Accounting (9706) | Investment appraisal

Investment Appraisal (A Level Cost and Management Accounting 9706)

Hello future CFOs! This chapter is where you learn how businesses make the biggest, most important decisions: whether or not to invest huge sums of money into long-term projects, like buying a new factory or machinery. This process is called Investment Appraisal (or Capital Budgeting).

It is crucial because these decisions commit the business for many years. We need robust methods to calculate which project will bring the best financial returns. Don't worry if the formulas look intimidating; we will break down each technique step-by-step!

1. The Fundamentals of Capital Investment Decisions

1.1 Capital Investment vs. Revenue Expenditure

Before we start, remember the difference between two types of spending:

• Revenue Expenditure: Spending on day-to-day running costs (e.g., wages, rent). These are expensed immediately in the Statement of Profit or Loss.
• Capital Investment (or Capital Expenditure): Spending on non-current assets (long-life assets) that will benefit the business over many years (e.g., buying a machine, building an extension). These are the focus of Investment Appraisal.

1.2 Cash Flow is Key!

In most investment appraisal techniques (Payback, NPV, IRR), we focus on Net Cash Flows, not accounting profit.

Why? Profit includes non-cash items like depreciation, which is an accounting concept and does not involve an actual movement of cash. Cash flow is the real money flowing in (inflows) and out (outflows) of the business.

1.3 The Time Value of Money (TVM)

This is the most critical concept for understanding Net Present Value (NPV) and Internal Rate of Return (IRR).

• Concept: A dollar today is worth more than a dollar received next year.
• Analogy: If you have \$100 today, you could invest it and earn interest. If you receive \$100 in a year, you missed out on that interest. Therefore, that future \$100 is worth less than \$100 *today*.
• Discounting: The process of reducing future cash flows to reflect their value today. The rate used for discounting is usually the company’s Cost of Capital (the minimum rate of return required).

2. Non-Discounted Techniques (Ignoring TVM)

These methods are simpler and often used as initial screening tools, but they ignore the time value of money, which is a major drawback.

2.1 Payback Period (PB)

The Payback Period measures the length of time it takes for a project’s cumulative net cash inflows to equal the initial investment.

How to Calculate Payback Period

Step 1: Determine the initial investment.
Step 2: Calculate the annual net cash flow.
Step 3: Calculate the cumulative net cash flow year by year.

If cash flows are equal each year, the formula is simple:
\( \text{Payback Period} = \text{Initial Investment} / \text{Annual Cash Flow} \)

If cash flows are uneven (which is more realistic and common in exams), use the cumulative method:

• Find the year where the cumulative cash flow turns positive.
• Calculate the fraction needed in the final year:
  \( \text{Fraction} = (\text{Cash still needed} / \text{Cash flow in that year}) \times 12 \text{ months} \)

Example: A project costs \$100,000. It brings in \$40,000 (Year 1), \$40,000 (Year 2), and \$30,000 (Year 3).

• After Year 2, \$80,000 is recovered, remaining need is \$20,000.
• Year 3 brings in \$30,000.
• Time needed in Year 3 = (\$20,000 / \$30,000) = 0.67 years.
• Payback Period = 2 years and 0.67 years (or 2 years and 8 months).

Decision Rule: Management typically sets a maximum acceptable payback period. If comparing projects, choose the one with the shortest payback period.

Advantages and Disadvantages of Payback

• A: Measures liquidity and risk (faster recovery means less time exposed to uncertainty).
• A: Simple to understand, especially useful for businesses facing cash flow problems.
• D: Ignores profitability after the payback period is achieved.
• D: Completely ignores the time value of money.

2.2 Accounting Rate of Return (ARR)

The Accounting Rate of Return (ARR) expresses the average annual profit generated by the investment as a percentage of the capital invested.

Crucial Point: ARR uses profit (after depreciation), not cash flow.

How to Calculate ARR

The required formula is:
\( \text{ARR} = (\text{Average Profit} / \text{Average Investment}) \times 100 \)

Step 1: Calculate Average Annual Profit
\( \text{Average Profit} = (\text{Total Cash Inflows} - \text{Total Depreciation}) / \text{Project Life in years} \)
(Remember, depreciation is the initial cost divided by the project life, assuming no residual value for syllabus purposes.)

