Investment Appraisal

The availability of cash resources is generally limited

Capital budgeting, or investment appraisal, is the planning process used to determine whether an
organization's long term investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth the funding of cash through the firm's capitalization
structure (debt, equity or retained earnings).

Methods of Investment evaluation

1. Payback period
2. Net present value
3. Discounted payback period
4. Accounting rate of return
5. Internal rate of return

1. Payback period (Cash payback period)

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from
the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
Remember, payback uses cash flows not profit

For even cash flow, the formula to calculate payback period is:

Cost of investment
Cash Payback Period =
Annual net cash flow

Worked example

For example, suppose you need to decide whether to buy a new computer costing $500; you expect the
computer to increase your net cash flow by $300 per year. Calculate payback period?

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then
use the following formula for payback period:

B
Payback Period = A +
C
In the above formula,
A is the total period with a cumulative cash flow;
B is the absolute value of cash flow needed to complete investment;
C is the total cash flow during the in the excess cash flow period above investment
 Advantages

 It is relatively easy to calculate

 Calculation of net cash flows is less subjective than calculation of profitability
 Payback is useful in technological industries, where a short pay back is preferred
 Short payback periods benefit business’s liquidity and facilitate faster growth

Disadvantages

 Life expectancy of project is ignored

 Payback considers the payback period only and does not take future cash flows into account
 Time value of money may be ignored

2. Net Present Value

Net present value is the present value of net cash inflows generated by a project including salvage value, if any,
less the initial investment on the project. It is one of the most reliable measures used in capital budgeting
because it accounts for time value of money by using discounted cash inflows.

Advantage

 Net present value considers time value of money.

 It is relatively easy to understand
 Greater importance is given to earlier cash flows

Disadvantage

 It is based on estimated future cash flows of the project and estimates may be far from actual results
 The current cost of capital may change over the life of the project
 The life of the project is difficult to predict

Cost of capital

Cost of capital is based on the weighted average cost of capital available to business

3. Discounted payback period

This method is widely used in business as a method of selecting a machine or project

4. Accounting rate of return

Accounting rate of return is the ratio of estimated accounting profit of a project to the average
investment made in the project. ARR is used in investment appraisal.
Remember, some projects will require an injection of additional working capital in the form of extra inventory
and as a result more trade payables. The increase in working capital can be assumed to be
 constant during the life time of the project. This means there is no need to calculate the average increase
in working capital over this time

Accounting Rate of Return is calculated using the following formula:

Average Profit
ARR =
Average Investment

Average investment = Cost of project + scrap value + working capital

2

Or

Cost of project - scrap value + working capital 2

Note:
Increase in working capital is cash outflow and decrease in working capital is cash inflow

Profit = cash inflow – cash outflow – depreciation

= net cash flow – depreciation
Net cash flow = profit + depreciation

Average profit = Total profit

No of years
Advantages

 Profitability of a project may be compared with present profitability of business

 It is relatively easy to calculate
 It takes into account the aggregate earnings of the project

Disadvantages

 Timing of cash inflows and outflows is ignored

 It ignores the payback risk factor
 It ignores the time value of money
 ‘Profit’ is subjective (provisions for depreciation, bad debts etc.)
 No commonly accepted method of calculating capital employed
 Ignores duration of project

5. Internal rate of return

Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero.
In other words, IRR is the discount rate which equates the present value of the future cash flows of an
investment with the initial investment. It is one of the several measures used for investment appraisal.
 The return on a project must cover the cost of capital, so if a business has cost of capital 12%, any project
undertaken must yield a return that is greater than 12%
When evaluating a capital project, internal rate of return (IRR) measures the estimated percentage return from
the project. It uses the initial cost of the project and estimates of the future cash flows to figure out the interest
rate.
In general, companies should accept projects with IRR that exceed the cost of capital and reject projects that
don’t meet that guideline

IRR = low DR + Difference in Discount factor x NPV at low DF

NPV at low DF – NPV at high DF

Advantages

 Indicates return actually to be expected from expenditure

 May assist in ranking different proposals
 Often used in businesses
 Recognizes time value of money

Disadvantages

 More difficult to calculate than NPV

 NPV is usually more useful in ranking different projects

Non quantitative method

 Better customer loyalty

 Enhanced safety
 Stronger employee morale
 Improved quality
 Protection of the environment

