INVESTMENT APPRAISAL AND CAPITAL BUDGETING

A form of decision-making where the investment occurs predominantly today and

the benefits of the investment occur in the future.

Financial Manager should go about making capital investment decisions. For

example, they may have to decide whether or not it is worthwhile investing
$1,000,000 in a new factory. Alternatively, they may have to make the choice
between several available investments.

Investment appraisal is of particular importance because of the following:

1. Long-term
2. Size (in relation to the business)
3. Outflow today (relatively certain), inflow in the future (uncertain).

 Investment Appraisal techniques

There are 2 main techniques to be mastered namely
 Basic techniques
 Accounting Rate of Return (ARR)
 Payback Period

 Discounted Cash flow (DCF) techniques

 Time value of money
 Discounted Payback period
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Annuities
 Perpetuities.

 ACCOUNTING RATE OF RETURN (ARR)

A measure that considers the impact of the investment on accounting profit. It is
similar in concept to the ROCE performance measure, but is not the same.

ARR= Average Annual Profit x 100

Average Investment
AAP = Total Profit
No of Years

AI = Initial Investment + Scrap value

2

Q1
A machine will cost $80,000.
It has an expected life of 4 years with an anticipated scrap value of $10,000.
Expected net operating cash inflows each year are as follows:
Year Cash flow ($)
1 20,000
2 30,000
3 40,000
4 10,000

Calculate the ARR of the project.

Solution:

Total Profit:

Total Cash flow : 20.000+ 30,000+40,000+10,000 = 100,000

Less Total Depreciation : 80,000-10,000 = 70,000
Total Profit = 30,000
Number of Years = 4
Average Annual Profit = $7,500
Average Investment:

AI = 80,000+10,000 = 45,000
2
ARR = 7,500 x100 = 16.67%
45,000

 Decision criteria

A profit measure that must be compared to a target profit. This profit is likely to be
related to the target performance measure.

 Advantages

1. It is easy to understand and easy to calculate.

2. The impact of the project on a company’s financial statement can also be
specified
3. ROCE is still the commonest way in which business unit performance is measured
and evaluated, and is certainly the most visible to shareholders
4. Managers may be happy in expressing project attractiveness in the same
terms in which their performance will be reported to shareholders, and
according to which they will be evaluated and rewarded.
5. The continuing use of the ARR method can be explained largely by its
utilisation of balance sheet and P&L account magnitudes familiar to managers,
namely profit and capital employed.

 Disadvantages

1. It fails to take account of the project life or the timing of cash flows and time
value of money within that life
2. It uses accounting profit, hence subject to various accounting conventions.
3. There is no definite investment signal. The decision to invest or not remains
subjective in view of the lack of objectively set target ARR.
4. Like all rate of return measures, it is not a measurement of absolute gain in
wealth for the business owners.
5. The ARR can be expressed in a variety of ways and is therefore susceptible to
manipulation.
  PAYBACK PERIOD

The payback period is defined as being the number of years it takes for a project to
recoup the original investment in cash terms.

The payback period is compared with a target period – if the project pays for itself
sooner then it should be accepted, if not then it should be rejected.

The payback period is useful when the future flows have a high level of uncertainty.
The further into the future we are forecasting, then the more uncertain the flows are
likely to be.

By choosing projects with faster payback periods, we are more certain that the
projects will indeed end up making a surplus.

Payback period and DCF techniques are often combined by calculating a discounted
payback period – this involves discounting the cash flows and then calculating how
many years it takes for the discounted cash flows to repay the initial investment.

Payback period = Initial investment / Annual inflow

Q2
A company invests in a project with an initial cash outflow of $100,000. Cash inflows
resulting from the project are $40,000 per annum.

Calculate the payback period.

SOLUTION

Payback period = $100,000/$40,000 = 2.5years

Q3
A company makes an investment with an initial cash outflow of $1,000,000. Cash
inflows resulting from the project are as follows:

Year Cash inflow

1 $100,000
2 $250,000
3 $350,000
4 $360,000
5 $500,000

Calculate the payback period.

SOLUTION

Year Cash inflow Balance remaining on initial

investment
0 ($1,000,000)
($1,000,000)
1 $100,000 1,000,000 – 100,000 =
($900,000)
2 $250,000 900,000 – 250,000 =
($650,000)
3 $350,000 650,000 – 350,000 =
( $300,000)
4 $360,000 300,000 – 300,000 =
0

PBP = 3 .83 years or 3 years 10 months

 Decision criteria
Accept the project in the event that the time period is within the acceptable time
period. What is an acceptable time period? It depends!!

 Advantages

1. It is simple to use (calculate) and easy to understand

2. It is a particularly useful approach for ranking projects where a company faces
liquidity constraints and requires a fast repayment of investment.
3. It is appropriate in situations where risky investments are made in uncertain
market that are subject to fast design and product changes or where future
cash flows are particularly difficult to predict.
4. The method is often used in conjunction with the NPV or IRR method and act
as the first screening device to identify projects which are worthy of further
investigation.
5. Unlike the other traditional methods payback uses cash flows, rather than
accounting profits, and so is less likely to produce an unduly optimistic figure
distorted by assorted accounting conventions.

 Disadvantages

1. It does not give a measure of return, as such it can only be used in addition to
other investment appraisal methods.
2. It does not normally consider the impact of discounted cash flow although a
discounted payback may be calculated (see later).
3. It only considers cash flow up to the payback, any cash flows beyond that point
are ignored.
4. There is no objective measure of what is an acceptable payback period, any
target payback is necessarily subjective.

 TIME VALUE OF MONEY.

$1000 received now is more valuable than $1000 received in, say, 2 years’ time.
Why?

1. Inflation

2. Uncertainty

3. Opportunities to invest.

 Discounted Cash Flow

Discounted cash flow (DCF) is a technique that takes into the timing of cash flows
and allows comparison between cash flows arising at different points in time, taking
account of these 3 factors.

