KCB Notes - Project Appraisal Techniques

Question 1

What is the purpose of a project appraisal?

Answer 1

Project (or investment) appraisal, is the financial and economic appraisal of a project or investment to assess its viability and the value it may generate.

Companies normally undertake investment appraisal to identify the attractiveness of an investment before committing to high levels of capital expenditure, such as investing in a new factory, buying new machinery or making investment portfolio decisions.

Question 2

There are 6 project appraisal techniques. 2 are known as the Traditional method, 4 are DCF methods. List them.

Answer 2

Traditional (PA)
Payback Period Method
Accounting Rate of Return

Discounted Cash Flow Methods (NIPD)
Net Present Value Method
Internal Rate of Return Method
Profitability Index Method
Discounted Payback Period Method

Question 3

Give a description of the Payback Period Method.

Answer 3

Payback Period Method measures the length of time the project takes to pay the initial investment back.

It is based on relevant cashflows, not on profits. Therefore it cannot be manipulated. Example, investment of £220k year £0, net cash flow year 1 is £53k, year 2 is £55k, year 3 is £57k and year 4 is £59k. Therefore the payback is in year 3 - actual amount.

** SUM TO GET MONTHS, TAKE AWAY THE AMOUNT LFET OVER FROM CASH FLOW, DIVIDE BY CASH FLOW and X 12.**

Question 4

What are the advantage of using the Payback Period Method?

Answer 4

The payback period uses cash flows, not profits.

It is simple to calculate.

It is adaptable to changing needs.

It encourages a quick return and faster growth.

It is useful in certain situations such as those involving rapidly changing technology.

It maximises liquidity

Question 5

What are the disadvantages of using Payback Period Method?

Answer 5

Disadvantages
* The payback period ignores cash flows after the project payback period.

• It is very subjective, as it gives no definitive investment answer to help managers decide whether or not to invest.
• It ignores the timings of the cash flows. This can be resolved using the discounted payback period which accounts for the time value of money.
• It only calculates the payback period and ignores profitability.

Question 6

Non Discount Method

The Accounting Rate of Return measures the average annual rate of return based on what?

Answer 6

The average annual rate of return (based on accounting profit) on initial investment.

Or

The average annual rate of return (based on accounting profit) on average investment

Question 7

What is the formula for ARR?

Answer 7

ARR = Average annual profit / Average Investment x 100%

How to calculate Average profit.
1. Work out annual depreciation (initial investment - scrap value) / useful years
2. Take depreciation away from initial investment = average accounting profit.

If ARR is more than the target rate of return, the project should be undertaken.

Question 8

What are the advantages of ARR?

Answer 8

Advantages:
* ARR is widely accepted and simple to calculate.
* It uses profits which are readily recognised by most managers. Managers’ performance may be evaluated using ROCE. As profit figures are audited, it can be relied on to some degree.
* It focuses on profitability for the entire project period.
* It is easy to compare with other projects as it is linked with other accounting measures.

Question 9

What are the disadvantages of using ARR?

Answer 9

Disadvantages
* ARR ignores factors such as project life (the longer the project, the greater the risk), working capital and other economic factors which may affect the profitability of the project.
* It is based on accounting profits that vary depending on accounting policies (such as depreciation policy).
* It does not take into account the time value of money.
* The return calculated via ARR can be calculated using different formulas. For example, the return can be calculated using profit after interest and tax, or profit before tax – thus leading to different outcomes. It is important to ensure that returns calculated via ARR are calculated on a consistent basis when comparing investments.
* It is not useful for evaluating projects where investment is made in stages at different times.
*It does not take into account any profits that are reinvested during the project period.

Question 10

What is compounding and discounting?

Answer 10

Compounding is the process of determining the future value of a present cash flow.

Discounting is the process of determining the present value of future cash flows.

Question 11

What is the Net Present Value Method of investment apprisal?

Answer 11

NPV is the net value of a capital investment calculated by adding the discounted present values of all cash inflows and out flows of that project, at an appropriate discounting rate.

Question 12

What are the advantages of NPV?

Answer 12

Advantages:
* Theoretically, the NPV method of investment appraisal is superior to all other methods.

