Chapter 4 Capital Budgeting and Basic Investment Appraisal Techniques

Premium Course Notes [Session 1 and 2]
Chapter 4 Capital Budgeting and Basic Investment Appraisal

Techniques
SYLLABUS
1. Calculate payback period and discuss the usefulness of payback as an investment

appraisal method.
2. Calculate discounted payback and discuss its usefulness as an investment appraisal
method.
3. Calculate return on capital employed (accounting rate of return) and discuss its
usefulness as an investment appraisal method.
4. Calculate net present value and discuss its usefulness as an investment appraisal method.
5. Calculate internal rate of return and discuss its usefulness as an investment appraisal
method.
6. Discuss the superiority of discounted cash flow (DCF) methods over non-DCF methods.
7. Discuss the relative merits of NPV and IRR.
8. Identify and calculate relevant cash flows for investment projects.
C a p ital
B u d g e tin g
B udget A p p ra is a l R e le v a nt
P ro c e ss T e c h n iq u es C ash
F lo w s
Payback A RR N PV IR R
M e th od
D isc o u n ted
Payback
M e th od
Prepared by Patrick Lui P. 64 Copyright @ Kaplan Financial 2015

1. Capital Investment
1.1 When a business spends money on new non-current assets it is known as capital
investment or capital expenditure. Spending may be for:
(a) Maintenance – spending to replace worn-out or obsolete assets, or to improve
safety and security of existing non-current assets.
(b) Profitability – spending to achieve cost savings, quality improvements,
improvements to productivity, etc.
(c) Expansion – spending to grow the business, make new products, open new
outlets, invest in research and development (R&D), etc.
(d) Indirect purposes – spending which is necessary for the smooth running of the
business but not directly related to operations, e.g. renovating office buildings.
1.2 A capital budget:
(a) is a program of capital expenditure covering several years
(b) includes authorized future projects and projects currently under consideration.
1.3 The capital budgeting process consists of a number of stages:
(Jun 09)
Stages Explanation
Identify investment  Arise from analysis of strategic choice, business environment,
opportunities R&D or legal environment, etc.
 Key requirement is to achieve the organizational objectives.
Screen investment  Select those proposals with best strategic fit and the most
proposals appropriate use of economic resources.
Analyse and evaluate  Analyse and evaluate which proposal(s) offer the most
investment proposals attractive opportunities to achieve company objectives, e.g.
increase shareholder wealth.
 Investment appraisal plays a key role here, e.g. choose highest
NPV among different proposals.
Approve investment  Pass to relevant level of authority for approval.
proposals  Large proposals approve by board of directors, smaller
proposals approve by divisional level.
Implementation  Responsibility for the project is assigned to a project manager
or other responsible person.
 Resources will be available and specific target should be set.
Monitoring  Progress must be monitored to check whether there are any
big variances and unforeseen events.
Post-completion audit  To facilitate organizational learning and to improve future

investment decisions.
1.4 The process of appraising the potential projects (stage 3 above) is known as
investment appraisal. This appraisal has the following features:
(a) assessment of the level of expected returns earned for the level of expenditure
made
(b) estimates of future costs and benefits over the project’s life.
2. Investment Appraisal Techniques
2.1 Payback method
2.1.1 The payback period is the time a project will take to pay back the money spent on it.
It is based on expected cash flows and provides a measure of liquidity.
2.1.2 Decision rule:
(a) only select projects which pay back within the specified time period
(b) choose between options on the basis of the fastest payback
(c) provides a measure of liquidity.
2.1.3 EXAMPLE 1
A project is expected to have the following cash flows:
Year Cash flow ($000)

0 (2,000)
1 500
2 500
3 400
4 600
5 300
6 200
What is the expected payback period?

Solution:
Year Cash flow Cumulative cash flow

($000) ($000)
0 (2,000) (2,000)
1 500 (1,500)
2 500 (1,000)
3 400 (600)
4 600 0
5 300 300
6 200 500
The payback period is exactly 4 years.
In the table above a column is added for cumulative cash flows for the project to
date. Figures in brackets are negative cash flows.
Each year’s cumulative figure is simply the cumulative figure at the start of the year
plus the figure for the current year. The cumulative figure each year is therefore the
expected position as at the end of that year.
2.1.4 Test your understanding 1

A project is expected to have the following cash flows:

0 (1,900)
1 300
2 500
3 600
4 800
5 500
What is the expected payback period?

Solution:
2.1.5 Advantages and disadvantages of payback
Advantages Disadvantages
 It is simple  It ignores returns after the payback
 It is useful in certain situations: period
 Rapidly changing technology  It ignores time value of money
 Improving investment  It is subjective – no definitive
conditions investment signal
 It favours quick return:  It ignores project profitability.
 Helps company growth
 Minimizes risk
 Maximizes liquidity
 It uses cash flows, not accounting
profit.