 Present value:
The value at time 0 of a future cash flow, having taken account of the time value of
money. In investment appraisal, it represents the maximum an investor would be
willing to invest for a future cash inflow given a specified required return.

 Compounding:
We move from a present value to a future value by adding compound interest each
year.

Future Value of a Single cash flow

FV = PV (1 + r)^n

Where:

PV = present value
FV = future value
r = rate of interest
n = number of periods

Q4
A company currently have a cash flow of $20,000 and intend investing it at an
interest rate of 18% p.a for 5 years .
Required.

How much will he get after the 5 years if interest is reinvested.

SOLUTION

FV = PV (1 + r)^n

FV = 20,000 (1 + 0.18)^5

FV = 20,000 (1 .18)^5

FV = 20,000 X 2.2878 = $45,756

 Discounting:
Discounting is the reverse of compounding – we start at the future value and work
back to the present value.

PV = FV ÷ (1 + r)^n

Or
1 .
PV = FV (1 + r)^n

Where:

PV = present value
FV = future value
r = rate of interest
n = number of periods

Q5
Calculate the present value of $80,000 at the end of year 5 if an interest rate of
10% per annum applies.

SOLUTION

PV = FV/(1 + r)^n

PV = 80,000 / (1 + 0.1)^5

PV = 80,000 / 1.61051 = $49,674

  Nominal and Effective Interest rate

Nominal rate of interest

is the official interest rate per annum even though the interest is compounded over
a period of less than one year. A nominal interest rate has not been adjusted for the
full effect of compounding, where compounding occurs more frequently than once a
year.

Effective annual interest rate (ER )

is the corresponding annual rate when interest is compounded at intervals shorter
than a year. This is the real rate per annum at which the investment is growing.

ER = (1 + r)^ n – 1

Where:
ER = effective annual rate
r = period rate
n = number of compounding periods

The period rate (r) is calculated by dividing the nominal rate by the number of
compounding periods in a year.

For example if the nominal rate is 8% p.a. compounded quarterly, the period rate is
r = 8% ÷ 4 compounding periods = 2% per quarter

Q6
A loan is offered with a nominal interest rate of 10% compounded weekly. What is
the effective annual rate?

SOLUTION

ER = (1 + (0.1/52)^52 – 1 = 10.51%

Q7
A machine will cost $80,000.
It has an expected life of 4 years with an anticipated scrap value of $10,000.
Expected net operating cash inflows each year are as follows:
Year Cash Flow($)
1 20,000
2 30,000
3 40,000
4 10,000

The cost of capital is 10%

Calculate the Payback period and Discounted Payback period of the project.

Discounted Pay back period

YEA CASHFLO DF @
R W 10% PV BAL

(80,000.0 (80,000.
0 0) 1.000 (80,000.00) 00)

20,000.0 (61,820.
1 0 0.909 18,180.00 00)

30,000.0 (37,040.
2 0 0.826 24,780.00 00)

40,000.0 (7,000.0
3 0 0.751 30,040.00 0)

20,000.0
4 0 0.683 13,660.00 0

DPBP = 3.51Years

 NET PRESENT VALUE (NPV)

The key investment appraisal method, it incorporates the time value of money in
calculating an absolute value of the project. It is called the NET present value
because there will be a range of outflows and inflows in the typical investment.

NPV =PV of cash inflow – PV of cash outflow

 Decision criteria
  If NPV is positive – project is financially viable -Accept
 If NPV is zero – project breaks even
 If NPV is negative – project is not financially viable-Reject
 The NPV gives the impact of the project on the shareholder wealth

 Advantages

1. A project with a positive NPV increases the wealth of the company’s, thus
maximise the shareholders wealth.
2. Takes into account the time value of money and therefore the opportunity
cost of capital.
3. Discount rate can be adjusted to take account of different level of risk
inherent in different projects.
4. Unlike the payback period, the NPV takes into account events throughout the
life of the project.
5. Superior to the internal rate of return because it does not suffer the problem
of multiple rates of return.
6. Better than accounting rate of return because it focuses on cash flows rather
than profit.
7. NPV technique can be combined with sensitivity analysis to quantify the risk
of the project’s result.
8. It can be used to determine the optimum policy for asset replacement.

 Disadvantages

1. NPV assumes that firms pursue an objective of maximising the wealth of their
shareholders.
2. Determination of the correct discount rate can be difficult.
3. Non-financial managers may have difficulty understanding the concept.
4. The speed of repayment of the original investment is not highlighted.
5. The cash flow figures are estimates and may turn out to be incorrect.
6. NPV assumes cash flows occur at the beginning or end of the year, and is not
a technique that is easily used when complicated, mid-period cash flows are
present.

Q8
A company is evaluating a project that has the following cash flows. It will purchase
a machine on 1 January 2024 for $50,000 and will receive net cash (ie revenue less
cash costs) each year from the trading activity as follows.

Year ended 31 December Cash received ($)

2024 20,000
2025 10,000
2026 20,000
2027 15,000
The company can borrow money at 10%.

Require
Calculate the NPV of the project.

SOLUTION

Year Cash Flow Discount Factor@ 10% Present

Value
0 ($50,000) 1
($50,000)
1 $20,000 0.909
$18,180
2 $10,000 0.826 $8,260
3 $20,000 0.751
$15,020
4 $15,000 0.683
$10,245

Net Present Value: $1,705

 INTERNAL RATE OF RETURN (IRR)

The rate of interest at which the NPV of the project is zero is known as the Internal
Rate of Return (IRR).

NPV =PV of cash inflow = PV of cash outflow

In order to estimate the IRR, we calculate the NPV of the project at two different
rates of interest and estimate a rate giving an NPV of zero assuming linearity. (In
fact the relationship of the NPV to the rate of interest is not linear but curvilinear.

However, the approximation resulting from an assumption of linearity is sufficient

for our purposes.

