Management Accounting

Capital Investment Appraisal

Investment can be defined as the acquisition of capital equipment. Investment Appraisal
is the means of assessing if an investment project is worthwhile or not. It is undertaken
for following reasons:

• To replace equipment
• To expand product capacity
• To reduce production costs
• To provide new facilities for new products

Investment Appraisal has following features:

• Level of expected returns earned for the level of expenditure made.

• Estimates of future costs and benefits over the project life

There are four types of Investment Appraisal is covered in Finance

Basic Investment appraisal (does not take into account time value of money)

ARR

Payback

Advanced Investment appraisal

NPV

IRR
ARR Accounting rate of return
Formula
ARR= (Average Annual profit/ initial capital costs) X 100

Example 1
An investment is expected to yield cash flows of £10,000 annually for the next 5 years
The initial cost of the investment is £20,000
Total profit therefore is: £ (50000-20000) =£30,000
Average annual profit = £30,000 / 5
= £6,000

ARR = (6,000/20,000) x 100

= 30%
(Remember the ARR does not take into account the time value of money or discounted
cash flow, this means the profit is simply found by adding the cash flows and subtracting
the initial investment)

Decision rule

Accept project greater than target or market rate or for two mutually exclusive projects
accept the one with higher ARR.

Advantages Disadvantages
Simple Does not take into account time value of
money.
Links with other accounting measures No definitive investment signal
Payback
The payback period is the time a project will take to pay back the money spent on it.
It is based on cash flows and provides a form of liquidity.

Example 1

For uneven annual cash flows

Year Cash flow Cumulative cash flow

0 (1900) 0
1 300 300
2 500 800
3 500 1300
4 700 2000
5 500 2700

Payback is in 3 years (6/7X12 )10 months.

(In year three it can be seen we have cash flow of 1300 so we need another 600 to
complete our payback but in year 4 we have cash flow of 700, therefore we take only 600
out of 700 in year 4 which will give us a fraction of 600/700. This fraction is multiplied
by 12 get in period of months.

The payback will be 3 years and the fraction of 6/7 X 12 will give us the figure in terms
of months which in this case 10.2 and therefore we round it up to get 10 months)

Decision Rule

Only choose projects which payback within the specified time period or for mutually
exclusive projects choose with the project with fastest payback.

Advantages Disadvantages
Simple Ignores return after payback
Easy to calculate and explain to managers Discriminates against projects with longer
payback period
It favours quick return- Liquidity V No definite investment signal
Profitability
NPV= Net Present Value
The difference between the present value of future cash inflows and the present value of
cash outflows. NPV is used in investment appraisal to analyze the profitability of an
investment or project.

Present Value Concept

Money received today is worth more than the same money received in the future. Eg.
£500 is today is more than £500 in five year’s time. An example of present value using
present value table is given below. The time = t and rate of return =r will be given in the
exam.

Example 1

What is the Present Value of £100,000 in 5 years time assuming r = 10%

Extracts from NPV (DCF) tables:

Rate of discount 8% 9% 10%
Year one .926 .917 .909
Year two .857 .842 .826
Year three .735 .772 .794
Year four .735 .708 .683
Year five .681 .650 .621
Year six .630 .596 .564

Present Value = 100,000 X .621= 62,100

(the present value is given by multiplying the figure received in the future X by the value
in the present value table which in this case is .621. The figure .621 is chosen because it
corresponds to year 5 and at the rate of return of 10% which is given in the question )
Example 2

Now assume a project had an initial investment of £40,000 and only one cash flow of
£100,000 was received in the 5th year of the project.

Year Cash flow Discounted Cash flow @5%

0 (40,000) (40,000)
1 0 -
2 0 -
3 0 -
4 0 -
5 100,000 62,100

NPV= Sum of present value cash flow(or DCF) - Initial Investment (or Initial Cost)

Therefore NPV of the project would be £ 62,100- 40,000 = 22,100

Decision Rule

Choose the project with a positive NPV and for mutually exclusive projects choose the
one with higher NPV. When NPV is equal to zero the project breaks even.

Advantages Disadvantages
Considers time and value of money Difficult to explain to managers
Uses cash flow not profit Cost of capital knowledge required
Considers whole life of project Complex if done manually
Definite investment signal
IRR (Internal Rate of Return)
IRR is another project appraisal method using present value techniques. The IRR
represents the discount rate where NPV =0. As such it represents the break even cost of
capital

Decision rule

Accept project if IRR is greater than cost of capital

Advantages Disadvantages
Considers time value of money It is not a measure of absolute profitability
Uses cash flow not profit Cost of capital knowledge required
Considers whole life of project Complex if done manually
It is a percentage and easily understood

The benefits of using investment appraisal techniques

or why a company will use investment appraisal techniques in the choice of allocating
finance to potential investment projects.

The reasons are

Large amounts of resources are often involved.

Many investments made by business involve laying out a significant proportion of its
total resources. If mistakes are made with the decision, the effects on the business could
be significant or catastrophic.

Often difficult and/ or expensive to ‘bail out’ of an investment

Investments made in a business are often specific to its needs. E.g. We invest in premises
which is designed to provide a particular service. This may make the premise less
attractive to other potential users with different needs. If the business finds the after
making the investment that the service is not providing enough cash inflow, they have to
shut it down or sell it at a cheap price incurring a huge loss to the business.

Assurance
Investment Appraisal is a plan for the investment and this gives confidence to existing
shareholders and potential shareholders about the direction of the business.

Option generation

Investment Appraisal techniques can be used to generate options of potential projects and
the firm can choose the project which increases shareholder’s wealth. As a results
Investment Appraisal techniques also ensures that the company are using its resources
efficiently.

Venture capitalists

Venture capital is a long term capital provided to small and medium sized firms wishing
to grow but do not have access to stock markets because of the large cost associated with
a listing. The risk faced by a venture capitalist is higher than the risk faced by traditional
providers of finance. The high risk is compensated by higher returns. Venture capitalist
who provides long term funds can also provide managerial and technical expertise.
Different forms of venture capitalist funds are used as

Start up capital
Growth capital
Recovery capital
Share purchase capital

Business Angels- Business Angels are wealthy individuals who investment in a business by
buying a portion of its share capital. They bring ‘contacts’ and ‘experience’ to the business.

Class discussion

Explain why firms increasingly look at ‘non-financial’ factors during the decision-making process

Non-financial factors
Environment

Society

Compliance with the Authority

Charities/ Sponsorships

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