Question 1:

Accountants make a distinction between Capital Expenditure and Revenue expenditure

(Dyson, 2007). Dyson further says capital expenditure provides benefit to an entity for more
than one year, while revenue expenditure does so for one year. Drury (2005) refers to
expenditures of a capital nature as Capital Investments describing them in the same manner
as Dyson. Collin (2007) defines investment appraisal as an analysis of the future probability
of capital purchases as an aid to good management. In this essay, we are going to discuss
investment appraisal, supporting the argument that investment appraisal should add value to
the organisation. We are also going to analyse critically, the NPV and IRR methods as the
two main discounted cash flow techniques of investment appraisal available to management.

Drury explains that capital investment decisions are applicable to all sectors of the society
and gives examples of such decisions in business firms (including investments in plant and
machinery, research and development, advertising and warehouse facilities) and the public
sector (including new roads, schools, and airports). He also highlights the importance of such
decisions, stating that they represent the most important decisions that an organisation
makes, since they commit a substantial portion of the firm's resources into actions that are
likely to be irreversible.

Barfield et al (2004) define clearly, an Investment Decision, stating that it is a judgement

about which assets to acquire, to achieve an entity's stated objectives. This clearly identifies
an important characteristic of investments decisions made during investment appraisal, being
that, they must be aligned with the company's stated objectives and should therefore
contribute towards the achievement of the set objectives – thereby adding value to the
organisation. In other words, selected investments should be value adding.

The idea of value creation is to capitalise on what, as an organisation, you are out for. The
organisation may be a business, a school, a corporation or a government department. For
example, to create value for its shareholders, a profit making business will only invest in
projects that yield a rate of return greater than the company's cost of capital. In the same way,
to create value for members of its community, a community run health centre will choose to
invest scarce capital resources only on projects that enhance the health and medical
conditions of members of the community.
Organisations serve a purpose. They exist to deliver certain services / values. Therefore the
activities of the organisation should be geared towards achieving the purpose for which it
exists. To achieve its objectives, an organisation makes use of tremendous amount of time,
effort, finance and other resources, and so it makes perfect sense to ensure judicious
utilization of these resources. The purpose of Investment Appraisal as an aid to management
is to ensure that management commits capital resources only to those projects that will create
or add value to the organisation.

Therefore, to attain its very goals and objectives, every investment appraisal effort by an
organisation should be geared towards selecting the best alternative that will add the most
value to the organisation by creating value for either its shareholders (for businesses) or
customers (for businesses) or members (for clubs and societies) or beneficiaries (for
charities), etc.

For the rest of this essay, we are going to discuss the two main discounted cash flow (DCF)
methods of investment appraisal available to management.

'Discounted cash flow techniques take account of the time value of money. This means
that they take into account the fact that £1 now is worth more than £1 received in the
future, because £1 received now can be invested and made to grow bigger as time
passes'
(Walker, 2009)

Dayanada et al (2002) identify two discounted cash flow methods, namely the Net Present
Value (NPV) method and the Internal Rate of Return. They go further to outline three basic
assumptions that underlie these DCF techniques, namely:

1. There is a single goal of wealth maximization for the firm:

2. All cash inflows and outflows of the project are known with certainty
3. There are no resource constraints (all the profitable projects can be accepted [and
undertaken])

NPV and IRR are used in both Accept / Reject decisions and Ranking decisions.

The Net Present Value (NPV) of a project is the Present Value of cash inflows over the life
the project less the present value of cash outflows. Present value can be described as the
value, now, of future cash flows. Drury states that the process of converting future cash flows
into a value at the present time by use of an interest rate is termed discounting. He provides
the following formula for present value:

1 FV
PV = FV x OR (1 + K)n
(1 + K)n

Where:
PV = present value
FV = future value
K= Cost of Capital (required rate of return for the investment)
n= number of years for which money is invested

1
and (1 + K)n is the discount factor (DF)

He goes further to provide an NPV formula as follows:

FV1 FV2 FV3 FVn

NPV = (1 + K) 1 +
(1 + K) 2 +
(1 + K)3 +. . . . + (1 + K)n - I0

Where:
I0 = initial investment
FV = future value received in 1 to n years

Shim & Siegel (1999) present the NPV formula as follows, summarising all the items in
bracket [from the above formula], as Present Value (PV):

NPV = PV – I0 where:
PV = Present value of future net cash flows

There are three possible results of NPV, looking at the above formula.
 1. If PV > I0, NPV will be positive: According to Drury, a positive NPV indicates that
the return on the project is greater that the return on an equivalent risk investment
traded in the financial markets, and therefore, management should accept the project.
2. If PV = I0, NPV will be equal to zero: Drury also states that an NPV of zero indicates
that the firm should the indifferent to whether the project is accepted or rejected [and
funds invested in an equivalent risk-free security in the financial markets].
3. If PV < I0, NPV will be negative: A negative NPV according to Drury, a negative
NPV indicates that the return on the project is lower that the return on an equivalent
risk investment traded in the financial markets, and therefore management should
reject the project – since the firm is better off investing in risk free securities.

