Making capital investment decisions

The nature of investment decisions

      Large amounts of resources are often involved

      It is often difficult and/or expensive to bail out of an investment once undertaken

 

Discounted payback period

      The discounted payback period essentially calculates the break-even point at which the discounted returns from a project are equal to the capital cost of the project.

      Shows how long it will take to recover the initial cost of the project after taking into account the cost of capital.

      Superior to the conventional payback period approach.

      Due to discounting of the cash flows from a project, the discounted payback period will always show a longer payback period than the standard payback period, and hence may be regarded as more conservative. 

Internal rate of return (IRR) ; IRR decision rule

 The relationship between the NPV and IRR methods

 The IRR method providing more than one solution

 Two main problems with the IRR method

      The possibility of arriving at multiple rates

      Concerns over the reinvestment rate

      Both problems can be overcome by modifying the IRR to arrive at a modified internal rate of return (MIRR)

Modified internal rate of return (MIRR)

      The conventional IRR is the discount rate at which the present value of a project’s future cash flows is equal to the initial investment.

      The most common form of MIRR compounds the net cash inflows to a single figure at the end of a project’s economic life, and then using the cost of the project as a base figure, calculates the modified return for a project using the following formula:

                [(Compounded cash inflows / Cost of project)^1/n - 1] × 100

      The cash inflow in the final period is arrived at by assuming a reinvestment rate equal to the cost of capital (not at the project’s internal rate of return), so the MIRR is generally lower than the IRR.

       

Practical points related to investment appraisal

 Investment appraisal in practice

 Managing the investment decision

 Capital rationing

      In determining investment funds available, the amount of funds available for a business’ investment may be limited by

                - external market for funds or

                - internal management.

      Situation where there are insufficient funds to finance all the potentially profitable investment opportunities available is referred to as capital rationing.

      Competing investment opportunities need to be prioritised and some modification to the NPV decision rule is necessary.