IRR = L + ( NL )
NL - NH X (H-L)
Where:
L = Lower discount rate
H = Higher discount rate
NL = NPV at lower discount rate
NH = NPV at higher discount rate

 Decision criteria

 If the IRR is greater than the cost of capital, accept the project
 If the IRR is less than the cost of capital, reject the project

 Advantages

1. Like the NPV method, IRR recognises the time value of money.
2. It is based on cash flows, not accounting profits.
3. More easily understood than NPV by non-accountant being a percentage
return on investment.
4. For accept/ reject decisions on individual projects, the IRR method will reach
the same decision as the NPV method.

 Disadvantages

1. Does not indicate the size of the investment, thus the risk involve in the
investment.
2. Assumes that earnings throughout the period of the investment are reinvested
at the same rate of return.
3. It can give conflicting signals with mutually exclusive project.
4. If a project has irregular cash flows there is more than one IRR for that project
(multiple IRRs).
5. Is confused with accounting rate of return.

Q9
A machine will cost $80,000.
It has an expected life of 4 years with an anticipated scrap value of $10,000.
Expected net operating cash inflows each year are as follows:

Year Cash Flow($)

1 20,000
2 30,000
3 40,000
4 10,000
The cost of capital is 10% p.a..
Calculate the IRR of the project.

SOLUTION:

YEA CASHFL DF@1 DF@15

R OW 0% PV@10% % PV@15%

(80,000. (80,000.
0 00) 1.000 00) 1.000 (80,000.00)

20,000.0 18,180.0
1 0 0.909 0 0.870 17,400.00

30,000.0 24,780.0
2 0 0.826 0 0.756 22,680.00

40,000.0 30,040.0
3 0 0.751 0 0.658 26,320.00

20,000.0 13,660.0
4 0 0.683 0 0.572 11,440.00

NPV 6,660.00 (2,160.00)

IRR = L + ( NL )
NL - NH X (H-L)

IRR = 10 + ( 6660 )
6660 +2160 X (15-10)
IRR = 13.78%

 NPV and IRR compared

 Single investment decision

A single project will be accepted if it has a positive NPV at the required rate of
return. If it has a positive NPV then, it will have an IRR that is greater than the
required rate of return.

 Mutually exclusive projects

Two projects are mutually exclusive if only one of the projects can be undertaken.

In this circumstance the NPV and IRR may give conflicting recommendation.

The reasons for the differences in ranking are:

1. NPV is an absolute measure but the IRR is a relative measure of a project’s

viability.

2. Reinvestment assumption. The two methods are sometimes said to be based

on different assumptions about the rate at which funds generated by the
project are reinvested. NPV assumes reinvestment at the company’s cost of
capital, IRR assumes reinvestment at the IRR.

 ANNUITIES

An annuity is a series of equal cash flows.

The discount factor for an annuity may be calculated using the following formula:

Annuity discount factor = 1−(1+r)^−n

r

Where:
r = discount rate
n = number of periods

Q10
A machine cost $100,000, the cost of capital is 12% p.a.
What is the Net present value of $30,000 receivable each year for 7 years.

SOLUTION

Present
Year Cashflow DF@ 12% Value
(100,000.0 (100,000.0
0
0) 1 0)
30,000.0 136,920.0
1--7
0 4.564 0
36,920.0
NPV 0

Q11
A machine cost $100,000, the cost of capital is 12% p.a.
What is the Net present value of $30,000 first receivable in 4 years time and
thereafter each year for a total of 7 years?

SOLUTION

Present
Year Cashflow DF@ 12% Value
(100,000.0 (100,000.0
0
0) 1 0)
30,000.0 97,440.0
4--10
0 3.248 0
(2,560.0
NPV 0)

ADF @12%: 1-10 5.650

Less ADF@12%: 1-3 2.402
 4--10 3.248

Q12
A machine cost $100,000, the cost of capital is 12% p.a.
What is the Net present value of $30,000 first receivable in 0 years time and
thereafter each year for a total of 7years?

SOLUTION

Present
Year Cashflow DF@ 12% Value
(100,000.0 (100,000.0
0
0) 1 0)
30,000.0 153,330.0
0--6
0 5.111 0
53,330.0
NPV 0

ADF @ 12%: 1-6 4.111

Add ADF@12%: of year
0 1.000
5.111

 PERPETUITIES

A form of annuity that arises forever (in perpetuity). In this situation the
calculation of the present value of the future cash flows is very straightforward.
This is of particular importance when considering cost of capital later.

Present value of the perpetuity = Annual Cash flow

Interest Rate
OR

Present value of the perpetuity= Annual cashflow x DF to perpetuity

The discount factor for perpetuity may be calculated using the following formula

Discount Factor to Perpetuity = 1 -

Interest rate

Q13
A machine costs $280,000 and is expected to generate $18,000 p.a. in perpetuity.
The cost of capital is 5% p.a.
What is the NPV of the project?

SOLUTION

Present
Year Cashflow DF@ 5% Value
(280,000.0 (280,000.0
0
0) 1 0)
18,000.0 360,000.0
1--P
0 20 0
80,000.0
NPV 0

DF to perpetuity = 1/0.05 = 20
Q14
A machine costs $280,000 and is expected to generate $18,000 p.a. first
receivable in 5 years’ time and thereafter annually in perpetuity.
The cost of capital is 5% p.a.
What is the NPV of the project?

SOLUTION

Present
Year Cashflow DF@ 5% Value
(280,000.0 (280,000.0
0
0) 1 0)
18,000.0 296,172.0
5--P
0 16.454 0
16,172.0
NPV 0

ADF @ 5% to perpetuity 20
Less ADF@ 5%: year1-4 3.546
16.454

Q15
A machine costs $280,000 and is expected to generate $18,000 p.a. first receivable
in 0 years’ time and thereafter annually in perpetuity?
The cost of capital is 5% p.a.
What is the NPV of the project?

