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
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.
|Year||Project 1||Project 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.
The typical use of present worth is to compare
two or more schemes each with a different initial investment and different
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.
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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.
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:
- A project requires £1000 initial investment.
- 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 %
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