2.2 Discounted payback

(Jun 09)
2.2.1 With discounted payback the future cash flows are discounted prior to calculating the
payback period. This is an improvement on the simple payback method in that it takes
into account the time value of money.
2.2.2 EXAMPLE 2
A project is expected to have the following cash flows. The discount rate is 10%.

0 (2,000)
1 600
2 500
3 600
4 600
5 300
6 200
What is the discounted payback period?
Solution:
Year Cash flow Discounted Cumulative cash

($000) Cash flow @10% flow
($000) ($000)
0 (2,000) (2,000) (2,000)
1 600 545 (1,455)
2 500 413 (1,042)
3 600 451 (591)
4 600 410 (181)
5 300 186 5
6 200 113 118
The payback period is about 5 years.

2.3 Accounting rate of return (ARR)

(Pilot, Jun 09, Dec 12)
2.3.1 This is also known as return on capital employed (ROCE) or return on investment
(ROI).
2.3.2 Decision rule
If the expected ARR for the investment is greater than the target or hurdle rate
then the project should be accepted.
2.3.3 This ratio can be calculated in a number of ways. There are three alternative versions
of ARR can be used. It should be noted that these are just three of all the possible ways
of calculating ARR, there are many more.
2.3.4 EXAMPLE 3

(5,000  5,000  5,000) / 3

ARR =  100% = 33.33%
15,000
If we now make the example slightly more sophisticated by assuming that the
machinery has a scrap value of $8,000 at the end of year 3, then the average capital
invested figure becomes:
(30,000 + 8,000) ÷ 2 = 19,000
2.3.5 Test your understanding 2

Arrow wants to buy a new item of equipment which will be used to provide a
service to customers of the company. Two models of equipment are available, one
with a slightly higher capacity and greater reliability than the other. The expected
costs and profits of each item are as follows.
Equipment Item X Equipment Item Y

Capital cost $80,000 $150,000
Life 5 years 5 years
Profits before depreciation
Year 1 50,000 50,000
Year 2 50,000 50,000
Year 3 30,000 60,000
Year 4 20,000 60,000
Year 5 10,000 60,000
Disposal value 0 0

ROCE is measured as the average annual profit after depreciation, divided by the
average net book value of the asset. You are required to decide which item of
equipment should be selected, if any, if the company’s target ROCE is 30%.
Solution:
2.3.6 Advantages and disadvantages of ARR
 It is a quick and simple calculation  It is based on accounting profit and
 It involves the familiar concept of a not cash flows. Accounting profits
percentage return are subject to a number of different
 It looks at the entire project life accounting treatments.
 It is a relative measure rather than
an absolute measure and hence takes
no account of the size of the
investment
 Like the payback method, it ignores
the time value of money.

2.4 Net present value (NPV)
2.4.1 To appraise the overall impact of a project using discounted cash flow (DCF)
techniques involves discounting all the relevant cash flows associated with the project
back to their PV.
2.4.2 If we treat outflows of the project as negative and inflows as positive, the NPV of the
project is the sum of the PVs of all flows that arise as a result of doing the project.
2.4.3 Decision Rule
The NPV represents the surplus funds (after funding the investment) earned on the
project, therefore:
 If the NPV > 0 – the project is financially viable, i.e. accepted.

 If the NPV = 0 – the project breaks even.
 If the NPV < 0 – the project is not financially viable, i.e. rejected.
If the company has two or more mutually exclusive projects under consideration it
should choose the one with the highest NPV.
The NPV gives the impact of the project on shareholder wealth.
2.4.4 NPV and shareholder wealth (Jun 08)
(a) All acceptable investment project should have positive NPV.

(b) The market value of the company, theoretically at least, increases by the
amount of the NPV.
(c) The share price of the company should theoretically increase as well.
(d) Objective of maximizing the wealth of shareholders is usually substituted
by the objective of maximizing the share price of a company.

2.4.5 EXAMPLE 4
An organization is considering a capital investment in the new equipment. The
estimated cash flows are as follows.
Year Cash flow

0 (240,000)
1 80,000
2 120,000
3 70,000
4 40,000
5 20,000
The company’s cost of capital is 9%.
Calculate the NPV of the project to assess whether it should be undertaken.
Solution:
Year Cash flow ($) Discounted factor PV ($)
at 9%
0 (240,000) 1.000 (240,000)
1 80,000 0.917 73,360
2 120,000 0.842 101,040
3 70,000 0.772 54,040
4 40,000 0.708 28,320
5 20,000 0.650 13,000
NPV = 29,760
The PV of cash inflows exceeds the PV of cash outflows by $29,760, which means
that the project will earn a DCF return in excess of 9%, i.e. it will earn a surplus of
$29,760 after paying the cost of financing. It should therefore be undertaken.

