ACCA F2C5 Capital Budgeting

C5.
Capital Budgeting and Discounted Cash Flows ACCA F2
C5.01. Capital and Revenue Expenditure
C5.01-A. Capital Investment
When a business spends money on new non-current assets it is known as capital investment or
capital expenditure. Spending is normally irregular and for large amounts. It is expected to generate
long-term benefits.
Capital investment decisions normally represent the most important decisions that an organisation
makes, since they commit a substantial proportion of a firm’s resources to actions that are likely to
be irreversible.
Many different investment projects exist including:
o replacement of assets
o cost-reduction schemes
o new product/service developments
o product/service expansions
o statutory, environmental and welfare proposals
Notes Prepared by M. Ramesh Kumar P a g e 1 | 36

C5. Capital Budgeting and Discounted Cash Flows ACCA F2
C5.01-B. What is Capital Expenditure?
Capital expenditure often represents a significant investment by a company.
We start with a reminder of what distinguishes capital from revenue expenditure. One of the
significant differences is that capital expenditure is often for very significant amounts. Therefore,
expenditure for the wrong reasons or on the wrong assets can have a disastrous effect on an
organisation's position.
Therefore, the need for capital expenditure should be assessed before any firm commitments are
made. Separate capital expenditure budgets need to be prepared, and expenditure and non-current
assets carefully monitored for problems or losses.
- Capital expenditure results in the acquisition of non-current assets or an improvement in

their earning capacity.
- Revenue expenditure is expenditure which is incurred for the purpose of the trade of the
business or to maintain the existing earning capacity of non-current assets.
A non-current asset is an asset which is acquired and retained in the business with a view to earning
profits and not merely turning into cash. It is normally used over more than one accounting period.
Examples of non-current assets:
o Motor vehicles (except for a motor trader)

o Plant and machinery
o Fixtures and fittings
o Land and buildings
Non-current assets are to be distinguished from inventories which we buy or make in order to sell.
Inventories are current assets and, as we have already seen, a part of the working capital of a
business, along with cash and amounts owed to us by customers.
- For a motor trader, motor vehicles for resale are inventories.

- For an estate agency business, say, company cars are a non-current asset.

C5.01-C. Capital and Revenue Expenditure
Capital expenditure is expenditure which results in the acquisition of non-current assets, or an

improvement in their earning capacity.
So, do you recall how capital expenditure is accounted for in the financial statements?
(a) Capital expenditure is not charged as an expense in the statement of profit or loss of a
business enterprise, although a depreciation charge will usually be made to write off the
capital expenditure gradually over time. Depreciation charges are expenses in the statement
of profit or loss.
(b) Capital expenditure on non-current assets results in the appearance of a non-current asset
in the statement of financial position of the business.
Special methods of accounting for capital expenditure apply in local authorities and in some other
public sector organisations.
Revenue expenditure is expenditure which is incurred for either of the following reasons.
(a) For the purpose of the trade of the business; this includes expenditure classified as selling
and distribution expenses, administration expenses and finance charges
(b) To maintain the existing earning capacity of non-current assets
Revenue expenditure is charged to the statement of profit or loss of a period, provided that it relates
to the trading activity and sales of that particular period.
- Suppose that a business purchases a building for $30,000. It then adds an extension to the
building at a cost of $10,000. The building needs to have a few broken windows mended, its
floors polished and some missing roof tiles replaced. These cleaning and maintenance jobs
cost $900. The original purchase ($30,000) and the cost of the extension ($10,000) are capital
expenditures, because they are incurred to acquire and then improve a non-current asset.
The other costs of $900 are revenue expenditure, because these merely maintain the building
and thus the 'earning capacity' of the building.