SOLUTION
 Present
Year Cashflow DF@ 5% Value
(280,000.0 (280,000.0
0
0) 1 0)
18,000.0 378,000.0
0--P
0 21 0
98,000.0
NPV 0

ADF @ 5% to perpetuity 20
Add ADF@ 5%: year 0 1
21

 FUTHER ASPECT OF DISCOUNTED CASH FLOW- NET PRESENT VALUE

(NPV)

Investment appraisal is a form of decision making. As such, it uses decision

making theory. The decision is based on:
 Relevant Cost
 Inflation
 Working Capital
 Taxation
 Tax savings (Capital Allowance)

 RELEVANT COST AND D.C.F.

A relevant cost has 3 criteria that must be fulfilled:

1. It must arise in the future

2. It must be a cash flow
3. It must arise as a direct consequence of the decision.

Example of Relevant costs

1. Opportunity cost
2. Variable cost
3. Incremental cost.

 Example of Non-relevant costs

1 money already committed (or sunk costs)
2 historic costs
3 non-cash flows (especially depreciation)
4 book values
5 interest costs (because these are dealt with by the discounting)

 INFLACTION AND D.C.F.

In order to calculate an NPV we need to estimate the cash flows which we expect
will occur for each year of the investment’s life.

In practice (and, more importantly, in the examination) it is often the case that
some cash flows would be expected to be constant each year were it not for the
effect of inflation. E.g. we might need to pay rent for new premises of $10,000 each
year. We do not expect to need different premises and therefore the rent would
remain at $10,000 for each year subject to inflationary increases.

There are two ways of dealing with inflation:

1. Include inflation by inflating up the cash flows year on year.
2. Exclude inflation (and take the cash flows in year 0 terms).

Include inflation (money analysis) Exclude inflation (real

analysis)

Inflate cash flows by the inflation rates given Leave cash flows in year 0
terms
and and
Use a money rate of return Use a real rate of
return
  The Fisher effect
The relationship between real and money interest is given below (also see tables)
(1 + m) = (1 + r) (1 + i)

M = (1+r)(1+i) -1
or
r = (1 + m) -1
(1 + I)

Where :
r = real discount rate
m = money discount rate
i = inflation rate

Q16
r = 8% i = 5%
Required: What is the money rate of interest?

SOLUTION

m = (1.08)(1.05) -1
M= 1.134-1
M= 0.134
M=13.4%
Q17
m = 10.6% i = 5%
Required: What is the real rate of return?

SOLUTION:

r = 1.106 , -1
1.05

r =5.3%

Q18
A new machine will cost $120,000 and is expected to last 3 years with no scrap
value.
It is expected that production will be 10,000 units p.a.
The selling price is $20 p.u. and the variable production costs $14 p.u. (both quoted
in current prices .
Inflation is expected to be 5% p.a., and the nominal of capital is 15% p.a..
Calculate the NPV of the project
(a) inflating each flow to get the nominal cash flows, and discounting at
the nominal cost of capital
(b) discount the real (current price) flows at the real cost of capital.

SOLUTION:

(a) inflating each flow to get the nominal cash flows, and
discounting at the nominal cost of capital
Year Detail Cash Flow DF @ 15% PV

Initial (120,000. (120,000.

0 Investment 00) 1 00)

1 Contribution 63,000.00 0.87 54,810.00

2 Contribution 66,150.00 0.756 50,009.40

3 Contribution 69,456.00 0.658 45,702.05

NPV 30,521.45

WORKING

YR 1 2 3
Unit 10000 10000 10000
Contribution
PU 6 6 6
Inflation 1.05 1.1025 1.1576
Inflacted
price 6.3 6.615 6.9456

66,150.0
Contribution 63,000.00 0 69,456.00

CPU = SP -VCPU
CPU= 20-14 = $6

(b) discount the real (current price) flows at the real cost of capital.

Year Detail Cash Flow DF @ 10% PV

0 Initial 1
 (120,000. (120,000.0
Investment 00) 0)

149,220.0
1--3 Contribution 60,000.00 2.487 0

NPV 29,220.00

1+r = 1.15
1.05

1-r = 1.0952
r = 1.0952 -1
r = 9.52% Appr 10%

 WORKING CAPITAL AND D.C.F.

It is very common in questions to be told that in addition to the cash needed to buy
a machine, cash is also needed immediately to finance working capital
requirements.

The working capital requirements relate to such things as the carrying of inventory
of raw materials and the financing of receivables resulting from the sales.

Unless told differently, we always assume that the working capital results in a cash
outflow at the time it is needed, that the requirement remains for the life of the
investment, but that it is released (and therefore results in a cash inflow) at the end
of the project.

Note that in several recent exam questions the examiner has stated within the
question that the machine in question will be replaced at the end of its life. This
implies that the product will still continue to be made and that therefore the
working capital will still be needed. In this case you should not recover the working
capital at the end of the project.

 TAXATION AND D.C.F.

There are three additional considerations associated with including taxation:

Good – Any investment in a capital asset will give rise to a capital allowance. The
capital allowance will lead to a reduction in the amount of tax subsequently paid –
CASH INFLOW

Bad – We would expect the investment to generate additional profits, these in

turn would lead to additional tax payable – CASH OUTFLOW

Ugly – Sometimes the examiner may delay all cash flow associated with taxation by
one year, this is done to reflect the delays between tax arising and being paid. Take
care and read the question carefully.

 TAX SAVINGS AND D.C.F- Writing down allowances

The tax allowance methodology can be whatever the examiner wants. It could be on
a reducing balance method or straight-line method.
.

Q19
An asset is bought on the first day of the year for $20,000 and will be used for four
years after which it will be disposed of (on the final day of year 4) for $5,000.the
company can claim a Tax allowable depreciation at 25% on the reducing balance
method . Tax is payable at 30% one year in arrears.

