M.Sc. Finance 
M.Sc. Investment & Finance 
M.Sc. International Banking & Finance 
and 
M.Sc. International Accounting & Finance 
 
2011/2012 
 
40901 – Finance I 
 
CAPITAL BUDGETING: 
Investment Decision‐Taking in Practice 

This chapter considers how the costs and benefits capital expenditure proposals
should be identified and structured for decision taking purpose. The costs and
benefits are defined in terms of cash flows and the analysis focuses on cash flows
rather than accounting profitability. But the consequences of an investment for a
firm’s profitability cannot be ignored as tax, in most cases a significant cash flow,
depends on the level of profits.
The capital expenditure decisions of a company will shape its future and it is
important that these decisions are taken on the basis of systematic assessment of the
costs and benefits. This chapter develops a simple framework for systematically
organising and evaluating the expected cash flows stemming from an investment
proposal.

The implications of inflation are considered it is demonstrated how the effects of

inflation can be taken into account in capital budgeting. Up till now we have assumed
future cash flows to be known with certainty, despite the fact that in the real world
this cannot be the case. So we introduce sensitivity analysis. If we cannot predict
what will happen in the future we need to be able to identify the consequences of
potential errors in our forecasts for the profitability of investments. This allows us to
focus on the inputs into the analysis that are likely to be the most critical
determinants of the investment’s outcome.
In this chapter we will discuss the principles of capital budgeting and
the application of the net present value rule in practical decision You should read chapter
taking. This requires the identification of the costs and benefits of an seven in Hillier et al in
investment proposal. We will also briefly consider how risk and conjunction with this unit.
uncertainty can be introduced into the analysis of investments. Costs
and benefits will be measured in terms of their impact on the
company’s expected net cash flows. We will demonstrate how the data
on costs and benefits can be systematically organised in a cash flow
statement to determine the expected change in net cash flows. While
the investment proposals are evaluated on the basis of their impact
on expected net cash flows rather than on profits, the implications of
investment proposals for accounting profits cannot be ignored. Tax
payments tend to be an important component of the cash flows of
most projects, and a company’s tax liability is assessed on the basis of
its profits rather than its cash flows. Consequently, we will have to
consider an investment’s impact on expected profits and tax payments
before we can complete the net cash flow analysis. This implies that
we will have to develop a profit and loss account for the investment
proposal.

Objectives
By the end of this chapter you should be able to:
ƒ explain why cash flows and not profit are the focus of capital
budgeting
ƒ identify the relevant cash flows of an investment proposal
ƒ analyse the consequences of an investment for a company’s tax
position
ƒ organise the data on expected net cash flows so as to allow the net
present value to be calculated
ƒ allow for the effects of inflation in investment analysis
ƒ consider the impact of risk and uncertainty on projects and
ƒ interpret and evaluate the estimated net present value for an
investment.
1 Net cash flows
As we have seen in Chapter 2, calculating the net present value or the
internal rate of return of an investment proposal is a simple
mathematical calculation once the net cash flows of the investment
are known. Determining the relevant cash flows to employ in the
exercise is rather more demanding. The primary difficulty stems from
the need to forecast cash flows into the future. Financial managers
generally rely on various specialists in the company, for example, the
market research manager, to provide the data that will form the basis
of the estimates of future costs and benefits. But once these estimates
have been obtained, the identification and organisation of the
relevant costs and benefits are not always a straightforward exercise.
There are some simple guidelines to be followed:
ƒ focus on cash flows, or cash flow equivalents, and not accounting
profits
ƒ determine the changes expected in the company’s cash flows if the
investment proposal under consideration is adopted
ƒ cash flows should be considered on an after tax basis
ƒ an allowance should be made for the possible effects of inflation.

Accounting profit and investment appraisal

When a company’s performance is evaluated, the first indicator to be
considered tends to be a measure of its profitability, such as the ratio
of profits to capital employed. Not surprisingly, in many companies
investment proposals are also evaluated on this basis. But this is
most unlikely to lead to the identification of the optimal set of
investments. Profitability may well provide a good basis for assessing
the ex-post performance of a business, but it is not an appropriate
criterion for evaluating investment proposals.

The rationale for the use of net cash flows in investment decision-
taking is quite simple and straightforward: the time cost of money is
tied to the firm’s cash flows and not to its profits. There is no need to
seek any further justification for the focus on cash flows.
When an investment is made in a new machine, the company needs
funds to make the purchase. Whether the company utilises internal
funds, resources already at its disposal, or external funding in the
form of a loan, the interest clock starts ticking when the machine is
acquired. A company using internal funds will forego either the
interest available on alternative uses of the funds, such as financial
investments or the possibility of returning the funds to shareholders
so that they can undertake financial investments on their own behalf.
When a company has to borrow to invest, the interest cost is quite
explicit.

Why is profit not also linked to the time cost of money? The
accountant starts with a firm’s transactions, and then organises and
adjusts the data in various ways to derive a profit figure to provide an
indication of the firm’s performance and ability to pay dividends
without running down the capital of the company. These are sensible
objectives, but the resulting profit figure is not linked to the time cost
of money. For example, the expenditure on capital equipment is not
recognised as an expense at the time it is incurred, but is spread over
the working life of the equipment in the form of a depreciation charge.

Many textbooks reinforce the argument by contending that measures

of profit are less objective than measures of net cash flow. This is
true: the form of the depreciation charge employed to recognise the
cost of capital asset in the determinations of the profit figure will
reflect the judgement of the accountant. (Should the company use the
straight-line, declining balance or some other form of depreciation?)
And the choice will influence the distribution of expected profit over
the life of the asset. It is quite possible to cite a number of other ways
in which the exercise of judgement by the accountant can influence
the reported level of profit. But the argument is redundant. Cash
flows are tied to the time cost of money and to the objective of
maximising the wealth of the shareholders, and this alone justifies
the concentration on net cash flows rather than on profits in assessing
the value of a potential investment.

Even though we shall focus on cash flows in our analysis, this does
not mean that the effects of an investment for a firm’s profitability
can be ignored. The change in a company’s tax payments resulting
from the adoption of a project may be a significant component of its
net cash flows. An assessment of a project’s impact on the firm’s profit
and loss account is, therefore, required to allow the cash flow analysis
of a project to be completed.

A digression on profits and cash flows

Taking a simple approach, profit can be defined as the difference
between revenues and expenses. But accountants would not be able to
justify their enviable salaries or their influence over business affairs
by keeping matters simple! For a business venture with a finite life,
the overall level of profit will be given by the difference between the
venture’s cash inflows and cash outflows. But companies do not have
a limited life span, and it is necessary to try to assess their profit over
a given period of time, such as a year. This is the source of most
accounting problems.

Decisions must be taken on the revenues and expenses to be

recognised for a particular period. Accountants are guided on these
decisions by various conventions and principles – by adhering to the
principles agreed by the profession, the need to rely on the discretion
and judgement of the individual accountant is minimised. The
principles tend to be a compromise between what follows from
rational analysis and the need to maintain credibility and confidence
by relying as far as possible on objectively measurable data.
Revenues are defined as the sales made during the period, whether
for cash or on credit. The revenues correspond to creation of an asset
for the company, either in the form of an increase in cash or debtors.
The revenues are recognised as soon as it is reasonable to assume
that the company has a legal right to be paid for the goods or services
that have been supplied. This implies that revenues for a period are
not necessarily going to be equal to the company’s cash inflow in any
one period. Some of the cash inflow may stem from sales made on
credit in the previous period, and some of the sales made on credit in
the current period may result in a cash inflow in the next period.

Expenses for a period are estimates of the costs incurred in

generating the revenues recognised in this period – in other words,
the costs of producing the goods or services that have been supplied.
Cash outflows differ from expenses for three main reasons:

ƒ Some resources employed in producing the output sold in the

current period will be obtained on credit and paid for in the next
period, while some resources employed in the previous period that
were acquired on credit will be paid for in the current period.
ƒ Some of the goods sold in the current period may have been taken
from items held in stock and purchased or produced in an earlier
period, while some of the items produced in the current period
will not be sold and will end up in the company’s stock at the end
of the period.
ƒ Some capital assets, such as premises and machines, provide
productive services over a number of time periods, and, as we
have seen, the cost of using such assets is allocated in the form of
a depreciation charge to the periods in which the assets are
expected to contribute to the generation of revenues – whereas
the cash outflow produced by the assets occurs when the assets
are purchased.
A depreciation charge is an accounting entry, involving a reduction in
the value recorded for the asset in the company’s accounts. It
recognises that, with use, the value of an asset such as a machine is
likely to fall as it wears out. Technological obsolescence with the
passage of time will also drive down the value of some assets.
Accountants do not generally attempt to estimate the actual decline
in the value of an asset during a time period but use some simple rule
of thumb to allocate its cost to the different time periods over its
working life. This avoids the use of judgement and maintains the
objectivity of the profit figure.