2.4.6 Advantages and disadvantages of NPV
 Considers the time value of money  It is difficult to explain to managers
 Is an absolute measure of return  It requires knowledge of the cost of
 Is based on cash flows not profits capital
 Considers the whole life of the  It is relatively complex.
project
 Should lead to maximization of
shareholder wealth.
 Can accommodate changes in
discount rate
 Has a sensible re-investment
assumption
 Can accommodate non-conventional
cash flows
2.4.7 Why NPV is superior to other methods?

(a) NPV considers cash flows
(b) NPV considers the whole life or an investment project
(c) NPV considers the time value of money
(d) NPV is an absolute measure of return
(e) NPV directly links to the objective of maximizing shareholders’ wealth
(f) NPV offers correct investment advice
(g) NPV can accommodate changes in the discount rate
(h) NPV has a sensible re-investment assumption
(i) NPV can accommodate non-conventional cash flows

2.5 Internal rate of return (IRR)

(Dec 07, Jun 08, Jun 09, Dec 11)
2.5.1 The IRR is the rate of return which equates the present value of future cash flows with
the outlay:
Outlays = Future cash flows discounted at rate r
Thus:
CF1 CF2 CF3 CFn
CF0     ... 
1  r (1  r ) 2
(1  r ) 3
(1  r ) n
CF1 CF2 CF3 CFn
CF0     ...  0
1  r (1  r ) 2
(1  r ) 3
(1  r ) n
The IRR (r) is the discount rate at which the NPV is zero.
2.5.2 Decision Rule
Projects should be accepted if their IRR is greater than the cost of capital.
2.5.3 Steps in calculating the IRR using linear interpolation

1. Calculate two NPVs for the project at two different costs of capital. One NPV
must be negative, and another one is positive.
2. Using the following formula to find the IRR:
NL
IRR = L +  ( H  L)
NL  NH
where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest
The diagram below shows the IRR as estimated by the formula.

2.5.4 EXAMPLE 5
A potential project’s predicted cash flows give a NPV of $50,000 at a discount rate
of 10% and – $10,000 at a rate of 15%.
Calculate the IRR.
Solution:
50,000
IRR = 10% +  (15%  10%) = 14.17%
50,000  10,000
2.5.5 Test your understanding 3 – IRR with even cash flows

Find the IRR of a project with an initial investment of $1.5 million and three years
of inflows of $700,000 starting in one year.
Solution:

2.5.6 Test your understanding 4 – IRR with perpetual cash flows

Find the IRR of an investment that costs $20,000 and generates $1,600 for an
indefinitely long period.
Solution:
2.5.7 Advantages and disadvantages of IRR

(Pilot, Jun 10)
 Considers the time value of money.  It is not a measure of absolute
 Is a percentage and therefore easily profitability.
understood.  It is fairly complicated to calculate.
 Uses cash flows not profits.  Non-conventional cash flows may
 Considers the whole life of the give rise to multiple IRRs.
project.  Can offer conflicting advice
 Means a firm selecting projects where between IRR and NPV in the
the IRR exceeds the cost of capital evaluation of mutually exclusive
should increase shareholders’ projects.
wealth.  Assume cash inflows being
reinvested at the IRR rate, this is
unrealistic when IRR is high.
2.5.8 EXAMPLE 6 – Non-conventional cash flows

The following project has non-conventional cash flows:
Year $000
0 (1,900)
1 4,590
2 (2,735)

Project X would have two IRRs as show in the following diagram.
The NPV rule suggests that the project is acceptable between costs of capital of 7%
and 35%.
Suppose that the required rate on project X is 10% and that the IRR of 7% is used in
deciding whether to accept or reject the project. The project would be rejected since
it appears that it can only yield 7%.
The diagram shows, however, that between rates of 7% and 35% the project should
be accepted. Using the IRR of 35% would produce the correct decision to accept the
project. Lack of knowledge of multiple IRRs could therefore lead to serious errors in
the decision of whether to accept or reject a project.
In general, if the sign of the net cash flow changes in successive periods, the
calculations may produce as many IRRs as there are sign changes. IRR should not
normally be used when there are non-conventional cash flows.
2.5.9 EXAMPLE 7 –Mutually exclusive projects

Consider two projects A and B. The discounted cash flow (DCF) from A is more
sensitive to the discount rate and falls more sharply than the DCF from B as the
discount rate is increased. This is illustrated below.

Hence, at low rates of discount NPV A > NPV B, and project A would be preferred
to project B. However, IRR A < IRR B, which indicates that project B would be
preferred to project A.