Step 2: Calculate Average Investment
\( \text{Average Investment} = (\text{Initial Investment} + \text{Residual Value}) / 2 \)
(Since the syllabus states questions involving residual value at the end of a project will not be set, for most questions, Residual Value will be zero, meaning Average Investment = Initial Investment / 2.)

Decision Rule: Choose the project with the highest ARR, provided it exceeds the target rate set by the business.

Advantages and Disadvantages of ARR

• A: Measures profitability (unlike Payback).
• A: Uses profit, a measure familiar to managers and stakeholders.
• D: Ignores the time value of money.
• D: Uses accounting profit, which can be manipulated by different depreciation methods, making it less reliable than cash flow methods.

3. Discounted Techniques (Considering TVM)

These are considered superior because they acknowledge that money received in the future is less valuable than money received today.

3.1 Net Present Value (NPV)

The Net Present Value (NPV) is the sum of the Present Values (PV) of all expected net cash flows (inflows and outflows), including the initial investment, using the cost of capital as the discount rate.

How to Calculate NPV

Step 1: Calculate the Present Value (PV) of each year's net cash flow using the given discount factors.

Step 2: Sum all the individual Present Values of the inflows.
Step 3: Subtract the initial capital outlay (which is already at present value, as it occurs at Year 0).

Decision Rule:

• If NPV is Positive (> 0): Accept the project. It generates a return greater than the cost of capital.
• If NPV is Negative (< 0): Reject the project. It will lead to a loss.
• If comparing projects, choose the one with the highest positive NPV.

Advantages and Disadvantages of NPV

• A: It considers the time value of money, making it financially sound.
• A: It calculates the total expected monetary gain (or loss) in today's money.
• D: It relies heavily on an accurate estimate of the cost of capital (the discount rate).
• D: It can be complex for managers who are not familiar with discounting tables.

3.2 Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate at which the Net Present Value (NPV) of a project is exactly zero. It represents the actual rate of return expected from the investment.

How to Calculate IRR

IRR is found using a trial-and-error process (often interpolation is used, although the syllabus focuses on the definition and application rather than complex mathematical derivation). You must find a discount rate that gives a positive NPV (NPV1) and a discount rate that gives a negative NPV (NPV2).

Decision Rule:

• If IRR is Higher than the Cost of Capital: Accept the project.
• If IRR is Lower than the Cost of Capital: Reject the project.
• If comparing projects, choose the one with the highest IRR.

Did you know? Many managers prefer IRR because they find a percentage rate of return (e.g., 15%) easier to compare against the cost of borrowing than a dollar value (e.g., \$5,000 NPV).

Advantages and Disadvantages of IRR

• A: Considers the time value of money.
• A: Provides a percentage return that is easy for non-accountants to understand and compare to the cost of borrowing.
• D: Calculation is complex (interpolation) and time-consuming.
• D: Can give conflicting results with NPV when comparing projects of very different sizes or lifetimes.

4. Making the Investment Decision and Evaluation

Management must not only calculate the financial figures but also evaluate the findings and justify their final decision using both quantitative (number-based) and qualitative (non-financial) factors.

4.1 Comparing the Techniques

4.2 The Significance of Non-Financial Factors

While a project might look great financially (high NPV), non-financial risks often override the numbers. You must consider and include these factors in your recommendations!

Here are some key non-financial factors:

• Quality and Reliability: Is the new machine reliable? Will it improve the quality of the product?
• Staff Morale and Skills: Will the new investment require training? Will it lead to redundancies (affecting morale)?
• Environmental/Ethical Impact: Does the new investment comply with current green regulations? Will it improve the company's reputation?
• Market Position: Does the investment align with the long-term strategic goals? (e.g., allows entry into a new market).
• Flexibility: Can the new machine be adapted for future product lines?

Key Takeaway for Recommendations: When answering an evaluation question, always state the financial conclusion first (e.g., "Project A has the highest NPV and lowest payback, therefore financially it is superior"). THEN, introduce the non-financial factors (e.g., "However, Project B offers better staff safety and environmental compliance, which may justify the slightly lower return.")