C5.01-D. Capital Income and Revenue Income
Capital income is the proceeds from the sale of non-trading assets (i.e., proceeds from the sale of
noncurrent assets, including non-current asset investments). The profits (or losses) from the sale of
non-current assets are included in the statement of profit or loss of a business, for the accounting
period in which the sale takes place.
Revenue income is derived from the following sources.
- The sale of trading assets

- Interest and dividends received from investments held by the business
C5.01-E. Other Capital Transactions
The categorisation of capital and revenue items given above does not mention raising additional
capital from the owner(s) of the business or raising and repaying loans. These are transactions
which do either of the following.
(a) Add to the cash assets of the business, thereby creating a corresponding liability (capital or
loan)
(b) Reduce the liabilities (loan) and the assets (cash) of the business when a loan is repaid
None of these transactions would be reported through the statement of profit or loss.
C5.01-F. Self-constructed Assets
Where a business builds its own non-current asset (e.g. a builder might build their own office),
then all the costs involved in building the asset should be included in the recorded cost of the non-
current asset. These costs will include raw materials, but also labour costs and related overhead
costs. This treatment means that assets which are self-constructed are treated in a similar way to
purchased non-current assets.

C5.01-G. Why is the distinction important?
Revenue expenditure results from the purchase of goods and services that will do either of the
following.
(a) Be used fully in the accounting period in which they are purchased, and so be a cost or
expense in the statement of profit or loss
(b) Result in a current asset at the end of the accounting period because the goods or services
have not yet been consumed or made use of (The current asset would be shown in the
statement of financial position and is not yet a cost or expense in the statement of profit or
loss.)
Capital expenditure results in the purchase or improvement of non-current assets, which are assets
that will provide benefits for the business in more than one accounting period, and which are not
acquired with a view to being resold in the normal course of trade.
The cost of purchased non-current assets is not charged in full to the statement of profit or loss of
the period in which the purchase occurs. Instead, the non-current asset is gradually depreciated
over a number of accounting periods.
Since revenue items and capital items are accounted for in different ways, the correct and consistent
calculation of profit for any accounting period depends on the correct and consistent classification
of items as revenue or capital.

C5.02. Capital Budgeting and Investment Appraisal
C5.02-A. Capital Budgeting and Investment Appraisal
A capital budget:
o is a programme of capital expenditure covering several years

o includes authorised future projects and projects currently under consideration
One stage in the capital budgeting process is investment appraisal. This appraisal has the following
features:
o estimates of future costs and benefits over the project's life

o assessment of the level of expected returns earned

Recurring and minor non-current asset purchases may be covered by an annual allowance provided
for in the capital expenditure budget. Major projects will need to be considered individually and
will need to be fully appraised.
o The capital expenditure budget is essentially a non-current assets purchase budget, and it will
form part of the longer-term plan of a business enterprise.
o Sales, production and related budgets cover, in general, a 12-month period. A detailed capital
expenditure budget should be prepared for the budget period but additional budgets should
be drawn up for both the medium and long term. This requires an in-depth consideration of
the organisation's requirements for land, buildings, plant, machinery, vehicles, fixtures and
fittings and so on for the short, medium and long term.
o Suitable financing must be arranged as necessary. We looked at sources of finance in earlier

chapters. If available funds are limiting the organisation's activities then it will more than
likely limit capital expenditure. The capital expenditure budget should take account of this.
o Some forms of capital expenditure may be budgeted for by means of a set annual 'allowance'
for the purchase and replacement of non-current assets. Examples here would be sets of new
tools, or relatively minor expenditure such as a few new desks and chairs.
o As part of the overall budget co-ordination process, the capital expenditure budget must be
reviewed in relation to the other budgets. Proposed expansion of production may well
require significant non-current assets expenditure which should be reflected in the budget.
o Before major capital expenditure is incurred, we need to be confident that the expenditure
is worthwhile.
We therefore need to appraise the project on which the expenditure is to be made, to see if it is
likely to be of positive value to the business.

