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CAPITAL INVESTMENT APPRAISAL

by Ann Irons
03 Mar 2004

By now you should all be familiar with the broad theme of

Paper 10. As the title states, it is about managing finances.
We are not talking here, of course, about managing our
personal finances, although some of the principles involved
in managing our own money are actually very relevant! We
are talking about businesses and other organisations
managing their finances.

When the Paper 10 syllabus was originally being written,

there was a big question mark hanging over whether capital
investment appraisal should be included. If you look at the
ACCA approved textbook for this subject, you will see that
the book is split into four parts as follows:

Part A: Cash Management

Part B: Working Capital Management
Part C: Sources of Finance
Part D: Capital Investment.
This gives a good indication of how Managing Finances fits
together. Firstly, you need to understand the cash flows a
business is likely to have - how the cash cycle is calculated,
how a business forecasts its cash requirements, and so
forth. Secondly, you need to understand how a business
manages its working capital as a whole, focusing particularly
on how debtors are managed. Thirdly, you must familiarise
yourself with how the banking system and financial markets
work as a whole, what influences those markets and how a
business seeks additional finance when it is required.
Finally, you must understand what capital expenditure
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budgeting is and how a business decides whether or not to

spend money on a particular project.

A famous English saying is that 'you must speculate to

accumulate'. By this, we mean that you need to invest
money into something before you can expect a return. This
is true not only when starting a business, but also during the
whole life of that business. If a business is to flourish and
reach its full potential, money must continue to be ploughed
back into it year after year. It is very tempting to extract the
profits in the form of drawings or dividends, but failing to re-
invest will cost the proprietors or shareholders dearly in the
future.

Since capital investment is therefore so important to the

success of a business, it is important in the overall context
of managing finances. What better reason for its inclusion in
the syllabus?

The key areas of capital investment appraisal covered

by the Paper 10 syllabus
Whenever I write an exam question, I have the ACCA
approved textbook in front of me. I do this to be sure that
students will not be asked anything that is not in the
textbook. For the sake of consistency, I have set out the key
areas of capital investment appraisal below in the way that
they appear in the textbook. They are as follows:

steps in project appraisal

relevant and non-relevant costs
accounting rate of return
payback period
time value of money
discounting and compound interest
discounted cash flow.
These are now discussed in turn below.

Steps in Project Appraisal

Different reference books may set out the steps in project

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appraisal differently, but the broad content is the same. You

need to know what the steps are and be able to say a little
bit about each. Broadly speaking, they are as follows:

Initial investigation of the proposal Firstly, a decision

must be made as to whether the project is technically
feasible and commercially viable. This involves assessing
the risks and deciding whether the project is in line with
the company's long-term strategic objectives.
Detailed evaluation A detailed investigation will take
place in order to examine the projected cash flows of the
project. Sensitivity analysis is performed and sources of
finance will be considered.
Authorisation For significant projects, authorisation must
be sought from the company's senior management and
Board of Directors. This will only take place once such
persons are satisfied that a detailed evaluation has been
carried out, that the project will contribute to profitability
and that the project is consistent with the company
strategy.
Implementation At this stage, responsibility for the
project is assigned to a project manager or other
responsible person. The resources will be made available
for implementation and specific targets will be set.
Project monitoring Now the project has started, progress
must be monitored and senior management must be kept
informed of progress. Costs and benefits may have to be
re-assessed if unforeseen events occur.
Post-completion audit At the end of the project, an audit
will be carried out so that lessons can be learned to help
future project planning.
Relevant and non-relevant costs
You need to understand the concept of relevant cash flows
for decision-making. You may be required to either discuss
relevant costing or apply the principles in a net present value
(NPV) calculation. Relevant costs are future costs A relevant
cost is a future cost arising as a direct consequence of a
decision. A cost which has been incurred in the past is
therefore totally irrelevant to any decision that is being made
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now. Such past costs are called 'sunk costs'.