3. Relevant Cash Flows
3.1 The following principles should be applied when identifying costs that are relevant to
a period.
Relevant costs Explanation

Future costs  Future cost arises as a direct consequence of a
decision.
 Sunk costs should not be included because it is past
and so irrelevant to any decision.
Cash flows  Future costs which are in the form of cash should be
included.
 So depreciation should be ignored because it is not
cash spending.
Incremental costs  Increase in costs results from making a particular
decision.
Opportunity costs  It is the value of a benefit foregone as a result of
choosing a particular course of action.
3.2 We should ignore the following costs:

(a) sunk costs
(b) committed costs – they are future cash flow but will be incurred anyway,
regardless of what decision will be taken.
(c) non-cash items
(d) allocated costs
(e) interest costs – they have already been included in the discount rate, if
counted, it will be double counted.
3.3 On the other hand, in capital investment appraisal it is more appropriate to evaluate
future cash flows than accounting profits, because:
(a) profits cannot be spent
(b) profits are subjective
(c) cash is required to pay dividends.

Multiple Choice Questions
I. Payback period and NPV
1. Steeperton plc is committed to maximising the wealth of its shareholders.
Given this objective, which one of the following methods of investment appraisal is
most appropriate for the company to use?
A Net present value

B Internal rate of return
C Payback period
D Accounting rate of return
2. Virunga Co uses the net present value (NPV) method, the internal rate of return (IRR)
method and discounted payback period (DPP) to appraise its new investment
opportunities. An investment opportunity was recently appraised using each of these
methods and was estimated to provide a positive NPV of $10·5 million, an IRR of 15%
and a DPP of three years. Following this appraisal, it was discovered that the cost of
capital of the company was lower than had been previously estimated.
What would be the effect (increase/decrease/no effect) on the figures provided by each
investment appraisal method of taking account of the lower cost of capital?
NPV IRR DPP

A Increase Increase Decrease
B Increase No effect Decrease
C Decrease No effect Increase
D No effect Decrease No effect
3. Which ONE of the following methods of investment appraisal is consistent with the
objective of shareholder wealth maximisation?
A Net present value

B Internal rate of return
C Accounting rate of return
D Payback period

4. A company is considering a project for investment which will cost $70,000 now and
another $10,000 in year five. The company has a cost of capital of 8%. The project has
the following discounted cash flows:
Year Discounted cash flows

$
1 23,148
2 30,007
3 19,846
4 14,701
What is its discounted payback period in years and months (to the nearest month)?
A 2 years, 10 months
B 3 years, 1 month
C 3 years, 3 months
D 3 years, 6 months
5. The payback period is the number of years that it takes a business to recover its original
investment from net returns, calculated
A before both depreciation and taxation

B before deprecation but after taxation
C after deprecation but before taxation
D after both depreciation and taxation
6. Which of the following is an advantage of the payback method of investment appraisal?
A It takes account of the timing of the cash flows within the payback period
B It uses accounting profits rather than cash flows
C It takes account of the cash flows after the end of the payback period and therefore
the total project return
D It can be used as a screening device as a first stage in eliminating obviously
inappropriate projects prior to more detailed evaluation

II. Accounting rate of return
7. The following statements about the drawbacks of the accounting rate of return (ARR)
were made at a recent meeting:
1. ARR is based on accounting profits and not cash flows, and can change because
profits are subject to different possible treatments.
2. ARR only considers cash flows within a given time period and ignores cash flows
after that time period.
3. With the ARR method $1 receivable today is worth the same as a $1 in five years.
Therefore it ignores the time value of money.
Which combination of the above statements is true?
A 1, 2 and 3
B 1 and 2 only
C 1 and 3 only
D 2 and 3 only
8. A company purchases a non-current asset with a useful economic life of ten years for
$1.25 million. It is expected to generate cash flows over the ten year period of $250,000
per annum before depreciation. The company charges depreciation over the life of the
asset on a straight-line basis. At the end of the period it will be sold for $250,000.
What is the accounting rate of return for the investment (based on average profits and
average investment)?
A 20%
B 15%
C 33%
D 25%

9. Consider the following statements concerning investment appraisal methods.
1. The accounting rate of return method ignores the time value of money.
2. The internal rate of return method ignores the relative size of investments when
ranking investment proposals.
3. The net present value method ignores the required returns from investors when
ranking investment proposals.
4. The payback method ignores non-operating cash flows relating to an investment
proposal when calculating the payback period.
Which two of the above statements are correct?
A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4
10. Acorn plc is considering purchasing a new machine at a cost of $110,400 that will be
operated for four years, after which time it will be sold for an estimated $9,600. Acorn
uses a straightline policy for depreciation.
Forecast operating profits to be generated by the machine are as follows:
Year $
1 39,600
2 19,600
3 22,400
4 32,400
Select the payback period (PP) and the average return on capital employed (ROCE),
calculated as average annual profits divided by the average investment.
A PP: 2.02 years ROCE: 47.5%