In ranking decisions, where selection has to be made between projects that all have a positive
NPV, clearly, the best decision is to select the project with the highest NPV since this
indicates a higher return.

According to Wisniewski (2006), in practice, the NPV method is the one to be favoured in
project appraisal. However, like everything else, the NPV method has its pros and cons.

Dyson provides the following advantages of the NPV method:

- The time value of money is taken into account

- It is easy to compare the NPV of different projects and to reject projects that do not have an
acceptable NPV

- The use of Net cash flows emphasizes the importance of liquidity

The Disadvantages of NPV include:

- It is not easy to select an appropriate rate of interest

- It is difficult to estimate the net cash flows for each year of the project's life

- It may be difficult to estimate the initial cost of the project and the time periods in which
instalments must be paid back

An alternative discounted cash flow method of investment appraisal is the Internal Rate of
Return (IRR) method. Dayanada et al, define IRR as the highest rate at which the future
cash flows can be discounted, making the project's NPV equal to zero. Simply put, the IRR is
the discount rate at which the project's NPV is equal to zero.

According to walker (2009), we can determine the IRR of a proposed investment by a trial
and error process of calculating the NPV at a number of discount rates until a result close to
zero is obtained.

According to Drury, we can also use the method of interpolation to calculate IRR without
carrying out trial and error calculations [he also mentions that the interpolation method only
provides an estimate of the IRR]. Barfield et al (2004) define interpolation as the process of
finding a term between two terms in a series. Therefore going by interpolation, it is important
to find two NPVs for the project, preferably one negative NPV and one positive NPV, since
the objective is to find between these two, the point at which NPV equals zero.

CIMA (2008) provides the following interpolation formula for calculating the IRR of a
project:

NPV1
IRR = DR1 + X (DR2 – DR1)
(NPV1 - NPV2)
Where:

NPV1 = Higher NPV (positive)

NPV2 = Lower NPV (negative)
DR1 = Lower Discount rate
DR2 = Higher Discount rate
The method of interpolation can also be represented graphically as shown below:

NPV

NPV1

IRR (NPV=0)

0 DR
DR1 DR2

NPV2
The IRR is determined as the point where the line crosses the x-axis. At this point NPV = 0.

The Decision Rule for IRR is that, if IRR is greater than the company's required rate of return
or cost of capital, then the NPV of the project will be positive and so the project should be
accepted. If the IRR is lower, the project should be rejected, since NPV will be negative.

Advantages of the IRR method are outlined below:

- Calculation takes account of all cash flows, whenever they occur

- Calculation does not require prior determination of cost of capital as the case with
NPV
- A percentage return is perhaps more easily understood by management that the
statement of an absolute amount of NPV.

A major drawback of the IRR method is that it is possible to find many rates at which the
NPVs of the project's cash flows equal to zero. This is occurs when the project cash flows are
uneven over the lifetime of the project.
Question 2a:

Investment Appraisal for AP Ltd

Workings:

(W1) Discount Factors

- Cumulative Discount Factor @ 14% for 10years (DF) = 5.216*
- Cumulative Discount Factor @ 20% for 10years (DF) = 4.192*

* Obtained from the established table of discount factors by summing the respective percentage
column from 0 to 10 years.

(W2) Present Values (PV)

- Present Value @ 14% = FV x DF
= £100,000 x 5.216 (W1)
PV@14% = £521,600

- Present Value @ 20% = FV x DF

= £100,000 x 4.192 (W1)
PV@20% = £419,200

(W3) Net Present Values (NPVs)

- NPV@14% = PV – I0
= £521,600 (W2) - £449,400
NPV1 = £72,200

- NPV @ 20% = PV - I0
= £419,200 (W2) - £440,400
NPV2 = - £21,200
Answers:

Project 1

Annual Net Cash Flow (FV) = £100,000

Initial Investment (I0) = £449,400
Cost of Capital (K) = 14%
Project life (n) = 10 years

A) The IRR is the discount rate at which NPV = 0.

By interpolation:

NPV1
IRR = DR1 + X (DR2 – DR1)
(NPV1 - NPV2)

Where:
NPV1= £ 72,200 (W3)
NPV2 = - £21,200 (W3)
DR1 = 14% and
DR2 = 20%

Therefore:
72200
IRR = 14% + X (20% – 14%)
(72200 - (-21200))

72200
IRR = 14% + X 6%
93400
 IRR = 18.6%

B) The NPV for Project 1 @ 14% = £72,200 (W4)

Project 2:

Annual Net Cash Flow (FV) = £70,000

Initial Investment (I0) = ?
Cost of Capital (K) = 14%
Project life (n) = 10 years
IRR = 20%

C) At an IRR of 20%, NPV = 0.