A basic framework
We will start with an illustration of the way in which the formal
analysis can be set out. For this purpose we will consider a proposal to
introduce a new product by Caledonia plc. This new product will be
sold at a price of £100, and 200 units are expected to be sold annually
for the next four years, after which the product will be withdrawn
from the market. The equipment and machinery required to produce
the item costs £8,000 and the variable cost per unit is expected to be
£70. The fixed costs are estimated at £1,000 per annum. The tax rate
is 40 per cent, and the tax authorities require that the expenditure on
equipment and machinery is depreciated over a four-year period. We
will assume that the taxable profit can be calculated as the revenues
minus the variable costs, the direct costs and the depreciation or
capital allowance.

Caledonia plc
Summary of the data
Investment outlay £8,000
Life 4 year
Price £100
Average variable cost £70
Sales (units) 200
Fixed cost £1,000
Depreciation charge (capital allowance) £2,000
Discount rate 10 per cent
Tax rate 40 per cent

Caledonia plc
Net cash flows
The net cash flows are derived from the analysis developed below:

Caledonia plc
Profit and loss account
0 1 2 3 4
Revenues 20,000 20,000 20,000 20,000
Direct costs (14,000) (14,000) (14,000) (14,000)
Fixed costs (1,000) (1,000) (1,000) (1,000)
Capital allowances (2,000) (2,000) (2,000) (2,000)
Profit 3,000 3,000 3,000 3,000

Tax (1,200) (1,200) (1,200) (1,200)

Cash flow statement

0 1 2 3 4
Investment outlay (8,000)
Revenues 20,000 20,000 20,000 20,000
Direct costs (14,000) (14,000) (14,000) (14,000)
Fixed costs (1,000) (1,000) (1,000) (1,000)
Tax ______ (1,200) (1,200) (1,200) (1,200)
NCF (8,000) 3,800 3,800 3,800 3,800
PVF 1.0000 0.9091 0.8264 0.7513 0.6830
Present values (8,000.00) 3,454.55 3,140.50 2,855.00 2,595.45
NPV £4,045.49
IRR 32%

The first statement, the projected profit and loss account, is necessary
to assess the tax implications of the project, and the second, to
determine the net cash flows, can be developed simultaneously. It is
useful in most instances to draw a distinction between the capital
transactions, usually concentrated at the beginning and end of the
project’s life, and the items that figure on a recurring annual basis.

Capital expenditure is recognised in the cash flow statement when

the outlay is made, while the depreciation charge is included in the
profit and loss account. The depreciation charge does not figure in the
cash flow statement as it is a non-cash expense. Moreover, its
inclusion would imply the double counting of the cost of the capital
cost outlay. It is necessary to differentiate between the depreciation
expense recognised in the company’s accounts and the deprecation
expense, generally referred to as the capital allowance, which the tax
authorities are prepared to recognise. It is the latter and not the
former that will be relevant in the evaluation of investment proposals
and is employed here.
The annual items in this instance are quite straightforward – the
revenues are included in both statements as positive entries, while
the variable and fixed costs go into both as negative entries. As we
have already noted, the depreciation charge acceptable for tax
purposes goes into the profit and loss statement but not into the cash
flow statement. The entries for the profit statement are now complete,
and the profit for each year can be calculated. The annual tax
payments can then be determined for inclusion as the last item in the
net cash flow statement. The columns in the net cash flow statement
are summed to give the series of expected net cash flows. Finally, the
net cash flows are multiplied by the relevant present value factors to
obtain the series of discounted net cash flows.

It is assumed in this example that the sales are made on a cash basis
and that the variable and fixed costs are paid as they arise. It is also
assumed that the project requires no working capital and that there is
no recovery value for the machines and equipment. We will add in
these possible complications a little later.
Although interest payments involve cash outflows, they should not be
taken into account in determining the net cash flows of a project. An
allowance is made for interest charges through the process of
discounting, and to recognise such charges as a cash outflow would
lead to the double counting of the item. Generally it is advisable to
consider financing and investment decisions separately, with the
discount rate providing the link between the two.

Taxation and investment appraisal

We have stressed the need to evaluate investment proposals after
taking tax into account, and given the general importance of tax in
financial decision taking we will develop the analysis a little further.
Before doing so, it should be noted that there is no simple way in
which to adjust a before-tax net cash flow analysis to derive the after-
tax outcome. For example, a pre-tax rate of return (IRR) of 20 per cent
does not imply that the post-tax rate of return is 12 per cent if the tax
rate is 40 per cent, ie 0.20(1−0.40) = 0.12. Not only is tax levied on
profit and not on cash flows, but there is no simple relationship
between pre- and post-tax cash flows. The problems of assessing the
implications of tax cannot be avoided.

The primary difference between net cash flow and profit arises from
the inclusion of non-cash expenses, particularly capital allowances, in
the calculation of the latter. To investigate the relationship, let R
stand for sales revenue, CC for cash costs, CA for depreciation, t for
the tax rate, and T for the tax liability.

The annual net cash flow (NCF) before tax is given by:

NCF (before tax) = R−CC

and taxable profit is defined as follows:

Profit = R−CC−CA

The tax liability is given by:

T = (R−CC−CA) t

The after-tax net cash flow is equal to the cash flow before tax less the
tax payment:
NCF (after tax) = NCF (before tax) −T
= (R−CC)−(R−CC−CA)t
This can also be written as:

NCF (after tax) = (R−CC)(1−t) + tCA

The last term in this equation emphasises the role of capital

allowances as a tax shelter: a non-cash expense that reduces a
company’s profit and thereby tax liability. The larger the capital
allowance that the tax authorities will accept in any period, the lower
the taxable profit, the lower the tax and the higher the net of tax cash
flow.

The net cash flow after tax can also be derived by adding back the
capital allowance to the after-tax profit figure. As the capital
allowance, a non-cash item, is deducted in the calculation of profit, it
must be added back to the profit after tax to determine the after-tax
net cash flow:
NCF (after tax) = (R−CC−CA)−(R−CC−CA)t + CA
= (R–CC–CA)(1−t) + CA
= (R−CC)(1−t) + tCA
It is beneficial to the company to postpone tax payments for as long as
possible as this minimises the present value of the tax liability. Any
tax payment that is postponed may be viewed as an interest-free loan
from the government. This implies that assets should be depreciated
at the fastest rate allowable by the government even though this
pushes down the reported profit figure.

Writing down allowances

The most commonly applied rules are straight-line and the declining
balance method. Straight-line depreciation is determined by dividing
the cost of the asset by its anticipated working life, giving a constant
annual charge. The declining balance approach assumes that the
value of an asset falls at a decreasing rate over its working life. It
allocates a fixed proportion of the residual or net value to each year.
For example, a 25 per cent writing down allowance allocates 25 per
cent of the cost to the first year, leaving a net value of 75 per cent of
the original asset cost, and in the second year the depreciation charge
will be 25 per cent of the residual 75 per cent, or 18.75 per cent of the
original cost, and so on. This approach does not depend on the
assumed life of the asset and will always leave some value remaining
at the end of the project’s life.
The schedule in the table below indicates the capital allowances for
an asset costing £1000 with an assumed working life of ten years and
no residual value. At the end of Year 10, the remaining book value of
the asset is written off. The schedule also specifies the capital
allowances for each unit of capital expenditure.

Capital allowances: writing down allowances

Initial outlay £1,000; writing down allowance (25 per cent)

Year Book value Capital

remaining (£) allowance (£)
1 1,000.00 250.00
2 750.00 187.50
3 562.50 140.63
4 421.87 105.45
5 316.42 79.11
6 237.31 59.33
7 177.98 44.49
8 133.48 33.37
9 100.11 25.03
10 75.08 75.08
In the early years of a project’s life, it is not unusual to register losses.
If the company is making profits on its other activities these losses
can be set against the profits to reduce the tax liability of the
company. Any tax savings should be recognised in the cash flow
statement as one of the benefits of the investment. The tax position
relating to losses is likely to differ from country to country.

In principle, the total amount of capital allowances that can be

claimed for an asset is given by the difference between the purchase
price and any recovery values, ie the net cost of the asset. This
implies that if there is any recovery value at the end of the life of an
asset, this will give rise to a tax charge if capital allowances
equivalent to the purchase price have already been claimed. This is
illustrated in the development of the example for the investment
undertaken by Caledonia plc considered earlier. It is assumed that
the recovery value of the capital assets is £1000. This is a capital gain
in relation to the book value of zero for tax purposes. The original
calculation is amended to show a cash inflow of £1000 in the net cash
flow statement, under the heading of recovery value, and a capital
adjustment, or gain, of £1000 is included in the profit and loss
statement. The capital adjustment leads to an increase in profits, and
thereby an increase in tax of £400. Once this is carried through to the
net cash flow statement, the overall impact is a rise in the net cash
flow in Year 4 of £600.

