2 methods to appraise a capex project
Payback period. Method.
The period of time it takes for the initial cost of capital investment to be repaid from net cash inflows.
Discounted cash flow. DCF Method. (also known as Net Present Value)
Is a method of capital investment appraisal which recognises that money has a time value - it compares net cash flows, at their present values, with the initial cost of the capital investment to give a net present value of the capital project.
IRR Internal rate of return
also called DCF (Discounted cash flow) YIELD.
The IRR is the rate of cost of capital at which the present value of the cash inflows exactly balances the initial investment. (Ie NPV is zero)
Ie. The break even % where income equals expenditure.
Higher IRR is preferred.
Decision making criteria when using IRR
Accept the higher IRR where there is a choice between different capital investments.
Accept projects with an IRR greater than either the cost of borrowing (the cost of capital) or the rate of return specified by the biz or organization.
When calculating payback remember
Use Net cash flows not discounted cash flows.
(Nb not just revenue ... must be revenue minus costs)
Cash flows for a capital project.
Cash inflows ?
Cash outflow?
Inflows : receipts from sales and disposals
Outflows : purchase of asset and expenses (excluding dep’n)
When calculating payback to nearest month...
Take amount needed to complete payback and divide by Total income for that year then multiply by 12.
Eg. £2000 (needed)/ £5000 you need 2/5 of a year so :
12/5*2 = 4.8 and round up to 5
If 2 projects have same payback period how to choose?
The earlier the cash flow the better
What does IRR show us
It shows the cost of capital, or rate of return, percentage at which the project breaks even.
The discount factors are basically ‘cost of capital’ or ‘rate of return’
1; 0.909; 0.826; 0.751
These are the factors for a 10% cost of capital or rate of return
Discounted cash flow method takes a cost of capital and you use that to work out NPV.
IRR (also known as DCF Yield) is just the cost of capital rate that gives a NPV of zero.
You have to work it out a bit like high-low method.
Interpolation
Payback pros and cons
Advantages include:
it is simple
it is useful in certain situations:
rapidly changing technology
improving investment conditions
it favours quick return:
helps company growth
minimises risk
maximises liquidity
it uses cash flows, not accounting profit.
Disadvantages include:
it ignores returns after the payback period
it ignores the timings of the cash flows. This can be resolved using the discounted payback period.
it is subjective as it gives no definitive investment signal
it ignores project profitability.
NPV pros and cons
Advantages
Theoretically the NPV method of investment appraisal is superior to all others. This is because it:
considers the time value of money
is an absolute measure of return
is based on cash flows not profits
considers the whole life of the project
should lead to maximisation of shareholder wealth.
Disadvantages
It is difficult to explain to managers
It requires knowledge of the cost of capital
It is relatively complex.