Therefore the objective is to calculate the initial investment that will be exactly equal
to the present value of an annual net cash flow of £70.000 discounted at 20% for 10
years, so that NPV = 0.

Mathematically,

NPV = PV - I0
0 = [70,000 x 4.192(W1)] - I0
0 = 293,440 - I0
I0 = £ 293,440

Therefore C = £293,440

D) At an IRR of 20%, NPV = 0

Therefore D = 0
Project 3:

Annual Net Cash Flow (FV) = ?

Initial Investment (I0) = £200,000
Cost of Capital (K) = ?
Project life (n) = 10 years
IRR = 14%
NPV = £35,624

E) The Annual Net cash flow (FV) will be the annual amount of net cash flow required
on the project to yield an NPV of zero at a predetermined discount rate of 14% over
10 years.

Therefore,

I0 - PV =0
200,000 - FV x 5.216(W1) = 0

FV = 200,000 / 5.216
FV = £38,344

Therefore E = £38,344

F) F is the cost of capital that will give an NPV of £35,624 for project 3.
To have an NPV of £35,624, the present value of future cash flows must be greater
than the initial investment by £35,624.

Therefore,

PV - I0 = £35,624
[FV x DF] - 200,000 = £35,624
[38,344 x DF] - 200,000 = £35,624
 38,344DF = 35,624 + 200,000
38,344DF = 235624

DF = 235624 / 38344
DF = 6.145

Referring to the table of cumulative discount factors, a cumulative discount factor of

6.145 at the 10th year is achieved under the 10% column. This means at a discount
rate of 10%, the discount factor (DF) is 6.145 which will yield an NPV of £35,624 for
project 3.

Therefore F = 10%

Project 4

Annual Net Cash Flow (FV) = ?

Initial Investment (I0) = £300,000
Cost of Capital (K) = 12%
Project life (n) = 10 years
IRR = ?
NPV = £39,000

G) G is the annual net cash flow that will yield an NPV of £39,000 on an initial
investment of £300,000 discounted at 12% for 10 years.

Mathematically,

NPV = PV - I0
NPV = [FV x DF] - I0

£39,000 = [FV x 5.650] - £300,000

 £39,000 = (5.650) FV - £300,000

£339,000 = (5.650) FV

FV = £339,000 / 5.650

FV = £60,000

Therefore G = £60,000

H)

NPV1 = NVP @ 12% = £39,000

NPV2 = NPV @ 20% = [FV x DF] - I0

= [60,000 x 4.192] - 300,000

= - £48,480

DR1 = 12%

DR2 = 20%

By interpolation,

NPV1
IRR = DR1 + X (DR2 – DR1)
(NPV1 - NPV2)

39000
IRR = 12% + X (20% – 12%)
(39000 - (-48480))
 39000
IRR = 12% + X 8%
87480

IRR = 15.6%

Question 2b

From the investment appraisal computations in part A, Project 2 has proven to be the most
viable project since it provides the highest Net Present Value and Internal Rate of Return.
This means that the project is going to yield a higher return per £1 invested in it.

Therefore I will choose to invest in project 2.

BIBLIOGRAPHY / REFERENCES:

1. Barfield et al (2004) Cost Accounting: Traditions and Innovations. 4th ed.

SouthWestern Thomson Learning: USA
2. Collin, S (2007) Dictionary of Accounting, 4th Ed. A & C Black, London

3. Collier, P. (2003) Accounting for Managers: interpreting accounting information for

decision making: John Wiley & Sons, England

4. CIMA (2008) P2 Management Accounting: Decision Management: CIMA Publishing,

Oxford

5. Dayanada, D. et al (2002) Capital Budgeting: Financial Appraisal of Investment

Projects: Cambridge University Press, Cambridge

6. Drury, C. (2005) Management Accounting for Business Decisions: 2nd ed: Thomson
Learning: London

7. Dyson, R. (2007) Accounting For Non-Accountants: 7th ed: Prentice Hall FT: England

8. Shim, J. & Siegel, J (1999) Theory and Problems of Managerial Accounting: 2nd ed.
McGraw-Hill, San Francisco

9. Walker, J (2009) Accounting in a Nutshell: Accounting for the Non-Specialist, 3rd ed.
Elsevier, Oxford

10. Wisniewski, M (2006) Quantitative methods for decision makers, 4th ed. Prentice
Hall, Edinburgh gate, England