B PP: 3.89 years ROCE: 25.8%
C PP: 3.89 years ROCE: 47.5%
D PP: 2.02 years ROCE: 25.8%

III. Internal rate of return
11. The net present value of a proposed project is $20,000 at a discount rate of 5% and
($28,000) at 10%.
What is the internal rate of return of the project, to the nearest one decimal place?
A 7.1%
B 7.5%
C 2.3%
D 8.6%
12. The net present value of a proposed project is a positive $56,000 at a discount rate of
10% and a negative $28,000 at 20%.
What is the internal rate of return of the project, to the nearest whole percentage?
A 17%
B 13%
C 30%
D 8%
13. Statement 1: Simple payback period takes into account the time value of money and
uses cash flows rather than profits.
Statement 2: Internal rate of return takes into account the time value of money and uses
cash flows rather than profits.
Which of the above statements is/are true?
A Statement 1 only
B Statement 2 only
C Both statement 1 and statement 2
D Neither statement 1 nor statement 2

14. Sonoran Co recently evaluated an investment project that had an initial cash outlay
followed by positive annual net cash flows over its life. The company employed the
internal rate of return (IRR) and discounted payback period (DPP) methods for the
investment appraisal. Later, it was discovered that the cost of capital figure used was
incorrect and that the correct figure was higher.
What will be the effect on the IRR and DPP of correcting for this error?
Effect on
IRR DPP
A No change No change
B Increase Increase
C Decrease Decrease
D No change Increase
15. Maia plc is considering investing in two competing projects: Delta and Gamma. Delta
has a net present value (NPV) of $16,500 and an internal rate of return (IRR) of 17%.
Details of the estimated cash flows of Gamma are as follows:
$000
Cash flows
Year 0 (200)
Year 1 120
Year 2 60
Year 3 80
The business has a cost of capital of 10%.
Which one of the following combinations is correct concerning the NPV and IRR of the
two projects?
Delta Gamma
A Higher NPV Higher IRR
B Higher NPV Lower IRR
C Lower NPV Higher IRR
D Lower NPV Lower IRR

16. Calcite Ltd used the NPV and IRR methods of investment appraisal to evaluate a project
that has an initial cash outlay followed by annual net cash inflows over its life. After the
evaluation had been undertaken, it was discovered that the cost of capital had been
incorrectly calculated and that the correct cost of capital figure was in fact higher than
that used.
What will be the effect on the NPV and IRR figures of correcting for this error?
Effect on
NPV IRR
A Decrease Decrease
B Decrease No change
C Increase Increase
D Increase No change
17. A business evaluates an investment project that has an initial outlay followed by annual
net cash inflows of $10 million throughout its infinite life. The evaluation of the inflows
produced a present value of $50 million and a profitability (present value) index of 2·0.
What is the internal rate of return and initial outlay of this project?
What is the internal rate of return and initial outlay of this project?
IRR (%) Initial outlay ($m)

A 20 25
B 20 100
C 40 25
D 10 100
18. Romer plc used the IRR and discounted payback methods of investment appraisal to
evaluate an investment proposal that has an initial cash outlay followed by annual net
cash inflows over its life. Following this evaluation, it was found that the cost of capital
figure used was incorrect and that the correct figure was lower.
What will be the effect on the IRR and discounted payback period of correcting for this
error?

Effect on
IRR figure Discounted payback period
A No change No change
B Increase Increase
C Decrease Decrease
D No change Decrease
19. ABC Co wishes to undertake a project requiring an investment of $732,000 which will
generate equal annual inflows of $146,400 in perpetuity.
If the first inflow from the investment is a year after the initial investment, what is the
IRR of the project?
A 20%
B 25%
C 400%
D 500%
20. Which of the following are advantages of the internal rate of return (IRR) approach to
investment appraisal?
1 Clear decision rule

2 Takes into account the time value of money
3 Assumes funds are re-invested at the IRR
4 Considers the whole project
A 1, 2 and 4 only
B 2, 3 and 4 only
C 2 and 4 only
D 1, 2 and 3 only

IV. Relevant cash flows
21. An accountant is paid $30,000 per month and spends two weeks working on appraising
project Alpha.
Why should the accountant NOT charge half his salary to the project?
A Because his salary is sunk

B Because his salary is not incremental
C Because his salary is not a cash flow
D Because his salary is an opportunity cost
22. Elara plc is considering an investment in a new process. The new process will require an
increase in stocks of $30,000 during the first year. There will also be an increase in
debtors outstanding of $40,000 and an increase of creditors outstanding of $35,000
during the first year. The new process will use machinery that was purchased
immediately before the first year of operations at a cost of $300,000. The machinery is
depreciated using the straight-line method and has an estimated life of five years and no
residual value. During the first year, the net operating profit before depreciation from the
new process is expected to be $180,000. The business uses the net present value method
when evaluating investment proposals.
When undertaking the net present value calculations, what would be the estimated net
cash flow during the first year of the project? (Ignore taxation)
A $85,000
B $215,000
C $145,000
D $155,000