Caledonia plc: with recovery value

Profit and loss account
0 1 2 3 4

Revenues 20,000 20,000 20,000 20,000

Direct costs (14,000) (14,000) (14,000) (14,000)
Fixed costs (1,000) (1,000) (1,000) (1,000)
Capital allowances (2,000) (2,000) (2,000) (2,000)
Capital adjustments _____ ______ ______ 1,000
Profit 3,000 3,000 3,000 4,000
Tax (1,200) (1,200) (1,200) (1,600)

Cash flow statement – with recovery value

0 1 2 3 4
Investment outlay (8,000)
Recovery value 1,000
Revenues 20,000 20,000 20,000 20,000
Direct costs (14,000) (14,000) (14,000) (14,000)
Fixed costs (1,000) (1,000) (1,000) (1,000)
Tax (1,200) (1,200) (1,200) (1,600)
NCF (8,000) 3,800 3,800 3,800 4,400
PVF 1.0000 0.9091 0.8264 0.7513 0.6830
Present values (8,000.00) 3,454.54 3,140.49 2,854.99 3,005.25
NPV £4,455.29
IRR 33%
2 Working capital
Most projects require some use of working capital – debtors,
inventories, etc. This tends to increase the cash outflow of a project in
its early years, but any investment in working capital should be
recovered at the end of the project’s life. The cash outflow for working
capital can be expected to be balanced by a subsequent inflow, but it
must be included in the analysis so as to allow for the time cost of the
money. The present value of the cash outflows exceeds the present
value of the cash inflows, the difference representing the present
value of the interest cost of employing working capital.

This is again demonstrated using the Caledonia example. We will

assume that the working capital requirement is £3,500. This is
needed at the outset of the project’s life and will be recoverable at the
end of Year 4. Its inclusion reduces the NPV and the IRR of the
investment. Before incorporating the effects of working capital in the
net cash flows of the project, we consider its impact on the NPV.

It is important to draw a distinction between the required level of

working capital and the investment in working capital. It is the
investment in working capital, and not the level of working capital,
that provides the correct basis for determining the relevant net cash
flows for investment appraisal. The annual investment in working
capital is given by the change in the level of working capital from year
to year. The level of production and sales in most new ventures builds
up over time and then evens off. As the level of activity increases, so
will the working capital requirements. But once the maximum level of
sales is reached and the level of working capital required to support
this level of sales has been built up as available, no further
investment will be necessary. If sales are expected to fall after a
number of years, working capital requirements will decrease and the
initial investment in working capital will begin to be recovered. This
may be illustrated by means of a simple example of an investment in
the stocks of a raw material (this should be valued at cost as we need
to identify the changes that occur in the company’s cash flows).
Year 0 1 2 3 4 5
Required level of 100 200 250 250 250 0
stocks (valued at cost)
Investment in stocks (100) (100) (50) 250*
* recovery of the funds invested

It would not be necessary to consider the investment in stocks as a

separate item if the planned payments for materials are entered
directly into the cash flow statement. For those periods in which
stocks are increasing, the payments for materials will exceed the
value of the materials embodied in the products that are sold, and
recognised in the cost of goods sold item in the profit and loss account,
and the opposite will be true when stocks are being run down. But it
is generally more convenient to recognise the cost of goods sold in the
cash flow statement, even though this does not correspond to the cash
outflow. The difference between the accounting measure and the cash
flow outflow is covered by a recognition of the investment in stocks in
the net cash flow statement. This is a convenient procedure to follow
when it is necessary to allow for tax, and a profit and loss statement
must be produced. (This reasoning also applies to work in progress
and stocks of finished goods.)

Caledonia plc: with working capital

Investment in working capital
0 1 2 3 4
Working capital (3,500) 3,500
PVF 1.0000 0.9091 0.8264 0.7513 0.6830
Present values (3,500.00) 0.00 0.00 0.00 2,390.55
NPV £(1,109.45)
Cash flow statement – with working capital
0 1 2 3 4
Investment outlay (8,000)
Revenues 20,000 20,000 20,000 20,000
Direct costs (14,000) (14,000) (14,000) (14,000)
Fixed costs (1,000) (1,000) (1,000) (1,000)
Working capital (3,500) 3,500
Tax _______ (1,200) (1,200) (1,200) (1,200)
NCF (11,500) 3,800 3,800 3,800 7,300
PVF 1.0000 0.9091 0.8264 0.7513 0.6830
Present values (11,500.00) 3,454.54 3,140.49 854.99 4,985.99
NPV £2,936.03
IRR 20%

It is also necessary to recognise the investment in net trade credit, the

difference between debtors (accounts receivable) and creditors
(accounts payable). Again, the cash flow statement could be directly
based on the cash receipts and payments, but it is generally easier to
continue to use the profit and loss account entries for revenues and
cost of goods sold in the cash flow statement, and allow for the
differences between these items and net cash flows through an entry
in the analysis for an investment in net trade credit.

The following example illustrates how to deal with debtors when sales
revenue has been estimated and debtors are assumed to be equivalent
to three months sales.

Basic data
Year 1 2 3 4 5 6*
Sales revenue 1,200 2,400 3,600 3,600 2,400
Debtors at end of year 300 600 900 900 600
Change in level of debtors (300) (300) (300) 0 300 600
(investment in debtors)
Net cash flow from sales 900 2,100 3,300 3,600 2,700 600*
* three months into the year

It is possible to use either the net cash flow from sales or the sales
revenue adjusted for the investment in debtors to determine the net
cash flow.
3 Incremental cash flows
With and without the project
The cash flows to be taken into account when evaluating an
investment are the changes in the firm’s overall cash flows
anticipated as a result of its adoption – the incremental cash flows.
This is referred to as the ‘with and without’ approach – the difference
between the firm’s expected cash flows with and without the project
defining the relevant cash flows.
It is sometimes assumed that the incremental cash flows of a
proposed investment can be derived by taking the difference between
a company’s expected cash flow before and after the adoption of a
project. But this can be misleading: cash flows can change even if a
project is not implemented. The with and without approach stresses
the possibility of changes occurring in the expected cash flows with
the passage of time, even if the proposed investment is not
introduced. For example, one of a firm’s products is losing ground to
competing products and management is considering investing in
facilities to introduce a new model to improve the company’s position.
It would not be appropriate to evaluate the profitability of the
proposed investment by comparing the cash flows following the
adoption of the new model with the current cash flows. This would
understate the profitability of the investment. The relevant
comparison is with the cash flows to be anticipated in the future if the
new product is not introduced and the competitive position of the
existing product continues to deteriorate.

In principle, the relevant cash flows are far easier to identify for a
project totally unrelated to the company’s existing business than they
are for one intertwined with the firm’s existing business, such as an
investment in replacement machinery. But forecasting the expected
revenues and costs for a new product investment is likely to pose far
more problems than the determination of the net cash flows of a
replacement investment.
Sunk costs
The application of the incremental cash flow principle implies that
costs incurred prior to the time at which the decision is taken are
irrelevant. For example, a company that has already incurred
substantial research and development costs in developing a new
product should ignore these costs in assessing whether or not to go
ahead and manufacture the product. This R&D expenditure is a sunk
cost and has no direct relevance to the current decision. Bygones are
always bygones in rational analysis!

As work on a project proceeds, more and more of the set-up costs may
be considered to be sunk. This makes it more and more likely that it
is worth proceeding with the project! Once a project is well under way,
it may be advantageous to complete it, even though it becomes
apparent that it should never have been started in the first place. Of
course, this does not imply that a project should never be abandoned
simply because so much has already been spent on it. In applying the
incremental principle, attention should be focused on the costs that
can still be avoided in relation to the future benefits that can be
anticipated.
To illustrate the principles relating to sunk costs, consider a project
with an outlay spread over two years, expected net cash flows for the
subsequent ten years and a required rate of return of 10 per cent:

Time period Cash flow PVF (10%) PV

0 (10,000) 1.0000 (10,000)

1 (10,000) 0.9091 (9,091)
2→11 4,500 5.5860* 25,137
NPV = £6,046

*PVAF2→11 / 0.10 = 5.5860

At a discount rate of 10 per cent, the project is profitable: it has a net

present value of £6,046. A decision is taken to proceed with this
project, and the initial expenditure of £10,000 is completed. At the
end of the first time period, the project is again assessed, and it is
estimated that the capital expenditure in the subsequent period will
be £11,000, and as a result of unfavourable market changes, the
expected benefits must be reduced by a third to £3,000 per annum. If
these developments had been anticipated before the commencement of
the project, it would have been rejected as the NPV would have been
minus £3,242:

Time period Cash flow PVF (10%) PV

0 (10,000) 1.0000 (10,000)

1 (11,000) 0.9091 (10,000)
 2→11 3,000 5.5860 16,758

NPV = £(3,242)

But this is not relevant for the decision to be taken at this time. Only
expected cash flows from now onwards should be taken into account.
The initial expenditure of £10,000 has been spent and should be
omitted when considering whether or not to proceed. It is a sunk cost.
The relevant analysis is as follows:

Time period Cash flow PVF (10%) PV

0 (11,000) 1.0000 (11,000)

1→10 3,000 6.1445 18,434

NPV = £7,434

Although it is recognised that the company would have been better off
if it had not embarked on the project at all, the expenditure today of
£11,000 is well justified given the expected annual net cash flow of
£3,000 for the next ten years.
Sunk costs should be ignored for decision-taking purposes, but the
company should critically examine its initial investment appraisal to
see if any of the adverse developments could have been foreseen and
change its approach in future if this is appropriate.

