Introduction to investment appraisal

In this chapter we will evaluate real investment decisions whereby entrepreneurs and companies consider whether a certain level of investment will generate sufficient cash flows in the future to make the investment worthwhile. In this section you will be introduced to three main forms of investment appraisal: (i) payback, (ii) net present value (NPV) and (iii) internal rate of return (IRR). We will also look at combinations of these.

Graham and Harvey surveyed 392 chief financial officers (CFOs) and asked them a variety of questions about capital budgeting decisions. They found that “Most respondents select net present value and internal rate of return as their most frequently used capital budgeting techniques; 74.9% of CFOs always or almost always … use net present value … and 75.7% always or almost always use internal rate of return …”

When asked to state, on a scale of 0 (never) to 4 (always), “how frequently does your firm use the following techniques when deciding which projects or acquisitions to pursue?”, the mean score was 3.09 for IRR, 3.08 for NPV and 2.53 for payback for the entire sample of firms.

However, for small firms the mean score was 2.87, 2.83 and 2.72 respectively, while for large firms it was 3.41, 3.42 and 2.25 respectively. It is evident that payback is preferred by small firms but NPV and IRR is more popular with large firms.

The net present value decision rule

We have previously seen that a dollar today is worth more than a dollar in the future. It is therefore not appropriate to focus on the actual level of future cash flows, as in “present value” terms they will decline over time. Therefore, if we wish to evaluate an investment project we need to focus on discounted cash flows, not the actual level of cash flows.

Moreover, previously we have learned that equities and bonds carry with them different degrees of risk and hence have different required rates of return. It follows that the interest rate used to discount cash flows will vary from investment to investment.