EPJ3760 Construction Investments
Lecture 4: September 2013
4.1 Investment Appraisal Techniques
4.1 Investment Appraisal Techniques
Which techniques do (100 large UK) firms use?
Source: Pike (1992)
Which techniques do firms use – according to academic research?
Source: Taylor (1994)
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4.1 Investment Appraisal Techniques
Which techniques do (Fortune 1000) firms use?
Source: Ryan and Ryan (2002)
4.2 Future and Present Values
Future Value (FV)
The value at a specific date in the future.
% of Fortune 1000 firms using each technique
Present Value (PV)
Technique
Always Often
Sometimes Rarely
Never
Net Present Value
49,8%
10,9%
1,0%
35,3%
2
3,0%
The current value (in today’s money) of a future sum of money or cash
flow.
Internal Rate of Return
44,6%
32,2%
15,3%
6,4%
1,5%
Discount rate (k)
Payback
19,4%
33,2%
21,9%
16,8%
8,7%
Discounted Payback
15,5%
22,2%
19,1%
21,1%
22,2%
The (interest) rate used to calculate the present value of future cash
flows. (Accounts for both time value of money and risk.)
Profitability Index
5,9%
15,5%
22,5%
21,9%
34,2%
Accounting Rate of Return
5,3%
9,5%
18,5%
16,4%
50,3%
Modified IRR
2,2%
7,1%
12,6%
27,9%
50,3%
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FVt = PV(1+k)t
PV =
FVt
(1+k)t
where t is time (usually the number of years)
4.3 Technique Definitions
4.3 Technique Definitions
Payback Period
The time taken to recover the initial investment cost from
the net cash flows.
Profitability Index (PI)
Benefit / cost ratio. The ratio of the present value of the
future net cash flows to the initial investment.
Discounted Payback
The time taken to recover the initial investment cost from
the discounted (i.e. the present values of the) net cash
flows.
Net Present Value (NPV)
The present value of the future net cash flows less the
initial investment.
Accounting Rate of Return (also called Average Rate of
Return, Average Return on Book Value & Simple
Rate of Return)
Various measures of profitability, typically the ratio of
average annual profit to either:
method 1: average investment
method 2: initial investment
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Internal Rate of Return (IRR)
The discount rate which equates the present value of the
future net cash flows with the initial investment.
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Modified Internal Rate of Return (MIRR)
The discount rate which equates the present value of all
the cash outflows (discounted at the MARR to the start
of the project) to the future value of all the cash inflows
(compounded at the MARR to the end of the project).
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EPJ3760 Construction Investments
Lecture 4: September 2013
4.4 Payback Period
4.4 Payback Period
Calculation
Payback Period
(The time taken to recover the initial investment
cost from the net cash flows.)
Payback period =
Time
Decision Rules
• Choose the project with the shortest payback
• Specify a maximum desired payback period
(also called a cutoff period or target period): .
-10000
-10000
Year 1
4000
-6000
Year 2
4000
-2000
Year 3
4000
2000
Year 4
4000
6000
Payback period
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4.4 Payback Period
= 2 years + (2000 / 4000) years
= 2,5 years
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4.4 Payback Period
Illustration of concept
net cash flow
net cash flow during
recovery year
Net cash flows Cumulative cash flow
Initial cash
outlay (time 0)
– Specified cutoff period depends on project risk (higher
risk = shorter cutoff)
– Accept projects with payback less than the cutoff
period.
unrecovered cost at
start of recovery year
no. of years prior
to full recovery of
investment
Benefits of using Payback Period
• Formerly (up to about the year 2000) this was
the most popular method and it is still widely
used in business
• Simple to understand
• Quick to calculate
cumulative cash
flow curve
payback period
Disadvantages
• Ignores the time value of money
• Ignores cash flows beyond the payback period
time
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4.5 Discounted Payback Period
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4.5 Discounted Payback Period
Calculation
Discounted Payback Period
(The time taken to recover the initial investment
cost from the discounted (i.e. the present values
of the) net cash flows.)
Same as for (simple) Payback Period but use Discounted
Cash Flows, e.g. with a discount rate of 10%:
Decision Rules
• Specify a cutoff period: .
Initial cash
outlay (time 0)
Time
– Specified cutoff period depends on project risk (higher
risk = shorter cutoff)
– Accept projects with a discounted payback period
less than the cutoff period.
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Net cash Present values of net
flows
cash flows
(discount rate = 10%)
Discounted
cumulative cash flow
-10000
-10000
-10000
Year 1
4000
3636,4
-6363,6
Year 2
4000
3305,8
-3057,9
Year 3
4000
3005,3
-52,6
Year 4
4000
2732,1
2679,5
Payback period
= 3 years + (52,6 / 2732,1) years
= 3,002 years
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EPJ3760 Construction Investments
Lecture 4: September 2013
4.5 Discounted Payback Period
4.6 Accounting Rate of Return
Benefits of using Discounted Payback Period
• Considers the time value of money
• Useful metric to know
• Compatible with Net Present Value calculations
Accounting Rate of Return
(Typically, the ratio of average annual profit to
either:
method 1: average investment
OR
method 2: initial investment)
Disadvantages
• Ignores cash flows beyond the payback period
• Difficult to set the cutoff period
• Validity of the chosen discount rate
Decision Rules
• Specify a required accounting rate of return: .
– Accept projects with an accounting rate of return
greater than the target rate of return.
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4.6 Accounting Rate of Return
4.6 Accounting Rate of Return
Calculation (one variant)
n
Accounting rate
of return
=
Σ
t=1
Calculation (continued from previous slide)
(Profit in year t ) / n
Profit in each year is:
year 1 = 4000 – 2375 = 1625
year 2 = 4000 – 2375 = 1625
year 3 = 4000 – 2375 = 1625
year 4 = 4000 + 500 – 2375 = 2125
(Initial investment + salvage value) / 2
Annual average profit
=
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Average investment
Example:
An initial investment of 10000 produces cash inflows of 4000 every
year for 4 years. Assuming straight-line depreciation and a salvage
value of 500 (which is realised at the end of year 4), calculate the
Accounting Rate of Return using the formula above.
With straight-line depreciation,
annual depreciation
= (Initial cost – salvage value) / useful life
= (10000 – 500)/4 = 2375
Annual average profit = (1625+1625+1625+2125)/4 = 1750
Average investment = (10000+500)/2 = 5250
Accounting Rate of Return = 1750/5250
= 33,3%
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4.6 Accounting Rate of Return
Benefits of using Accounting Rate of Return
• Simple to calculate and based on readily available
accounting information which is familiar to business
managers
• Relates to the overall company accounts (Return on
Assets)
Disadvantages
• Ignores the time value of money
• Based on accounting profit rather than cash flows
• Is a ratio of 2 accounting measures (income to
investment) both of which may be measured in various
different ways causing confusion Several different
variations
It is NOT recommended for investment appraisal
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