Investment Appraisal

What you need to know before submitting your investment proposal to us

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The world has no shortage of brilliant ideas. Here at Lambros Industries, we love hearing exciting new business opportunities. While we put in every effort to review each proposal that comes to us, sometimes we just do not have enough information to make an informed decision. As a result, we are forced to let go of opportunities that we cannot effectively evaluate.

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To make it easier for you to prepare your investment proposal, we have created an outline of the techniques we use in project appraisal.

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Our thought process

The purpose of project appraisal is to identify the attractiveness of an investment by assessing the viability of the project, programme or portfolio decisions and the value it will generate. Project appraisal methodologies are used to assess a proposed project’s potential success. There are two basic approaches to project appraisal: non-discounted and discounted cash flow methods.

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We estimate and evaluate the costs and benefits of a proposed capital project over its expected useful life, along with any risks from the projects. In particular, we assess (i) the costs and benefits over the project’s life, (ii) the level of expected returns from the project or invested expenditure, and (iii) the risk involved, including uncertainty about the timing and volume of returns.

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When analysing a project, we ask the following questions to ascertain whether the project is viable:

• What for? The objectives of the project – such as meeting a gap in the market.

• How? The process, and the internal and external resource requirements.

• Who? For whom, by whom – project partners, stakeholders.

• When? The time factor.

• Where? The location.

• Costs? The administrative costs and fees. 

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Non-discounted cash flow method – accounting rate of return (ARR)

ARR uses accounting profits to estimate the average rate of return that the project is expected to yield over the life of the investment.
 

The ARR is measured as:

Average annual profits - initial capital cost or average capital cost × 100%

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Where:

Average capital cost = initial investment + scrap value ÷ 2

 

And:

Average annual profits = total accounting profit over the investment period- years of investment

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Our target rate of return varies depending on the business environment. As a rule of thumb, a project is accepted when ARR is equal to or greater than the target rate of return. Where projects are mutually exclusive, we will select the project with the highest ARR (that also meets the target rate).

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Non-discounted cash flow method – payback period

The payback period is the time (number of years) it takes a project to recover the original investment. It is based on expected cash flows rather than profits and provides a measure of liquidity. Where cash flows are uneven, the cumulative cash flow over the life of the project is used to calculate the payback period.
 

The formula for payback method is:

Original cost of investment or initial cash outflows ÷ annual cash inflows

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As a rule of thumb, a project is accepted if it is in our opinion that the project is capable of paying back the original investment within the specified time period. When we choose between mutually exclusive projects, the project with the fastest payback is chosen.

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Discounted cash flow method - discounted payback period

The discounted payback period method (or adjusted payback period) helps to determine the time period required by a project to break even. It combines the techniques used in the payback period and DCF techniques to calculate a discounted payback period. This involves discounting the cash flows and then calculating how many years it takes for the discounted cash flows to repay the initial investment.

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Discounted payback is calculated using the same formula as the straight payback method, but uses discounted cash flows to take into account the time value of money.

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The formula is:

Discounted payback period = PV of investment ÷ PV of annual cash flow
 

The acceptance criteria mirrors that of payback period.
 

Discounted cash flow method – net present value (NPV)

NPV is the net value of a capital investment or project, obtained by discounting all cash outflows and inflows to their present values by using an appropriate discounted rate of return.
 

It can be summarised as:

NPV = Present Value of cash inflows – Present Value of cash outflows
 

As a rule of thumb, we accept a project if the NPV is positive. When comparing mutually exclusive projects, we will select the project with the highest positive NPV.
 

Discounted cash flow method – internal rate of return (IRR)

Internal rate of return calculates the rate of return at which the NPV of all the cash flows from a project or investment equals zero. In other words, IRR is the discount rate at which NPV is zero – the discount rate that allows the project to break even. IRR uses the same concepts as the NPV method.

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The calculation for IRR is more complex and thus will not be discussed in this article.

Our discount rate varies depending on the market condition. As a rule of thumb, a project is accepted if the IRR is greater than the cost of capital/discount rate. In the case of mutually exclusive projects, we will select the project yielding the highest IRR.

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Discounted cash flow method – profitability index (PI)

PI shows the amount of surplus a project offers for every dollar invested. A profitability index of 1 indicates break-even and any value lower than one would indicate that the project’s present value is less than the initial investment.

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The formula for PI is:

PI = Present Value of Future Cash Flows or (NPV of the Project + Initial Investment) / Initial Investment

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As a rule of thumb, a project is accepted if the PI is greater than 1. In the case of mutually exclusive projects, we will select the project with a greater PI value (assuming both values are greater than 1).

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Good Luck!