Sensitivity Analysis

The time horizon involved in making sound capital investment decisions is generally long. Looking into the
future makes the reliability of forecast data uncertain.
Sensitivity analysis measures how responsive the outcome of such decisions is to variability of revenues and
costs

Sensitivity of the project to changes in the cost of the machinery

= Net present value/cost of machine * 100

 Sensitivity of the project to changes in the selling price

Net present value per year = net present value / sum of discount

factor Sp per unit = NPV per year / No of units sold

Changes in % = Sp per unit / original selling price * 100

Sensitivity Applied to Investment Appraisal

(a) Sensitivity of Selling Price: NPV/Present Value of Sales * 100

(b) Sensitivity of Initial Cost: NPV/Initial Cost *100

ON/22/31
X Limited has the option of buying an expensive machine. Production using this machine would be
as follows:

Year Units
1 18 000
2 20 000
3 26 000
4 24 000

It is expected that the machine could be sold at the end of year 4 for proceeds of $16 000.

The company has a cost of capital of 10%. Applying this rate the purchase of the machine has a
small
negative net present value (NPV) of $180. It has a payback period of 3 years and 10 months.

Answer the following questions in the question paper. Questions are printed here
for reference only.

(a) Explain how a project could pay back during the life of the project whilst having a
negative NPV. [2]

Additional information

It is the policy of the company to reject any project with a negative NPV.

The supplier of the machine has stated that the machine should receive a maintenance
service once for every 500 units produced. Each service costs $300. The cost of this level of
servicing had been included in the calculation of the negative NPV.

The finance director has suggested servicing the machine only once for every 2000 units
produced, in order to reduce costs and improve the NPV.
 The production manager has said that reducing servicing in this way would increase the
repair costs. He estimates that the increase in repair costs would be as follows:

Year $
1 2 000
2 5 600
3 12 600
4 19 900

(b) Complete the table (given in the question paper) to calculate the changes in
costs which would occur if the level of servicing was reduced. [5]

Discount factors for the 10% cost of capital are as follows:

Year
1 0.909
2 0.826
3 0.751
4 0.683

(c) Calculate the NPV which the purchase of the machine would have if the level of
servicing was reduced. [5]

(d) Advise the directors whether or not they should purchase the machine if it was operated
with the reduced level of servicing. Justify your answer. [5]

Additional information

The production manager also thinks that the sales proceeds of the machine at the end of year
4 would be different from the existing estimate if the machine was perceived as not properly
maintained.

(e) Calculate the sales proceeds at which the NPV would be zero. [4]

(f) Explain how a business would calculate its internal rate of return (IRR). [4]

MJ/22/32
The directors of M Limited plan to buy a machine for a new product at the cost of $160 000. It has
a useful life of four years with no residual value.

The number of units produced and sold are expected to be as follows.

Year 1 Year 2 Year 3 Year 4 Total

5000 7500 8500 4200 25 200

The unit selling price is $28 and the variable cost is $10 per unit. Annual fixed costs including
depreciation are $90 000 up to the level of 6500 units. The fixed costs will increase by $10 000
 each time the production level increases by up to 1500 units.

Answer the following questions in the question paper. Questions are printed here
for reference only.

(a) Calculate the net cash flows for each year throughout the life of the machine. [4]

Additional information

The cost of capital is 10%. Relevant discount factors are:

10% 16%
Year 1 0.909 0.862
Year 2 0.826 0.743
Year 3 0.751 0.641
Year 4 0.683 0.552

(b) Calculate for the proposed purchase:

(i) the net present value (NPV) [4]

(ii) the internal rate of return (IRR). [4]

(c) Advise the directors whether or not the machine should be purchased. Justify your answer.
[3]
The directors decide that the NPV method should be adopted. One of the directors has
concerns about the total sales target. To achieve the total sales of 25 200 units, he has the
following suggestion.

