INVESTMENT APPRAISAL

ARR
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:
1 20,000
2 30,000
3 40,000
4 10,000
Calculate the ARR of the project.

PAYBACK
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:
1 20,000
2 30,000
3 40,000
4 10,000
Calculate the payback period of the project.

NET PRESENT VALUE

EG. 1
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:
1 20,000
2 30,000
3 40,000
4 10,000
The cost of capital is 10% p.a..
Calculate the Net Present Value of the investment and determine whether or not it should be accepted.
USING THE INFORMATION ABOVE
(a) Calculate the NPV of the project at an interest rate of 15%
(b) Estimate the IRR of the project using your results from part (a) and from Example 1.
(c) Interpret the result of (b).

EG. 2
A machine will cost $45,000 and is expected to generate $8,000 for each of the following 8 years. The
cost of capital is 15% p.a..
Calculate the NPV of the investment.

EG. 3
The cost of capital is 12% p.a.
What is the present value of $20,000 first receivable in 4 years time and thereafter each year for a total of
10 years?

EG. 4
A machine costs $100,000 and is expected to generate $12,000 p.a. in perpetuity.
The cost of capital is 10% p.a.
What is the NPV of the project?

EG. 5
The rate of interest is 5%. p.a.
What is the present value of $18,000 first receivable in 5 years time and thereafter annually in perpetuity?

RELEVANT CASHFLOWS
A research project which to date has cost the company $150,000 is currently under review.
If the project were allowed to proceed, it will be completed in approximately one year, when the results
would be sold to a government agency for $300,000.
Shown below are the additional expenses which the managing director estimates will be necessary to
complete the work.
Materials:
The materials required have just been purchased at a cost of $60,000. They are toxic and, if not used in
this project must be disposed of at a cost of $5,000.
Labour:
Skilled labour is hard to recruit. The workers concerned have been transferred to this project from a
production department, and the production manager claims that if the men were returned to him they
could generate sales of $150,000 in the next year. The prime cost of these sales would be $100,000
including $40,000 for the labour cost itself. The overhead absorbed into this production would amount to
$20,000.
Research staff:
It has already been decided that when work on this project ceases, the research department will be closed.
Research wages for the year are $60,000, and redundancy and severance pay has been estimated at
$15,000 now, or $35,000 in one years time.
Equipment:
The project utilises a special microscope which cost $18,000 three years ago. It has a residual value of
$3,000 in another two years, and a current disposal value of $8,000. If used in the project it is estimated
that the disposal value in a years time will be $6,000.
Share of general building services:
The project is charged with $35,000 p.a. to cover its share of general building expenses. Immediately the
project is discontinued, the space occupied by the project could be sub-let for an annual rental of $7,000.
Advise the managing director as to whether or not the project should be allowed to proceed,
explaining your reasons for the treatment of each item.

WORKING CAPITAL
EG. 1
A machine costs $100,000 to purchase. In addition, a further $20,000 working capital will be required at
the start of the project. The project is expected to last 4 years and to have a scrap value of $20,000 at the
end of its useful life.
Net operating cash flows are expected to be $30,000 p.a. for the first two years and $40,000 p.a. for the
following two years.
All operating flows are to be assumed to occur at the ends of year.
Calculate the net cash flow for each of the years in question (you are not required to discount or
arrive at an investment decision).
EG. 2
A machine costs $15,000 and is expected to last for 4 years with a scrap value of $2,000 at the end
of 4 years. The sales revenue and operating costs for each of the 4 years have been estimated as follows:
Year 1 2 3 4
Sales revenue 5,000 11,000 8,000 9,000
Operating costs 2,000 2,000 2,000 2,000
Working capital of 10% of the years revenue is required at the start of each year
Calculate the net cash flow for each of the years in question.

TAXATION
A company has a year end of 31 December each year. It is considering the purchase of a new machine on
1 January 2003 at a cost of $10,000. The machine is expected to generate net operating cash flows of
$5,000 during the first year , $7,000 during the second year, and $8,000 during the third year. It is
intended to sell the machine at the end of the third year for $6,000. Additional working capital of $1,000
will be required at the start of the project.
Corporation tax is 30% payable one year in arrears.
Capital allowances are available at 25% p.a. on a reducing balance basis.
The cost of capital is 10%
Calculate the NPV of the project and advise as to whether it should be accepted or rejected.

INFLATION
EG. 1
Ventspils plc 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.
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.

EG. 2
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 cost 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

CAPITAL RATIONING
A company has the following 4 projects available:
A B C D
0 (500) (600) (300) (400)
1 221 207 194 181
2 221 207 194 181
3 221 207 – 181
4 – 207 – –
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.
REPLACEMENT
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?

LEASE VS BUY
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?
SENSITIVITY ANALYSIS
Daina 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

EXPECTED VALUES
Daiga plc 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. Daiga 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