Investment Appraisal: Management Accounting Cambridge A Level Paper 3 last 2 questions: Payback period: Discounted Payback period: Accounting Rate of Return (ARR): Net Present Value (NPV): Internal Rate of Return (IRR) : Sensitivity Analysis: Cambridge A2 Standard Costing Past Papers

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Investment Appraisal
Sanjaya Jayasundara
B.Sc.(Finance) Sp.
University of Sri Jayewardenepura,
Investment Advisor,
International School Teacher

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Content
Investment Appraisal
Introduction.
The need for appraisal of capital projects.
Methods of appraisal.
NPV
ARR
Payback
Discounted payback
IRR
Past paper questions.
Model questions.
Summary
Syllabus according to Cambridge
2.4 Investment appraisal
Candidates should understand the process of investment appraisal.
Candidates should be able to:
• ascertain future net cash inflows and outflows arising from the project, including the treatment of
working
capital
• discuss the advantages and disadvantages of and apply the following capital investment appraisal
techniques:
– net present value (NPV)
– accounting rate of return (ARR)
– payback
– internal rate of return (IRR)
• make investment decisions and recommendations using supporting data
• evaluate, apply and discuss sensitivity analysis techniques in respect of the data prepared.

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Introduction
The need for appraisal of capital projects
Non-current assets are the wealth generators of a business. They are acquired with the
intention that they will generate profits. They are used in the business for more than one
financial time period. Non-current assets used in business include land, buildings, machinery,
plant, vehicles and office equipment.
Cash is a scarce resource, so some form of capital rationing is often required. Managers look
for good value when they purchase non-current assets. They plan carefully so that they get
the best value for the money they spend. They want to ensure that they earn maximum
benefits from their purchase
Capital investment appraisal techniques assist managers to help them in their choice of
appropriate investment opportunities. Care should be taken when making capital investment
decisions because:
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It is important that managers obtain as much detailed information as possible from all sources
that may be affected by the decision or that may affect the decision.
Capital projects are evaluated in terms of their potential earning power. If managers have to
replace a machine, they must decide which machine is most appropriate. There would be no
decision to be made if there was only one machine available: the only question would be
whether to buy or not to buy. However, there are usually alternatives from which to choose.
Machines might:
 have different prices
 have different qualities
 produce different quantities of goods
 produce goods of different quality
 have different life spans
 have different rates of obsolescence

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Methods of appraisal
There are five main methods of evaluating a capital project:
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All methods require predictions about future flows of either cash or profits. If predictions are
inaccurate, there could be serious problems for the business.
Managers often use more than one method of appraising a project that could affect the
business for many years.
Capital expenditure appraisal considers only additional revenues generated by a project and
additional expenditure that may be incurred by the project (expenditure may include
opportunity costs)
Net present value
The net present value (NPV) method of investment appraisal is calculated by taking the
present-day (discounted) value of all future net cash flows based on the business's cost of
capital and subtracting the initial cost of the investment.
A discount factor allows the value of future cash flows to be calculated in terms of their value
today. Managers evaluate a project by comparing the capital investment with the return that
the investment will bring in the future. In order to make a meaningful comparison between the
amount originally invested and the income generated in the future by that investment, the cash
flows need to be discounted so that they are the equivalent of cash flows now. The discount
factor used in net present value calculations is generally based on a weighted average cost of
capital available to the business. If you are given a number of discount factors to choose from,
select the one identified in the question as the cost of capital.
Cash flows are calculated from the revenue receipts less revenue expenditure (both
discounted, of course). Any project that yields a positive net present value should be
considered. Projects that yield negative net present values should be rejected on financial
grounds but may be considered on other grounds – for example, to keep a good customer
happy, to keep a skilled workforce within the business or perhaps to get further orders in the
future.
Examination questions generally require a mutually exclusive decision. When a selection has
to be made, the machinery that yields the highest net present value should be chosen. If all
the machines yield a negative net present value, none of them should be purchased.