1 The selling price should be reduced by $1.

2 Advertising costs of $8000 should be incurred in both Year 1 and Year 3.

3 The units produced and sold for each year should be the same. This would also keep
the fixed cost to its minimum.

(d) Explain what is meant by the term ‘sensitivity analysis’ for investment appraisal. [3]

(e) Assess the impact of the director’s suggestion on the decision to buy the new
machine. Support your answer with calculations. [7]

ON/21/32
Kurt runs a manufacturing business. He has decided to invest in some new machinery so that he
can produce a new product. He anticipates that the net cash inflows resulting from the
manufacture and sales of the new product would be as follows:

Year $
 1 89 000
2 76 000
3 63 000
4 41 000

Answer the following questions in the question paper. Questions are printed here
for reference only.

(a) Explain what is meant by the term ‘net cash inflow’.

[2]

Additional information

Kurt uses a cost of capital of 12%. The discount factors for this are as follows:

Year
1 0.893
2 0.797
3 0.712
4 0.636

Kurt is considering two options for the purchase of the machinery to make the new product.

Option 1: The purchase of machinery costing $150 000 which would have no scrap value at
the end of year 4. This would result in the manufacture of the new product having a net
present value (NPV) of $60 981.

Option 2: The purchase of machinery costing $290 000 which would have a scrap value at
the end of year 4, although as yet this scrap value has not been estimated.

(b) Calculate the scrap value of the machinery at the end of year 4 which would result in
Option 2 having an NPV:

(i) of zero [8]

(ii) equal to the NPV of Option 1. [4]

(c) Explain why the payback period is shorter for Option 1 than it is for Option 2 when
the net cash flows are the same. [2]

(d) Explain why a shorter payback period is preferable to a longer one.

[2]

(e) Explain why a project having a zero NPV is not the same as its having a zero total profit. [2]
Additional information

It was later determined that under Option 2 the machinery could be sold at the end of year 4
for proceeds of $225 000. With this value the accounting rate of return for Option 2 would be
 lower than the accounting rate of return for Option 1.

Advise Kurt which option he should implement. Justify your answer. [5]

MJ/21/31
The directors of W Limited plan to buy a new machine costing $220 000 for making a new product.
The machine will have a useful life of 4 years with no scrap value.

The cash inflows and cash outflows from the new product for four years are expected to be as
follows:

Inflows Outflows
$ $
Year 1 100 000 36 000
Year 2 132 000 50 000
Year 3 160 000 68 000
Year 4 92 000 50 000

The cost of capital is 8%.

The following discount factors are given:

8% 12%
Year 1 0.926 0.893
Year 2 0.857 0.797
Year 3 0.794 0.712
Year 4 0.735 0.636

Answer the following questions in the question paper. Questions are printed here
for reference only.

(a) Calculate for the new machine:

(i) the accounting rate of return (ARR) [5]

(ii) the net present value (NPV) [3]

(iii) the internal rate of return (IRR) [4]

(b) Advise the directors whether or not they should buy the new machine. Justify your answer.
[3]

Additional information

The directors are of the view that the NPV method should be used to make decisions
on investment.

(c) State three advantages of using the NPV method.

 [3]

Additional information

Due to a change in economic conditions, the directors consider that the cost of capital
should be 12%.

(d) Explain the effect on the directors’ decision on investment of the change in the cost of capital.
[2]
The directors also consider that the negative impact from the increase of cost of capital can
be offset by increasing the revenue. Additional advertising costing $20 000 incurred in year 1
can help increase the sales revenue in years 2 and 3. Year 2 sales revenue is expected to
increase by
$24 000.

(e) Calculate the minimum increase in sales revenue in year 3 to justify the directors
deciding to buy the new machine. [5]

MJ/21/34
AN plc wishes to manufacture a new product for a period of three years. To do this it can take
either option 1 or option 2.

Option 1 involves buying all the machinery at a cost of $460 000 and selling it at the end of year 3
for an estimated $160 000.

Option 2 involves buying some of the machinery at a cost of $100 000 and selling it at the end of
year 3 for an estimated $10 000, and renting some of the machinery.

The following additional estimated data relating to the options is also available.

Option 1
Year Cash inflows Cash outflows Depreciation
$ $ $
1 350 000 200 000 100 000
2 350 000 200 000 100 000
3 350 000 200 000 100 000

Option 2
Year Cash inflows Cash outflows Depreciation
$ $ $
1 350 000 310 000 30 000
2 350 000 310 000 30 000
3 350 000 310 000 30 000

AN plc uses a cost of capital of 10%. The discount factors for this are as follows.

