There are many techniques that can be adopted by the decision-maker to assist them in accepting certain investment opportunities. Besides the financial statement analysis, which is a core tool to assess investment, we must prefer Investment Appraisal Techniques. These techniques are payback period, return on capital employed, net present value and internal rate of return.
>> You can refer to post of Financial Statement Analysis in Investment Decision
A company seeks the best or most profitable investment so that it can maximize the return to its shareholders. This is not always an easy assessment because it is dependent upon the period and the level of risk prepared to take. We will go into detail to get an understanding of the advantages and disadvantages of each method mentioned above.
1. The Payback Method
It is the most popular investment appraisal method. The payback period is the number of years expected to take to recover the original investment from the net cash flows resulting from a capital investment project. The decision rule when using the payback method to appraise investment is to accept a project if its payback period is equal to or less than a predetermined target value. Shorter paybacks mean more attractive investment. Investors and managers can use it to make quick judgments of their investments.
Example of the Payback Method
| Year | Cash flow ($) | Cumulative cash flow ($) |
| 0 1 2 3 4 5 | (450) 100 200 100 100 80 | (450) (350) (150) (50) 50 130 |
After 3 years, the project has generated total cash inflows of $400. During the fourth year, the remaining $50 of initial investment will be recovered. To draw up a table of cumulative cash flow is useful to determine the payback period.
Payback period between 3 and 4 years = 3 + 50/100 = 3.5 years (3 years 6 months)
1.1 Advantages of the Payback Method
It is straightforward to understand. It is simple and easy to apply. The payback period is calculated by using cash flows, not accounting profits. So it should not be open to manipulation by managerial preferences for particular accounting policies.
It can be calculated as formula below
| Payback period = Initial Investment / Estimated Annual Cash Flow |
This analysis method is particularly helpful for smaller firms. Because it focuses on short-term cash flow only. The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments.
1.2 Disadvantages of the Payback Method
It ignores the time value of money and adjusts the cash inflows accordingly. The time value of money is the value of cash today will be worth more than in the future because of the present day’s earning potential.
Another serious disadvantage of the payback method is that it ignores all cash flow outside the payback period. It does not consider the project as a whole. It also fails to compare the overall profitability between two projects which have the same payback period. The project given in the example above will be rejected if the company decides to reject all projects with payback periods greater than 3 years. Even this project had been expected to generate a cash inflow of $100 in year 4. These expected cash inflows have been ignored if the sole investment appraisal method applied was the payback method.
Besides, it does not give any indication of whether an investment project increases the value of company. Because it does not measure profit.
1.3 Discounted Payback Method
The problem of ignoring the time value of money is partly remedied by using the discounted payback method. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. It is used to evaluate the feasibility and profitability of a given project.
We consider the example given below, where the appropriate discount rate is 15%
| Year | Cash Flow ($) | 15% PV | Present Value ($) | Cumulative NPV ($) |
| 0 | -5000 | 1 | -5000 | -5000 |
| 1 | 2300 | 0.87 | 2001 | -2999 |
| 2 | 2500 | 0.756 | 1890 | -1109 |
| 3 | 1200 | 0.658 | 790 | -319 |
| 4 | 1000 | 0.572 | 572 | 253 |
| 5 | 1000 | 0.497 | 497 | 750 |
The discounted payback period is approximately 3.5 years. An un-discounted payback period is approximately 2.2 years. It means there is a long period to cover initial investment if using the discounted payback period.
2. The Return on Capital Employed Method
It is also called return on investment (ROI) and accounting rate of return (ARR). It measures the annual income of a project as a percentage of the total investment cost. That is something that simple payback does not do.
| ROCE = (Average Annual Accounting Profit / Average Investment) x 100 |
| Average Investment = (Initial Investment + Scrap Value) / 2 |
An investment project will be accepted if its return on capital employed is greater than a target or hurdle rate of return set by the investing company. If only one of two investment projects can be undertaken, the project with the higher return on capital employed should be accepted.
2.1 Advantages of the Return on Capital Employed Method
It measures an investment’s profitability and the efficiency with which its capital is used. It is also a reasonably simple method to apply and can be used to compare mutually exclusive projects. Unlike the payback method, it considers all cash flows arising during the life of an investment project. It can indicate whether a project is acceptable by comparing the ROCE of the project with the target rate.
It is also a relatively straightforward method. That is easy to understand.