Opportunity cost
Not all costs and benefits of an investment will involve the
expenditure or the receipt of cash. Some inputs required to undertake
a project may already be owned by the company. In these
circumstances, an input should be valued by identifying the potential
cash flow lost by its use in the proposed project. The historic cost or
the current book value is irrelevant for the valuation of any owned
inputs other than for the implications this value might have for the
tax position of the company.

The following examples ignore the possible tax implications:

ƒ A company intends using some land purchased five years ago for
£100,000 in a project. The current resale value of this land is
£250,000. Use of the land in the project involves forgoing a cash
inflow of £250,000, and this should be allocated to the project as a
cost. It makes no difference that the purchase price five years ago
was £100,000 – the opportunity cost today would still be £250,000
even if the land had been acquired for nothing five years ago.

ƒ Some material was bought six months ago for £1,000. The
company no longer has any use for this material other than in a
project currently being appraised. The current purchase cost of
the material is £1,100 and its resale value is £900. What is the
 real cost of using this material in the project under consideration?
As the use of the material implies that the company has to forgo
the £900 resale proceeds, this is the cost that should be
recognised.

ƒ A project requires 100,000 cubic feet of storage space, and the

company has a warehouse with spare capacity of 120,000 cubic
feet available. What is the opportunity cost of using this spare
capacity in the project? If the company has no alternative use for
this capacity, now or during the life of the proposed project, and it
cannot be sold and it is not feasible to rent it out, the opportunity
cost is zero.

It should be clear from these examples that the relevant cash flows
for discounted cash flow analysis do not always involve cash
transactions. But it should also be clear that forgoing the possibility
of generating cash is as much of a cost as making an explicit cash
payment. (This is why we referred earlier to cash flows or cash flow
equivalents as providing the basis of the analysis.)

Overhead costs
The allocation of overhead costs, such as managerial salaries and
general administrative expenses, to individual projects is frequently a
source of error in investment appraisal. Management accounting
systems often attempt to allocate overhead costs to the various
activities that the firm undertakes, and new projects are expected to
meet a share of such costs. It is argued that overheads have to be
covered if a firm is to make a profit, and any project that cannot make
an adequate contribution to overheads should be rejected. Overheads
are frequently assigned to the firm’s activities, and to proposed
projects on a simple and arbitrary basis, eg in proportion to direct
labour expense. Any system of allocation needs to be viewed with
caution, particularly if it fails to differentiate between both fixed and
variable overheads and joint and separable overheads.

The only overhead costs that should be included in the appraisal of a

proposed investment are the additional overheads that can be
anticipated if the investment is undertaken. This follows directly from
the incremental principle. Most internal accounting systems that are
designed for purposes other than appraising investments are unlikely
to produce good data on the changes in the overhead expense likely to
occur as a result of the adoption of a project.

Consider a firm that allocates overheads to its operating units in

proportion to their direct labour costs. This implies that an operating
unit introducing a labour-saving machine would benefit from lower
direct labour costs plus a reduction in its allocated overhead burden.
Should the reduction in the assigned overhead be taken into account
in the evaluation of such an investment? Not unless overheads are
really expected to decline, which is only likely to occur if these costs
are directly linked to the level of employment. Even if some decline is
anticipated in these costs, it is likely to differ from the figure
suggested for the change in overheads allocated by the accounting
system. It is not likely, for example, that an investment in labour-
saving equipment will have much of an impact on head office
expenses, usually a component of overhead expenses. Recognising a
reduction in the allocated overhead, the result of the fall in the direct
labour requirements, as a cost saving attributable to the investment
clearly cannot be justified if the actual overhead expense remains
unchanged. On the other hand, if overheads consist primarily of the
expense of supervisory labour, some savings should be anticipated.
(When dealing with case studies and exercises, think carefully about
the nature of any overhead costs, and in the absence of sufficient data
to differentiate between fixed and variable components, make
whatever assumptions seem reasonable. Take a pragmatic view and
choose those assumptions that allow you to complete the quantitative
analysis as simply as possible!)

Comprehensive perspective on cash flows –

take side effects into account
The introduction of a new model or new product may often have an
adverse impact on the sales of an existing product. When this is
anticipated, the potential decrease in net receipts should be taken
into account when evaluating the new product. This may be an
incidental side effect of the proposed investment, but it still needs to
be recognised as a component of the relevant incremental cash flows.
In the marketing literature this is referred to as product
cannibalism.

In the analysis of the way in which projects affect the cash flows of
the firm’s other activities, it is essential to adopt a with and without
approach rather than a before and after perspective. The possibility of
the loss of sales from existing products even in the absence of the
introduction of a new product by the firm has to be considered.
Product cannibalism might allow a firm to retain customers that
would otherwise have been lost to a competitor. In these
circumstances, the allowance to be made for the loss of sales on
existing products may be substantially less than would be appropriate
if the role of competing products could be safely ignored. The
incremental principle requires, as noted earlier, a comparison of the
company’s expected cash flows with and without the project, and the
future cash flows without the project employed in this exercise should
not be assumed to be equivalent to the current cash flow. If
improvements in the products of competitors are anticipated,
resulting in lower expected cash flows for the company, it is these
cash flows that should form the basis of the without approach.
Focusing on the cash flows currently generated by existing products
can produce a myopic and misleading analysis when evaluating
replacement products.

Constructing the investment appraisal

Next we will summarise the entries in a typical profit and loss
account necessary to derive the tax cash flows:

ƒ The outlay on capital items, such as equipment and machines, is

not recognised at the time of the expenditure but in the form of
annual capital allowances (the depreciation charge allowed for tax
purposes) spread over the life of the project:

ƒ The annual profit figure during the life of the project should
be calculated as revenues minus operating costs minus fixed
costs minus depreciation charges.

ƒ The use of assets already owned by the company may produce

changes in the expected tax payments – an asset that can be
sold for a sum greater than its residual taxable value will
generate a taxable capital gain when sold, and this should be
entered as a negative figure in the profit and loss account if
the asset is retained by the company and the cash inflow from
its potential sale is forgone.

ƒ Working capital should not be included in the profit and loss

account as it is a non-depreciable item.

ƒ The calculation of an annual depreciation charge or allowance for

tax purposes should not take into account the expected resale
value unless required to do so by the tax authorities.

ƒ The expected resale value of a capital asset should consequently

be recognised as a capital gain (if the asset is fully depreciated by
the end of the project’s life).

Let us now summarise the main elements of a standard net cash flow
statement:
ƒ the investment outlay will be recognised as a cash outflow at the
start of the project and is usually one of the more straightforward
elements in the analysis

ƒ some of the outlay may be recoverable as a resale value,

particularly buildings and land, or a scrap value at the end of the
life of the project
ƒ if any of the company’s existing assets are to be employed in the
project, their cost should be determined on an opportunity cost
basis and recognised as cash outflows
ƒ some of the value of the owned asset may be recoverable at the
end of the life of the profit

ƒ any investment in working capital should be recognised at the

start of the life of the project and an allowance made for its
recovery at the end of the project’s life

ƒ the annual inflows from the sale of the product or service can be
identified by the expected sales revenue (any difference between
cash inflow and revenues being covered by the entry for working
capital)

ƒ the annual outflows can be identified by the expected operating

expenses, fixed costs and tax cash flows (no depreciation charges
or capital allowances – these are non-cash expenses), and

ƒ interest charges are taken into account through the discounting

and should not be taken into account.

Illustrative example: the Strathclyde Manufacturing Company

The Strathclyde Manufacturing Company is considering the
possibility of expanding the output of one of its standard products to
meet a new and unexpected order. This order is large in relation to
the company’s usual business. It is for 2,000 units for each of the next
four years at a special price of £50 each. The Marketing and
Production Directors wish to accept the order, but the Finance
Director has some reservations as the profit margin is only 10 per
cent of the selling price whereas the company’s usual business offers a
margin close to 20 per cent.

To undertake the order, the company will have to invest in new

machinery costing £100,000. This would be sold at the end of the
contract for about £30,000. In addition, it will have to use equipment
that has been employed in the production of other items that have
now been discontinued. This equipment is fully written off for tax
purposes but has a net of tax second-hand value of £50,000. There
would be no need to invest in any new buildings as space is available
in the company’s existing factory. An investment of £15,000 in stocks
of raw material would be necessary at the start of production. The
production costs of the company can be estimated with some
confidence as the company has considerable experience of
manufacturing this product.