Relevant costs are cash flows

Only those future costs that are in the form of cash should
be included. This is because relevant costing works on the
assumption that profits earn cash. Therefore, costs which do
not reflect cash spending should be ignored for the purpose
of decision-making. This means that depreciation charges
should be ignored.

Relevant costs are incremental costs

A relevant cost is the increase in costs that results from
making a particular decision. Any costs or benefits arising as
a result of a past decision should be ignored.

Opportunity costs
An opportunity cost is the value of a benefit foregone as a
result of choosing a particular course of action. Such a cost
will always be a relevant cost.
Other non-relevant costs Certain other costs will be
irrelevant to decision-making, such as 'committed costs'. A
committed cost is a future cash outflow that will be incurred
anyway, regardless of what decision will be taken. Interest
costs are also ignored. This is not because they do not meet
the above criteria, but because they are taken into account
in the discounting process. If these costs were included as
relevant they would be double counted.

Accounting rate of return

You will need to be able to calculate the accounting rate of
return (ARR) of a project. Since ARR is based on profits
rather than cash flows, the calculations may involve
reconciling cash flow to profit. You can find an example of
such a reconciliation in Question 1 of the Pilot Paper, which
is to be found at the back of the approved textbook for Paper
10.

There are several ways of writing the ARR formula.

Whichever you choose, be sure to use the same one
throughout the calculation. It may be that the question
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specifically tells you to use a certain ARR formula. If this is

the case, be sure to use the formula given or you will fail to
gain maximum marks for that question. The most common
formula is:

Estimated average profits x 100%

Estimated average investment

To calculate the value of the average investment you must

first add the initial investment cost to the residual value. This
gives the total amount of money tied up and it should be
divided by two to find the average. Many candidates make
the mistake of thinking that the average investment is
calculated by taking the residual value from the initial cost.
By doing this, candidates fail to gain easy marks. In an
exam, you may also be required to discuss the usefulness of
ARR as a method of project appraisal. The advantages and
disadvantages are set out below:

Advantages

easy to understand
widely used
data readily available to calculate it.
Disadvantages

it does not take into account the time value of money

it is based on accounting profits and these are subjective.
Payback period
You may be required to calculate a project's simple or
discounted payback period, or to discuss the usefulness of
this method of project appraisal.
The simple payback period is calculated by identifying the
point at which cumulative net cash inflows equal the cost of
the initial investment. To calculate the discounted payback
period, all cash flows must first be discounted to take into
account the time value of money. Then, as with simple
payback, the payback period is calculated by identifying the
point at which cumulative (discounted) net cash inflows equal

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the cost of the initial investment (also discounted if not

occurring immediately).

It always surprises me, when marking exam papers, how

many candidates automatically calculate the discounted
payback period even though they have not been asked to do
so. A lot of time is then wasted performing unnecessary
calculations for which no marks are available. Read the
question - if it says 'calculate the payback period' or
'calculate the simple payback period' then don't do any
discounting!

The advantages and disadvantages of the payback period

method of project appraisal are set out below.

Advantages

easy to understand
widely used
helps to minimise risk by giving greater weight to earlier
cash flows.
Disadvantages

simple payback does not take into account the time value
of money
it ignores cash flows received after the end of the
payback period
it does not take into account the overall profitability of the
project.
Time value of money
You need to be able to discuss the concept of the time value
of money. Most candidates understand it when they are first
introduced to it but some always struggle to actually explain
it. You do not need to have a fantastic grasp of the English
language to score marks in an exam question on the time
value of money. You just need to be able to explain that most
people would prefer £100 today rather than £100 in 10
years' time. Why? Because £100 will probably buy you less
in 10 years' time than it will today. Also, because 'a bird in
the hand is worth two in the bush' - meaning that people
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would rather have the certainty of the £100 now rather than
waiting for 10 years - by which time the payer might have
gone bankrupt or died.