2.2 Disadvantages of the Return on Capital Employed Method
The method uses average profits, it also ignores the timing of profit. For example, we consider 2 projects A & B below
| Year | 0 | 1 | 2 | 3 | 4 |
| Project A | |||||
| Cash Flows | -45000 | 11000 | 12250 | 12250 | 32000 |
| Depreciation | 11250 | 11250 | 11250 | 11250 | |
| Accounting Profit | -250 | 1000 | 1000 | 20750 | |
| Project B | |||||
| Cash Flows | -45000 | 17250 | 17250 | 1670 | 16250 |
| Depreciation | 11250 | 11250 | 11250 | 11250 | |
| Accounting Profit | 6000 | 6000 | 5500 | 5000 |
Both projects have the same initial investment and zero scrap value. Hence, it also has same average investment of $22500 (=$45000/2)
Both projects have the same average annual accounting profit
- Project A: (-250+1000+1000+20750)/4 = $5625
- Project B: (6000+6000+5500+5000)/4 = $5625
So their return on capital employed is also same as calculated
ROCE = (100 x 5625)/22500 = 25%
We can see that project B has a smooth pattern of returns, whereas project A has not. Project A gets loss in the first year, gets little in the next 2 years, and then a large return in the final year. Even though they both have the same ROCE, project B is preferable than project A. It means that this method ignores the pattern of cash flow when they occur.
It also fails to take into account the length of the project life since it is expressed in percentage term. The length of the project may be an estimate, so later cash flows are unlikely to be accurate as they are longer-term forecasts.
A more serious limitation is that the return on capital employed method does not consider the time value of money. It gives equal weight to profits whenever they occur. One project returns more revenue in the early years compared to another project, which returns revenue in the latter year. That project is not assigned by this method.
For these reasons, the return on capital employed method cannot be seen as offering sensible advice about whether a project creates wealth or not.
3. The Net Present Value Method
The method of investment appraisal uses discounted cash flows to evaluate capital investment project. Money earned in the future will not be worth as much as money earned in the present due to inflation. Therefore, if a business wishes to compare two possible investments, which deliver different returns in the future, it must convert all future return into present value (PV) by discounting future returns. To evaluate the worth of an investment, we will need to calculate the Net Present Value
| Net Present Value = -I₀ + C1 / (1+r) + C2 / (1+r)² + C3 / (1+r)³ +…+ Cn / (1+r)ⁿ |
Where: I₀ is the initial investment
C1, C2, C3,…, Cn are the project cash flows occurring in year 1, 2, 3, …, n
r is the cost of capital or required rate of return
- NPV is positive: An investment will be profitable
- NPV is zero: the inflows equal the outflows. The project may or may not be rejected
- NPV is negative: that is result of loss. The project will be rejected
Example
| Period | Project A ($) | Project B ($) |
| 0 | -5000 | -5000 |
| 1 | 800 | 2000 |
| 2 | 900 | 2000 |
| 3 | 1200 | 2000 |
| 4 | 1400 | 100 |
| 5 | 1600 | 100 |
| 6 | 1300 | 100 |
| 7 | 1100 | 100 |
NPV for Project A
| Period | Cash flow ($) | 10% PV factor | PV ($) |
| 0 | -5000 | 1 | -5000 |
| 1 | 800 | 0.909 | 727 |
| 2 | 900 | 0.826 | 744 |
| 3 | 1200 | 0.751 | 902 |
| 4 | 1400 | 0.683 | 956 |
| 5 | 1600 | 0.621 | 993 |
| 6 | 1300 | 0.564 | 734 |
| 7 | 1100 | 0.513 | 564 |
| NPV | 621 |
NPV for Project B
| Period | Cash flow ($) | 10% PV factor | PV ($) |
| 0 | -5000 | 1 | -5000 |
| 1 | 2000 | 0.909 | 1818 |
| 2 | 2000 | 0.826 | 1653 |
| 3 | 2000 | 0.751 | 1503 |
| 4 | 100 | 0.683 | 68 |
| 5 | 100 | 0.621 | 62 |
| 6 | 100 | 0.564 | 56 |
| 7 | 100 | 0.513 | 51 |
| NPV | 212 |
If the projects are mutually exclusive, then Project A should be selected since it has higher NPV than Project B. If the projects are not mutually exclusive, there is no restriction on capital available for investments, all two projects should be undertaken as all have a positive NPV.
3.1 Advantage of the Net Present Value Method
It takes account of the time value of money, which is one of the key concepts in corporate finance. The net present value uses cash flows rather than accounting profit. It takes account of both the amount and the timing of project cash flows. It also considers all relevant cash flows over the life of an investment project. It is more scientific than the other methods. For all these reasons, the net present value is the academically preferred method of investment appraisal.
3.2 Disadvantage of the Net Present Value Method
It seems to be complex to calculate. It has also been pointed out that it is difficult to estimate the value of cash flows over the life of project. If the estimate of net cash flow is wrong, we cannot calculate the correct NPV. It is difficult to forecast the cash flows. That is a problem of investment appraisal in general
Besides, the selection of the discount rate is very important, not remain constant over the life of project. So it may be difficult to estimate. Since it is influenced by the dynamic economic environment within which all business is conducted.