23. Merton plc is currently considering a new investment project and uses the NPV method
for appraisal purposes.
Which one of the following items relating to the project should be included in the NPV
appraisal?
A The payment of $30,000 for a market research report, which was commissioned
last month and will be paid for next month.
B The apportionment of fixed costs of $10,000 per year over the life of the project to
represent a fair share of the total fixed costs of the factory.
C An offer of $100,000 to acquire raw materials that were due to be sold but which
will be used in the project if it goes ahead.
D A depreciation charge of $10,000 per year over the life of the project for
machinery that will be used in the project.
24. LW Co has a half empty factory on which it pays $5,000 pa. If it takes on a new project,
it will have to move to a new bigger factory costing $17,000 pa and it could rent the old
factory out for $3,000 pa until the end of the current lease.
What is the rental cost to be included in the project appraisal?
A $14,000
B $17,000
C $9,000
D $19,000
25. Which of the following is an example of a relevant cash flow to be considered in an

investment appraisal process for a new project?
A Market research expenditure already incurred

B Additional tax that will be paid on extra profits generated
C Centrally allocated overheads that are not a consequence of undertaking the project
D Tax allowable depreciation

26. Garfield plc is considering whether to enter into a new project. The machinery which
would be used to produce the goods for the contract was purchased seven years ago at a
cost of $80,000, with an estimated life of ten years. Depreciation is on a straightline
basis. The machinery has been idle for some time, and if not used on this contract would
be scrapped and sold immediately for an estimated $5,000. After use on this contract the
machinery would have no value, and would have to be dismantled and disposed of at a
cost of $1,500.
Ignoring the time value of money, what is the relevant cost of the machine to the new
contract?
A $3,500
B $5,000
C $6,500
D $24,500
27. In decision making, costs which need to be considered are said to be relevant costs.
Which of the following are characteristics associated with relevant costs?
1 Future costs
2 Unavoidable costs
3 Incremental costs
4 Cash costs
A 1 and 3 only
B 1 and 2 only
C 1,3 and 4 only
D All of them

Examination Style Questions
Question 1 – NPV
Silly Filly Ltd is a recently established company specialising in the manufacture of talking toy
horses for children. The Silly Filly range currently comprises three key products – all of
which are toy horses – plus approximately thirty accessories to complement the range, from
stables to grooming kits.
The Silly Filly range has been such a success in the last year that the management is
considering producing an animated film to accompany the range. This is in accordance with
the company’s long-term expansion plans, culminating in a stock exchange flotation in three
year’s time.
The film will take one year to make. In the year following that, sales of the film will
commence.
You, an accounting technician for the company, have been asked to assist in appraising the
project to decide whether it should go ahead. The following information is relevant to your
calculations.
(i) Market research has already been carried out at a cost of £1·2 million.
(ii) The services of a company specialising in animation will be required at a total cost of
£520,000. 50% of these costs will be paid immediately with the remainder being paid in
one year’s time.
(iii) Two producers will be employed throughout the first year of the project. They will each
be paid salaries of £120,000.
(iv) Other production costs during the year are expected to be £650,000.
(v) A film director will be employed immediately on a one-year contract at a cost of
£160,000.
(vi) The animated film is expected to generate revenues of £1·2 million in the first year of
sales, £2·2 million in the second year, and £1·6 million in the third year.
(vii) The two producers and the director will each be paid royalties from the film. These will
be paid at the rate of 1·5% of gross revenues for EACH of the producers and 2% for the
director. They will always be payable one year in arrears.
(viii) Specialist equipment will need to be purchased immediately for the film production.
This will cost £2·3 million but can be sold at the end of the year for £1·7 million.
(ix) A loan for £1 million will be taken out to assist in financing the project. The loan will be
repayable in two year’s time, with interest of 8% per annum being payable for its
duration.
(x) The company’s cost of capital is 10% per annum.
(xi) Assume that all cash flows occur at the end of each year, unless otherwise stated.
Required:
(a) Calculate the project’s net present value (NPV) at the company’s cost of capital.
Conclude as to whether the company should proceed with the project, giving a reason
for your conclusion. (10 marks)
Question 2 – NPV and IRR

