CHAPTER

18 Investment appraisal

This chapter explores a variety of decision-making techniques.

Objectives . Time value of money;

. Net present value (NPV);
. Internal rate of return (IRR);
. Payback period (PBP);
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. Accounting rate of return (ARR).

Introducing business decisions

Importance of
the subject M anagers take many types of decisions, some concerning the day-to-day
running of a department or business and others of strategic importance.
Strategic decisions often involve large sums of capital invested in long-term
projects. Examples include buying a competitor company, launching a new pro-
duct, modernising production methods and manufacturing in a foreign location.
Once capital is committed to these projects it is difficult to withdraw. For
instance, if a manufacturing facility has been planned, built and equipped, the
only way to release the funds is to find a buyer for the new facility. This can be
difficult, particularly as the most interested parties are likely to be competitors.
Good strategic decision making and the careful appraisal of long-term invest-
ments is key to business success.
Time horizons Most managerial tasks operate within a 12-month time horizon. Strategic deci-
sions usually operate within a five to ten-year horizon, which reduces the impor-
tance of the distinction between cash and profit. Within one year there can be
marked differences between cash flow and profit, because of depreciation, stock,
debtors and creditors, etc. Over ten years these differences are insignificant.
Consider a business start up situation in which all the equipment and materials
are paid for in the first month. The net cash flow profile compared to profits
might be as follows:

Year 1 Year 2 Year 3 Total

Cash flow 10,000 20,000 25,000 35,000
Profit 1,000 16,000 20,000 35,000

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 Accounting for Business Studies

Structure In every year, especially the first year, there is a marked difference between cash
and profit; however, taking the three years in total there is no difference. Because
investment opportunities have implications stretching over a number of years,
cash provides the more convenient basis for investment appraisal decisions,
rather than profit. This also helpfully avoids judgmental issues such as deprecia-
tion, stock valuation, etc.
Activities and This chapter focuses first on the ‘time value of money’, the essential concept in
outcomes decision making. The main techniques relevant to decision making, net present
value, internal rate of return, payback period and accounting rate of return, are
then examined. After completing this chapter you will understand the time value
of money and the cost of capital. You will be able to employ several types of
investment appraisal techniques and understand different perspectives on the
same investment opportunity. Use the multiple choice questions at the end of the
chapter to test your understanding before moving on to the rest of the questions.
You may also find the summary of key terms in the conclusions section useful as
you progress through the chapter.
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Time value of money

There are many different ways of investing cash, such as depositing it in a bank
account to earn interest, investing in shares to earn dividends or investing in a
business to earn profit. Before money can be invested in a business it first has to
be withdrawn from a bank or other investment. Consequently, investing in a
business means losing the interest that would have been earned. This loss of
interest should be taken into account when evaluating new business ideas or
investments. The profits earned from a business investment should be greater
than the interest that could have been earned by keeping the money in a bank.
Consider £1,000,000 currently earning 5% interest (£50,000) per annum. The
money could be withdrawn from the bank and invested in a business earning a
profit of, say, £140,000. The profit is £90,000 greater than the interest, indicating
the investment was beneficial. Many businesses, however, do not make a profit in
the first year. If no profit was earned until the second year, two years’ interest
(£50,000  2 ¼ £100,000) has been lost in order to earn the £140,000 profit. The
business investment seems less beneficial if no profit is earned until the second
year. If no profit is earned until the third year, three years’ interest has been lost
(£50,000  3 ¼ £150,000). This suggests the business investment is a poor one,
since the interest lost is more than the profit earned. This loss of interest is often
referred to as the ‘time value of money’. The longer a business investment takes
to earn profit, the more interest is foregone and the less attractive the investment
seems.
Taking into account the time value of money, i.e. the lost interest, reduces the
value of cash received in the future. The further in the future cash is received, the
less it is worth. This is termed the ‘discounting’ of future cash flows. Discount
tables (see Appendix 1) are readily available showing the value of £1 in one
year’s time, two years’ time, etc. at different rates of interest. Consider the
table below which shows the value of £1 at a 5% interest rate:

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