F2 MANAGEMENT ACCOUNTING

EAGLES BUSINESS SCHOOL

F2 MANAGEMENT
ACCOUNTING
TOPIC: INVESTMENT APPRAISAL
TECHNIQUES

TUTOR: MR
KANYONGANISE
+263 782 487 521

Corner Angwa and Kwame Nkrumah, 3rd Floor Robinson House, Opp Karigamombe Building
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OBJECTIVES

Capital budgeting and discounted cash flows

a) Discuss the importance of capital investment planning and control.

b) Define and distinguish between capital and revenue expenditure.
c) Outline the issues to consider and the steps involved in the preparation of a capital
expenditure budget.
d) Explain and illustrate the difference between simple and compound interest, and between
nominal and effective interest rates.
e) Explain and illustrate compounding and discounting.
f) Explain the distinction between cash flow and profit and the relevance of cash flow to capital
investment appraisal.
g) Identify and evaluate relevant cash flows for individual investment decisions.
h) Explain and illustrate the net present value (NPV) and internal rate of return (IRR) methods
of discounted cash flow.
i) Calculate present value using annuity and perpetuity formulae.
j) Calculate NPV, IRR and payback (discounted and non-discounted).
k) Interpret the results of NPV, IRR and payback calculations of investment viability.

INTRODUCTION

Capital and revenue expenditure:

 Capital expenditure is expenditure on assets that are not for resale (ie what would be
termed fixed assets) the purpose of which is to generate ongoing profits for the business.
 Revenue expenditure is anything that is not capital expenditure. It is typically bought with a
view to resale(eg inventories) or it is the expenditure on administration, distribution or
maintenance.
 Capital investment usually results in a large immediate cash outflow with cash inflows arising
from the investment occurring in the future. There are a number of different methods which
can be employed to assess the value of an investment:
1. Payback.
2. Net present value (NPV).
3. Internal rate of return (IRR)

SIMPLE AND COMPOUND INTEREST

 If you invest a sum of money now, you would expect that investment to be worth more in
one year’s time. A simple example is when you put money in the bank, you expect to earn
interest on the amount you deposit. Interest can be calculated in 2 ways:
1. Simple interest
2. Compound interest

Simple interest

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 Simple interest involves adding interest to an invested capital sum of money, whereby the
interest that is added each period is added to the capital sum only and not to the interest
earned in previous periods.

Simple interest formula FV = PV (1 + rn)

 Where:
 V = total at end of period
 P = amount invested
 r = rate of interest
 n = number of periods

Exercise 1

$1,000 is invested at the start of year 1 and simple interest is added each year at 10% per annum.
How much income will the investment generate by the end of Year 2?

Compound interest

 Compound interest is a system that adds interest each year to both the original capital plus
any interest added to date.

Compound interest formula FV = PV (1 + r)n

 V = total at end of period

 P = amount invested
 r = rate of interest
 n = number of periods

Exercise 2

$1,000 is invested at the start of year 1 and compound interest is added each year at 10% per
annum. Calculate the value of the investment at the end of Year 3.

COMPOUNDING AND DISCOUNTING

Time Value of Money

 $1000 received now is more valuable than $1000 received in, say, 2 years’ time. Why?
1. Inflation
2. Uncertainty
3. Opportunities to invest.

Discounted Cash Flow

 Discounted cash flow (DCF) is a technique that takes into the timing of cash flows and allows
comparison between cash flows arising at different points in time, taking account of these 3
factors.

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Present value: The value at time 0 of a future cash flow, having taken account of the time value of
money. In investment appraisal, it represents the maximum an investor would be willing to invest
for a future cash inflow given a specified required return.

Compounding: We have just studied how compounding works – we move from a present value to a
future value by adding compound interest each year.

Discounting: Discounting is the reverse of compounding – we start at the future value and work back
to the present value.

𝑛
PV = FV ÷ (1 + r)

Where:

 PV = present value
 FV = future value
 r = rate of interest
 n = number of periods

Exercise 3 ; Calculate the present value of $80,000 at the end of year 5 if an interest rate of 10% per
annum applies.

Exercise 4 ; A company requires a cash flow of $100,000 at the end of 2 years where the current
interest rate is 15% p.a. How much needs to be invested now?

NET PRESENT VALUE

 Net present values look at a comparison of how much cash will an investor get back from an
investment compared to how much cash they have had to pay for the investment.
Everything is compared in present value terms.
 This technique is used to evaluate whether or not a project should be accepted. There are 3
steps to apply in a question on NPV:

Step 1 Sort out the numbering of the years between the investment and each future value

Step 2 Decide what cost of capital to use and find discount factors

Step 3 Multiply each future value by the relevant discount factor to give the present values If the
investment has a positive NPV then the project should be accepted (negative rejected). A positive
NPV means that the project will increase the wealth of the company by the amount of the NPV at
the current cost of capital.

Exercise 5

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A company is evaluating a project that has the following cash flows. It will purchase a machine on 1
January 2011 for $50,000 and will receive net cash (ie revenue less cash costs) each year from the
trading activity as follows.

Year ended 31 December Cash received ($)

2011 20,000
2012 10,000
2013 20,000
2014 15,000

The company can borrow money at 10%. Is the project worthwhile?

 (Note: Present value table will be given to you in the exam)

Year Cash Flow Discount Factor@ 10% Present Value

0 ($50,000) 1 ($50,000)

NPV

THE INTERNAL RATE OF RETURN (IRR)

The internal rate of return (IRR) is the rate of return at which the NPV is zero. (shown below on
graph)

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 If the IRR is greater than the cost of capital the project should be accepted, because this
suggests that the NPV is positive at the cost of capital.

Exercise 6

A project costing £1,000 will return £1,180 in the following year. What will be the NPV at discount
rates of 10% and 20%? Using this information, calculate the IRR.

 The IRR can be estimated be using linear interpolation. The following formula applies:

IRR = L + (NL ÷ [NL – NH]) X (H − L)

 Where: L = lower discount rate

 H = higher discount rate
 NL = NPV at lower discount rate
 NH = NPV at higher discount rate

NB The formula is not given in the exam.

Exercise 7

Using an interest rate of 12% per year the net present value (NPV) of a particular investment has
been calculated as $120. If the interest rate is increased by 1% the NPV of the project falls by $30.
What is the internal rate of return (IRR) of the project?

ANNUITIES

 An annuity is an investment that gives a return in the form of a series of equal cash flows.
For example:

Year Cash flow

0– Initial investment (600)
1 250
2 250
3 250

Exercise 8

A project costing $2,000 has returns expected to be $1,000 each year for 3 years at a discount rate
of 10%.

Required:

Calculate the NPV:

a. Using the existing NPV analysis.

b. Using annuity tables.
 Solely considering the annuity, what if the cash flows commenced in:

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a. Year 4
b. Year 6
c. Year 0

PERPETUITIES

 A perpetuity is an annuity which arises forever. PV of a perpetuity = Cash flow per annum /
Interest rate

Exercise 9 . A company expects to receive $1,000 each year in perpetuity. The current discount rate
is 10%.

Calculate:

(a) The present value of the perpetuity.

(b) What is the value of the perpetuity if it starts in 3 years’ time?

PAYBACK

 This is the length of time it takes for cash inflows from trading to pay back the initial
investment. Payback period = Initial investment / Annual inflow

Exercise 10

A company invests in a project with an initial cash outflow of $100,000. Cash inflows resulting from
the project are $40,000 per annum. Calculate the payback period.

Exercise 11

A company makes an investment with an initial cash outflow of $1,000,000. Cash inflows resulting
from the project are as follows:

Year Cash inflow

1 $100,000
2 $250,000
3 $350,000
4 $360,000

5 $500,000
Calculate the payback period.

NOMINAL AND EFFECTIVE INTEREST RATES

 Nominal rate of interest is the official interest rate per annum even though the interest is
compounded over a period of less than one year. A nominal interest rate has not been

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adjusted for the full effect of compounding, where compounding occurs more frequently
than once a year.
 Effective annual interest rate (ER or APR) is the corresponding annual rate when interest is
compounded at intervals shorter than a year. This is the real rate per annum at which the
investment is growing.

ER = (1 + r) 𝑛
1

 Where:
 ER = effective annual rate
 r = period rate
 n = number of compounding periods

The period rate (r) is calculated by dividing the nominal rate by the number of compounding periods
in a year. For example if the nominal rate is 8% p.a. compounded quarterly, the period rate is r = 8%
÷ 4 compounding periods = 2% per quarter

Exercise 12

A loan is offered with a nominal interest rate of 10% compounded weekly. What is the effective
annual rate?

RELEVANT CASH FLOWS

Relevant cash flows are the cash flows which change as a result of a particular investment decision.
So it will be the additional revenue earned or additional costs incurred due to the investment.

Relevant cash flows will include

 Future cash flows arising as a result of the investment

 Expenditure due to investment
 Revenue earned from investment
 Opportunity costs. Opportunity cost will include any revenues which are lost as a result of
the investment decision.

Exercise 13

A company has a machine it was planning to sell for proceeds of £15,000 as the machine is no longer
in use by the company. The machine cost £70,000 5 years ago. A customer has requested a specific
contract which the machine would be required for. The duration of the contract would be 1 year. At
the end of the contract, the machine would have no sales value. The cost of disposing the machine
would be £5,000. What is the relevant cost of the machine for this contract?

A £70,000

B £20,000

C £15,000

D £5,000

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