Managing Financial and Human Resources

1 HR 7003-Managing Financial and Human Resources for Sustainable Business Success

Topic Overview 8: Investment Appraisal

Contents:

1. Introduction

2. Cost Comparison Method

3. Profit Comparison Method

4. Average Rate of Return Method

By the end of this week, you will be able to:

• Understand what the Cost Comparison Method is

• Understand what the Profit Comparison Method is

• Understand the Average Rate of Return Method

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1. Introduction

What we mean by the word “Investment”? Instead of trying to identify a specific definition in

terms of words, we can approach it from the calculating perspective by using two examples. John

decides to pay 10,000$ to buy a piece of land, in order to sell it 5 years later, expecting to make

profit out of it. While he was going to make that purchase, he felt hungry and decided to stop and

buy a sandwich. He enjoyed the sandwich and then he bought the land he wanted. 5 years later,

John managed to find a buyer for the land he purchased and sold it for 11,000$.

Having in mind the two above examples we can visit a definition of an investment project.

According to Götze et al. (2008), an investment project is the combination of several cash inflows

and outflows in several periods. The example of the land is obviously an investment, while the

purchase of a sandwich is not.

Götze et al. (2008), suggest that the investments are consisted of several phases, while the main

are planning, implementation and utilization. The following figure summarizes what are the main

activities of the planning and control phases, of the management process of firms according to the

authors.

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While there is a huge discussion going on in the academic literature and among the market

participants for every stage and task described above, the current week’s material is focused on

the appraisal of the investment choices, a company or an individual face.

You may believe that, as John in the above example has received 1,000$ more than the amount he

has paid to acquire the piece of land, it was a good investment. However, there are many factors

to be considered before arriving to that conclusion.

There are several methods to assess whether an investment project is a good idea to be undertaken.

Many key decisions, according to Götze et al. (2008), requiring the use of investment appraisal

methods to be answered, such as:

Key decision How to decide

Should an investment be undertaken or rejected? Absolute profitability of an investment project

In the case of mutually exclusive investment

projects, which one should be preferred?

Relative profitability of an investment project

For how long should an investment project be

utilized?

Optimum economic life of an investment project

When should the investment project be started? Optimum investment point in time

Which of the investment projects should be

preferred and carried out when a limited

financial budget restricts the number that can be

undertaken at the same time?

Optimum investment program

Which investment and financial projects should

be undertaken, in what numbers and amounts

and at what time?

Optimum investment and financial program

Which investment projects and product types

should be pursued and manufactured, in what

number and at what time?

Optimum investment and production program

2. Cost Comparison Method

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Götze et al. (2008), explains that for the cost comparison method (CCM) the target measure is, the

cost(s) of an investment project. We assume that the revenues of mutually exclusive investment

alternatives are identical. Thus, we need to investigate only the costing differences. Typical costs

could be the following:

• personnel expenditures (wages, salaries, social expenditure etc.)

• cost of raw materials

• depreciation

• interest

• taxes and fees

• costs of outside services (such as repair or maintenance)

For the better understanding of the method, we will use the example proposed by the authors where

the following information is known for two projects, A and B.

Here we will try to assess whether the best option for the company is the Project A, B or an

alternative C. The product C can be purchased at the price of 125 per unit, while the units to be

produced are 8,000.

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Please note that several costs are fixed and other are variable. The fixed costs are constant, not

affected either 8,000 or 0 units are produced, while the variable costs increase with the level of

production.

The first step is to determine the costs of the projects. We assume that costs of materials and wages

are variable, thus the total variable cost is consisted of materials, wages and other variable costs.

For Project A:

Variable costs of A (CvA) for 8,000 units.

CvA = 220,000 + 400,000 + 30,000 = 650,000 per year

Variable costs of B (CvB) for 10,000 units.

CvB (x = 10,000 units) = 560,000 per year

CvB (x = 8,000 units) = (560,000/year 8,000 units)/ 10,000 units = 448,000 per year.

The fixed costs consist of salaries, depreciation, interest and other fixed costs.

Average annual depreciation = (initial investment - liquidation value) / economic life (years)

* initial investment = purchase price paid and additional related costs like carriage costs etc.

liquidation value = amount receivable in reselling the investment project

The average depreciation therefore is:

project A: 240,000/6 years = 40,000 per year

project B: (600,000 - 60,000)/6 years = 90,000 per year

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Interest costs must be taken into consideration if the projects differ in terms of the initial

investment, calculating the interest cost on the average amount of capital tie-up.

Interest cost = average capital tie-up * interest rate

Average capital tie – up = (Initial investment outlay + Liquidation value) / 2

project A:

average capital tie-up = 240,000/2 = 120,000

Interest cost = 120,000 * 0.08 = 9,600

project B:

average capital tie-up = (600,000 + 60,000) / 2 = 330,000

Interest cost = 330,000 * 0.08 = 26,400

Now we can calculate the total average fixed costs =

Salaries + Other fixed costs + Depreciation + Interest costs

project A = 50,000/year + 40,000/year + 40,000/year + 9,600/year = 139,600/year

project B = 50,000/year + 160,000/year + 90,000/year + 26,400/year = 326,400/year

The sum of total variable and fixed costs is the total average cost.

