Introduction to Capital Investment Appraisal
by Bilal Siddiqui (Karachi Editor)
“Our customized notes are getting quite a response from our readers and we have been receiving requests for more notes of different areas. I would therefore like to clear one thing that there are few topics that we cannot cover in one article so please readers you have to be a little patient”
Capital Investment Appraisal
The purpose behind capital budgeting is to assist managers of organisations make better informed decisions on acquiring and disposing of assets. For example, how and when would you know, without some form of detailed analysis, whether and when to buy a new machine for your factory; or a new vehicle to deliver your goods; or even new land on which to build an extension to your showrooms?
Although there are many aspects to capital budgeting other than the numerical aspects, it is these aspects with which this page is solely concerned. The output of any of the following techniques tells us whether a project is viable – in financial terms only.
Additionally, although I have said that capital budgeting is concerned with acquiring and disposing of assets, I will not be giving examples relating to disposals in this article. The techniques can easily be applied to such situations; and if you are interested in following through to disposals either let me know or look for financial management texts in a good library which contain examples of disposals.
The key numerical techniques to be covered in this page are:
- The Net Present Value Technique (NPV)
- The Internal Rate of Return Technique (IRR)
- The Payback Period Technique (PB)
Net Present Value
The idea behind the NPV technique is that it DISCOUNTS the cash flows generated by an asset back to the present day: thus the NPV technique is concerned with the time value of money. The result we are faced with is usually in the form:
|Net Present Value||24,659.63|
The residual value is taken to be zero.
The key points to notice here are that we are dealing with the NET present value which is the net of the initial (original) cost and the present value of all other cash flows. This is as opposed to the present value of the cash flows which would simply be the sum of 17,319.30 + 18,903.59 … + 5,145.78 = 49,659.63
Thus we are dealing with the value, in terms of today’s prices, of an asset for which we are expecting to pay £25,000 today. A positive NPV of £24,659.63 says that we are being asked to pay £25,000 for an asset worth £49,659.63: a bargain!! Had the NPV been negative – let’s say MINUS £24,659.63 – then we would not be facing such a bargain. In this example, a negative NPV of the value just given would say we were being asked to pay £25,000 for an asset worth only £340.37: definitely not a bargain.
The above example is a case of a CONVENTIONAL investment. A conventional investment is one where an initial outflow of cash (the original capital cost) is followed by positive inflows. A non conventional investment would behave differently: for example, it could have several negative initial outflows followed by some positive and some negative inflows:
The fact that an investment is non conventional does not alter the way the NPV technique works: it is merely another fact for you to impress your friends with!!;-)
Internal Rate of Return
In some senses this is the simplest of the techniques to understand. However, it is the most difficult to cope with mathematically. The best way of viewing the IRR of a project is to consider it in the form of a graph: the NET PRESENT VALUE PROFILE:
Construct a Net Present Value Profitle for yourself!
Reading from the point where the NPV profile itself cuts the horizontal (interest rate) axis gives the value of the IRR – in this case it is 66.15%.
By appreciating that this is how to find the value of the IRR, you can, in fact, define the term yourself: it is the rate of interest applying to a project at which its net present value is precisely zero. The usefulness of this knowledge is that if the IRR is known (and it is relatively simple to discover it for any project with either a good calculator or a computer) then, for any rate of interest which the company has to bear, the management will know whether the project under review is a good one, a risky one or a safe one.
In the example above, then, if the current interest rate being borne by that company is 15% on average, then it knows, with an IRR of 66.15% that interest rates will have to rise a long way before this project becomes non viable. It follows from this that, in general, if the rate of interest being borne or considered is LESS THAN the IRR, the net present value of the project is sure to be positive; and similarly, if the rate of interest is GREATER THAN the IRR, the NPV is sure to be negative.
Confirm the last few statements by inspecting the NPV profile and considering the numerical aspects of that example for yourself.
The Payback Period
In spite of what I said above about the IRR technique being the simplest to understand of all the techniques being presented here, in fact, PB outshines them all for simplicity – once you have got used to it!!
The payback period is measures the length of time it takes a project to repay its initial capital cost. For example, if I buy a machine for £10,000 and it earns me a cash flow of £10,000 for the whole of the first year of its life, I can see immediately that the cash flows have repaid the initial capital cost and therefore that the payback period is exactly one year.
If the same machine gave rise to £5,000 cash flow in the first year and £5,000 cash flow in the second year then the payback period has become two years since that is how long it has taken cumulative cash flows to equal the initial capital cost. Developing that idea more generally now, let’s go back to our original example above: