Business Finance Decision (BFD) Chapter wise Theory Notes

Investment Appraisal-IA (Including International IA)

1) Investment Appraisal techniques

Investment appraisals and decision-making of major capital expenditures are based on different popular
techniques. These techniques can be grouped as follows:

Non-discounted cash flow techniques:

 Accounting Rate of Return (ARR)

 Payback Period (PBP)

A higher ARR % or a lower PBP make a project relatively acceptable against a target rate or period.
However, each technique has its own advantages and disadvantages.

Discounted cash flow (DCF) techniques:

 Net Present Value (NPV)

 Internal Rate of Return (IRR)
 Profitability Index (PI)
 Discounted Payback Period

2) Advantages of using the ARR method

The main advantages of the ARR are that:

 It is fairly easy to understand. It uses concepts that are familiar to business managers, such as profits
and capital employed.
 It is easy to calculate.

3) Disadvantages of using the ARR method

there are significant disadvantages with the ARR method.

 It is not linked to the wealth maximization objective. In other words, it does not select projects based
on their ability to increase the wealth of the owners of the company.
 It can be calculated in different ways so may cause confusion in interpretation.
 It is based on accounting profits (mainly based on accrual and historical cost convention), and not cash
flows. However investments are about investing cash to obtain cash returns. Investment decisions
should therefore be based on cash flows, and not accounting profits.
 Since it is based on profits (more subjective) is easy to manipulate and will be different under different
accounting policies and estimates.
 The ARR method ignores the time value of money.
 The ARR is a percentage return, relating the average profit to the size of the investment. It does not
give us an absolute return. However the absolute return can be significant.
 When using the ARR method for investment appraisal, a decision has to be made about what the
minimum target ARR should be. There is no rational economic basis for setting a minimum target for
ARR. Any such minimum target accounting return is a subjective target, with no economic or
investment significance.

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 Business Finance Decision (BFD) Chapter wise Theory Notes
4) Advantages of the payback method

The advantages of the payback method for investment appraisal are as follows:

 Simplicity – The payback is easy to calculate and understand.

 The method analyses cash flows, not accounting profits. Investments are about investing cash to earn
cash returns. In this respect, the payback method is better than the ARR method.
 Payback concentrate on earlier cash flows in the project’s life time, which are more certain and more
important if the firm has liquidity concerns.

5) Disadvantages of the payback method

The disadvantages of the payback method are as follows:

 It is not linked to the wealth maximization objective. In other words, it does not select projects based
on their ability to increase the wealth of the owners of the company. There is no measure of the
change in wealth either in absolute (Rs) or relative (%) terms.
 Setting a minimum payback period is very subjective. (Note: The deep you go in time period to collect
cash from the project, less attractive it would be due to higher uncertainty and risks).
 Target payback period may cause the company to select a less attractive project in terms of NPV just
because its payback period is more than target payback period.
 It ignores all cash flows after the payback period, and so ignores the total cash returns from the
project. This is a significant weakness with the payback method.
 It ignores the timing of the cash flows during the payback period.

6) Internal rate of return (IRR)

The internal rate of return method (IRR method) is a method of investment appraisal using DCF.

The internal rate of return of a project is the discounted rate of return on the investment.

 It is the average annual investment return from the project

 Discounted at the IRR, the NPV of the project cash flows must come to zero.
 The internal rate of return is therefore the discount rate that will give a net present value of zero.

The interpolation formula

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 Business Finance Decision (BFD) Chapter wise Theory Notes
7) The investment decision rule with IRR

A company might establish the minimum rate of return that it wants to earn on an investment. If other
factors such as non-financial considerations and risk and uncertainty are ignored:

 If a project IRR is equal to or higher than the minimum acceptable rate of return, it should be
undertaken
 If the IRR is lower than the minimum required return, it should be rejected.

Since NPV and IRR are both methods of DCF analysis, the same investment decision should normally be
reached using either method.

The internal rate of return is illustrated in the diagram below:

It is more correct to say that IRR is estimated rather than calculated.

8) Advantages of the IRR method

 The main advantage of the IRR method of investment appraisal (compared to the NPV method) is
often given as it is easier to understand an investment return as a percentage return on investment
than as a money value NPV.
 Another advantage of the IRR method is that it does not require an estimate of the cost of capital.
 Considers the whole life of the project
 Percentage term, which is easy to communicate and understand.
 A company selecting projects where IRR exceeds the cost of capital should increase shareholders
wealth.

9) Disadvantages of the IRR method

 It is a relative measure, not an absolute measure.