C5.02-B. Cash Flows Used for Investment Appraisal
In capital investment appraisal it is more appropriate to evaluate future cash flows rather than
accounting profits.
- Cash and profit are very different.
- Profit is calculated on the statement of profit or loss and cash is a current asset on the
statement of financial position.
The differences arise because:
o Revenue is recognised in the statement of profit or loss when it is earned, but this is not
necessarily when the cash is received.
o Costs are recognised in the statement of profit or loss when they are incurred but this is not
necessarily when the cash is paid.
o Non-cash expenses – the statement of profit or loss of a business is charged with a number
of non-cash expenses such as depreciation and provisions for doubtful debts. Although these
are correctly charged as expenses in the statement of profit or loss, they are not cash flows
and will not reduce the cash balance of the business.
o Purchase of non-current assets – these are often large cash outflows of a business but the
only amount that is charged to the statement of profit or loss is the annual depreciation
charge not the entire cost of the noncurrent asset.
o Sale of non-current assets – when a non-current asset is sold this will result in an inflow of
cash to the business but the figure to appear in the statement of profit or loss is not the cash
proceeds but any profit or loss on the sale.
o Financing transactions – some transactions, such as issuing additional share capital and
taking out or repaying a loan, will result in large cash flows in or out of the business with no
effect on the profit figure at all.
When appraising a possible capital investment, it is necessary to use the actual cash flows in and
out of the business rather than profits as profits are subjective and cannot be spent.

Cash flows that are appraised should be relevant to or change as a direct result of making a decision
to invest. Relevant cash flows are:
o future costs and revenues – it’s not possible to change what has happened so any relevant
costs or revenues are future ones
o cash flows – actual cash coming in or leaving the business not including any non-cash items
such as depreciation and notional costs
o incremental costs and revenues – the change in costs or revenues that occurs as a direct result
of a decision to invest.
Relevant cost terminology

o Differential costs are the differences in total costs or revenues between two alternatives.
o Opportunity cost is an important concept in decision making. It represents the best

alternative that is foregone in taking the decision. The opportunity cost emphasizes that
decision making is concerned with alternatives and that the cost of taking one decision is
the profit or contribution foregone by not taking the next best alternative.
o Avoidable costs are the specific costs associated with an activity that would be avoided if that
activity did not exist.
Non-relevant cost terminology

o Sunk costs are past or historical costs which are not directly relevant in decision making, for
example, development costs or market research costs.
o Committed costs are future costs that cannot be avoided, whatever decision is taken.
o Non-cash flow costs are costs which do not involve the flow of cash, for example,
depreciation and notional costs. A notional cost is a cost that will not result in an outflow of
cash either now or in the future, for example, sometimes the head office of an organisation
may charge a 'notional' rent to its branches. This cost will appear in the accounts of the
organisation but will not result in a 'real' cash expenditure.
o General fixed overheads are usually not relevant to a decision. However, some fixed
overheads may be relevant to a decision, for example, stepped fixed costs may be relevant if
fixed costs increase as a direct result of a decision being taken.
o Carry amount of non-current assets are not relevant costs because like depreciation, they
are determined by accounting conventions rather than by future cash flows.

C5.03. Methods of Project Appraisal
A long-term view of benefits and costs must be taken when reviewing a capital expenditure project.
The key methods of project appraisal are:
o The Payback Period

o Net Present Value
o Discounted Payback Period
o Internal Rate of Return (IRR)
C5.03A. The Payback Period
The payback period is the time taken for the initial investment to be recovered in the cash inflows
from the project. The payback method is particularly relevant if there are liquidity problems, or if
distant forecasts are very uncertain.
The payback period method is one which gives greater weight to cash flows generated in earlier
years. The payback period is the length of time required before the total cash inflows received from
the project is equal to the original cash outlay. In other words, it is the length of time the investment
takes to pay itself back.

