THE COPPERBELT UNIVERSITY

In association with

TECHNICAL AND VOCATIONAL TEACHERS’ COLLEGE

BACHELOR OF BUSINESS STUDIES WITH TEACHER EDUCATION

BBSTE 4th Year

EN 420 ENTREPRENEURSHIP

INVESTMENT APPRAISAL TECHNIQUES

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UNIT 11

INVESTMENT APPRAISAL TECHNIQUES

At the beginning of the course, we saw that one of the three major decision areas in an
organization is that of investment appraisal. An entrepreneur has to use appraisal
techniques in order to decide which of the projects should be accepted and which ones
to be rejected. Investment appraisal techniques are the financial models and techniques
that are commonly used in capital budgeting.

The capital budgeting techniques will largely shape the future of the organization and its
ability to manage its future operations. Such decisions are costly and generally difficult
to reverse once made. That is why an entrepreneur should ensure that the decisions
are right the first time they are made.

Reasons for Capital Expenditure

Maintenance

This is spending on new assets to replace worn-out assets or obsoletes. This could also
be spending on existing fixed assets to improve safety and security features.

Profitability

This is spending on new assets to improve profitability of existing business, to achieve

cost savings, quality improvement and improved productivity

Expansion

This is spending to expand the business, to make new products, open new outlets, and
invest research and development.

The investment Appraisal Techniques considered in this unit are those of long term
nature; ie which last for more than one year, such as

- Plant and machinery,- buying new technologically advanced machinery

- Land and buildings ;- new factories and warehouse space for expansion

- Redundancies;- when becoming more capital intensive

- Marketing ;- when spending a substantial amount of money on long term

brand building

- Patents;- when an organization spends a lot of money to protect its inventions ( to

prevent copywriting)

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- An entire company;- an acquisition of a competitor or a supplier

All the above have some kind of benefit which is achieved in one of the two ways,
namely;

i will make the business increase its revenue or;

ii or reduce its costs of doing business

FTC Foulks Lynch (2005) outlines the following Investment Appraisal Techniques;

a) The Net Present Value Method (NPV)

A present value for a future cash flow is calculated by multiplying the future cash flow by
a factor provided in a discount factors and discount table and the formula is; 1/ 1 +r n

This method takes into account the time value of money; thus; a kwacha today is worth
more than its value in the unforeseen future. For this reason, it is important that an
investor works out the present value of an expected future cash flow to determine
whether it is worth investing in or not.

Note that, to calculate a present value for future cash flows, you multiply the future cash
flow by the given discount factor in the discount table. The formula is; 1/ 1 +r n

Or cash flow (1+r) n-

Example; If you are calculating the discount factor at 10 % cost of capital, then it will be
as shown below; using the formula is; 1/ 1 +r n

1/1.10 = 0.909

1/1.10 2 = 0.826

1/1.10 3 = 0.751

Any cash flows that take place “now” (at the start of the project) take place in the year 0.
The discount factor for year 0 is 1.0 regardless of what the cost of capital is.

NPV is the value obtained by discounting all cash outflows or inflows at the cost of
capital. It’s the sum of the present value (PV) of all the cash inflows from a project
minus the PV of all cash out flows.

The sum of the present value of all the cash flows from the project is the “Net” present
value amount. The NPV is the sum of the present value (PV) of all the cash inflows
from project minus the PV of all cash outflows. (i.e. the amount invested)

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Example

Rug Limited is considering a capital investment in new equipment of K240,000. The

estimated cash flows from this investment are as follows;

1 80,000

2 120,000

3 70,000

4 40,000

5 20,000

The company’s cost of capital is 9%. Calculate the NPV of the Project to assess
whether it should be undertaken or not.

Solution

Year cash flow discount factor at 9% Present Value (K)

K K

0 (240,000) 1.000 (240,000)

1 80,000 0.917 73,360

2 120,000 0.842 101,040

3 70,000 0.772 54,040

4 40,000 0.708 28,320

5 20,000 0.650 13,000

Net present Value = Total in flows – initial investment

= K269,760 – K240,000 = +K29,760

Since it is a positive value, the investment is profitable and should be under taken.

Therefore, the decision rule is, accept the project. The PV of cash inflows exceeds the
PV of cash outflows by K 29,760.

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Decision criteria: Accept a project with a positive NPV

b) Payback period method of Appraisal

Michael Barratt (2000) explains that; Payback is the time that a project will take to pay
back the money spent on it and that, Payback period method is one of the methods
used to measure the success of any investment proposal. The method determines how
quickly the cost of the investment can be recouped. It is based on expected cash flows
from the project, not accounting profit. At the end of the payback period the cash inflows
from a capital investment project will equal the cash outflows. (FTC Foulks Lynch 2005).

Calculating payback for constant annual cash flow

If the expected cash inflows from a project are equal amount, the payback period is
calculated simply as:

Payback period = initial payment/ annual cash flow

Example 1

An expenditure of K2 million is expected to generate cash inflows of K500,000 each

year for the next seven years.

What is the payback period for the project?

Solution

Payback = K2,000,000/ K500,000 = 4 years

Example 2

What would be the payback period?

Solution

Payback = K1,800,000/K350,000 = K5.1429 years

This can be stated in either of the following ways

Payback will be in 5.1years

Payback will be 5 years 2 months

Payback in years and months is calculated by multiplying the decimal fraction of a year
by 12 months.

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In the above example 0.1429 years = 1.7 months (0.1429x12 months), this is rounded
to 2 months.