 IRR assumes that all the cash flows are reinvested in the project at calculated IRR which may be invalid
in case of high IRR.
 IRR produces multiple answers in case of non-conventional cash flows.
 IRR is not helpful in choosing the best answer in case of mutually exclusive projects because IRR is a
relative measure and it does not consider the size of the project

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 Business Finance Decision (BFD) Chapter wise Theory Notes
10) Advantages of the NPV method (compared to the IRR method)

 NPV provides a single absolute value which indicates the amount by which the project should add to
the value of the company.
 The NPV decision rule is consistent with the objective of maximization of shareholders’ wealth.

11) Disadvantages of the NPV method (compared to the IRR method)

The following are often stated as the main disadvantages of the NPV method (compared to the IRR
method).

 The time value of money and present value are concepts that are not easily understood by those
without a financial education.
 There might be some uncertainty about what the appropriate cost of capital or discount rate should
be for applying to any project. The approach would give a perfect answer in a perfect world but
companies do not operate with perfect information so this undermines the usefulness of NPV.

12) Conflict between IRR and NPV:

Whenever there is conflict between results given by IRR and NPV then decision given by NPV prevails
because it is technically superior method and IRR techniques suffers from some drawbacks. Moreover
NPV is also in line with financial management’s objective i.e. maximization of Shareholders’ Wealth.

13) Modified internal rate of return (MIRR)

MIRR is a modification of the IRR and as such aims to resolve some problems with the IRR. It is used in
investment appraisals and capital budgeting to rank alternative investments of equal size.

MIRR assumes that that positive cash flows are reinvested at the firm’s cost of capital and the initial
outlays are financed at the firm’s financing cost. Whereas IRR assumes that the project cash flows are
reinvested at the IRR itself. Therefore, MIRR more accurately reflects the cost and profitability of a project.

Using MIRR for project appraisal

It might be argued that if a company wishes to use the discounted return on investment as a method of
capital investment appraisal, it should use MIRR rather than IRR, because MIRR is more realistic because
it is based on the cost of capital as the reinvestment rate.

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 Business Finance Decision (BFD) Chapter wise Theory Notes
14) Economic Internal Rate of Return (EIRR)

ERR is another variation of the standard IRR. While IRR measures the financial performance of the
proposed investment. Whereas EIRR measures the economic additionality expected from the proposed
investment. EIRR measures the increased economic acivity generated from an investment by quantifying
the financial and non-financial benefits (where possible) from an investment.

The economic internal rate of return (EIRR) is calculated in the same way as the FIRR. However, it includes
values for externalities in addition to the basic project cash flows. In other words it takes account of the
possible impact that a project might have on other parties who might be affected by it.

This is particularly important for the appraisal of projects by governments and government bodies.

 A government planning a project might use the FIRR to estimate the commercial viability of the project
and the EIRR to see if the project is justifiable in terms of its impact on other parties.
 A government might consider granting a licence for a particular activity based on an EIRR appraisal.

Possible problems

Possible problems in the use of EIRR include the following

 It may not be easy to identify externalities related to a project;

 Once identified it might be difficult to attach a value to a given externality;
 Using the FIRR, a project is acceptable if the FIRR is greater than the company’s cost of capital.
However, there is no consensus on arriving at an acceptable rate of return for projects that include
externalities.

15) Risk and uncertainty

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 Business Finance Decision (BFD) Chapter wise Theory Notes
16) Methods of assessing risk and uncertainty

There are several methods of analysing and assessing risk and uncertainty. In particular:

 Sensitivity analysis can be used to assess a project when there is uncertainty about future cash flows;
 Probability analysis can be used to assess projects in which there is risk.
 Risk modelling and simulation;
 Using discounted payback as one of the criteria for investing in capital projects.

17) Sensitivity analysis

Sensitivity analysis is a technique where input variables in a financial model are changed to assess the
affect on target variables. This is also called as what-if or simulation analysis.

Purpose

Sensitivity analysis is a useful but simple technique for assessing investment risk in a capital expenditure
project when there is uncertainty about the estimates of future cash flows. It is recognized that estimates
of cash flows could be inaccurate, or that events might occur that will make the estimates wrong.

The purpose of sensitivity analysis is to assess how the NPV of the project might be affected if cash flow
estimates are worse than expected.

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 Business Finance Decision (BFD) Chapter wise Theory Notes
Method

There are two main methods of carrying out sensitivity analysis on a capital expenditure project.

1. Sensitivity analysis can be used to calculate the effect on the NPV of a given percentage reduction in
benefits or a given percentage increase in costs.
2. Alternatively, sensitivity analysis can be used to calculate the percentage amount by which a cash flow
could change before the project NPV changed.