The Finance Director has provided the following analysis of the

proposed transaction:

£ £
Annual revenues, 2,000 @ £50 100,000
Expenses: raw material 30,000
wages 20,000
 other expenses 5,000
share of overhead (50% of wage bill) 10,000
depreciation (straight-line, 4 years) 25,000 90,000
10,000
The company can write off expenditure on machinery for tax purposes
at a rate of 25 per cent on a reducing balance basis. Corporation tax is
payable at 35 per cent of profits one year in arrears. The company
usually requires a minimum rate of return on investment of this
nature of 10 per cent.

The Managing Director would like the Finance Director to take the
analysis further and determine the NPV of the proposed investment.
He would also like to see the main assumptions underlying the
analysis made explicit.

Financial analysis of the investment

Change in profit and loss – to calculate expected tax payments (£)

Year 0 1 2 3 4 5
Increase in revenue 100,000 100,000 100,000 100,000
Increase in materials (30,000) (30,000) (30,000) (30,000)
Increase in wages (20,000) (20,000) (20,000) (20,000)
Other expenses (5,000) (5,000) (5,000) (5,000)
Increase in overheads – – – –
Change in profit before 45,000 45,000 45,000 45,000
depreciation
Tax allowances on new machine (25,000) (18,750) (14,062) (10,547)
Balancing allowance on machine (1,641)
(capital loss)
Change in taxable profit 20,000 26,250 30,938 32,812
Change in tax (at 35%) (7,000) (9,187) (10,828) (11,484)
(to be paid one year in arrears)
Change in cash flows (£)
Year 0 1 2 3 4 5

New machinery (100,000)

Existing machinery (50,000)
Change in profit before 45,000 45,000 45,000 45,000
depreciation
Sale of new machine 30,000
Change in tax payments (7,000) (9,187) (10,828) (11,484)
Stocks (15,000) 15,000
Net cash flow (165,000) 45,000 38,000 35,813 79,172 (11,484)

PV factor at 10% 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209

Present values (165,000) 40,909 31,403 26,906 54,074 (7,130)

NPV = £(18,838)

On the basis of the assumptions listed below, this order should not be
accepted.

Assumptions of the analysis

1 The new machine is expected to have a second-hand value of
£30,000 at the end of Year 4. This implies that a capital loss of
£1,641 will be made on the machine. By the end of Year 4 capital
allowances of £68,359 will have been claimed. But the company
will be entitled to claim £70,000 – the difference between a
purchase price of £100,000 and an anticipated resale value of
£30,000.

2 The machine already owned by the company will last four years
but will have no value at the end of the Year 4.

3 The net of tax resale value of £50,000 is a fair statement of the

existing machine’s opportunity cost.

4 No working capital other than raw materials will be required and

interest is the only cost incurred in holding these stocks.

5 The sales of existing products will not be affected by the lower

profit margin on this large order.

6 There will be no increase in the company’s overhead expenditure.

7 Costs and selling prices remain constant for the period of the
project.

8 The space used for manufacture has no opportunity cost.

9 The rate of corporation tax and the cost of capital remain
constant.
4 Replacement decisions
The same general principles should be followed in the assessment of
replacement investments as for new investment. But as the analysis
differs in detail for replacement investments, it might be helpful to
consider some of the more important differentiating features of such
investments. The need to focus on incremental cash flows is more
apparent in the case of replacement investments than it is in the case
of new investments: the cost of the investment in the new equipment
or machinery has to be assessed in relation to the reduction in
operating costs that this can be expected to produce.

In defining the net capital requirements of a replacement investment,

the net proceeds from the disposal of the existing asset need to be
taken into account. In many instances it will also be necessary to
consider the tax implication of the sale of the existing asset. Any
capital gains or losses arising from any difference between the resale
proceeds and the accounting or book value of the asset, the initial cost
of the asset less any capital allowances that have already been
claimed, will result in tax liabilities or savings. The underlying
principle is quite straightforward: the total expense that can be
recognised for tax purposes from using an asset over its working life
is its net cost – the difference between the cost of acquiring the asset
and resale proceeds it realises. A capital gain or loss is part of the
settling up process to ensure the expenses recognised for the use of
the asset is equivalent to its net cost. You may feel that basing the
capital allowance on the expected net cost rather than the initial cost
would be simpler, avoiding the need for an adjustment at the end of a
project’s life. However, it is in the interests of the company to
recognise the highest capital allowance acceptable to the tax
authorities, even if this implies some capital adjustment at the end of
the period.
The cash flow statement should also include an estimate of what the
old machine could have been expected to realise at the end of the
period covered by the analysis if it had continued to be used. By
selling it now, this cash flow is forgone. It is also necessary to
recognise that any capital gain or loss implicit in the resale expected
transaction will not take place if the machine is replaced now. (An
anticipated capital gain that will no longer occur is recognised as a
negative entry in the profit and loss account.)

With most replacement decisions, the determination of the time

period over which the cash flows of the two alternatives should be
compared poses some problems. Generally, the replacement asset can
be expected to last longer than the existing asset. But to be able to
complete the analysis it is usually necessary to assume that the
existing asset will last as long as the replacement asset. If this
assumption exaggerates the useful life of the existing asset, as it may
well do, the analysis will be biased towards the rejection of the
replacement option. How important this bias is will depend on how
far the existing asset’s life is likely to fall short of that of the new
asset. If, despite the bias, the replacement option produces a positive
net present value, it is clearly worthwhile adopting. However, if the
NPV turns out to be negative it is not immediately obvious whether
this is the result of the limited benefits expected from the
replacement asset or simply a reflection of the assumptions on which
the assessment has been based. It is often necessary to exercise some
judgement over the interpretation of the results of the analysis. It
might in some circumstances be more appropriate to assess the
alternatives over the remaining useful life of the existing asset,
recognising a residual value for the replacement asset at the end of
this period.

If the assets are being employed in some activity that is expected to

continue indefinitely into the future, a more precise assessment can
be undertaken. The replacement of the existing asset must be
undertaken at some time in the future, and this will set up a
replacement cycle that can be compared with a replacement cycle
starting now.

We will now consider an example of a replacement decision. For the

first, Glen Manufacturing, we will not consider the tax implications,
but these will be addressed in the second.

Replacement investment and incremental cash flows

Glen Manufacturing
The financial manager of Glen Manufacturing is considering a
proposal to replace a machine that has not been running very
efficiently. It has needed constant adjustments and has led to a
relatively high wastage of raw materials. The machine is used in the
manufacture of a product that the company plans to withdraw from
the market in about three years. The financial manager is reluctant
to purchase a new machine as it would then have to be sold at a price
substantially below its purchase price at the end of the three-year
period. It would cost £60,000, and it is anticipated that it could be sold
after three years for no more than £25,000. The existing machine can
be sold for scrap and would realise about £5,000, the amount that can
also be expected three years from now if it continues to be used.
Operating costs would be about £18,000 a year lower if the new
machine is adopted. Ignoring the complications presented by tax
implications and assuming a required rate of return of 20 per cent, is
this a profitable project?

Analysis
To evaluate the proposed investment it is necessary to identify the
changes in the net cash flow that would occur at each point in time as
a result of replacing the machine:
ƒ the purchase of the new machine will lead to a cash outflow of
£60,000 at time 0
ƒ the sale of the new machine will lead to a cash inflow of £25,000
at the end of Year 3
ƒ the sale of the old machine will lead to a cash inflow of £5,000
today (time 0)
ƒ the sale of the old machine now implies that it will not be
available to sell at the end of Year 3, and this is recognised as a
loss of cash flow at that time
ƒ for each of the next three years there will be cost savings of
£18,000.
Year 0 1 2 3

Purchase of new machine (60,000)

Expected resale proceeds from 25,000
sale of new machine
Resale proceeds from sale of old 5,000 (5,000)
machine 18,000 18,000 18,000
Net cash flow (55,000) 18,000 18,000 38,000

PVF (20 per cent) 1.0000 0.8333 0.6940 0.5787

Present values (55,000) 15,000 12,500 21,991

NPV = £(5,509)

Decision Y reject – do not replace machine.

 5.1 Brynmor Dairy Company

The management of Brynmor Dairy Company is considering the

purchase of a new bottling machine that is expected to reduce
handling costs by £8,000 per annum. This machine costs £50,000
and is expected to have a working life of ten years. It is anticipated
that it could be sold for scrap at the end of this period for £4,000.
The machine would replace existing equipment that cost £30,000
five years ago. The equipment is being depreciated for tax
purposes over a ten-year period on a straight-line basis and has a
current book value of £15,000. Although the existing equipment
requires maintenance costing about £1,000 per annum, an expense
that would not be incurred if the new machine is adopted, it could
be kept in operation for another ten years or so. If it is sold now it
would realise about £2,000.

Is this a profitable investment if the company requires a 10 per

cent return and the tax rate is 40 per cent? Use the template
overleaf for your calculation.