Year
1 0.909
 2 0.826
3 0.751
2.486

Answer the following questions in the question paper. Questions are printed here
for reference only.

(a) State two ways in which the directors may have estimated the future cash inflows. [2]

(b) Calculate for option 1:

(i) the net present value (NPV)

[6]

(ii) the payback period, in years. [3]

(c) Calculate for option 2:

(i) the net present value (NPV)

[6]

(ii) the payback period, in years. [3]

(d) Advise the directors which, if either, of the options they should choose. Justify your answer. [5]

ON/20/31

Samir has a business in the leisure industry. He is purchasing a boat and plans to start luxury river
cruises. In his original plan, which had a positive net present value (NPV), he anticipated the
following revenue.

number of tickets price per ticket

sold per year $
year 1 8000 100
year 2 8300 110

He is now considering a revised plan, employing local historians to accompany the cruises and
give lectures on the history of the area. He thinks that this will result in 20% more tickets being
sold each year. The selling price of the tickets would be $10 higher than under the original plan.

Answer the following questions in the question paper. Questions are printed here
for reference only.

(a) Calculate the total revenue for each year for:

(i) the original plan [1]

(ii) the revised plan. [1]

 Additional information

The majority of the running costs of the cruises will be fixed. Variable costs are expected to
amount to $30 for each ticket sold.

(b) Calculate the total variable cost for each year for:

(i) the original plan [2]

(ii) the revised plan. [2]

Additional information

1 The cost of employing the historians will add $125 000 per annum to the total fixed
costs of running the cruises.

2 The capacity of the boat restricts the total number of tickets which can be sold each
year to 10 000.

3 Samir uses a cost of capital of 10% per annum. The discount factors for this rate
are as follows.

year 1 0.909
year 2 0.826

(c) Calculate the increase in NPV which would arise if the revised plan was used instead
of the original. [8]

(d) Calculate the total number of tickets Samir would have to sell in year 1 under the
revised plan so that the increase in revenue equalled the additional fixed costs. [3]

(e) Assess any concerns Samir might have about the revised plan. [2]

(f) Advise Samir whether or not he should implement the revised plan. Justify your answer.
[3]

Explain how sensitivity analysis helps in investment appraisal. [3]

Mar/20

The directors of W Limited plan to buy a machine costing $480 000 from an overseas
manufacturer. The machine has an estimated useful life of four years with no residual value.

Estimated receipts and payments are as follows:

Receipts Payments
$ $
Year 1 260 000 90 000
Year 2 290 000 120 000
Year 3 330 000 140 000
 Year 4 130 000 80 000

The cost of capital of W

Limited is 10%. The

discount factors are as

follows:
7% 10%
Year 1 0.935 0.909
Year 2 0.873 0.826
Year 3 0.816 0.751
Year 4 0.763 0.683

Answer the following questions in the Question Paper. Questions are printed here
for reference only.

(a) Calculate for the proposed investment:

(i) the payback period (in months) [3]

(ii) the net present value (NPV) [4]
(iii) the internal rate of return (IRR). [4]

(b) Advise the directors whether or not they should buy the machine. Justify your
answer by reference to your calculations in part (a). [4]

Additional information

The cost of the machine, $480 000, includes the purchase price plus a 20% tariff (import
duty) on the purchase price. Due to a recent trade agreement, it is highly probable that the
20% tariff will be abolished.

On the basis that the tariff is to be abolished, the directors have recalculated the payback
period and NPV and decided to buy the machine.

(c) Comment on the directors’ decision to buy the machine when the tariff is abolished.
Support your answers with relevant calculations. [6]

(d) Explain why the directors of W Limited use the payback period and NPV to
make their investment decisions. [4]
ON/17/32
3 Wong Ho owns a small factory. A machine has started to break down regularly and needs to be
replaced.

A replacement machine is expected to cost $55 000. It is expected to last 5 years and will
be depreciated using the straight-line method of depreciation. At the end of the period the
machine will be scrapped with no residual value.

The following information is available for the replacement machine:

 1 The selling price for each unit produced by the machine is expected to be $40 for years 1
and 2.
This is expected to increase by 25% for
year 3. There is no expected change for
year 4.
However, the selling price is expected to increase by a further 10% for year 5.