Advantages of Payback Method Disadvantages of Payback Method
It is easy to calculate and understand. Total profitability is ignored.
It is widely used in practice as a first screening The time value of money is ignored.
method.
Its use will tend to minimise the effects of risk It ignores any cash flows that occur after the
and help liquidity, because greater weight is project has paid for itself. A project that takes
given to earlier cash flows which can probably time to get off the ground but earns substantial
be predicted more accurately than distant cash profits once established might be rejected if the
flows. payback method is used, whereas a smaller
project, paying back more quickly, may be
accepted.
It identifies quick cash generators. The cut-off period for deciding what is
acceptable is arbitrary.
A more scientific method of investment appraisal is the use of discounted cash flow (DCF)
techniques. Before DCF can be understood it is necessary to know something about the time value
of money.

C5.03B. The Time Value of Money
The time value of money is an important consideration in decision making.
- Money is spent to earn a profit. For example, if an item of machinery costs $6,000 and would
earn profits (ignoring depreciation) of $2,000 per year for three years, it would not be worth
buying because its total profit ($6,000) would only just cover its cost.
- In addition, the size of profits or return must be sufficiently large to justify the investment.
In the example given in the previous paragraph, if the machinery costing $6,000 made total
profits of $6,300 over three years, the return on the investment would be $300, or an average
of $100 per year. This would be a very low return, because it would be much more profitable
to invest the $6,000 somewhere else (eg in a bank).
We must therefore recognise that if a capital investment is to be worthwhile, it must earn at least
a minimum profit or return so that the size of the return will compensate the investor (the business)
for the length of time which the investor must wait before the profits are made.
- When capital expenditure projects are evaluated, it is therefore appropriate to decide

whether the investment will make enough profits to allow for the 'time value' of capital tied
up. The time value of money reflects people's time preference for $100 now over $100 at
some time in the future. DCF is an evaluation technique which takes into account the time
value of money.

C5.03B1. Discounting and Compound Interest
If we were to invest $1,000 now in a bank account which pays interest of 10% per annum, with interest
calculated once each year at the end of the year, we would expect the following returns.
(a) After one year, the investment would rise in value to:
$1,000 plus 10% = $1,000 (1 + 10%) = $1,000  (1.10) = $1,100
Interest for the year would be $100. We can say that the rate of simple interest is 10%.
(b) If we keep all our money in the bank account, after two years the investment would now be worth:
$1,100  1.10 = $1,210.
Interest in year two would be $(1,210 − 1,100) = $110.
Another way of writing this would be to show how the original investment has earned interest over
two years, as follows.
$1,000  (1.10)  (1.10) = $1,000  (1.10)2 = $1,210
(c) Similarly, if we keep the money invested for a further year, the investment would grow to
$1,000  (1.10)  (1.10)  (1.10) = $1,000  (1.10)3 = $1,331 at the end of the third year
Interest in year three would be $(1,331 − 1,210) = $121.

C5.03B1a. Compound Interest
This example shows, in a different way to that given earlier in this Text, how compound interest
works.
The amount of interest earned each year gets larger because we earn interest on both the original
capital and also on the interest now earned in earlier years.
A formula which can be used to show the value of an investment after several years which earns
compound interest is: S = P(1 + r)n
where
S = future value of the investment after n years
P = the amount invested now
r = the rate of interest, as a proportion.
For example, 10% = 0.10, 25% = 0.25, 8% = 0.08
n = the number of years of the investment
For example, suppose that we invest $2,000 now at 10%. What would the investment be worth
after the following number of years?
(a) Five years (b) Six years
The future value of $1 after n years at 10% interest is given in the following table.
n (1 + r)n with r = 0.10
1 2 3 4 5 6 7
1.100 1.210 1.331 1.464 1.611 1.772 1.949
The solution is as follows.

(a) After 5 years: (b) After 6 years:
S = $2,000 (1.611) = $3,222 S = $2,000 (1.772) = $3,544
The principles of compound interest are used in DCF, except that discounting is compounding in
reverse.

