Capital investment appraisal 2

Chapter 20: Capital investment appraisal


On completion of this topic you should be able to

 Explain the purpose of capital investment appraisal
 Calculate and interpret the payback period for an
investment project
 Calculate and interpret the accounting rate of return for
an investment project
 Describe the advantages and disadvantages of these two
techniques


Independent study

 Study Chapter 20
 Progress test and practice question(s) as set

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Capital investment appraisal


Whilst cost accounting provides information to management for making short-term decisions about revenue
expenditure, this topic provides information for long-term decisions about capital expenditure



Capital investment appraisal is ‘the evaluation of proposed investment projects, with a view to determining which is
likely to give the highest financial return’ (Collis and Hussey, 2007, p. 335)

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Characteristics of capital investment decisions
Time span

2+ years

Nature

Strategic (eg whether to build or buy a
new factory)

Level of
expenditure

Medium – high

External factors

Very important (eg interest rates and
rates of inflation)

Typical techniques

Payback period
Accounting rate of return
Discounted cash flow techniques

Adapted from Jones, 2002, p. 452
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The capital investment decision


Capital investment appraisal techniques are used for making decisions concerning the investment of large amount of
capital in a long-term project



Management needs to know that the investment project will be worthwhile

 Either it will generate more cash than the initial amount
invested or it will provide cost savings over the life of the
project that will exceed the capital invested


At the very least, management needs to know that the business will get its money back

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Exercise 1
Capital investment decisions

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Exercise 1
Capital investment decisions

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Solution 1
Capital investment decisions

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Solution 1
Capital investment decisions (continued)


Machine 3 looks best as the net cash inflow is £25,000 (£5,000 higher than for Machines 1 or 2)

 But waiting until Year 3 to get most of the cash increases
risk – the annual net cash flows are estimates and the
further ahead the forecast, the more unreliable it is


Machines 1 & 2 both give the same total net cash inflow, so either is worth considering, but Machine 1 is the more
favourable because the cash comes in sooner



It’s difficult to decide - we need a technique to help

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Capital investment appraisal techniques
Capital investment
appraisal

Payback period

Accounting
rate of return

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Discounted
cash flow

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Payback period


The payback period is ‘the time required for the predicted net cash flows to equal the capital invested in a proposed
investment project’ (Collis and Hussey, 2007, p. 338)

 The project that repays the capital invested in the
shortest time is considered to be the most favourable


The following estimates are needed

 The amount of capital required
 The amount and timing of the net cash flows
generated by the investment project

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Conventions and assumptions


Year 0 is a conventional way of referring to the start of Year 1



Year 1, 2, 3 etc means the end of Year 1, 2, 3, etc



It is assumed that the cash outflow from the initial investment of capital will take place at Year 0



It is assumed that the net cash inflows during a year will be received evenly throughout the year



Negative cash flows are shown in brackets

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Exercise 2
Mr Cornetto’s ice cream van project

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Solution 2
Mr Cornetto’s ice cream van project


The payback period for the ice cream van project is
Initial capital investment = £12,000
Annual net cash flow

£4,000
= 3 years exactly



We have been able to use this formula because Mr Cornetto expects the net cash flows to be the same every year over
the life of the project, but we can’t use it if the projected annual net cash flows are expected to differ…

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Exercise 3
Mr Cornetto’s pasta van project


An alternative project is to invest in a pasta van that will also cost £12,000 and last 4 years



Because take-away pasta may take some time to catch on, the annual net cash flows are expected to be £2,000 in year
1, rising to £3,000 in year 2, £5,000 in year 3 and £6,000 in year 4



Required

 Using the pro forma, calculate the payback period in
years and months for the pasta van project

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Pro forma
Mr Cornetto’s pasta van project

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Solution 3
Mr Cornetto’s pasta van project

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Advantages and disadvantages of payback period




Advantages
 Simple to calculate and easy to understand
 Useful for risky projects where prediction of future cash
flows beyond first few years is difficult (eg IT)
 Useful if short-term cash flows are more important to
survival of the business than long-term cash flows
 Useful if borrowing or gearing is a concern
Disadvantages
 Does not take account of the time value of money (cash
now is worth more than cash received later)
 Ignores cash flows after the payback period
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Accounting rate of return


The payback period focuses on cash flows, but the accounting rate of return (ARR) focuses on profit



The accounting rate of return ‘measures the predicted average profit before interest and tax as a percentage of the
average capital employed in a proposed investment project’ (Collis and Hussey, 2007, p. 342)



When comparing ratios from different sources, care must be taken that the same definition of profit and capital
employed have been used

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Exercise 4
Fresh Farm Foods ARR

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Pro forma
Fresh Farm Foods ARR

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Solution 4

Fresh Farm Foods ARR

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Conclusions
Advantages and disadvantages of ARR




Advantages
 Simple to calculate and easy to understand
 Takes account of the entire life of the project
 Compatible with the performance ratio, ROCE
Disadvantages
 Does not take account of the time value of money
 Ignores the timing of profits (eg benefit of earning a larger
proportion of profit in early years) and timing of cash flows
 No standard definition of terms (limits comparisons)
 Averages can be misleading (actual figure may be ↑ or ↓)
 No guidance on what is an acceptable rate of return
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