceptable or not*? Perhaps, we can compare it to other companies in the industry. But don’t forget that the other companies might be using different accounting convention, Secondly, high accounting rate of return, the project or investment can be rejected because this cannot be compared to other past returns. This is despite that the high returns are still profitable to the company.

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