C5.03B1b. Discounting
With discounting, we look at the size of an investment after a certain number of years, and calculate
how much we would need to invest now to build up the investment to that size, given a certain
rate of interest.
This may seem complicated at first, and an example might help to make the point clear. With
discounting, we can calculate how much we would need to invest now at an interest rate of, say,
6% to build up the investment to (say) $5,000 after four years.
The compound interest formula shows how we calculate a future sum S from a known current
investment P, so that if S = P (1 + r)n, then:
This is the basic formula for discounting, which is sometimes written as: P = S(1 + r) -n
To build up an investment to $5,000 after four years at 6% interest, we would need to invest now:
Further examples of discounting
If you have never done any discounting before, the basic principle and mathematical techniques
might take some time to get used to. The following examples might help to make them clearer.


C5.03B2. Equivalent Rates of Interest
An effective annual rate of interest is the corresponding annual rate when interest is compounded
at intervals shorter than a year.
C5.03B2a. Non-annual Compounding
In the previous examples, interest has been calculated annually, but this isn't always the case.
Interest may be compounded daily, weekly, monthly or quarterly.
- For example, $10,000 invested for 5 years at an interest rate of 2% per month will have a
final value of $10,000 x (1 + 0.02)60 = $32,810.
Notice that n relates to the number of periods (5 years x 12 months) that r is compounded.
Effective annual rate of interest
The non-annual compounding interest rate can be converted into an effective annual rate of
interest. This is also known as the APR (annual percentage rate) which lenders such as banks and
credit companies are required to disclose.
Effective annual rate of interest: (1 + R) = (1 + r)n
Where R is the effective annual rate

r is the period rate
n is the number of periods in a year
Nominal rates of interest and the APR
A nominal rate of interest is an interest rate expressed as a per annum figure although the interest
is compounded over a period of less than one year. The corresponding effective rate of interest is
the annual percentage rate (APR) (sometimes called the compound annual rate, CAR).
Most interest rates are expressed as per annum figures even when the interest is compounded over
periods of less than one year. In such cases, the given interest rate is called a nominal rate. We can,
however, also work out the effective rate (APR or CAR).



C5.03C. Discounted Cash Flow
Discounted cash flow techniques take account of the time value of money – the fact that $1 received
now is worth more because it could be invested to become a greater sum at the end of a year, and
even more after the end of two years, and so on. As with payback, DCF techniques use cash figures
before depreciation in the calculations.
Discounted cash flow is a technique of evaluating capital investment projects, using discounting
arithmetic to determine whether or not they will provide a satisfactory return.
- A typical investment project involves a payment of capital for non-current assets at the start
of the project and then there will be returns coming in from the investment over a number
of years.
- As we noted earlier, DCF can be used in either of two ways:
o the net present value method, or
o the internal rate of return (sometimes called DCF yield, DCF rate of return) method.
We will now look at each method in turn.

C5.03C1. The Net Present Value (NPV) method of DCF
The net present value method calculates the present value of all cash flows and sums them to give
the net present value. If this is positive, then the project is acceptable.
The net present value (NPV) method of evaluation is as follows.
(a) Determine the present value of costs
- In other words, decide how much capital must be set aside to pay for the project. Let this be
$C.
(b) Calculate the present value of future cash benefits from the project
- To do this we take the cash benefit in each year and discount it to a present value. This
shows how much we would have to invest now to earn the future benefits, if our rate of
return were equal to the cost of capital. ('Cost of capital' is explained below.) By adding up
the present value of benefits for each future year, we obtain the total present value of
benefits from the project. Let this be $B.
(c) Compare the present value of costs $C with the present value of benefits $B
- The NPV is the difference between them: $(B C).
(d) NPV is positive
- The present value of benefits exceeds the present value of costs. This in turn means that the
project will earn a return in excess of the cost of capital. Therefore, the project should be
accepted.
(e) NPV is negative
- This means that it would cost us more to invest in the project to obtain the future cash
receipts than it would cost us to invest somewhere else, at a rate of interest equal to the cost
of capital, to obtain an equal amount of future receipts.
- The project would earn a return lower than the cost of capital and would not be worth
investing in.