Project A: 650,000/year + 139,600/year = 789,600/year

Project B: 448,000/year + 326,400/year = 774,400/year

project C = 8,000 units/year * 125/unit = 1,000,000/year

As it is obvious the best project to be undertaken based on the Cost Comparison Method is project

B which has the lowest total average cost.

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3. Profit Comparison Method

The profit comparison method is similar to the Cost Comparison Method discussed above with

one key difference. The assumption of similar revenues among the investment projects to be

studied does not hold. Thus, we must calculate both the costs and revenues of the alternatives

(Götze et al., 2008). The purpose of the method is to estimate the average profit, which is the

difference between income and expenses. The following example is suggested by the authors to

understand this method.

First, we are calculating the average income (Revenues) as:

Revenue = units * selling price

Project A = RA = 9,000 units/year * 10/unit = 90,000 per year

Project B = RB = 12,000 units/year * 10/unit = 120,000 per year

The average cost of the two alternatives is calculated in the same way as in the CCM approach.

The total costs equal = Depreciation + Interest + Other fixed costs + Variable costs

Project A:

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Total cost = CA = 37,000 + 6,270 + 4,000 + 18,000 = 65,270

Project B:

Total cost = CB = 42,000 + 7,320 + 20,000 + 22,800 = 92,120

Average Profit = Revenue – Costs = R – C

Project A = RA - CA = 90,000/year - 65,270/year = 24,730 per year

Project B = = RB – CB = 120,000/year - 92,120/year = 27,880 per year

Both projects are profitable, while the Project B has a higher profitability compared to Project A

(Relative Profitability). Thus, the company must take both investments if it has enough resources

for the initial investment, while if it is not possible and one of the two could be undertaken, Project

B must be selected.

It is important to highlight that the classification of the projects under investigation is key for the

above-discussed decision-making process. Dayananda et al. (2002) explain that there are three

basic categories:

▪ independent projects: the acceptance or rejection of which does not directly eliminate other

projects from consideration

▪ mutually exclusive projects: cannot be pursued simultaneously

▪ contingent projects: acceptance or rejection of which is dependent on the decision to accept

or reject one or more other projects

4. Average Rate of Return Method

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The 3rd method to be discussed is the Average Rate of Return Method which focuses on the return

earned by choosing and investment project. The return is calculated by investigating the

relationship between the profit to be produced by an investment and the capital required (Götze et

al., 2008). While several approaches are available to determine the profit and capital measures to

be used, here we have:

capital measure = average capital tie-up

profit measure = average profit + average interest

 Average rate of return = (Average profit + Average interests) / Average capital tie – up

An important difference of that approach compared to the PCM, is that the interest that we deduct

from revenues as a cost in the PCM, here we add it back to the profit we calculate.

Using the information used for the example of PCM exercise, we will investigate which project

would be the best. As you can see below the ARR of Project A is higher than that of Project B.

For Project A we have:

▪ Profit (per year) 24,730

▪ Interest (per year) 6,270

▪ Average capital tie-up 104,500

For Project B we have:

▪ Profit (per year) 27,880

▪ Interest (per year) 7,320

▪ Average capital tie-up 122,000

Average rates of return:

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Project A: ARRA = (24,730/year + 6,270/year) / 104,500 = 0.2967 = 29.67%

Project B: ARRB = (27,880/year 7,320/year) / 122,000 = 0.2885 = 28.85%

While both projects achieve a rate of return above the interest rate in the market (6%), they are

profitable. However, investment project A outperforms the investment project B, achieving the

relative profitability.

Concluding, while the above methods are just some of the several options available for the senior

management of corporations that are responsible for the decision making process, all are based on

the same idea. Proceed with a project only when it is profitable, as that is the purpose of

corporations: To make profits enhancing the wealth of the owners-shareholders (Hillier et al.,

2011). While the decisions usually are more complex and difficult, especially when probabilities

and expected cash flows must be estimated as in several cases the future cash flows cannot be

estimated accurately. In addition, the classification of the projects is important in the decision-

making process.

Magni and Marchioni (2020) discuss more complex and advanced methods for assessing capital

asset projects than those we have discussed in the current week. However, the importance of

both rates of return and profitability is confirmed in the decision whether a project is financially

efficient or not.

References

11 HR 7003-Managing Financial and Human Resources for Sustainable Business Success

Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P., 2002. Capital budgeting:

financial appraisal of investment projects. Cambridge University Press.

Götze, U., Northcott, D. and Schuster, P., 2008. Investment appraisal. Methods and models,

Berlin: Springer.

Hillier, D., Grinblatt, M. and Titman, S., 2011. Financial markets and corporate strategy.

Magni, C.A. and Marchioni, A., 2020. Average rates of return, working capital, and NPV-

consistency in project appraisal: A sensitivity analysis approach. International Journal of

Production Economics, 229, p.107-769.