Change in profit and loss 0 1→5 6→9 10

Items
Capital loss on old machine
Capital gain on new machine
Reduced handling costs
Reduced maintenance
Change in depreciation
Change in profit

Change in tax

Change in net cash flows 0 1→5 6→9 10

Items
Recovery value on old machine
New machine
Recovery value on new machine
Reduced handling costs
Reduced maintenance
Change in tax
Change in net cash flow
PVF
Present values
NPV =
5.2 Morven Manufacturing

Morven Manufacturing Company’s sales have been expanding

quite rapidly over the last few years, and it can no longer produce
all the output required by its customers. It has been necessary to
subcontract a substantial proportion of its production
requirements to other firms in the industry. The Chief Accountant
has been considering a proposal to expand the company’s capacity
and at the same time to replace the company’s existing machinery
with a more efficient model that has recently become available.

The existing machinery, which has a capacity of 50,000 units per

annum, was bought six years ago. It cost £200,000 and has been
depreciated for tax purposes on a straightline basis over a ten-year
period. As the machinery is in good working order, it is estimated
it will last for another ten years. However, the development of the
more efficient model has led to the resale value of the machinery
falling to £20,000. The new machinery being considered for
purchase will have a capacity of 80,000 units per annum and will
cost £250,000. This new machinery is less durable than the
existing machinery and is expected to have a working life of only
ten years. The operating costs of the existing and new machinery
are given in the table opposite.

If Morven Manufacturing Company goes ahead with the proposed

investment it will need to invest an additional £100,000 in
buildings to house the larger machines. As output will increase, it
will also be necessary to expand working capital from the current
level of £50,000 to £100,000. The company is already selling 80,000
units per annum at a price of £4 per unit, with 30,000 units per
annum being purchased from other manufacturers at a cost of
£3.50 per unit. Sales are expected to remain at this level over the
next ten years. The company pays tax at a rate of 40 per cent,
payments being made one year in arrears. The expenditure on the
machinery and buildings has to be depreciated for tax purposes on
a straight-line basis over ten years.
Production costs of machinery operated at full capacity

Old machines (£) New machines (£)

Materials 30,000 40,000

Labour 60,000 80,000
Power 20,000 30,000
Maintenance 30,000 20,000
Overhead* 30,000 40,000
Depreciation** 20,000 35,000
Total 190,000 245,000

Capacity 50,000 units 80,000 units

* calculated as 50% of labour costs

** buildings depreciated at 10% per annum

5 Inflation and investment decisions
Up until now we have assumed that prices are constant over time and
that the rate of inflation is zero. We will now relax this assumption
and consider the implications of inflation for investment appraisal.

Inflation is likely to have an impact on:

ƒ the cash flows that an investment is expected to produce

ƒ the discount rate to be employed in evaluating an investment’s

cash flows.

Inflation and prices

Consider first the effects of inflation on expected prices and future
cash flows. If the price of a product today is P0 and this price is
expected to increase in line with the general rate of inflation, the
price by the end of the year will be:

P1 = P0 + P0 f

where ƒ is the rate of inflation. This can be written as:

P1 = P0 (1+ f )
If inflation continues to affect prices at the same rate for a second
year, the price by the end of Year 2 will be:
P2 = P1 (1+ f )
= P0 (1+ f )(1+ f )
= P0 (1+ f )2

Given a constant rate of inflation, prices in any future time period can
be expressed in terms of the initial price and an inflation factor:

Pn = P0 (1+ f )n

The mathematical treatment of rising prices is seen to be the same as

that for compound interest.
Example
What will the price of an item be in three years’ time if it costs 160p
today and the rate of inflation is expected to be constant at 8 per cent
per annum?

P3 = P0 (1 + f )3
3
= 160 p(1 + 0.08 )
= 160 p(1.2597 )
= 202p

If inflation is expected to differ from year to year, no such simple

representation of future prices is possible. For example, if inflation in
Year 2 is expected to differ from that in Year 1, the price at the end of
Year 2 must be developed as follows:
P1 = P0 (1+ f1 )
P2 = P1 (1+ f 2 )
= P0 (1+ f1 )(1+ f 2 )

Where f1 indicates the rate of inflation in the first year and f 2

indicates the rate of inflation in the second year.
Projecting prices with a constant rate of inflation is a simple
mathematical exercise:

Pn = P0 (1+ f )n

The determination of equivalent price today of some future price is

equally straightforward:
1
P0 = Pn
(1+ f )n
Constant prices, or prices in today’s money, may be determined by
discounting expected future prices at the expected rate of inflation.

Inflation and interest rates

With inflation the purchasing power of the pound declines over time –
pounds to be received or paid in the future will buy fewer goods than
these sums could purchase today. Lenders and borrowers will be
aware of this, and the expected rate of inflation will influence the
interest rates they are prepared to accept and pay. Lenders faced by
inflation will require a higher nominal rate of interest to compensate
them for the decline in the purchasing power of their capital and
interest receipts. Borrowers, on the other hand, aware that they will
be repaying their loans and paying their interest charges in pounds of
lower real value, will be prepared to pay a higher nominal interest
rate to obtain funds.
For the nominal or market rate (rm ) to compensate fully for the effects
of inflation it must be equal to
rm = r0 + f + r0 f

where r0 is the real rate of interest and f is the rate of inflation that
is expected to prevail.
Where the rate of inflation is low, the last term (r0 f ) tends to be
insignificant and tends to be ignored for practical purposes:
rm = r0 + f

The adjustment to the rate of interest necessary to allow for inflation

is known as the Fisher effect, as the analysis was first developed by
the American economist Irving Fisher.

The equation giving the precise adjustment for inflation is easily

derived. For each pound lent out in the absence of inflation the return
at the end of the first period will be given by:
(1+ r0 )
If inflation is expected to prevail at a rate equal to f , the payoff
(1+ r0 ) must be increased to:
(1+ r0 )(1+ f )
for its expected purchasing power to remain unchanged. This is equal
to:
1+ r0 + f + r0 f

and implies that the monetary rate of interest must be set equal to:
r0 + f + r0 f

for the real value of a loan to be maintained in an inflationary

environment.

The decline of the purchasing of capital is covered by ƒ, while

r0 f provides compensation for the decline in the purchasing power of
the interest payments.
Consider an economy without inflation and a real rate of interest of
10 per cent. Someone lending out £100 today anticipates a payoff of
£110 at the end of the year. Let us assume that this will be spent on
acquiring an item with a price of £110. If inflation is now expected to
prevail at 20 per cent, goods that would have cost £110 in one year’s
time will now cost £110 (1 + 0.20) = £132. For £100 to grow to £132 by
the end of the year, thereby allowing the purchase of the item that
could have been acquired in the absence of inflation, a rate of interest
of 32 per cent is required. The equation specifying the monetary rate
of interest confirms that this is the relevant rate:
 rm = r0 + f + r0 f = 0.10 + 0.20 + 0.10 × 0.20 = 0.32

This is a mechanical adjustment for inflation and implicitly assumes

that there is a general agreement on the expected rate of inflation. It
makes no allowance for any increase in the interest rate that might
occur if the government tightens monetary policy in an attempt to
reduce inflation. There is also no allowance for any increase in the
interest rate stemming from uncertainty about the inflation rate.

Allowing for inflation in investment decisions

The NPV of a project in an inflationary environment may be
determined either by:

ƒ specifying the cash flows in terms of the prices expected to prevail

in the future and discounting at the monetary rate of interest, or

ƒ specifying the cash flows in terms of constant prices and

discounting at the real rate of interest.
Consider a simple two-period project in a non-inflationary
environment:
1 1
NPV = − C0 + C1 + C2
(1+ r0 ) (1+ r0 )2
where – C0 ,C1 and C2 stand for cash flows in constant prices and r0 is
the constant real rate of interest. Cash flows measured in nominal or
inflated prices will be indicated as C *1 . If inflation at rate ƒ is now
expected to prevail and all prices in the economy are uniformly
affected:
C *1 = C1 (1+ f )

C *2 = C2 (1+ f )2

and as we have seen the interest rate can be expected to adjust

upwards:
rm = r0 + f + r0 f

and we may recall that:

(1+ rm )= (1+ r0 )(1+ f )
The net present value, calculated on the basis of the inflated cash
flows and the monetary rate of interest, is given by:
1 1
NPV = − C0 + C *1 + C *2
(1+ rm ) (1+ rm )2
Alternatively, the NPV may be calculated by deflating the future cash
flows and expressing them in terms of constant prices and discounting
the resulting series of cash flows at the real rate of interest:
 ⎡ 1 ⎤ 1 ⎡ 1 ⎤ 1
NPV = − C0 + C *1 ⎢ ⎥ + C *2 ⎢ 2⎥
⎣ (1 + f ) ⎦ (1 + r0 ) ⎣⎢ (1+ f ) ⎦⎥ (1+ r0 )
2

But as (1+ f )(1+ r0 ) is equal to (1+ rm ) , this is equivalent to:

1 1
NPV = C0 + C *1 + C *2
(1+ rm ) (1+ rm )2
And this NPV is also equivalent to the NPV calculated in the absence
of inflation. As long as inflation is fully anticipated, affects all prices
and interest rates equally and there are no distorting tax effects, it
should have no impact on real decisions in the economy.