Discounting and compound interest

Moving on from the concept that £100 today is worth more
than £100 in 10 years' time, for Paper 10 you will need to be
able to discuss discounting and compounding.

Discounting helps us to understand how much we would

need to invest today if we wanted to receive £100 in 10
years' time, given a certain rate of interest. Compounding is
simply the reverse of this. It helps us to calculate the future
sum that will be received if the £100 were invested today for
10 years.

Discounted cash flow

By taking into account the time value of money and
discounting cash flows according to when monies are paid
out or received, projects can be appraised before the
investment decision is made. It is important to note that it is
the cash flows of the project that are discounted, not the
profits.

In the exam, you may be asked to calculate the NPV of a

project and interpret the result. Alternatively, you may need
to explain this method of project appraisal. When performing
NPV calculations, the following approach should be taken:

identify the relevant cash inflows and outflows of the

project, not forgetting the initial investment
set up a table and discount each of the cash flows to its
present value, using the company's required rate of return
- discount tables will be provided on the day to facilitate
calculations
calculate the net present value of the project by taking the
outflows away from the inflows
decide whether or not the project should be accepted on
the basis of whether or not it has a positive NPV.
The advantages and disadvantages of NPV as a method of
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project appraisal are set out below:

Advantages

shareholder wealth is maximised

it takes into account the time value of money
it is based on cash flows, which are less subjective than
profits.
Disadvantages

it can be difficult to identify an appropriate discount rate

some managers are unfamiliar with the concept of NPV
cash flows are usually assumed to occur at the end of a
year, but in practice this is over simplistic.
Internal rate of return (IRR)
You may be asked to calculate the internal rate of return and
interpret the results, or discuss its uses as a method of
investment appraisal. The internal rate of return tells us the
rate at which the NPV of a project is neither positive nor
negative. There are four steps to an IRR calculation:

1. Calculate the project's NPV at any reasonable

discount rate (this may be given to you in the exam).
2. If the above NPV is positive, choose a higher discount
rate (again this may be given in the exam) and
calculate the NPV again. If the above NPV was
negative, choose a lower discount rate.
3. Either way, you must end up with one positive and one
negative NPV. You must now calculate the IRR by
using the following formula:
IRR = A + a x (B - A)
a-b
Where A is the lower discount rate and B is the higher
rate, a is the NPV at the lower rate and b is the NPV at
the higher rate.
4. The IRR must then be compared to the company's
required rate of return. If it is higher than the required
rate of return, the project should be accepted. If it is
lower than the required rate of return, the project
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should be rejected.

Please note that all workings should be shown when

performing NPV calculations. Even if you are using a
sophisticated calculator to help you, you won't gain full marks
unless your workings are clearly set out. Such calculators
are really not that useful in this exam, and will not give you a
competitive advantage. The advantages and disadvantages
of IRR as a method of project appraisal are set out below:

Advantages

it takes into account the time value of money, which is a

good basis for decision-making
results are expressed as a simple percentage, and are
more easily understood than some other methods
it indicates how sensitive decisions are to a change in
interest rates.
Disadvantages

projects with unconventional cash flows can have either

negative or multiple IRRs - this can be confusing to the
user
IRR can be confused with ARR or Return on Capital
Employed since all methods give answers in percentage
terms - hence, a cash-based method can be confused
with a profit-based method
it may give conflicting recommendations to NPV
some managers are unfamiliar with the IRR method
IRR cannot accommodate changes in interest rates over
the life of a project
it assumes funds are re-invested at a rate equivalent to
the IRR itself, which may be unrealistically high.
Conclusion
Investment appraisal is a key area of the new Paper 10.
There is no reason why you should not perform well in this
area if it comes up on the day, especially given that it
revisits an old area of your studies, albeit in more detail. All
that's really left to say is good luck in your exams.
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Ann Irons is examiner for CAT Scheme Paper 10

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