Paradise Ltd is a large company specialising in luxury holidays for the rich and famous. It has
recently purchased an uninhabited island, close to the popular resort of Luca, at a cost of £2
million. The company has already spent £1·5 million on preparing the land for construction
work. Over the next year it plans to develop the island extensively, with the aim of making it
one of the most exclusive holiday locations in the region.
An offer has just been made to buy the land for £5 million. Paradise Ltd has therefore decided
to reappraise the project in order to decide whether they should still proceed with the project,
or should instead accept the offer. If they decide to accept the offer, the sale will take place
immediately, incurring legal fees of £20,000. If they reject the offer, development will
continue and accommodation will be available for rent in one year’s time.
The company’s project accountant has provided estimates of costs and revenues for the next
five years as set out below.
1. Total construction costs for the seven hotels on the island are £37 million. Of the total,
£2 million has already been spent in the form of down payments to several construction
firms. These down payments are irrecoverable.
2. Total construction costs for the forty luxury self-catering lodges that will be attached to
the hotels are £24 million. A down payment of £4 million is required immediately.
3. The cost of furnishing the hotels and lodges is estimated at £3·2 million.
4. Each lodge will have its own private swimming pool. The cost of each pool is expected
to be £12,000.
5. Six restaurants will be built on the island at a cost of £15 million. Paradise Ltd has
already had to commit to £3 million of these costs in order to attract the chefs it
requires. Although these monies have not yet been paid over, Paradise Ltd is
contractually bound to pay them, irrespective of whether the project now proceeds.
6. A small parade of shops will be developed at a cost of £4 million.

7. Annual cash overheads are expected to be £2 million for the hotels. Revenues for the
hotels are estimated at £13 million per annum.
8. Maintenance costs for each of the lodges will be £7,000 per annum, compared to rental
income of £390,000 per annum, per lodge.
9. Depreciation totalling £1·5 million per annum will be charged in Paradise Ltd’s
accounts for the hotels, lodges, restaurants and shops.
10. The restaurant and shops are expected to generate net income of £4·73 million per
annum, in total.
11. Interest on money borrowed to finance the project will be £2·5 million per annum.
All the set-up costs will occur within the next year, before the resort is open. The annual
revenues and overheads relate to the four years following this. Assume that all cash flows
occur at the end of each year, unless otherwise stated, and that there are no terminal values to
consider at the end of the four years.
The company’s cost of capital is 10% per annum.
Required:
(a) Explain the main principles used to differentiate between relevant and irrelevant costs
for investment appraisal, using the information in the question to illustrate your points.
(8 marks)
(b) Calculate the project’s net present value (NPV) at the company’s required rate of return.
Conclude as to whether the company should accept the offer or continue with the
project, giving a reason for your conclusion. (16 marks)
(c) Calculate the internal rate of return (IRR) for the project, using the discount rates in the
tables provided. (4 marks)
(d) State three advantages and three disadvantages of using the IRR as a method of project
appraisal. (6 marks)
(e) Briefly outline each of the following stages involved in evaluating capital projects:
(i) Initial investigation of the proposal;
(ii) Detailed evaluation;
(iii) Authorisation;
(iv) Implementation;
(v) Project monitoring;
(vi) Post-completion audit. (6 marks)
(40 marks)
(Workings should be in £’000, to the nearest £’000.)
Question 3 – NPV and Payback

Taxi Ltd is a long established company providing high quality transport for customers. It
currently owns and runs 350 cars and has a turnover of £10 million per annum.
The current system for allocating jobs to drivers is very inefficient. Taxi Ltd is considering the
implementation of a new computerised tracking system called ‘Kwictrac’. This will make the
allocation of jobs far more efficient.
You are an accounting technician for an accounting firm advising Taxi Ltd. You have been
asked to perform some calculations to help Taxi Ltd decide whether Kwictrac should be
implemented. The project is being appraised over five years.
The costs and benefits of the new system are set out below.
(i) The central tracking system costs £2,100,000 to implement. This amount will be payable
in three equal instalments: one immediately, the second in one year’s time, and the third
in two years’ time.
(ii) Depreciation on the new system will be provided at £420,000 per annum.
(iii) Staff will need to be trained how to use the new system. This will cost Taxi Ltd
£425,000 in the first year.
(iv) If Kwictrac is implemented, revenues will rise to an estimated £11 million this year,
thereafter increasing by 5% per annum (i.e. compounded). Even if Kwictrac is not
implemented, revenues will increase by an estimated £200,000 per annum, from their
current level of £10 million per annum.
(v) Despite increased revenues, Kwictrac will still make overall savings in terms of vehicle
running costs. These cost savings are estimated at 1% of the post Kwictrac revenues
each year (i.e. the £11 million revenue, rising by 5% thereafter, as referred to in note
(iv)).
(vi) Six new staff operatives will be recruited to manage the Kwictrac system. Their wages
will cost the company £120,000 per annum in the first year, £200,000 in the second
year, thereafter increasing by 5% per annum (i.e. compounded).
(vii) Taxi Ltd will have to take out a maintenance contract for the Kwictrac system. This will
cost £75,000 per annum.
(viii) Interest on money borrowed to finance the project will cost £150,000 per annum.
(ix) Taxi Ltd’s cost of capital is 10% per annum.