Calculating payback for un even cash inflows of a Project;

Under this calculation, annual cash flow from a project varies from year to year. It is
calculated by working out the cumulative cash flow over the year of the project.
Cumulative cash flow is worked out by adding each year’s cash flows on cumulative
basis, to net cash flow to date for the project. (FTC Foulks Lynch 2005)

Decision criteria: Accept a project with the shortest payback period

Example 3

A project is expected to have the following cash flows.

Year Cash flow

K(000)

0 (2000)

1 500

2 500

3 400

4 600

5 300

6 200

Calculate the expected Payback Period for this project.

Solution

Year Cash flow Cumulative cash flow

K(000) K(000)

0 (2000) (2000)

1 500 (1500)

2 500 (1000)

3 400 (600)
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4 600 0

5 300 300

6 200 500

The payback period is exactly 4 years

Take note that, Payback period is not always an exact number.

Example 4

Calculate the Payback periods for the following two Projects with an investment outlay
of K10,000.

Year Project Y Project Z

Cash flows Cash flows

0 (K10, 000) (K10, 000

1 K5, 000 K 5,000

2 K6, 000 K 4,000

3 K7, 000 K12, 000

Solution

Project A

Year Cash flows Cumulative CFs

0 (K10, 000) ( K10,000)

1 K5,000 ( K 5,000)

2 K6,000 (we only need K5,000 from the K6,000 inflow)

3 K 7,000

To find the months it will take for the Project to make the K5,000 in a year, we
use the formular;

= Investment amount still needed / Cash flow x 12 Months

= K5,000/ K6,000 X 12Months = 10 Months

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Therefore, the payback period for the Project is 1 year 10 Months

Self Test Try to calculate the Payback period for Project Z

Project Z Cash flows

0 (K10, 000)

1 K 5,000

2 K 4,000

3 K12, 000

Merits of payback

Simplicity – as a concept its easily understood and easily calculated

Payback favours project with quick returns- rapid paybacks lead to rapid returns

Cash flows- it uses cash flows rather than profits

Payback minimizes risk- the shorter the payback period the lesser chances that
something will go wrong.

Rapid payback maximizes liquidity

Payback improves investment conditions

Rapid payback leads to rapid company growth

Demerits of Payback

It ignores project returns- cash flows arising after the payback period are totally
ignored.

Payback ignores profitability and concentrates on cash flows and liquidity.

Time value of money is ignored because cash flows are categorized as pre-
payback or post payback

Payback takes into account of the effects on business profits and

periodic performance of the project as evidenced in the financial statement.

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c) The Accounting Rate of Return (ARR) or Return on Investment (ROI)

The method is used to measure profitability as a rate of return on an investment

and is a simple method of assessing the profitability of different investment
proposals.

In its simplest form, it is calculated by finding the percentage of the investment

that the profit gained represents.

The Accounting rate of return divides the average profit by the initial
investment to get the ratio or return that can be expected from an investment.

There are several steps to this calculation, demonstrated by the following

example;

Step 1 Calculate total cash flows expected

Step 2 Calculate profit; i.e. Expected total cash inflows minus

Step 3 Calculate Average profit by; dividing profit by number of years (periods of
investment) i.e. Profit / number of years

Step 4 Calculate the Average Annual Rate of Return (AAR of R) or Accounting

Rate of Return (ARR); Divide average profit by the initial investment;

(AAR of R) or (ARR) = Average profit / initial investment x 100 to get the %.

Decision criteria: Accept a project with a highest ARR.

Example; The two Projects are proposed for investment using K10,000 available
resource. The expected Cash inflows are given below;

Year Project Y Project Z

0 (K10, 000) (K10, 000

1 K5, 000 K 5,000

2 K6, 000 K 4,000

3 K7, 000 K12, 000

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Required; Calculate the ARR for each of the projects;

Solution;

Year Project A

Cash flows

0 (K10, 000)

1 K 5,000

2 K6,000

3 K7,000

Accounting Rate Of Return (ARR) OR Average Annual Rate of Return ( AARR) will be;

Step 1 Total Cash inflows = K18,000

Step 2 Profit on the project in 3 years =

Total cash flows – Investment = K18,000 – K10,000 = K8,000

Step 3 Average profit = Profit in 3 years / Number of periods = K8,000/3 =K2,667

Step 4 ARR = Average profit/ Investment = K2, 667/K10, 000 = 26.67 % or 27%

Self Test: Try and calculate the ARR for Project B

The other methods available are;

-Internal Rate of Return (IRR)

-The Cost Benefit Ratio or Profitability Index (PI)

Note: Since forecasting Profitability and Investment Appraisal Techniques are covered
in detail by another course, there is no need to go into details at this level.

REFERENCE

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PRESCRIBED BOOKS

1. Scarborough M (2008) Essentials of Entrepreneurship and Small

business Management. New Jersey: Pearson education.

3. Calvin R (2002) Entrepreneurial Management. USA: McGraw- Hill Education

4. Hisrich PH. D et al (2005) Entrepreneurship. New York : Mcgraw-

Hill Education.

RECOMMENDED READINGS

1. TEVETA Trainers Manual (2003) Entrepreneurship Skills

Development Programme Chart No. 138: Zambia.

2. Kirby David A (2003) Entrepreneurship. USA: McGraw-Hill Education

3. Kotler Philip et al (2005) Principles of Marking 4th Ed. New Jersey:

Prentice Hall Inc

4 Michael Barratt and Andy Mottershead; (2000) Business Studies 1st

Edition. Pearson Education Limited, Edinburgh Gate. England

Related Reading: Linear Approach to Forecasting & Valuation Techniques

http://www.businessdictionary.com/definition/innovation.html#ixzz2zz37LkLy

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