Required:
Calculate the writing down allowance and hence the tax savings for each

Solution

Tax Timin
YR $ Savings g

20,000.0
1 COST 0

CA @ 25%* (5,000.0 @ 1,500.0

$20,000 0) 30% 0 2

15,000.0
2 WDV 0

CA @ 25%* (3,750.0 @ 1,125.0

$15,000 0) 30% 0 3
3 WDV
 11,250.0
0

CA @ (2,812.5 @
25%*$11,250 0) 30% 843.75 4

4 WDV 8,437.50
@
CA&BAL ALL (3,437.50 ) 30% 1,031.25 5

SCRAP 5,000.00

Q20
An asset is bought on the first day of the year for $20,000 and will be used for four
years after which it will be disposed of (on the final day of year 4) for $5,000.the
company can claim a Tax allowable depreciation at 25% on a straight-line method .
Tax is payable at 30% one year in arrears.

Required:
Calculate the writing down allowance and hence the tax savings for each

SOLUTION

Annual depreciation= 20,000-5000 / 4= $3,750

Tax savings = 0.3 x $3,750 = $1,125 yearly

 Key Pro forma (THE BIG 6)

1. Net trading revenue – The inflows and outflows from trading

2. Tax payable - The net trading revenue X tax rate
3. Tax Savings– separate working for the capital allowances: Capital
Allowance x Tax rate
4. Investment
5. Working Capital
6. Residual value

NPV FORMATE

YEAR 0 1 2 3 4 5
$ $ $ $ $ $
Sale X X X X
Variable cost (X) (X) (X) (X)
Contribution X X X X
Relevant Fixed
cost (X) (X) (X) (X)
Net Trading
Revenue XX XX XX XX
(X
Tax Deduction (X) (X) (X) )
Tax Savings X X X X
Working Capital (X) (X) (X) (X) X
Initial Investment (X)
Scrap Value X
Net Cash Flow XX XX XX XX XX XX
Discount Factor X X X X X X
Present Value XX XX XX XX XX XX
NPV XX

Q21
JED Consult ltd are considering buying a new machine in order to produce a new
product.
The machine will cost $2,800,000 and is expected to last for 3 years at which time it
will have an estimated scrap value of $1,000,000
They expect to produce 100,000 units p.a. of the new product which will be sold for
$20 p.u. in the first year.
Production costs p.u. (at current prices) are as follows:
Materials $8
Labour $7
Materials are expected to inflate at 8% p.a. and labour is expected to inflate at 5%
p.a.
Fixed overheads of the company currently amount to $1,000,000. The management
accountant has decided that 20% of these should be absorbed into the new product
The company expects to be able to increase the selling price of the product by 7%
p.a.
An additional $200,000 of working capital will be required at the start of the project.
Working capital will suffer inflaction of 5%
Capital allowances: 25% reducing balance
Tax: 25%, 1 year in arrears
Cost of Capital: 10%
Calculate the NPV of the project and advise as to whether or not it should be
accepted.

Solution:

JED CONSULT LTD

YEAR 0 1 2 3 4
$'000 $'000 $'000 $'000 $'000
2,000 2,140 2,289
Sale(W1) .00 .00 .80
(864 (933 (1,007
Materia (W2) .00) .10) .76)
Labour(3) (735 (774 (810
 .00) .75) .32)
40 43 47
Contribution 1.00 2.15 1.72
Relevant Fixed
cost 0 0 0
Operating Cash 40 43 47
flow 1.00 2.15 1.72
Tax Deduction @ (10 (10
25% 0.25 ) 8.04 ) (117.93 )
17 13
Tax Savings(W4) 5.00 1.25 143.75
(200. 22
Working Capital 00) (10) (10.5) 0.50
Initial (2,800
Investment .00)
1,000
Scrap Value .00
(3,000 39 49 1,715
Net Cash Flow .00) 1.00 6.40 .43 25.82
Discount Factor
10% 1 0.909 0.826 0.751 0.683
(3,000 35 41 1,288
Present Value .00) 5.42 0.03 .29 17.64
(928.
NPV 63)

WORKING 1 SALE
1 2 3
Unit 100000 100000 100000
current price 20 20 20
Inflation 1 1.07 1.1449
Inflacted price 20 21.4 22.898

2,000,000 2,140,000 2,289,800.

Sale .00 .00 00
WORKING 2 MATERIA
Unit 100000 100000 100000
current price 8 8 8
Inflation 1.08 1.1664 1.2597
Inflacted price 8.64 9.3312 10.0776

864,000.0 933,120.0 1,007,760.

Materia cost 0 0 00

WORKING 3 LABOUR

Unit 100000 100000 100000

current price 7 7 7
Inflation 1.05 1.1025 1.1576
Inflacted price 7.35 7.7175 8.1032

735,000.0 771,750.0 810,320.0

Labour cost 0 0 0

Working 4 Capital Allowance

TAX Tax Timin
YR RATE Savings g

2,800,000.
1 COST 00
CA @ 25% @ 25% 2
ON 2,800,000 (700,000.0 175,000.
 0) 00

2,100,000.
2 WDV 00

CA @ 25% (525,000.0 131,250.

ON 2,100,000 0) @ 25% 00 3

1,575,000.
3 WDV 00

CA/BAL (575,000.0 143,750.

ALLAWANCE 0) @ 25% 00 4

1,000,000.
SCRAP VALUE 00

Working 5 Working Capital

Working capital Relevant Year
Year Requird Cashflow needed

1 200,000.00 (200,000.00) 0

2 210,000.00 (10,000.00) 1

3 220,500.00 (10,500.00) 2

3 220,500.00 3

-
  INVESTMENT APPRAISAL UNDER RISK AND UNCERTAINTY

A major reservation of any investment appraisal decision is that the figures used in
the calculations are only estimates and stand to be risky and uncertain. Clearly if
any of the cash flows used in the decision turn out to be different from what was
estimated, the decision itself could be affected.

Risk is a situation where there are a number of possible outcomes and the
probability of each outcome is known, due to past experience and knowledge.
Uncertainty: Here, there are a number of possible outcomes, but the probability of
each outcome is not known. Usually, due to lack of experience with that particular
area of decision making.

