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Investment Appraisal

Payback period - Present Worth - DCF Yield

Investment Appraisal

Contractors use investment appraisal techniques to assess their own capital investments (plant, equipment, buildings, etc.) and in their assessment of their potential projects, i.e. it is part of their bidding process. In the context of bidding investment appraisal is used to evaluate the envisaged capital requirements of projects.

In an investment appraisal only the incremental expenditure and receipts directly attributable to the project under scrutiny should be included; sunk costs ( i.e. those which have already been incurred) should be ignored as they are irrelevant to decisions about the future.

Methods of investment appraisal

Payback period

The payback period method of appraisal calculates how long it takes for a project to repay its original invested capital. The shorter the payback period the greater is the likelihood that it will be profitable. Projects 1 and 2 below are examples of projects with payback periods 3.25 and 2.5 years respectively. Therefore, project 2 is to be preferred to project 1.

YearProject 1Project 2
0- 9,000.0- 9,000.00
1+ 2,000.0+ 4,000.00
2+ 2,000.0+ 4,000.00
3+ 4,000.0+ 2,000.00
4+ 4,000.0+ 2,000.00

The payback period method of appraisal is a very simple one but fails to take into account the pattern of inflows beyond break even point, which constitutes the revenue in the long run. Nor does it take into account the pattern of payment stream prior to beak even point and subsequent additional costs in the form of interest rate on unpaid back invested capital.

Present Worth

The typical use of present worth is to compare two or more schemes each with a different initial investment and different running costs. 
For example assume a contractor has two alternatives either to purchase construction equipment equipment A with an initial cost $5000 and annual running cost of $500, or to buy construction equipment B with an initial cost of $4000 and annual running cost of $800. Life time for both equipments is 6 years.

Try Our Free Present Worth Calculator page

Using the above tool, If interest rate is 10% the present worth for two alternatives would be:
Equipment A: $7,177.63
Equipment B: $7,484.21
Thus since equipment A has the smaller present worth it is said that it is more economic to purchase equipment A.
The above comparison assumes same life time for both equipments. However, if the two equipments of different lives are being compared it is necessary to take steps to have an analogy that presents two alternatives of the same life.

DCF Yield

DCF Yield is the maximum interest rate that could be paid on borrowed capital assuming that all capital needed to fund the project is acquired as an overdraft.

A trite example is an investment of £100 and a return of £110 compared with an investment of £1000 and a return of £1011. While the net profit is larger in the second case, the return on capital will not be satisfactory.
The generally accepted way of measuring return on capital is the discounted Cash Flow yield; DCF yield

To illustrate DCF yield consider the following example:
  1. A project requires £1000 initial investment.
  2. The annual return is expected to be £400, for its 3 years lifetime.
It is required to find the Discounted Cash Flow yield.
Assuming an interest rate of 8%:
By the end of the first year, the account is -£1000-£80+400 = -£680
By the end of the second year, the account is -£680-£54.4+400 = -£334.4
By the end of the third year, the account is -£334.4-£26.75+400 = +£38.85
Since 8% leaves £38.85 at the end then it is not the maximum.

Assuming an interest rate of 10%:
By the end of the first year, the account is -£1000-£100+400 = -£700
By the end of the second year, the account is -£700-£70+400 = -£370
By the end of the third year, the account is -£370-£37+400 = -£7
Since 10% leaves -£7 at the end then it is greater than the maximum.
The DCF yield lies between 8% and 10%, with further reiteration we can reach the DCF Yield which is 9.70%

The process of trial and error is surely a time and effort consuming. We provide below an easy way to calculate DCF Yield %

DCF yield Calculator

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Recommended Readings:

Construction Loans and Alternative Finance sources

Present Worth Calculator

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