Required:
(a) Calculate the net present value of the new Kwictrac project to the nearest £000.
(10 marks)
(b) Calculate the simple payback period for the project and interpret the result.
(3 marks)
(c) Calculate the discounted payback period for the project and interpret the result.
(3 marks)
(d) Taxi Ltd wants to ensure that it has enough cash available to pay the second and third
instalments for the Kwictrac system, when they fall due. The company has therefore
decided to invest the cash on time deposits with its local bank. The rates of interest paid
by the bank are as follows:
6 month deposits 7% per annum

One year deposits 8% per annum
Two year deposits 9% per annum
Three year deposits 10% per annum
Interest is paid once a year, at the end of the year.
Calculate the total amount of cash that Taxi Ltd needs to put on deposit immediately in
order to meet the final two instalments for Kwictrac. (4 marks)
NOTE: You should assume that all cash flows occur at the end of the year, unless
otherwise stated.
(Total 20 marks)

Chapter 4 Capital Budgeting and Basic Investment Appraisal Techniques

Uploaded by

Copyright:

Available Formats

Chapter 4 Capital Budgeting and Basic Investment Appraisal Techniques

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 4 Capital Budgeting and Basic Investment Appraisal Techniques

Uploaded by

Copyright:

Available Formats

Premium Course Notes [Session 1 and 2]

Chapter 4 Capital Budgeting and Basic Investment Appraisal

1. Calculate payback period and discuss the usefulness of payback as an investment

Prepared by Patrick Lui P. 64 Copyright @ Kaplan Financial 2015

Prepared by Patrick Lui P. 65 Copyright @ Kaplan Financial 2015

2. Investment Appraisal Techniques

2.1 Payback method

Year Cash flow ($000)

What is the expected payback period?

Prepared by Patrick Lui P. 66 Copyright @ Kaplan Financial 2015

Year Cash flow Cumulative cash flow

The payback period is exactly 4 years.

2.1.4 Test your understanding 1

Year Cash flow ($000)

What is the expected payback period?

Prepared by Patrick Lui P. 67 Copyright @ Kaplan Financial 2015

2.1.5 Advantages and disadvantages of payback

Prepared by Patrick Lui P. 68 Copyright @ Kaplan Financial 2015

2.2 Discounted payback

Year Cash flow ($000)

What is the discounted payback period?

Year Cash flow Discounted Cumulative cash

The payback period is about 5 years.

Prepared by Patrick Lui P. 69 Copyright @ Kaplan Financial 2015

2.3 Accounting rate of return (ARR)

2.3.2 Decision rule

Prepared by Patrick Lui P. 70 Copyright @ Kaplan Financial 2015

(5,000  5,000  5,000) / 3

2.3.5 Test your understanding 2

Equipment Item X Equipment Item Y

Prepared by Patrick Lui P. 71 Copyright @ Kaplan Financial 2015

2.3.6 Advantages and disadvantages of ARR

Prepared by Patrick Lui P. 72 Copyright @ Kaplan Financial 2015

2.4 Net present value (NPV)

2.4.3 Decision Rule

 If the NPV > 0 – the project is financially viable, i.e. accepted.

The NPV gives the impact of the project on shareholder wealth.

2.4.4 NPV and shareholder wealth (Jun 08)

(a) All acceptable investment project should have positive NPV.

Prepared by Patrick Lui P. 73 Copyright @ Kaplan Financial 2015

Year Cash flow

The company’s cost of capital is 9%.

Calculate the NPV of the project to assess whether it should be undertaken.

Prepared by Patrick Lui P. 74 Copyright @ Kaplan Financial 2015

2.4.6 Advantages and disadvantages of NPV

2.4.7 Why NPV is superior to other methods?

Prepared by Patrick Lui P. 75 Copyright @ Kaplan Financial 2015

2.5 Internal rate of return (IRR)

Outlays = Future cash flows discounted at rate r

2.5.2 Decision Rule

2.5.3 Steps in calculating the IRR using linear interpolation

The diagram below shows the IRR as estimated by the formula.

Prepared by Patrick Lui P. 76 Copyright @ Kaplan Financial 2015

Calculate the IRR.

2.5.5 Test your understanding 3 – IRR with even cash flows

Prepared by Patrick Lui P. 77 Copyright @ Kaplan Financial 2015

2.5.6 Test your understanding 4 – IRR with perpetual cash flows

2.5.7 Advantages and disadvantages of IRR

2.5.8 EXAMPLE 6 – Non-conventional cash flows