Advantages and Disadvantages of NPV
Advantages of NPV Disadvantages of NPV
Shareholder wealth is maximized. It can be difficult to identify an appropriate

discount rate.
It takes into account the time value of money. For simplicity, cash flows are sometimes all
assumed to occur at year ends: this assumption
may be unrealistic.
It is based on cash flows which are less subjective Some managers are unfamiliar with the concept
than profit. of NPV.
Shareholders will benefit if a project with a

positive NPV is accepted.

C5.03C2. Discounted Payback Method
The discounted payback method applies discounting to arrive at a payback period after which the
NPV becomes positive.
We have seen how discounting cash flows is a way of reflecting the time value of money in
investment appraisal. The further into the future a cash flow is expected to be, the more uncertain
it tends to be, and the returns or interest paid to the suppliers of capital (i.e., to investors) in part
reflects this uncertainty. The discounted payback technique is an adaptation of the payback
technique, which we looked at earlier, taking some account of the time value of money. To calculate
the discounted payback period, we establish the time at which the NPV of an investment becomes
positive.

Comparison with the basic payback method
Like the basic payback method, the discounted payback method fails to take account of positive
cash flows occurring after the end of the payback period.
The cost of capital
We have mentioned that the appropriate discount rate to use in investment appraisal is the
company's cost of capital. In practice, this is difficult to determine. It is often suggested that the
discount rate which a company should use as its cost of capital is one that reflects the return
expected by its investors in shares and loan notes, the opportunity cost of finance.
Shareholders expect dividends and capital gains; loan note investors expect interest payments. A
company must make enough profits from its own operations (including capital expenditure
projects) to pay dividends and interest. The average return is the weighted average of the return
required by shareholders and loan note investors. The cost of capital is therefore the weighted
average cost of all the sources of capital.

C5.03C3. Annuities
Annuities are an annual cash payment or receipt which is the same amount every year for a number
of years.
In DCF the term 'annuities' refers to an annual cash payment which is the same amount every year
for a number of years, or else an annual receipt of cash which is the same amount every year for a
number of years.
In the question above, the profits are an annuity of $5,000 per annum for 6 years. The present value
of profits is the present value of an annuity of $5,000 per annum for 6 years at a discount rate of
12%. When there is an annuity to be discounted, there is a shortcut method of calculation. You
may already have seen what it is. Instead of multiplying the cash flow each year by the present
value factor for that year, and then adding up all the present values (as shown in the solution above),
we can multiply the annuity by the sum of the present value factors.
Thus, we could have multiplied $5,000 by the sum of (0.893 + 0.797 + 0.712 + 0.636 + 0.567 +
0.507) = 4.112. We then have $5,000 x 4.112 = $20,560.
This quick calculation is made even quicker by the use of 'annuity' tables. These show the sum of
the present value factors each year from year one to year n.




C5.03C4. Annual Cash Flows in Perpetuity

C5.03C5. Calculating a ‘breakeven’ NPV
You might be asked to calculate how much income would need to be generated for the NPV of a
project to be zero. This must be referred to as 'breakeven' NPV.
For the project in “Example – Annuities” above, calculate how much the annual income from the
project could reduce before the NPV would reach a breakeven zero level.

C5.03D. Internal Rate of Return (IRR)
The internal rate of return technique uses a trial and error method to discover the discount rate
which produces the NPV of zero. This discount rate will be the return forecast for the project.
The internal rate of return (IRR) method of DCF involves two steps.
- Calculating the rate of return which is expected from a project
- Comparing the rate of return with the cost of capital
If a project earns a higher rate of return than the cost of capital, it will be worth undertaking (and
its NPV would be positive). If it earns a lower rate of return, it is not worthwhile (and its NPV would
be negative). If a project earns a return which is exactly equal to the cost of capital, its NPV will be
0 and it will only just be worthwhile.
Advantages of the IRR method
The following are advantages of using IRR.
(a) It takes into account the time value of money, unlike other approaches such as payback.
(b) Results are expressed as a simple percentage, and are more easily understood than some other
methods.
(c) It indicates how sensitive calculations are to changes in interest rates.
Problems with the IRR method
The following are problems of using IRR.

