Investment in Fixed Assets and Working Capital

Chapter 7 – Capital Investment Appraisal

Chapter 7

Capital Investment Appraisal

Investment in fixed assets and working capital:

Firms need to invest funds in land, building, machinery etc. in order to do business and to make profit. Hence, firms need to assess the following things:-

The amount of cash needs to invest (outflow) and the amount of cash (return) getting from these investments (inflow),

The life of the investment,

The degree of risk involved, and

The cost of obtaining funds.

In most industrial project, investment is required, both in working capital and in fixed capital. The risk attached to working capital is less than that for fixed capital. Values of land and building may appreciate but money invested in machinery is a sunk cost, which is unlikely to be recovered fully.

Techniques for capital investment appraisal

The following are the important techniques used for capital investment appraisal:

(i)Payback period

(ii)Accounting rate of return

(iii)Net present value

i. PAYBACK PERIOD: The time required for a capital investment project to return its investment out of its cash inflows is called Payback period.

When deciding between two or more projects, the projects with shortest payback period is normally preferred.

Payback period =

For example, if RO. 500,000 Rial is earned each year for 7 years from the investment of 2 million Rial. The payback period is :

Payback period = = 4 years

Payback period with uneven cash flows:

If cash inflows are uneven the payback period can be calculated in cumulative method as given below:

Example2: A project which costs 2,000 Rials has the following cash inflows:

Then the payback period can be calculated as follows:

The payback period is 4 years.

Advantage:

1. Simplicity – easy to understand and calculate
2. Rapidly cashing technology
3. Favours projects with quick return.

Disadvantage:

1. Projects return may be ignored: cash arising after the payback period are totally ignored.
2. Time ignored- time value of money is ignored.
3. Lack of objectivity

ii. ACCOUNTING RATE OF RETURN: The accounting rate of return (ARR) expresses the profit from a project as percentage of capital cost.

ARR = x 100

Where Average annual profit is profit before interest and tax but after depreciation

Example3: A project purchased for RO. 100,000. It would generate annual cash flows of RO.24,000 for five years, starting year 1. The life of the plant is five years. Calculate ARR.

Answer:

Annual depreciation = 100,000 / 5 years

= 20,000

Annual amount after depreciation = 24,000 – 20,000 = 4,000

ARR = X 100

= 4%

Advantage:

1. Simplicity – Easy to understand and calculate
2. Link with other accounting measures,
3. ARR is expressed in percentage terms with which managers and accountants are familiar.

Disadvantages:

1. It does not consider project life and the timing of cash flows (time value of money)
2. It will vary within specific accounting policies.
3. It ignores working capital requirement.
4. There is no definite investment signal since no minimum ARR is set.

iii. NET PRESENT VALUE:

Under this method the present value of future earnings of a capital investment proposal is compared with the initial investment. Then NPV is the difference between the initial investment (outflow) and the present value of the total inflows of the same capital investment.

“NPV” method considers ‘time value of money’ of the cash flows associated with a project.

NPV = Present value of total inflows - Initial Investment

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EXERCISE

(1) A project which costs 25,000 Rials has the following cash inflows:

Calculate payback period

(2) From the following information, calculate Payback period of Machine A and Machine B and suggest which Machine is better for the company.

Inflows

(3)M/s. Bahwan Furniture LLC needs ONE machinery to produce Tables. Three types of Machineries are available in the market for the purpose. You are required to identify the best Machinery for the company by applying Pay back Period method. Following information are available from the market.

(4) Calculate ARR for Machinery B

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University of Nizwa / CEMIS / Department .of Management Studies / BUSINESS FINANCE / Dr.Ayoob / Page