3.3 The Profitability Index
If a company does not have sufficient funds to undertake all projects that have a positive NPV. What investment opportunities must be chosen that is questions need to find. It needs to rank investment projects in terms of desirability. The NPV method cannot be used to rank investment projects if capital is rationed, since ranking by NPV may lead to incorrect investment decision. When ranked by NPV, the smaller projects are ranked below the larger one. But a combination of smaller projects may collectively offer a higher NPV than a single project.
The profitability Index (PI) is an approach to rank projects. It tells us how much we can expect to receive, in present value terms, for each unit of currency invested in the project.
| Profitability Index = Present Value of Future Cash Flows / Value of Initial Capital Invested |
Investment with higher PI should be undertaken. A PI greater than 1 indicates that the project should proceed. In contrast, a project with PI below 1 should be abandoned.
4. The Internal Rate of Return Method
The internal rate of return (IRR) of an investment project is the cost of capital or required rate of return which, when used to discount the cash flows, produces a net present value of zero. This method is used to calculate the IRR of a project, usually by linear interpolation. Then it is compared with target rate of return or hurdle rate. All independent investment projects with an IRR greater than the company’s cost of capital or target rate of return will be accepted.
| C1 / (1+IRR) + C2 / (1+IRR)² + C3 / (1+IRR)³ +…+ Cn / (1+IRR)ⁿ – I₀ = NPV = 0 |
Where: C1, C2, C3,…, Cn are the project cash flows occurring in year 1, 2, 3,…,n
IRR is the internal rate of return
I₀ is the initial investment
4.1 Advantage of the Internal Rate of Return Method
The most important thing is that the internal rate of return method considers the time value of money when evaluating a project. It is used to compare the profitability of establishing new operations with expanding the existing one. A project with substantially higher IRR value than others will provide a much better chance of strong growth.
If the IRR exceeds the cost of capital, that is a profitable project. The company will often establish a required rate of return (RRR) to determine the hurdle rate (minimum acceptable return rate) that the investment in question must earn the profit. The hurdle rate is difficult to decide. In the IRR method, there is no requirement for finding out the IRR hurdle rate. Any project with an IRR higher than RRR, it can be accepted.
IRR is useful in evaluating stock buyback programs. It can be compared to the prevailing rate of return in the securities market. If there is no project with IRR higher than returns generated in the financial markets, the company invests its retained earnings into the securities market.
4.1.1 IRR vs. Compound Annual Growth Rate
The compound annual growth rate (CAGR) measures the return on an investment over a certain period. The IRR is also rate of return but is more flexible than the CAGR. CAGR can be calculated by hand by using the beginning and ending value. IRR considers all cash flows which reflect the fact that cash inflows and cash outflows often constantly occur when it comes to investment. So IRR is used in evaluating for more complicated investment that has many different cash inflows and cash outflows.
4.1.2 IRR vs. Return on Investment
Return on investment (ROI) is the percentage increase or decrease of an investment over a set period. ROI calculation will vary depending on which figures are included as earnings and cost. The investment has a longer period, it is more challenging to determine earnings, cost and other factors such as the rate of inflation or the tax rate. The estimation of cost and earnings is difficult to estimate correctly. For this reason, ROI may be less meaningful for long term investment, so IRR is often preferred.
4.2 Disadvantage of the Internal Rate of Return Method
When we consider 2 mutually exclusive projects, the project with higher IRR must be preferred. Since the projects are mutually exclusive, so the IRR method is not enough to give decisions. We must refer to NPV. The correct decision is to choose the project with the higher NPV even it has lower IRR compared to another project. The IRR method is only a relative measure of return. NPV measures the absolute increase in the value of company.
If an investment project has cash flows of different sign in successive period (a cash inflow followed by cash outflow, followed by a further cash inflow), it may have more than one internal rate of return. The existence of multiple internal rate of return will cause to take incorrect decision if the IRR method is applied only. In this case, the NPV method gives the correct investment advice as it can accommodate unconventional cash flows.
Cash flows are often reinvested at the cost of capital, not the same rate at which they were generated in the first place. So there are changes in the cost of capital over the life of an investment project. While IRR assumes that the growth rate remains constant. It is very easy to overstate the profitability of a project. NPV method will be used to resolve this problem as it can easily incorporate changes in the discount rate.
In conclusion, after understanding the techniques to be employed, NPV is considered to be the most valid technique in evaluating an investment project. A company using discounted cash flow investment appraisal methods should, therefore, perform better than those using simplistic methods. The best investment project is chosen that will maximize shareholder wealth.
(Source from Investopedia)
Anna Do It 