Assessment of risk is particularly important when performing investment appraisal

due to:

1. Long timescale
2. Outflow today, inflow in the future
3. Large size in relation to the size of the company
4. Strategic nature of the decision.

 TECHNIQUES IN EVALUATING RISK AND UNCERTAINTY

1. Sensitivity analysis
2. Expected values
3. Adjusted discount rates
4. Payback.
5. Simulation

 SENSITIVITY ANALYSIS

A technique that considers a single variable at a time and identifies by how much
that variable has to change for the decision to change (from accept to reject).

Key working

Sensitivity Margin = Net Present Value ‘ x

100
PV of cashflow under consideration
Q22
JED Consult has just set up a new company and estimates that the cost of capital is
15%.
Her first project involves investing in $150,000 of equipment with a life of 15 years
and a final scrap value of $15,000.
The equipment will produce 15,000 units p.a. generating a contribution of $2.75
each. She estimates that additional fixed costs will be $15,000 p.a..

(a) Determine, on the basis of the above figures, whether the project is worthwhile
(b) Calculate the sensitivity to change of:
i. the initial investment
ii. the sales volume p.a.
iii. the contribution p.u.
iv. the fixed costs p.a.
v. the scrap value
vi. the cost of capital
(c) comment on the results

Solution.

(a) Determine, on the basis of the above figures, whether the

project is worthwhile

DF @
YR Detail Cashflow 15% PV
Initial (150,000 (150,00
0 Cost .00) 1 0.00)
Contributi 41,25 241,18
1--15 on 0.00 5.847 8.75
Fixed (15,000 (87,70
1--15 Cost .00) 5.847 5.00)
 15,00 1,84
15 Scrap 0.00 0.123 5.00
5,32
NPV 8.75

Working:
Contribution = 15000unit x $ 2.75 = $ 41,250

(b) Calculate the sensitivity to change of:

i. the initial investment

SM = 5328.75 X 100 = 3.55%

150,000

ii. the sales volume p.a.

SM = 5328.75 X 100 = 2.2%

241,188.75

iii. the contribution p.u.

SM = 5328.75 X 100 = 2.2%

241,188.75

iv. the fixed costs p.a.

SM = 5328.75 X 100 = 6.07%
87,705

v. the scrap value

SM = 5328.75 X 100 = 288.8%

1,845

vi. the cost of capital

DF @
YR Detail Cashflow 20% PV
Initial (150,000 (150,00
0 Cost .00) 1 0.00)
Contributi 41,25 192,84
1--15 on 0.00 4.675 3.75
Fixed (15,000 (70,12
1--15 Cost .00) 4.675 5.00)
15,00 9
15 Scrap 0.00 0.065 75.00
(26,30
NPV 6.25)

IRR = 15+ 5328.75 x (20-15) = 15.84 %

5328.75+26306.25
SM= 0.84 =5.6%
15

 EXPECTED VALUES
Where there are a range of possible outcomes which can be identified and a
probability distribution can be attached to those values. In this situation then we
may use a variety of techniques to establish some sort of ‘average’ return. The
measure of average return is then assumed to be the value that we should use.
The expected value is the arithmetic mean of the outcomes as expressed below:

EV = Epx

Where P = the probability of an outcome

x = the value of an outcome

Q23
JED Consult ltd is considering launching a new product.
This will require additional capital investment of $200,000.
The selling price of the product will be $10 p.u. .JED has ascertained that the
probability of a demand of 50,000 units p.a. is 0.5, with a probability of 0.4 that it
will be 20% higher, and a 0.1 probability that it will be 20% lower.
The company expects to earn a contribution of 50% and expects fixed overheads to
increase by $140,000 per year.
The time horizon for appraisal is 4 years. The machine will be sold at the end of 4
years for $50,000.
The cost of capital is 20% p.a.
(a) Calculate the expected NPV of the project
(b) Assuming that the demand is certain at 50,000 units p.a. what is the NPV of the
project if fixed overheads are uncertain as follows:
Fixed overheads Probability
100,000 0.20
140,000 0.35
180,000 0.25
220,000 0.20

SOLUTION.

(a) Calculate the expected NPV of the project

Expected Demand

outcome X P PX
50,00 25,00
Normal 0.00 0.5 0.00
60,00 24,00
Higher 0.00 0.4 0.00
40,00 4,00
Lower 0.00 0.1 0.00
53,00
EV 0.00

DF @
YR Detail Cashflow 20% PV
Initial (200,000 (200,00
0 Cost .00) 1 0.00)
1--4 Contributi 265,00 2.589 686,08
 on 0.00 5.00
Fixed (140,000 (362,46
1--4 Cost .00) 2.589 0.00)
50,00 24,10
4 Scrap 0.00 0.482 0.00
147,72
NPV 5.00

Working

Sale Value = 53,000 x $10 = $530,000

Contribution : 0.5 x $ 530,000 = $265,000

(b) Assuming that the demand is certain at 50,000 units p.a. what is
the NPV of the project if fixed overheads are uncertain as follows:

Fixed overheads Probability

100,000 0.20
140,000 0.35
180,000 0.25
220,000 0.20

SOLUTION
Expected Value

outcome- P PX
 X
100,00 20,00
0.00 0.2 0.00
140,00 49,00
0.00 0.35 0.00
180,00 45,00
0.00 0.25 0.00
220,00 44,00
0.00 0.2 0.00
158,00
EV 0.00

DF @
YR outcome Cashflow 20% PV
Initial (200,000 (200,00
0 Cost .00) 1 0.00)
Contributi 250,00 647,25
1--4 on 0.00 2.589 0.00
Fixed (158,000 (409,06
1--4 Cost .00) 2.589 2.00)
50,00 24,10
4 Scrap 0.00 0.482 0.00
62,28
NPV 8.00

Working

Sale Value = 50,000 x 10 = $ 500,000

Contribution : 0.5 x $ 500,000 = $250,000

 ADJUSTED DISCOUNT RATES.

