Question

Explain the various methods of appraising capital projects, including their relative merits
and demerits.

Answer 1

The capital prject appraisal techniques used to measure capital investment appraisal of a business project include:

• Net present value
• Accounting rate of return
• Internal rate of return
• Modified internal rate of return
• Adjusted present value
• Profitability index
• Equivalent annuity

Net Present Value (NPV) – this Capital investment appraisal technique measures the cash in-flow, whether excess or shortfall, after the routine finance commitments are met with. All capital investment appraisals have a single objective – drive towards a positive NPV. The NPV is a mathematical calculation involving net cash flow at a particular present time 't' at discount rate at the same time, i.e. (t – initial capital outlay). Thus there is an inverse proportional relation between discount rate and NPV. A high discount rate would reduce the net present value of capital. A high interest rate increases discount rates over a period of time and most capital investment appraisals are wary of such an increase.

Accounting Rate of Return (ARR) – this capital investment appraisal technique compares the profit that can be earned by the concerned project to the amount of initial investment capital that would be required for the project. Projects that can earn a higher rate of return is naturally preferred over ones with low rate of return. ARR is a non discounted capital investment appraisal technique in that it does not take into consideration the time value of money involved.

Internal Rate of Return (IRR) – Capital investment appraisal techniques define IRR as discount rate that gives a value of zero to NPV or net present value. Among all capital investment appraisal techniques, IRR is generally considered to measure the efficiency of the capital investment. Thus, if cost of capital investment in company works out to be greater than the IRR value, the project is highly likely to be rejected. On the other hand, a low cost of capital has more chances of being accepted. IRR is calculated by equating NPV to zero and then deriving the discount rate. Even though IRR and NPV are related capital investment appraisal techniques they are different from each other. IRR considers the time value of money over the project life time and derives the world discount rate.

Modified Internal Rate of Return (MIRR) – the IRR does not give the actual annual profitability of a capital investment since it does not take into consideration the intermediate cash flows which is never reinvested equalling project IRR. Hence the IRR capital investment appraisal technique is not effective enough since the rate of return in actual is certainly going to be lower. This flaw is over come by a more efficient capital investment appraisal technique – MIRR. MIRR evaluates capital investment projects assuming that reinvestment rate equals the company's cost of capital.

Adjusted Present Value (APV) – APV capital investment appraisal technique overcomes the shortcomings of NPV technique and evaluates a project on the basis of risks associated to prospective company undertaking the investment.

Profitability Index (PI) – evaluates a project based on calculation of value per unit of investment. Also known as value investment ratio and profit investment ration, this capital investment appraisal technique is a ratio of amount of money invested to profit or pay off of the project.

Equivalent Annuity – capital investment appraisals done using equivalent annuity usually compares projects with different life spans. In cases where two projects have different time spans, NPV would not justify a fair comparison. This capital investment appraisal technique divides the NPV value with annuity factor resulting in expressing NPV in relation to annualized cash flow.

Net present value :

Advantages

1. Tells whether the investment with increase the firm value

2. Consider all the cash flows

3. Consider the time value of money

4. Consider the risk of future cash flows

Disadvantages

1. Requires an estimate of the cost of capital in order to calculate Net Present Value.

2. Expressed in terms of Dollers, not as percentage.

Internal Rate of Return

Advantages Internal Rate of Return

1.TIME VALUE OF MONEY

2.SIMPLICITY

3.HURDLE RATE / REQUIRED RATE OF RETURN HAS NOT REQUIRED

Disadvantages of Internal Rate of Return

1.ECONOMIES OF SCALE IGNORED

2.IMPRACTICAL IMPLICIT ASSUMPTION OF REINVESTMENT RATE

3.DEPENDENT OR CONTINGENT PROJECTS