The document discusses capital investment appraisal and evaluation methods. It aims to help readers understand investment decision making, time value of money, and four appraisal methods: payback period, accounting rate of return, net present value, and internal rate of return. An example compares two investment projects using these four methods, showing calculations and recommending the superior project based on the analyses. Advantages and disadvantages of each method are also summarized.

1. 1
Capital Investment
Appraisal
February 20th 2007

2. 2
Learning Objectives
• To understand the nature and importance of
investment decision-making in organisations
• To understand the concept of the time value of money
and how to calculate discount factors
• To identify the four investment appraisal methods and
how to evaluate investment proposals using these
methods ***
• To summarise advantages and disadvantages of these
methods both in theory and practice
• To make recommendations based on your analyses

3. 3
Recommended Readings
• Drury C (2001) Management Accounting for Business
Decisions 2nd Edition. Thomson. (Chapter 9)
• Gowthorpe C (2003) Business Accounting and Finance for
Non-Specialists. Thomson. (Chapter 21)
• McLaney E and Atrill P (2002) Accounting: An Introduction,
2nd edition. Prentice Hall: Europe. (Chapter 14)
• Cashmore C (2002) ‘Cut to the Chase’, CIMA Insider,
September.
• Dugdale D & Jones C (1991) ‘Discordant voices: accountants’
views of investment appraisal’Management Accounting,
November.
• Dugdale D (1992) ‘Is there a ‘correct’ method of investment
appraisal?’ Management Accounting, May.
• Scarlett B (2002) ‘That Sinking Feeling’, CIMA Insider,
September.

4. 4
Nature & Importance
• Nature
– Long-term rather than short-term
– Large investment rather than small investment
– More complicated from concerns of future cash
flows and/or time value of money
• Importance
– Large amounts of resources are often involved:
business strategy, profitability, and survive
– Difficult to “bail out”, once an investment made
– Close relationship with shareholders: wealth
maximisation

5. 5
Methods of Investment Appraisal
• Payback period
– The length of time: cash proceeds recover the initial capital
expenditure
• Accounting Rate of Return (ARR)
– A return measurement by using average annual profits
• Net Present Value (NPV)
– The present value of the net cash inflows less the initial
investment
• Internal Rate of Return (IRR)
– A return measurement takes into account the time value of
money

6. 6
Example
There are two optional projects for your
company to choose. However, you can only
choose one of them. The data for the initial
investments are in the following table. You are
required to calculate:
– Payback period
– ARR
– NPV
– IRR, and
– Your recommendation

7. 7
Data for the Projects
Project A Project B
Initial investment £100,000 £100,000
Cash inflows
Year 1 £45,000 £30,000
Year 2 £40,000 £30,000
Year 3 £35,000 £44,000
Year 4 £30,000 £46,000
• The depreciation is £20,000 per year.
• The residual value for both projects is the same, £20,000.

8. 8
Payback Period
• The Payback period = the point in time at which
cash flows turn from negative to positive
Project A Cash flows Cumulated cash flow
Year 0 -100,000 -100,000
Year 1 45,000 -55,000
Year 2 40,000 -15,000
Year 3 35,000 +20,000
Year 4 50,000 +70,000

9. 9
Payback Period
• Payback period (A) = change in cash flow
required to reach zero/total cash flow in year
=15,000/35,000 = 0.43 + 2 years = 2.43 years
• Payback period (B) = 40,000/44,000 = 0.91 +
2 years = 2.91 years
• Which project is the better one based on
payback period?

10. 10
Payback Period
Project B Cash flows Cumulated cash flow
Year 0 -100,000 -100,000
Year 1 30,000 -70,000
Year 2 30,000 -40,000
Year 3 44,000 +4,000
Year 4 66,000 +70,000

11. 11
ARR
Step 1: calculate annual profit
– Annual profit = net cash inflow - depreciation
Step 2: calculate average profit
– Average profit = total profits / number of years
Step 3: calculate average capital invested
– Average capital invested = (initial cost + residual
value) /2
Step 4: calculate ARR
– ARR = average profit/average capital invested x
100

12. 12
ARR
• Project A
– Average profit = (25,000 + 20,000 + 15,000 + 10,000)/4 =
70,000/4 = 17,500
– Average capital invested = (100,000+20,000) /2 = 60,000
– ARR = 17,500/60,000 x 100 = 29%
• Project B
– Average profit = (10,000 + 10,000 + 24,000 + 26,000)/4 =
17,500
– Average capital invested = (100,000 + 20,000)/2 = 60,000
– ARR = 17,500/60,000 x 100 = 29%
• Which project is the better one?