2 The cost of production for each unit produced is expected to be $20 for years 1 and 2. This
will increase by 25% for year 3 and then remain unchanged.

3 The present value for the net cash flows for the years 1 to 5 have been calculated as follows:

Year Discount factor 14% Present value $

1 0.877 3 683.40
2 0.769 6 536.50
3 0.675 9 483.75
4 0.592 14 977.60
5 0.519 21 019.50

REQUIRED

(a) Distinguish between the payback method of investment appraisal and the net present value
method. [4]

(a) Calculate the expected net present value for the replacement machine. [1]

(b) (i) Calculate the annual net cash flows for years 1 to 5 for the replacement machine. [5]

(ii) Calculate the payback period for the replacement machine. [2]

(ii) Calculate the number of units for each year that Wong Ho expects to produce with
the replacement machine. [8]

(c) Recommend whether or not Wong Ho should purchase the replacement machine. Justify
your answer. [5]
MJ/17/32
1 Tisha is considering buying a new machine for her factory. The machine will cost $125000. At
the end of Year 5 the machine will be sold for $65 000. The machine will be used to manufacture
one of Tisha’s existing products.

The following information is available:

1 The current annual sales volume of the existing product is 10 000 units. This will remain constant
over the 5-year period.

2 The selling price per unit is currently $12. Tisha plans to increase this to $13 per unit to help
cover her costs of the new machine.
3 The variable cost is currently $5 per unit. This is expected to fall to $3 per unit by using the
new machine.

4 The maintenance cost for the new machine will increase the annual fixed costs by $5000.

5 At the end of Year 1, Tisha will have to pay a one-off service fee of $1000.

REQUIRED

(a) Prepare one table which shows the change in cash flows for each of the Years 0 to 5
that arise as a result of the purchase of the machine. [5]

(b) Calculate the payback period for the machine. [2]

(c) State three reasons why payback may be a useful investment appraisal technique. [3]

Additional information

Tisha’s cost of capital is 10%. Discount factors are as follows:

Year Discount factor

0 1.000
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621

REQUIRED

(d) Calculate the Net Present Value (NPV) of buying the machine. [3]

Additional information

When using a discount factor of 20%, the machine had a negative NPV of $24 953.

REQUIRED

(e) Calculate the Internal Rate of Return (IRR) of the machine to three decimal places. [4]
Additional information

Tisha has recently discovered an alternative machine that would also be suitable for producing
the same product. This also has an expected life of 5 years. Tisha has a limited amount of capital
available and only needs one machine.

The following information has been calculated for the alternative

 machine: Capital outlay NPV IRR Payback

period
$ $ %
135 000 10 350 9.597 4 years 6 months

REQUIRED

(f) Recommend, with reasons, which machine Tisha should buy. [4]

(g) Discuss which factors, other than those you have considered in (f), Tisha should consider
when making her decision. [4]

Mar/17
4 The main cutting machine of LH Limited needs to be replaced. A replacement machine will cost
$260 000.

The current machine cuts 40 000 units a year. The number of units is expected to be reduced by
10% in year 1 due to the time taken to install the new machine. The number of units is expected
to increase to 42 000 units a year for both year 2 and year 3.

The following information is available.

1 The cost of capital is 14%.

2 It is assumed that revenues are received and costs are paid at the end of the year.

3 Each unit of production costs $26 to manufacture. This will increase to $27.80 in year 2 and
$28.50 in year 3.

4 Each unit is expected to sell for $30 in years 1 and 2, increasing by 5% in year 3.

5 It is assumed that all production is sold.

The following is an extract from the present value table for $1.

12% 14% 16% 18% 20%

Year 1 0.893 0.877 0.863 0.847 0.833
Year 2 0.797 0.769 0.743 0.718 0.694
Year 3 0.712 0.675 0.641 0.609 0.579

REQUIRED

(a) Distinguish between the net present value method of investment appraisal and the internal
rate of return. [4]

(b) Calculate the expected net present value for the replacement machine. [9]
(c) Calculate the expected internal rate of return of the replacement machine. [7]

(d) Analyse the benefits to LH Limited of purchasing the replacement machine. [5]