a) Projects with unconventional cash flows can produce negative or multiple IRRs.
b) IRR may be confused with return on capital employed (ROCE), since both give answers in
percentage terms.
c) It may give conflicting recommendations with mutually exclusive projects, because the result
is given in relative terms (percentages), and not in absolute terms ($s) as with NPV.
d) Some managers are unfamiliar with the IRR method.
e) It cannot accommodate changing interest rates.
f) It assumes that funds can be reinvested at a rate equivalent to the IRR, which may be too
high.





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C5.

Capital Budgeting and Discounted Cash Flows ACCA F2

C5.01. Capital and Revenue Expenditure

C5.01-A. Capital Investment

Many different investment projects exist including:

Notes Prepared by M. Ramesh Kumar P a g e 1 | 36

C5.01-B. What is Capital Expenditure?

Capital expenditure often represents a significant investment by a company.

- Capital expenditure results in the acquisition of non-current assets or an improvement in

Examples of non-current assets:

o Motor vehicles (except for a motor trader)

- For a motor trader, motor vehicles for resale are inventories.

Notes Prepared by M. Ramesh Kumar P a g e 2 | 36

C5.01-C. Capital and Revenue Expenditure

Capital expenditure is expenditure which results in the acquisition of non-current assets, or an

(b) To maintain the existing earning capacity of non-current assets

Notes Prepared by M. Ramesh Kumar P a g e 3 | 36

C5.01-D. Capital Income and Revenue Income

Revenue income is derived from the following sources.

- The sale of trading assets

C5.01-E. Other Capital Transactions

C5.01-F. Self-constructed Assets

Notes Prepared by M. Ramesh Kumar P a g e 4 | 36

C5.01-G. Why is the distinction important?

Notes Prepared by M. Ramesh Kumar P a g e 5 | 36

C5.02. Capital Budgeting and Investment Appraisal

C5.02-A. Capital Budgeting and Investment Appraisal

o is a programme of capital expenditure covering several years

o estimates of future costs and benefits over the project's life

Notes Prepared by M. Ramesh Kumar P a g e 6 | 36

o Suitable financing must be arranged as necessary. We looked at sources of finance in earlier

Notes Prepared by M. Ramesh Kumar P a g e 7 | 36

C5.02-B. Cash Flows Used for Investment Appraisal

- Cash and profit are very different.

The differences arise because:

Notes Prepared by M. Ramesh Kumar P a g e 8 | 36

Relevant cost terminology

o Opportunity cost is an important concept in decision making. It represents the best

Non-relevant cost terminology

Notes Prepared by M. Ramesh Kumar P a g e 9 | 36

C5.03. Methods of Project Appraisal

The key methods of project appraisal are:

o The Payback Period

C5.03A. The Payback Period

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Advantages of Payback Method Disadvantages of Payback Method

It is easy to calculate and understand. Total profitability is ignored.

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C5.03B. The Time Value of Money

The time value of money is an important consideration in decision making.

- When capital expenditure projects are evaluated, it is therefore appropriate to decide

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C5.03B1. Discounting and Compound Interest

$1,000 plus 10% = $1,000 (1 + 10%) = $1,000  (1.10) = $1,100

$1,100  1.10 = $1,210.

Interest in year two would be $(1,210 − 1,100) = $110.

$1,000  (1.10)  (1.10) = $1,000  (1.10)2 = $1,210

Interest in year three would be $(1,331 − 1,210) = $121.

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C5.03B1a. Compound Interest

(a) Five years (b) Six years

n (1 + r)n with r = 0.10

The solution is as follows.

S = $2,000 (1.611) = $3,222 S = $2,000 (1.772) = $3,544