The Institute of Chartered Accountants of Sri Lanka

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1 The Institute of Chartered Accountants of Sri Lanka Quantitative Methods for Business Studies Handout 06: Investent Appraisal Investent Appraisal Investent appraisal is called as capital budgeting. It is the used to deterine whether an organization's long ter investents such as new achinery, replaceent of achinery, new plants, new products, and research developent projects are worth the funding. It should in accordance with the fir's capitalization structure. 1. The Accounting Rate of return Accounting rate of return is also known as the Average rate of return (ARR). This is a financial ratio used in capital budgeting. The key advantage of ARR is that is easy to copute and understand. The ain disadvantage of ARR is that it disregards the tie factor in ters of tie value of oney or risks for long ter investents. The ARR is built on evaluation of profits and it can be easily anipulated with changes in depreciation ethods. The ARR can give isleading inforation when evaluating investents of different size The accounting Rate of Return = Average annual return/average annual investent *100 Average annual return is the profits after depreciation. Average annual investent = (Purchased cost -residual value)/2 The accounting rate of return is widely used to evaluate investent projects. It produces a percentage value. The decision akers can easily copare interest rates with the accounting rate of return to identify viability of the investent.

2 Exaple 01. ABC Transport Copany thinking of purchasing a luxury car to sustain its prestige custoers. The purchase cost of the vehicle is Rs. 12,000,000. The copany anticipates that it will use the vehicle for five years and at the end of the period it can sell for 4,000,000. The expected revenue generation is as follows: By end of the year Net profits before depreciation ,500, ,000,000 Copute the Accounting Rate of Return. Average annual profits before depreciation ( + ++2,500,000+2,000,000)/5 = 2,700,000 Fro this aount annual cost of depreciation shall be subtracted ( )/5 = 1,600,000 The average annual profits after depreciation = 2,700,000 1,600,000 = 1,100,000 The average annual investent = ( )/2 = 4,000,000 The Accounting Rate of return = 1,100,000/4,000,000 * 100 = 27.5%

3 Payback Period This is a straight forward concept. The payback period does not take into account the tiing of the cash flows. The period required to cover the investent is coputed as an investent appraisal ethod. Eg. ABC Transport Copany thinking of purchasing a luxury car to sustain its prestige custoers. The purchase cost of the vehicle is Rs. 12,000,000. The copany anticipates that it will use the vehicle for five years and at the end of the period it can sell for 4,000,000. The expected revenue generation is as follows: year By end of the Net profits before depreciation 2,500,000 2,000,000 The net cash flows are suarized as follows: End of Year Cost/receipts Net cash flow Cuulative cash flow 0 Cost of the vehicle -12,000,000-12,000,000 1 Net profits before depreciation -9, Net profits before depreciation -6,000,000 3 Net profits before depreciation - 4 Net profits before depreciation 2,500, ,000 5 Net profits before depreciation 2,000,000 1,500,000 5 Sale of vehicle 4,000,000 5,500,000 Payback period = ,000/2,000,000 = 4.25 Years

4 Discounting (present value) Present value of the ordinary annuity n p 1 (1 r / ) Pva r/ Discounting is the reverse of copounding. Its ajor application in business is in the evaluation of capital expenditure projects, to decide whether they offer satisfactory return to the investor. r n A P(1 ) r Fv Pv(1 ) Fv Pv r n (1 ) n 1 DCF r (1 ) n Net Present value The net present value (NPV) ethod works out the present values of all ites of incoe and expenditure related to an investent at a given rate of return, and then works out a net total. If it is positive, the investent is considered to be acceptable. If it is negative, the investent is considered to be unacceptable. 01. A copany is looking options to expand their business by investing for Digital printing achine. There are two copanies produces this achine, however the cost of the achine and the printing capacity are different. The cash flows of the two achines are as follows. Machine A - Abba Co. End of Year Cost /Receipts Net Cash flow (Rs) 0 Cost of the achine Net Profit before Depreciation Net Profit before Depreciation Net Profit before Depreciation Net Profit before Depreciation

5 5 Net Profit before Depreciation Sale of achine Machine B Alpex End of Year Cost /Receipts Net Cash flow (Rs) 0 Cost of the achine Net Profit before Depreciation Net Profit before Depreciation Net Profit before Depreciation Net Profit before Depreciation Net Profit before Depreciation Sale of achine Copute the payback period and discuss the liitations. 2. What would be the present value of Rs. 60,480 which will be receivable in 4 years fro today? The discount rate for the period would be 8% per annu. 3. You are supposed to receive Rs. 160,000 after six years. If the discount rate is 10%. Copute the present value. 4. To cover the cost of higher education for his two children, a father has to ake a Rs. 75,000 payent five years fro now. How uch will he need to invest today to eet his tuition fee, if the investent earns 6% annually? 5. Copute the discount factors considering discount rate as 10% for the first five years. 6. A copany invest Rs.100,000 and earned Rs.40,000 in the year 1 and Rs in the year 2 and Rs. 20,000 in year 3. If the cost of capital of the copany is 12%. Calculate the net present value. 7. A new achine was purchased for Rs.120,000 and it was found that it will generate Rs. 30,000 end of every year for the next five years. The scrap value of the achine would be Rs. 10,000. Considering the 10% discount rate copute the net present value of the investent. 8. As per the new econoic policy the governent decided to reduce the interest rates accordingly the deand for investents went up. Identify whether the stateent is true of false.

6 9. A copany is wondering whether to spend Rs. 180, 000 on an ite of equipent, in order to obtain cash profit as follows. Year Cash inflows 1 60, , ,000 If the copany requires a return of 10% per annu, is the project viable 10. The cash flows of the two projects are given below: Year Details Project x Project y 0 Investent 120, ,000 1 Net incoe 80,000 40,000 2 Net Incoe 40,000 50,000 3 Net Incoe 40,000 30,000 Consider the cost of capital of the two projects is 10%. Copute NPV for both projects and advice the copany. Copute the Internal Rate of Return of both projects.