STRATEGIC INVESTMENT DECISIONS 189
This is a more informative presentation of the comparison because it presents the
cash flows as an effective interest rate. The project with the highest internal rate of
return would be preferred, provided that the rate exceeds the cost of capital (i.e.
the borrowing cost).
Comparison of techniques
While the accounting rate of return method provides an average return on
investment and a business may select the highest return, it ignores the timing
of cash flows. Sometimes where there are high short-term ROIs, managers may
prefer those investments even though the longer-term impact is detrimental to
the organization. This is because managers may be evaluated and rewarded on
their short-term performance (see Chapter 13). Payback measures the number of
years it will take to recover the capital investment and while this takes timing into
account, it ignores cash flows after the payback period. Both methods ignore the
time value of money.
Discounted cash flow techniques take account of the time value of money and
discount future cash flows to their present value. This is a more reliable method of
investment appraisal. Discounted cash flow is similar to the method of calculating
shareholder value proposed by Rappaport and described in Chapter 2.
However, for investment evaluation, while all projects with a positive net
present value are beneficial, a business will usually select the project with the
highest net present value, or in other words the highest internal rate of return,
sometimes using the initial cash investment (CVA) or the cost of capital (IRR) as a
benchmark for the return.
Because of rapid change in markets and increased demands for shareholder
value, the use of discounted cash flow techniques has declined in many businesses.
Boards of directors typically set quite high ‘hurdle’ rates for investing in new
assets. These are commonly in terms of payback periods of two to four years or
ROI rates of 25 – 50%. This approach reduces the importance of discounted cash
flow techniques.
However, for larger investments where returns are expected over many years,
discounted cash flow techniques are still important. Investments in buildings,
major items of plant, mining exploration and so on etc. commonly use NPV and
IRR as methods of capital investment appraisal.
The following case study provides an example of investment appraisal.
Case study: Goliath Co. – investment evaluation.................
Goliath Co. is considering investing in a project involving an initial cash outlay for
an asset of £200,000. The asset is depreciated over five years at 20% p.a. Goliath’s
cost of capital is 10%. The cash flows from the project are expected to be as follows: