Further aspects of investment appraisal

Approaches to investment appraisal usually involve a mixture of traditional techniques, such as payback and accounting rate of return, or discounted cash flows. In the case of the latter there are two problems to resolve:

• How to incorporate the value of flexibility into the NPV? This is covered by considering the topic of real options.
• How to apply discounted cash flow techniques where the project changes the risk profile of the firm. This is discussed in more detail below.

Which approach to take to investment appraisal?

A common approach to project appraisal is to use the existing WACC as a discount rate to calculate a project NPV.

Ideally we want a project discount rate that reflects project business risk and project finance. The existing company WACC will reflect the company's business risk and the company's financial structure. Consequently we can only use the company WACC as a proxy project discount rate if:

• the project business risk is the same as that for the company - i.e. the project involves an extension of the company;'s existing line of business.
• the project financial risk is that same as that for the company - i.e. the project is financed in such as way as to keep the company's gearing ratio constant.

Thus the existing company WACC should only be used as a discount rate for a new investment project if the business risk and the capital structure (financial risk) are likely to stay constant. In essence the project looks like the company in miniature.

If these conditions do not hold then a different approach is needed.

If the business risk of the new project differs from the entity's existing business risk

Instead of a company WACC, a project risk- adjusted WACC can be calculated and used to determine a project NPV.

This is done by recalculating the cost of equity to reflect the business risk of the new project. This often involves the technique of 'degearing' and 'regearing' beta factors as part of using CAPM.

If the capital structure (financial risk) is expected to change when the new project is undertaken

The simplest way of incorporating a change in capital structure is to recalculate the WACC using the new capital structure weightings. This is appropriate when the change in capital structure is not significant,or if the new investment project can be effectively treated as a new business, with its own long term gearing level.

Alternatively, if the capital structure is expected to change significantly, the Adjusted Present Value method of project appraisal could be used. This approach separates the investment element of the decision from the financing element and appraises them independently. APV is generally recommended when there are complex funding arrangements (e.g. subsidised loans).

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