Formula

Sensitivity of a Variable = NPV of Project / PV of all cash flows of the variable (net of tax)

The usefulness of sensitivity analysis

Sensitivity analysis is useful because it directs management attention to the critical variables in the
project. These are the variables where a variation in the cash flows by a fairly small amount – and certainly
by an amount that might reasonably be expected, given uncertainty about the cash flows – would make
the NPV negative and the project not financially viable.

Major drawback

A major problem with sensitivity analysis is that only one variable is varied at a time (keeping other
variables constant), and it is assumed that all variables are independent of each other. In reality variables
may all vary to some extent and they may be interdependent. For this reason, simulation models may
provide additional information when assessing risk.

18) Simulation

Simulation can address the weaknesses of sensitivity analysis. The main advantage is that it allows the
effect of more than one variable changing at the same time to be assessed. This gives more information
about the possible outcomes and the spread of possible outcomes, which will allow the directors to make
a more informed decision against their appetite for risk and risk strategy.

19) Advantages of using expected values

The advantages of using expected values of the NPV are as follows:

 It is a weighted average measure of all the possible outcomes. It is therefore, arguably, a more
appropriate measure of return than the most likely or most probable EV of NPV.
 It provides a single figure, not a range of different figures, for making an investment decision.

20) Disadvantages of using expected values

The disadvantages of using expected values of the NPV are as follows:

 The estimates of probabilities might be subjective, and based on judgement and guesswork.
 The EV of the NPV is not a value for any of the actual possible outcomes. In other words, the EV itself
will not happen. It is simply an average representing a number of different possible outcomes.

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 Business Finance Decision (BFD) Chapter wise Theory Notes
 An EV is much more reliable for estimating the average outcome from events that will happen
repeatedly, many times over. A weighted average is not nearly as suitable for estimating the expected
outcome for a once-only capital expenditure project.
 Most important of all, an EV does not provide any analysis of the project risk. When capital investment
projects are evaluated, and a decision is made whether or not to undertake the investment, there
should be a thorough analysis of the risk as well as the expected returns.

21) Difference b/w mutually exclusive investments and independent investments

The difference between mutually exclusive investments and independent investments is that for mutually
exclusive investments, once one project is selected another must be forgone because the projects are in
competition, whereas for independent investments/projects, the selection of one project does not
foreclose the selection of others.

22) Particular preferences to the corporate manager

“Ascertaining exactly who owns a company’s shares and what, if any, are their particular preferences and
objectives” is a basic piece of information needed by management, if it is to ensure that, as far as possible,
it is acting in the shareholder’s interest. the major advantages which may accrue to the corporate finance
manager from obtaining this information include the following:

(i) Dividend Policy: The knowledge of shareholders’ preferences with regards to dividends or capital
appreciation and marginal tax rates will assist in the determination of the company’s optimal dividend
policy.

(ii) Risky Investment: Shareholders’ preferences may assist corporate management when making
decisions concerning risky capital investments. Depending on their attitude to risk and their specific
circumstances, they may dislike, or prefer the company to undertake risky investments with the possibility
of a higher return.

(iii) Financing Decisions: With respect to the level of debt to employ, the risk attitude of shareholders can
again be useful; generally speaking, a risky approach is to employ more and more debt, since in the event
of default, the shareholders are paid last. However, a high level of risk is matched by a high potential
return to equity holders.

(iv) Rebuffing a take-over: A company whose shares are held by a few may find an unwanted take-over
bid less easy to rebuff as the bidder needs to convince only a few shareholders for the bid to be successful.
However, if shares are held by a few key shareholders, it may be easier to provide these shareholders with
the type of return they require with a possible reduction in their likely acceptance of any take-over.

(v) Measurement of performance: Ascertaining how shareholders judge performance may enable
management to optimize this measure or measures, when making decisions, although this measure may
not be in the prime interest of the company in terms of value maximization.

(vi) Religious belief: Knowing the religious belief of the shareholders will assist in deciding the type of
business to be involved in. For example, Islam forbids investment in businesses involved in the
manufacture and sale of alcohol. Such information will enable corporate finance managers to tailor their
performance to satisfy the expectations of the shareholders.

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 Business Finance Decision (BFD) Chapter wise Theory Notes
23) why a publicly quoted company might seek to know the detailed composition of its shareholders
and their objectives in investing in the company.

A publicly quoted company seeks to know the detailed composition of its shareholders and their
objectives in investing in the company for the following reasons:

(i) To enable it take various decisions in accordance with the preferences of such shareholders.

(ii) To prevent the occurrence of conflict of interest as related to principal and agents.

24) Features of capital budgeting decisions

Features of capital budgeting decisions include the following:

(i) They involve large outlay.

(ii) The benefits will accrue over a long period of time, usually well over one year and often much longer,
so that the benefits cannot all be set off against costs in the current year’s Statement of profit or loss.

