Ibrahim Sameer (MBA - Specialized in Finance, B.Com Specialized in Accounting & Marketing)
Introduction A long term view of benefits and costs must be taken when reviewing a capital expenditure project.
Methods of Project Appraisal The key methods of project appraisal are: The payback period Net present value (NPV) Discounted payback period Internal rate of return (IRR)
The payback period The payback period is the time taken for the initial investment to be recovered in the cash inflows from the project. The payback method is particularly relevant if there are liquidity problems, or if distant forecast are very uncertain. In other word, it is the length of time the investment takes to pay itself back.
The payback period Advantages of payback method It is easy to calculate & understand It is widely used in practice method It identifies quick cash generator.
The payback period Disadvantages of payback method Total profitability is ignored. The time value of money is ignored. It ignores any cash inflows that occur after the project has paid for itself.
The Time Value of Money The time value of money is an important consideration in decision making.
Compound Interest Formula S = P(1+r)ⁿ S = future value of the investment after n years P = the amount invested now r = the rate of interest n = the number of years of the investment
Compound Interest Suppose that we invest $2,000 now at 10%. What would the investment be worth after 5 years?
Compound Interest Answer S = P(1+r)ⁿ S = $2,000(1+0.10)⁵ S = $2,000(1.10)⁵ S = $3,221.02
Compound Interest With discounting we look at the size of an investment after a certain number of years, and calculate how much we would need to invest now to build up the investment to that size, given a certain rate of interest.
Compound Interest
Compound Interest Calculate how much we would need to invest now at an interest rate, of 6% to build up the investment $5,000 after four years.
Compound Interest Answer P = 5000 x 1/(1+0.06)^4 P = $3960
Equivalent Rates of Interest An effective annual rate of interest is the corresponding annual rate when interest is compounded at intervals shorter than a year.
Equivalent Rates of Interest Effective annual rate of interest: (1+R) = (1+r)ⁿ R is the effective annual rate r is the period rate n is the number of period in a year
Nominal rates of interest & the annual percentage rate A nominal rate of interest is an interest rate expressed as a per annum figure although the interest is compounded over a period of less than one year. The corresponding effective rate of interest is the annual percentage rate (APR) (sometimes called the compound annual rate CAR)
Discounted Cash Flow (DCF) DCF techniques take account of the time value of money the fact that $1 received now is worth more because it could be invested to become a greater sum at the end of a year, and even more after the end of two years, and so on. As with payback, DCF techniques use cash figure before depreciation in the calculation.
Discounted Cash Flow (DCF) DCF is a techniques of evaluating capital investment project, using discounting arithmetic to determine whether or not they will provide a satisfactory return.
The NPV method of DCF The NPV method calculate the present value of all cash flow, and sums them to give the NPV. If this is positive, then the project is acceptable.
The NPV method of DCF Advantages of NPV Shareholders wealth is maximized It takes into account the time value of money Shareholders will benefit if a project with positive NPV is accepted.
The NPV method of DCF Disadvantages of NPV It can be difficult to identify an appropriate discount rate. For simplicity, cash flows are sometimes all assumed to occur at year ends: this assumption may be unrealistic. Managers are unfamiliar with the concept of NPV
Discounted Payback Method The discounted payback method applies discounting to arrive at a payback period after which the NPV become positive.
Annuities Annuities are an annual cash payment or receipt which is the same amount every year for a number of years.
Annual Cash Flow in Perpetuity A perpetuity is an annuity that lasts forever.
Internal Rate of Return (IRR) The IRR techniques uses a trial and error method to discover the discount rate which produces the NPV of zero. This discount rate will be the return forecast for the project.
Internal Rate of Return (IRR) Advantages of IRR It takes into account the time value of money, unlike other approach such as payback Results are expressed as a simple percentage, and are more easily understood than some other method.
Internal Rate of Return (IRR) Disadvantages of IRR IRR may be confused with ROCE, since both give answers in % terms. Some managers are unfamiliar with IRR method It cannot accommodate changing interest rates.
Q & A