• It considers the time value of money through the discount rate.
• It is an absolute measure of return.
• It is based on cash flows, not profits (which vary depending on accounting policies).
• It takes into account all cash flows throughout the life of a project.
• It maximises shareholder wealth by only undertaking projects with positive NPVs that ensures a surplus over and above the costs of finance.

Question 13

What are the disadvantages of NPV?

Answer 13

Disadvantages:
* The NPV method can be difficult to explain to managers as it uses cash flows rather than accounting profits.
* The calculation of discount rates can be challenging and requires knowledge of the cost of capital.
* It is relatively complex compared to non-discounting methods such as the payback period and ARR

Question 14

What is the Internal Rate of Return when appraising investments?

Answer 14

IRR is the discounting rate at which the NPV of a project is equal to zero.

Question 15

What are the advantages of using IRR?

Answer 15

• The IRR method evaluates potential returns and the attractiveness of potential investments.
• It uses real cash flows rather than profits, which can be manipulated by the use of different accounting policies.
• It takes account of the time value of the money.
• It considers risk of future cash flows (through comparison with the cost of capital in the decision rule).
• Excess IRR over the cost of capital indicates the excess return for the risk contained in the project.
• It gives a percentage rate that can be compared to a target (cost of capital). This is easier for management to understand and interpret than the concept of NPV

Question 16

What are the disadvantages of using IRR?

Answer 16

Disadvantages:
* The IRR is a relative measure that gives a percentage rate that can be compared to a target cost of capital. It ignores other factors such as project duration, future costs and the relative size of the investments. A larger project with a lower IRR may generate a larger surplus than a smaller project with a higher IRR.

• It is not a measure of profitability in absolute terms (unlike the NPV method). The IRR method does not measure the absolute size of the investment or the return.
• It is the most complex of all the investment appraisal methods to calculate. Interpolation by trial and error only provides an estimate, thus requiring a spreadsheet for a more accurate estimate.
• It may not lead to value maximisation when used to compare mutually exclusive projects.
• It may not lead to value maximisation of projects when used to choose projects when there is capital rationing.
• The interpolation method cannot be used for non-conventional cash flows. A project that has large negative cash flows later in its life may give rise to multiple IRRs.
• It assumes that the positive future cash flows are reinvested to earn the same return as the IRR. This may not be possible in real life.

Question 17

What is the Discounted Pay Back Period Method (KCB think might come up!!!)

Answer 17

The length of time the project takes to pay the initial investment back using the discounted cash flow.

Question 18

What are the advantages of Discounted Pay Back Period?

Answer 18

• The discounted payback method considers the time value of money.
• It uses cash flows, not profit.
• It considers the riskiness of the project’s cash flows (through the cost of capital).
• It determines whether the investments made are recoverable.

Question 19

What are the disadvantages of using Discounted Pay Back Period?

Answer 19

The discounted payback method is subjective as it gives no concrete decision criteria that indicates whether the investment increases the firm’s value.

It requires an estimate of the cost of capital in order to calculate the payback period.

It ignores cash flows beyond the discounted payback period.

Calculations can become complex if there are multiple negative cash flows during the project’s life.

Question 20

Explain capital rationing and the types available?

Answer 20

Shareholder wealth is maximised if a company undertakes all possible positive NPV projects. However, when there are insufficient funds to do so, investment capital is rationed or limited.

Capital rationing is a strategy implemented when a company has more acceptable projects than can be financed from existing funds.

Hard capital rationing - when lending institutions impose a limit on the amount of finance available.

Soft capital rationing - when a company voluntarily imposes restrictions that limit that amount of funds available for investments in projects.

Question 21

Profitability index (KCB guess that this might come up!!)

What is it?

Answer 21

When there are a shortage of funds for one period, it is referred to as single capital rationing.

When projects are divisible, e.g. when any fraction of the project can be undertaken and the returns are generated in the same proportion to the amount of the investment undertaken, the profitability index can be used.

The Profitability Index calculates the present value of cash flows generated by the project per unit of capital outlay. Key is, use only when limited budget and divisible projects.

Formula PI = NPV / original cost of investment

higher the PI gets picked. Figures will be for example 0.19 which means that for every £1, the project will generate £0.19 additional value.