The discount rate we have assumed so far is that reflecting the cost of capital of the
business. In simple terms this means that the rate reflects either the cost of
borrowing funds in the form of a loan rate or it may reflect the underlying return of
the business (i.e. the return required by the shareholder), or a mix of both.

An individual investment or project may be perceived to be more risky than existing

investments. In this situation the increased risk could be used as a reason to adjust
the discount rate up to reflect the additional risk.

 PAYBACK.

As discussed earlier in the notes payback gives a simple measure of risk. The
shorter the payback period, the lower the risk.

 SIMULATION.

Simulation is a technique which allows more than one variable to change at the
same time.

You will not be required in the examination to actually perform a simulation, but you
should be aware of the principle involved.

Essentially, the stages are as follows:

๏ identify the major variables

๏ specify the relationship between the variables
๏ attach probability distributions to each variable and assign random numbers to
reflect the distribution
๏ simulate the environment by generating random numbers
๏ record the outcome of each simulation
๏ repeat the simulation many times to be able to obtain a probability distribution of
the possible outcomes

 DISCOUNTED CASH FLOW – FURTHER ASPECTS

This aspect deals with three specific situations of investment appraisal which are
occasionally asked in the examination –

 capital rationing;
 Asset replacement decisions;
 lease v buy decisions.

For each of these situations it is important to understand the nature of the problem
and the way in which the standard techniques, which we have already covered, are
applied.
  CAPITAL RATIONING

Capital rationing is the term used to cover the situation when the company has
limited funds available for investment.

there are two types:

 Hard Capital rationing (externally imposed)
 Soft Capital rationing (Internally imposed)

 Hard capital rationing

Externally imposed by banks.
Due to:
1. Wider economic factors (e.g. a credit crunch)
2. Company specific factors
(a) Lack of asset security
(b) No track record
(c) Poor management team.

 Soft capital rationing

Internally imposed by senior management.
Issue: Contrary to the rational aim of a business which is to maximise
shareholders’wealth (i.e. to take all projects with a positive NPV)
Reasons:
1. Lack of management skill
2. Wish to concentrate on relatively few projects
3. Unwillingness to take on external funds
4. Only a willingness to concentrate on strongly profitable projects.

 The limit on the level of funding could be for a period as such we

have:

 Single period capital rationing

 Multiple period capital rationing

 Single period capital rationing

There is a shortage of funds in the present period which will not arise in following
periods. Note that the rationing in this situation is very similar to the limiting
factor decision that we know from decision making. In that situation we
maximise the contribution per unit of limiting factor.
  Multi-period capital rationing

A more complex environment where there is a shortage of funds in more than one
period. This makes the analysis more complicated because we have multiple
constraints and multiple outputs. Linear programming would have to be employed

 The project could also be:

 Infinitely Divisible
 Non-Infinitely Divisible
 Divisibility and mutually exclusive

 Infinitely divisible projects

If projects are said to be infinitely divisible, it means that it is possible to invest

in any fraction of a project (up to a maximum of 100% of the project). We also
assume that if we invest in (say) 10% of a project then all the flows will be 10%
of the full project flows and that therefore the resulting NPV will be 10% of the
full project NPV.

The approach is as follows:

๏ calculate the NPV per $ of initial investment (the profitability index =
NPV/Initial Investment)
๏ Rank the projects in terms of their profitability indexes
๏ Invest as much as possible in the project with the highest profitability index,
then go to the project with the next highest, and so on until the capital available
is exhausted.

 Non-infinitely divisible projects

If projects are not infinitely divisible it is only possible to invest in whole projects.
In this situation there is no ‘quick’ method – the only approach is to look at all
possible combinations of projects that are possible using the limited amount of
capital available, and choose the combination that gives the highest total NPV.

 Infinitely divisible and Mutually exclusive projects

Where again we can take any part of a project and the return is proportionate to the
investment and the taking of one project precludes the taking of another.
Q24
A company has the following 4 projects available:

Y A B C D

0 (500) (600) (300) (400)

1 221 207 194 181

2 221 207 194 181

3 221 207 181 207

4 0 207 0 0

NPV @ 10% 50 57 36 50

What should the company’s investment decision be if:

(a) There is no capital rationing
(b) Capital is restricted to $1,600 at time 0 and the projects are infinitely divisible
(c) Capital is restricted to $1,600 at time 0 and the projects are not infinitely
divisible.
(d) Capital is restricted to $1,600 at time 0 but project C & D are mutually Exclusive

Solution:
(a)There is no capital rationing

All project with positive NPV will be accepted

(b)Capital is restricted to $1,600 at time 0 and the projects are
infinitely divisible
 P.I. = NPV/Investment

PROJE NP INVESTM RANKI

CT V ENT PI NG
A 50 500 0.1 3
0.09
B 57 600 5 4
C 36 300 0.12 2
0.12
D 50 400 5 1

FUNDS ALLOCATION.
Funds Projects
available undertaken NPV earned
$ $
1,6
00.00
(40
0.00) D 50
1,2
00.00
(30
0.00) C 36
9
00.00
(50
0.00) A 50
4
00.00
(40 B- (400/600 x
0.00) 57 38

- NPV 174
With limited fund of $ 1,600 the company will execute 100% of
project D,C,A and 67% of project B and will earn a total NPV of
$174
 c) Capital is restricted to $1,600 at time 0 and the projects are not
infinitely divisible
A = 500
B = 600
C= 300
D= 400

$1,600

PROJECT MIXED TOTAL NPV

50+57+36=
A,B,C 143
50+57+50=
A,B,D 157
50+36+50=
ACD 136
57+36+50=
BCD 143

If the project is Non Divisible , the company will execute project

A,B,D as that is the mixed that give the maximum NPV - $157

(d) Capital is restricted to $1,600 at time 0 but project C & D are

mutually Exclusive
PROFITABILITY INDEX
PROJEC INVESTM RANK- RANK-
T NPV ENT PI EXCLUDE C EXCLUDE D
A 50 500 0.1 2 2
0.09
B 57 600 5 3 3
C 36 300 0.12 EXCLUDED 1
0.12
D 50 400 5 1 EXCLUDED
 FUNDS ALLOCATION.