(iii) They are very risky.

(iv) They involve irreversible decision.

25) Reasons why capital budgeting decision is important

(i) The continued existence of any company is not predicated on its investment on short-term basis but
rather on its long-term investment strategies.

(ii) Investment decisions facilitate the identification of viable projects in order to maximize the wealth of
the shareholders.

(iii) Companies need to undertake long-term investments which are the pre-requisite to the concept of
“on-going concern” basis.

(iv) Capital budgeting ensures that the management team does not mortgage the future of the company
for their personal individual financial gains through short-term investments.

(v) It assists the streamlining of the projects being executed by the organization.

Difference b/w Money and Real Method

Money Method

 Adjust individual cash flows for specific inflation to convert to money cash flows
 Discount using money rate

Real method

 No need to adjust any individual cash flows for inflation to convert to money cash flows
 Discount using Real rate
 This is the simplest technique
 Remove the effects of general inflation from money cash flows to generate real cash flows.
 Achieves the same result as money method

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 Business Finance Decision (BFD) Chapter wise Theory Notes
Note:
 In case of general inflation, either of the two methods can be used.
 In case of specific inflation, only applicable method is Money method

26) Capital Rationing

Capital rationing occurs when there is a restriction on an organization’s ability to invest in all projects due
to insufficient fund available therefore the shareholder wealth will not maximize.

Single Period Capital rationing

If Project is Divisible (there will be no surplus cash left in this case)

Step 1 Calculate Profitability Index by using the formula PI = NPV/Initial Investment.

Step 2 Rank each project on the basis of PI.
Step 3 Allocate funds on the basis of raking.

If Project is Indivisible (any unused funds are assumed to have been invested at only cost of capital
generating zero NPV) Calculate NPVs of all possible combination of projects within the available capital
limit and then choose the combination with highest NPV. This method is known as Trial & error.

Multi-Period Capital rationing

If there are only two projects the linear programming can be solved using graphical approach in the usual
way.

Step 1: Define variables.

Step 2: Construct an objective function
Step 3: Construct inequalities to represent the constraints.
Step 4: Plot the constraints on a graph
Step 5: Identify the feasible region.
Step 6: Identify the proportion of the projects that lead to the optimum value of the objective function.
Step 7: Quantify the optimum solution.

27) Reasons of capital rationing

Hard capital rationing

Hard capital rationing is the term applied when the restrictions on raising funds are due to causes external
to the company.

Soft capital rationing

Soft capital rationing refers to restrictions on the availability of funds that arise within a company and are
imposed by managers. There are several reasons why managers might restrict available funds for capital
investment. Managers may prefer slower organic growth to a sudden increase in size arising from
accepting several large investment projects. This reason might apply in a family-owned business that
wishes to avoid hiring new managers. Managers may wish to avoid raising further equity finance if this
will dilute the control of existing shareholders. Managers may wish to avoid issuing new debt if their

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 Business Finance Decision (BFD) Chapter wise Theory Notes
expectations of future economic conditions are such as to suggest that an increased commitment to fixed
interest payments would be unwise.

28) Reasons why business organizations engage in cross-border investment

Reasons why business organizations engage in cross-border investment include the following:

(i) To take advantage of new markets e.g coca-cola, electronics etc

(ii) To seek raw material e.g. Us Oil companies establishing business in nations where there are oil
deposits.
(iii) In search of new technology.
(iv) Avoidance of political and regulatory hurdles.
(v) Diversification.
(vi) Tax avoidance.
(vii) Possible benefits from variations in exchange rates.
(viii) Protection of profit margin.
(ix) Depriving another firm of any abnormal profit

29) Whether it is appropriate to use the existing cost of capital to appraise an international project.

An evaluation of an investment opportunity requires a company to estimate future free cash flows and
discount these at the opportunity cost of capital that will prevail over the life of the project. Investors
must decide on the level of risk that applies to a company and its usual investments, and price the
investment accordingly. Companies therefore go through a process to deduce the level of return that
investors require based on the current risks.

If a company invests in a different country, it is realistic to expect that the risks will be different and so
the project should, therefore, be discounted at a different rate. It is possible to use financial modelling to
estimate the change required to the discount rate.

The general risk of a country is usually reflected in its sovereign yield spread. This can be evaluated further
using the CAPM model, which calculates the required return as:

Required return = Risk free return + β (Market return – Risk free return + Country risk premium)

Where β is the measure of systematic risk for the company.

To estimate the country risk premium, the sovereign yield spread should be adjusted by the ratio of
volatility between the country's equity markets and its government bond market. A more volatile equity
market would increase the premium further. The country risk premium could then be calculated as:

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