Illustrative example of investment appraisal given inflation

Consider the following project in a non-inflationary world:

C0 = − 1000 C1 = + 650 C2 = + 650 r0 = 0.10

Where C1 stands for the cash flow in period and r0 stands for the real
rate of interest.
Non-inflationary environment: appraisal using real cash flow
0 1 2
Outlay (1,000)
Cash 650 650
NCF (1,000) 650 650
PVF (10%) 1.0000 0.9091 0.8264
PV 1,000 591 537
NPV = 128

Let the fully anticipated and uniform rate of inflation be 5 per cent
per annum:
C0 * = − 1000 C1 * = 683 = C1 (1 + 0.05)
C2 * = 717 = C2 (1 + 0.05)2
rm = 0.155 = 0.10 + 0.05 + 0.10 × 0.05

where Ct * stands for cash flows at inflated prices (nominal cash flows)
and rm stands for nominal rate of interest.
Appraisal using nominal cash flows and nominal interest rate
(inflation at 5 per cent) 0 1 2
Outlay (1,000)
Cash inflow 683 717
NCF (1,000) 683 717
PVF (15.5%) 1.000 0.8658 0.7496
PV (1,000) 591 537
NPV = 128

Next consider the analysis if the cash flows are estimated initially in
monetary terms and the cash flows are discounted at the rate of
inflation to produce estimates of the cash flows in real terms.

Appraisal using real cash flows and the real rate of interest
(inflation at 5 per cent) 0 1 2
Cash flows in monetary values (1,000) 683 717
Deflation factor (5%) 1.000 0.9523 0.9070
Real cash flows (1,000) 650 650
PVF (10%) 1.000 0.9091 0.8264
PV (1,000) 591 537
NPV = 128

The example we have just considered may give the impression that it
is not really necessary to allow for inflation at all in the analysis of
investment projects. The same NPV was obtained for the project both
with and without inflation. But this was simply the result of the
assumption that all prices increased at the same rate and that the
monetary rate of interest reflected this general rate of inflation. If the
rates of inflation for project costs and output prices differ and diverge
from the general rate of inflation, inflation will inevitably affect the
NPV. This suggests that it is necessary to predict the future prices of
all project inputs and outputs.

Predicting the general rate of inflation, let alone the rates of inflation
of the different inputs and outputs, is a hazardous business. Some
comfort may be taken from the notion that the expected price changes
for different items are not likely to differ significantly simply as a
result of general inflationary forces. Relative prices may alter as a
result of changing markets and technology but are unlikely to change
for very long simply as a result of inflation. The costs of producing an
item cannot increase more rapidly than its price in the long run if it is
still to be produced. Costs rising faster than prices will reduce
profitability, and this will eventually lead to a reduction in supply,
which will tend to produce higher prices. This line of reasoning
suggests that apart from over the short term, defined to last no more
than one or two years, it is not unreasonable to assume that prices
will tend to change at the same rate as a result of general inflationary
forces. This implies that the effects of inflation will tend to cancel out.
Beyond Year 1 and Year 2 we can therefore use the same rate of
inflation for estimating all costs and prices in monetary terms
without this distorting the analysis unduly.

Illustrative example: Pricewise plc

Pricewise plc is considering an investment of £100,000 to
manufacture a new product. The following information has been put
together by Ron Myopic, the firm’s financial analyst:

Expected selling price £8 per unit

Direct costs £4 per unit
Sales volume Year 1 6,000 units
Year 2 8,000 units
Years 3-6 10,000 units
Fixed costs £5,000 per annum
Depreciation for tax purposes £20,000 per annum
(for tax purposes the assumed life is 5 years)
Tax rate is 40 per cent
Required rate of return 10 per cent

Ron Myopic also produced the following NPV analysis:

Profit and loss projection

0 1 2 3 4 5 6
Sales revenue 48,000 64,000 80,000 80,000 80,000 80,000
Direct costs (24,000) (32,000 (40,000) (40,000) (40,000) (40,000)
Fixed costs (5,000) (5,000) (5,000) (5,000) (5,000) (5,000)
Depreciation (20,000) (20,000) (20,000) (20,000) (20,000) –
Profit (1,000) 7,000 15,000 15,000 15,000 35,000
Tax (40%) 400 (2,800) (6,000) (6,000) (6,000) (14,000)
Cash flow analysis
0 1 2 3 4 5 6
Outlay (100,000)
Sales revenue 48,000 64,000 80,000 80,000 80,000 80,000
Direct costs (24,000) (32,000) (40,000) (40,000) (40,000) (40,000)
Fixed costs (5,000) (5,000) (5,000) (5,000) (5,000) (5,000)
Tax _______ 400 (2,800) (6,000) (6,000) (6,000) (14,000)
NCF (100,000) 19,400 24,200 29,000 29,000 29,000 21,000

PVF 10% 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645

PV 1,000,000 17,637 19,999 21,788 19,807 18,006 11,854

NPV = £9,090

The managing director, Len Foresight, commended Ron on the

neatness of his work but questioned the absence of any allowance for
inflation. Ron responded by saying that the figures were given in
terms of today’s prices, and as the real rate of interest has been used
as a discount rate there was no need to make any specific allowance
for inflation. Len Foresight suggested that while the general rate of
inflation over the life of the project is expected to be around 8 per
cent, the firm could not expect its prices to rise by more than 6 per
cent per annum over the next two years. On the other hand, the firm’s
direct costs were likely to rise by about 10 per cent in each of the next
two years. Fixed costs could be expected to rise in line with the
general rate of inflation. Ron Myopic agrees to reconsider his analysis
taking these inflation estimates into account.

Pricewise plc: analysis reconsidered

It will be assumed that:

ƒ the market rate of interest is 18.8 per cent

rm = r0 + f + r0 f
= 0.10 + 0.08 + (0.10)(0.08)
= 0.188

ƒ all prices will increase at the general rate of inflation of 8 per cent
per annum after the end of the second year.

ƒ the estimate of sales volume will remain the same despite the
proposed price adjustments.
 1 2 3 4 5 6
Price estimates
Inflation rate 6% 6% 8% 8% 8% 8%
Price £8.48 £8.99 £9.71 £10.48 £11.32 12.23
Direct cost estimates
Inflation rate 10% 10% 8% 8% 8% 8%
Cost per unit £4.40 £4.84 £5.23 £5.65 £6.10 £6.58
Fixed cost estimates
Inflation rate 8% 8% 8% 8% 8% 8%
Fixed cost estimates £5,400 £5,832 £6,299 £6,802 £7,347 7,934

Profit and loss projection

0 1 2 3 4 5 6
Sales revenue 50,880 71,920 97,100 104,800 113,2000 122,300
Direct costs (26,400) (38,720) (52,300) (56,500) (61,000) (65,800)
Fixed costs (5,400) (5,832) (6,299) (6,802) (7,347) (7,934)
Depreciation (20,000) (20,000) (20,000) (20,000) (20,000) ______
Profit (920) 7,368 18,501 21,498 24,583 48,566
Tax (40%) 368 (2,947) (7,400) (8,599) (9,941) (19,426)

Cash flow analysis

0 1 2 3 4 5 6
Outlay (100,000)
Sales revenue 50,880 71,920 97,100 104,800 113,200 122,300
Direct costs (26,400) (38,720) (52,300) (56,500) (61,000) (65,800)
Fixed costs (5,400) (5,832) (6,299) (6,802) (7,347) (7,934)
Tax _______ 368 (2,947) (7,400) (8,599) (9,941) (19,426)
NCF (100,000) 19,448 24,421 31,101 32,899 34,912 29,140

PVF 18.8% 1.0000 0.8418 0.7085 0.5964 0.5020 0.4226 0.3557

Present value (100,000) 16,371 17,302 18,549 16,515 14,754 10,365

NPV = £(6,144)
A project that appeared to be profitable is now found to produce a loss
as a result of the differential impact of inflation on the prices of its
output and the costs of its inputs.
6 Risk and uncertainty and investment decisions
Up until now we have proceeded on the assumption that cash flows of
an investment are known with complete certainty. Obviously, as
investments are characterised by costs and benefits spread out over
time, this is not a realistic assumption: needless to say, we cannot
know with certainty what is going to happen in the future. In the
final section of this chapter we will briefly consider some of the
techniques that can be employed for the analysis of risk in investment
decision-taking.

Sensitivity analysis
For the investment decisions considered in this chapter we have
assumed one particular value for each of the factors included in the
analysis, eg capital outlay, direct cost per unit, etc. As the investment
is implemented, it is likely that some, if not all, of the values of the
factors will differ from those assumed in the analysis. It is useful to
know how the profitability of the investment will be affected by these
deviations. One technique for considering the possible impact of such
deviations is referred to as sensitivity analysis.