EXCLUDE C EXCLUDE D
Funds Funds Project
available Projects NPV available s NPV
$ $ $ $
1,6 1,6
00.00 00.00
(40 (30
0.00) D 50 0.00) C 36
1,2 1,3
00.00 00.00
(50 (50
0.00) A 50 0.00) A 50
7 8
00.00 00.00
(60 (60
0.00) B 57 0.00) B 57
1 2
00.00 00.00
NPV 157 NPV 143
  ASSET REPLACEMENT

The decision how to replace an asset. The asset will be replaced but we aim to
adopt the most cost effective replacement strategy. The key in all questions of this
type is the lifecycle of the asset in years.

 Equivalent annual cost (EAC)

After calculating the NPV in the normal way we are then able to calculate some
measure of equal cost for each year by using the following calculation:

NPV of Asset
Equivalent annual cost = ---------------------
Annuity factor

Q25
A machine costs $72,000 and has a maximum life of 3 years.
The running costs each year are as follows:
Year
1 7,200
2 9,600
3 12,000
The estimated scrap values are as follows:
Year
1 24,000
2 16,600
3 9,600
The cost of capital is 15%
How often should the machine be replaced?

Solution:

Cost to Replace Every 1 year

YR Detail Cashflow DF @ 15% PV

Initial (72,000.00 (72,000.

0 Cost ) 1 00)

Runing (6,264.0
1 Cost (7,200.00) 0.87 0)

Scrap 20,880.0
1 value 24,000.00 0.87 0

(57,384.
NPV 00)

EAC = 57,384 = $65,958.62

0.870

Cost to Replace Every 2 year

YR Detail Cashflow DF @ 15% PV

Initial (72,000.00 (72,000.

0 Cost ) 1 00)

Runing (6,264.0
1 Cost (7,200.00) 0.87 0)

Runing (7,257.6
2 Cost (9,600.00) 0.756 0)

Scrap 12,549.6
2 value 16,600.00 0.756 0

(72,972.
NPV 00)

EAC = 72,972 = $44,878.23

1.626

Cost to Replace Every 3 year

YR Detail Cashflow DF @ 15% PV

Initial (72,000.00 (72,000.

0 Cost ) 1 00)

Runing (6,264.0
1 Cost (7,200.00) 0.87 0)

Runing (7,257.6
2 Cost (9,600.00) 0.756 0)

Runing (12,000.00 (7,896.0

3 Cost ) 0.658 0)
Scrap
3 value 9,600.00 0.658 6,316.80

(87,100.
NPV 80)
EAC = 87,100.80 = $38,151.91
2.286

It will be cost effective to replace the machine every 3 years

 LEASE OR BUY DECISION

A specific decision that compares two specific financing options, the use of a
finance lease or buying outright financing via a bank loan.

Key information

 The discount rate will be the post tax cost of borrowing

 Cash Flow

Bank loan Finance Lease

1/ Cost of the investment

2/ Runing/Maintenance Cost 1/ Lease rental
- in advance
3/ Tax Saving on investment / Runing cost - annuity /Arrear

4/ Residual value 2/ Tax Savings on rental

Q26
A company is considering whether to buy a new machine at a cost of $100,000 or
alternatively to lease it for $35,000 p.a. (lease payments payable at the start of
each year).
Buying it will involve borrowing money at an after tax interest cost of 7% p.a.
If the machine is bought, it will be bought on the last day of current financial year.
The machine will be needed for 4 years, and (if purchased) will have a scrap value
after 4 years of $10,000.
Corporation Tax is 30% (payable one year after the end of the financial year)
Capital allowances are 25% (reducing balance)
.
Should the machine be leased or purchased?

Solution:
To Buy

0 1 2 3 4 5
$ $ $ $ $ $
(100,000.
Cost 00)
Tax 7,500 5,625 4,218 9,656
saving .00 .00 .75 .25
10,000
Scrap .00
(100,000. 7,500 5,625 14,218 9,656
NTR 00) - .00 .00 .75 .25
DF @ 0.93 0.
7% 1 5 0.873 0.816 763 0.713
(100,000. 6,547 4,590 10,848 6,884
PV 00) - .50 .00 .91 .91

(71,128.6
NPV 9)

Working- Tax Savings

Tax Timin
YR Savings g

100,000.0
1 COST 0
 CA @
25% of (25,000.00 @
100,000 ) 30% 7,500.00 2

2 WDV b/f 75,000.00

CA @
25% of (18,750.00 @
75,000 ) 30% 5,625.00 3

3 WDV b/f 56,250.00

CA @
25% of (14,062.50 @
56,250 ) 30% 4,218.75 4

4 WDV b/f 42,187.50

CA/BAL (32,187.50 @
ALL ) 30% 9,656.25 5

SCRAP 10,000.00

To Lease

0 1 2 3 4 5
$ $ $ $ $ $

(35,000.0 (35,000. (35,000. (35,000.

Cost 0) 00) 00) 00)
Tax
savin 10,500.0 10,500.0 10,500. 10,500.
g 0 0 00 00

(35,000.0 (35,000. (24,500. (24,500. 10,500. 10,500.

NTR 0) 00) 00) 00) 00 00
DF @
7% 1 0.935 0.873 0.816 0.763 0.713

(35,000.0 (32,725. (21,388. (19,992. 8,011.5 7,486.5

PV 0) 00) 50) 00) 0 0

(93,607.5
NPV 0)

Working – Tax Saving

30% x $35,000= $ 10,500

The company should Purchase the Machine.