13. 13
The Time Value of Money
• What a difference between £1 now and £1 in a year’s
time?
• Factors change the value of money
– Interest cost
– Inflation
– Other risks to materialise the money
• For example: the annual interest rate is 10%, I lend
you £1 now and will get back after 1 year, how much
worth of that £1 in a year’s time?
– ? x (1+10%) = £1
– ? = £0.91
• 10% is called “cost of capital”; “?” is called the
“discount factor”

14. 14
NPV
• Assume that your company’s cost of capital is
10%
• Discount factors at 10% are:
– Year 1 0.909
– Year 2 0.826
– Year 3 0.751
– Year 4 0.683

15. 15
NPV
Project A Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 45,000 0.909 40,905
Year 2 40,000 0.826 33,040
Year 3 35,000 0.751 26,285
Year 4 50,000 0.683 34,150
NPV £34,380

16. 16
NPV
Project B Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 30,000 0.909 27,270
Year 2 30,000 0.826 24,780
Year 3 44,000 0.751 33,044
Year 4 66,000 0.683 45,078
NPV £30,172
• Which project is the better one based on NPV?

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IRR
• IRR: the discount rate when the net present value is zero
• Project A
– NPV = £34,380 when the discount rate is 10%
– NPV = ? When the discount rate is 25%
Project A Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 45,000 0.800 36,000
Year 2 40,000 0.640 25,600
Year 3 35,000 0.512 17,920
Year 4 50,000 0.410 20,500
NPV £20

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IRR
• Project B
– NPV = £30,172 when the discount rate is 10%
– NPV = ? When the discount rate is 25%
Project B Cash flow Discount factor Dis.d cash flow
Year 0 -100,000 1.00 (100,000)
Year 1 30,000 0.800 24,000
Year 2 30,000 0.640 19,200
Year 3 44,000 0.512 22,258
Year 4 66,000 0.410 27,060
NPV -7,482

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IRR
• Project A: IRR = 25%
• Project B
– Total change in NPV = 30,172 + 7,482 =
37,654
– Total change in discount rate = 25% -
10% = 15%
– IRR = 10% + 30,172/37,654 x15 = 22%
• Which project is better?

20. 20
Project Selection
Methods Single project Choice of projects A or B?
Payback less than the target
period
Shortest payback
period
A
ARR Above the target
rate
With the highest
ARR
N/A
NPV A positive NPV With the highest
NPV
A
IRR Higher than the
target rate (cost of
capital)
With the highest IRR A

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Advantages & Disadvantages
Method Advantages Disadvantages
Payback • simple and easy to understand and
use
• objective – using cash flows
• liquidity – commercially realistic
• cautious & risk averse – ignores later
cash flows
• ignores the time value
of money
• ignores cash flows
after the payback
period
ARR • simple and easy to understand and
use
• aids internal and external
comparisons
• looks at the whole life of the project
•A useful tool to measure divisional
managerial performance
• subjective – profit,
not cash flows
• ignores the time value
of money
• difficulty in use when
with same ARR and
various project sizes

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Advantages & Disadvantages
Method Advantages Disadvantages
NPV • takes account of the time value
of money
• concerns of shareholder wealth
• takes account of risk
• looks at the whole life of the
project
• difficult to be understood
by managers
• adverse effects on
accounting profits in the
short run
• how to choose discount
rate?
IRR • takes account of the time value
of money
• easy to be understood by
managers
• difficult to use in choosing
projects of varying sizes
• difficult to choose when
have the same IRR

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Tips of Exam Question
• How to use four methods based on
examples
• How to interpret and compare your
calculations
• How to select the best choice
• How to distinguish advantages and
disadvantages of four methods