In its simplest form, the values of each of the factors to be included in

the appraisal of the investment can be allowed to vary by 10 per cent
while holding the value of all the other factors constant, allowing the
resulting change in the investment’s present value to be determined.
The analysis identifies those factors to which the NPV of the project is
most sensitive. This analysis cannot provide any insights into the
probability of any particular deviation occurring; it simply identifies
the consequence of possible deviations.

Once it becomes apparent that the profitability of a proposed

investment critically depends on the value of some factor, it might be
worth considering whether or not it is feasible to reduce any
uncertainty relating to its value. For example, if the size of the
market appears to be a critical determinant of an investment’s NPV,
some expenditure on additional market research is likely be
beneficial. Or if a project’s success is found to depend on the accuracy
of operating cost estimates, the construction of a pilot plant might
help to reduce uncertainty relating to these estimates. The costs of
reducing uncertainty must be considered in relation to the potential
losses that might arise if it is decided to proceed with the project and
unfavourable outcomes occur.

One weakness of sensitivity analysis is that it considers the

implications of deviations occurring in the value of each factor while
keeping all others constant. But in practice it is likely that the value
of more than one factor will deviate from its assumed value as the
project is implemented. If, for example, the market forecasts for a new
product turn out to have been too optimistic, it is possible that the
price will be lower than anticipated as well as sales. To explore the
possibility of a number of determinants of the profitability of an
investment turning out to be different from their expected values, use
must be made of ‘scenario analysis’. This technique considers the
implications of a set of pessimistic or optimistic assumptions. This
will tend to make managers more aware of the range of possible
outcomes for a project.

Decision trees
The development of many investment projects involves a number of
stages, and at each stage it may be possible to influence the nature of
the project or to decide to withdraw from the project entirely. How the
project evolves will depend on the decisions that are taken, and the
outcome of these decisions will depend in part on chance. A decision
tree, or decision flow diagram, is a technique for analysing projects
that involve sequential decisions the outcomes of which are uncertain.
The use of decision trees brings out the nature of the project, enabling
the different stages, as well as the range of possible outcomes, to be
identified.

A decision tree maps out the possible sequences of events and

decisions that are presumed to follow from the initial consideration of
a proposal. Each possible sequence is set out as a branch of a tree and
reflects:

ƒ sequential decisions, and

ƒ possible outcomes assumed to follow from each decision.

Abandonment value of projects

Abandoning a project before the end of its planned life may be
desirable if the project is not turning out as well as expected. A
project should be terminated whenever its salvage or disposal value
exceeds the present value of the cash flows that can be anticipated if
it is allowed to continue. Funds should not be tied up in a project if
they cannot be expected to cover their opportunity costs. The
abandonment value of a project is an important factor when
considering a project’s risk and the expected value of its NPV. The
higher the abandonment value, the lower the losses an investment
can be expected to produce if it turns out less well than was initially
anticipated.

Abandonment values will depend on the nature of the resources being

employed. Some projects make considerable use of general and
flexible assets that maintain their values independently of the project,
while others employ highly specific assets with a relatively low
disposal value. The possibility of the abandonment values varying
with the prospects of the project also needs to be recognised. If a
project is doing badly because of overall market conditions, the
potential resale value of the project’s assets is likely to be low. This is
particularly likely to be the case where the project is employing highly
specific assets.
7 Interpretation of net present values
Positive NPVs and abnormal profits
In a highly competitive economy it will not be easy for a firm to
identify positive net present value projects. A positive net present
value implies an ability to earn abnormal profits, and economic
analysis suggests that such profits can be anticipated only if:

ƒ markets are in disequilibrium, or

ƒ markets are imperfectly competitive.

If the demand for a product exceeds the available supply and the price
rises, firms in the industry may well generate abnormal profits. But
these disequilibrium profits will disappear as firms recognise the
opportunities and invest in additional capacity. How quickly the
abnormal profits will disappear will depend on the nature of the
industry and its technology. Abnormal profits can also occur as a
result of market imperfections, such as monopoly positions. For
example, a firm may have a patent on a new product or a process that
limits the effects of competition. Firms may also earn abnormal
returns as a result of developing a strong competitive advantage, such
as a reputation for high-quality products or a well-known brand
name. (The abnormal returns can then be considered in one sense to
be no more than a normal return on the intangible asset provided by
the firm’s reputation or brand name.)

Abnormal profits may also arise as a result of a firm having at its

disposal various factors of production that are not paid in line with
their contribution to the firm’s profits. For example, a firm may be
able to capitalise on a succession of technological developments
initiated by a brilliant research and development director. If he or she
was paid a salary commensurate with his or her abilities, the
research cost of projects might be increased in a way that would
eliminate their expected net present values.
Whenever an analysis of an investment produces a positive net
present value, it should be recognised that this might be the result of
not having identified a profitable project but of poor analysis. Unless
there is a good reason to anticipate abnormally high profits, it should
be assumed that the NPV is unlikely to be realised.
A critical appraisal of the way in which forecasts are generated can
often reveal possible sources of error. Inconsistencies may arise in the
general assumptions being employed by those providing the different
components of the overall cash flow forecasts. For example, the
market price and revenue forecasts could be based on a different
inflation assumption from that employed by the engineers and cost
accountants responsible for the project costing. Errors can also arise
as a result of various biases being introduced, consciously or
unconsciously, into the estimating processes. Managers favouring a
particular project may deliberately inflate the net cash flow estimates
to increase the probability of its acceptance. It is also possible that the
enthusiasm of some managers for a project may lead to a
subconscious exaggeration of its expected net cash flows. But in an
uncertain world even the most detailed scrutiny of cash flow forecasts
will not identify all the biases in the estimates being employed. This
suggests that a cautious approach should be adopted, and unless it is
possible to identify the source of the abnormal profits supporting the
positive NPV, it should be assumed that the analysis is characterised
by overly optimistic expectations.

If the end product of an investment appraisal, the estimated net

present value, is to be questioned, it might be thought that there is
little value in undertaking any formal quantitative analysis of
proposals. But for some investments, such as replacement
investments, the role of competitive forces expected in pushing NPVs
towards zero is far less clear-cut. Even where projects are undertaken
in a competitive environment and the expected source of positive net
present value needs to be identified, a quantitative investment
appraisal is valuable. It provides a systematic framework for
considering an investment, it encourages those concerned with an
investment to be more explicit about their assumptions, and it helps
to reveal the nature of the proposal.

Projects offering possibility of future benefits

While projects appearing to promise positive net present values need
to be carefully scrutinised before any major commitment of resources
is undertaken, it should also be recognised that some projects
expected to produce a negative net present value may be worth
accepting. This would be the case, for example, if the project embodies
a valuable option to continue operating in a sector at the end of the
life of the proposed project, an option that would be lost if the project
is rejected. Net present value analysis will understate the value of a
project if no allowance is made for the benefits it provides in widening
the choice of future projects open to a company. Investments today
may increase the flexibility of a firm’s future investment programme.

Consider, for example, a decision whether or not to continue operating

a railway line, which would require a substantial investment in
relaying its track. If the decision is taken to relay the track, the trains
could be run over the next ten years before any further major
commitment of resources would be required. If the line is closed, there
is no possibility of reopening the line in future should there be any
change in the expected profitability of the business. Keeping the line
open, on the other hand, maintains the possibility, or option, of
continuing in business indefinitely into the future. It is conceivable
that the value placed on keeping this option open is sufficient to offset
any negative net present value of the current investment. Even if the
current outlook for railways ten years hence is no better than it is
today, the possibility that conditions in the industry will change is
sufficient to give the option of continuing some value. Resources
would not be committed to any investment ten years from now unless
it appeared profitable at that time.
One of the most interesting features of such future investment
possibilities, contingent on decisions being taken today, is that the
greater the uncertainty currently perceived about their future value,
the higher their value today. That is as long as it can be assumed that
this uncertainty can be resolved prior to a decision having to be taken
on whether or not to exploit the option that is being created.

Conclusion
In this chapter we have considered some of the more practical aspects
of investment decision-taking. Given the relevant data, you should
now be in a position to develop a cash flow statement and determine
the net present value for a proposed investment. We have also
considered on a preliminary basis how risk and uncertainty might be
introduced into the analysis. Finally, we considered some of the
problems associated with the interpretation of the estimated net
present value of a project, recognising that the net present value and
the internal rate of return have to be put into context before a final
decision on a proposed investment can be taken.

Suggestions for Further Reading

Durnev, A., Merck, R. and Yeung, B. (2004) “Value Enhancing
Capital Budgeting and Firm Specific Stock Return Variation.”
Journal of Finance Vol. 59, No. 1.

Graham J.R. and C.R. Harvey “The Theory and Practice of Corporate
Finance” Journal of Financial Economics Vol. 60, No.2

Porter, Michael E. (1985) Competitive Advantage New York: Free

Press.