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The advantages and disadvantages of using NPV
Advantages Disadvantages
Accounting rate of return (ARR)
The accounting rate of return (ARR) shows the return on the investment expressed as a
percentage of the average investment over the period.
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It seems improbable that the scrap value is added, but it works.
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Some projects 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 a
constant during the lifetime of the project. This means that there is no need to calculate the
average increase in working capital over this time.
Example
K Lts is considering an investment in a new project. The initial investment is $450 000. The
project requires an increase in working capital of $50 000. The average investment in the
project is $275 000.
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The advantages and disadvantages of using ARR
Advantages Disadvantages

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Payback
The payback period is the number of years required for the total cash flows to equal the initial
capital investment. Risk is an important factor when considering a project lasting a few years.
The sooner the capital expenditure is recouped, the better. If a machine has a scrap or trade-
in value, this is treated as an income in the year of disposal.
There are two types of examination question:
When profits are given in the question, any non-cash expenses such as depreciation must be
added to the profit to obtain the cash flows generated.
When annual cash inflows and outflows are shown separately, the outflows must be deducted
from the inflows to obtain the net cash flows.
The advantages and disadvantages of using payback
Advantages Disadvantages
Discounted payback
A major drawback of the payback method is that it does not take into account the time value
of money. However, we can take the current cost of capital into account by using a discounting
technique. This method is widely used in business as a method of selecting a machine or
project. At the end of a project's life, there may be some residual or scrap value. This should
be treated as income in the year in which it occurs.
Internal rate of return
A business must ensure that all projects undertaken are profitable in order to survive. Net
present value compares present-day values of future estimated cash inflows with present-day
cash outflows. However, such comparisons do not give managers the rate of return expected
on the investment.
If a business has a cost of capital of 12 %, the return on a project must cover the cost of capital
and yield a return that is greater than 12 %. Managers should be able to calculate the internal
rate of return (IRR) that any project under consideration is likely to yield. This expected yield

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the cost of the capital needed to fund the project. The process involved is to calculate the
present value of future cash flows which, when discounted, will equal zero.
Select two discounting rates: one that gives a positive net present value and another that gives
a negative net present value. The results are then used in the formula:
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If n is a negative value, it should be added to the value of p in the denominator as
mathematically the subtraction of a negative number will result in an increase in value
The internal rate of return can be calculated using two positive net present values. However,
the n part of the denominator should be deducted from the value of p.
Other considerations affecting
Social accounting issues
Investment decisions are often linked to social accounting issues. You might be asked to
consider how a decision arrived at by using any of the methods of appraisal might affect:
 the workforce-does the decision require more workers Does the decision mean that
some workers will lose their jobs
 the environment-cod the decision ham the environment or cause pollution?
 the locality is more space needed for expansion? is the local infrastructure capable of
supporting the new project?
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 the variability of revenues and
costs As you can imagine, in the real world sensitivity analysis can be much more complicated
because, in a dynamic business environment, it is likely that several variables could change
after the projected data were produced.
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Past Paper Questions
May/ June 2019 – Variant 31/33

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May/ June 2019 – Variant 32

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October/ November 2018 – Variant 31

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October/ November 2018 – Variant 33

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May/ June 2018 – Variant 32

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October/ November 2017 – Variant 32

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Now test yourself:
1 Explain the term 'capital rationing'
2 What is the difference between payback and discounted payback?
3 What is the payback period?
4 Identify two advantages of using payback as a method of investment appraisal.
5 Write down the formula for calculating accounting rate of return.
6 The initial investment in a project is $200 000 and the project requires additional working
capital of $40000. Calculate the average investment in the project.
7 A project yields a negative net present value. Identify two reasons why the managers of
a business might still go ahead with the scheme.
8 Write down the formula for calculating the internal rate of return on a project and identify
each component.
9 What does the internal rate of return represent?
All the best children…!
I wish you an enjoyable learning session...!
Sanjaya Jayasundara
Study well and be a good citizen to motherland Sri Lanka…!