Chapter 5

Project appraisal -
applications
 Learning Objectives
• Identifying the relevant information in investment analysis.
• Evaluating replacement and other investment decisions.
• Handling inflation.
• Assessing the effects of taxation on investment decisions.
• Investment appraisal practices, strengths and limitations.
• Identifying the appropriate discount rate.
 Incremental Cash Flow Analysis
Incremental Cash Flows can be found by calculating the differences between the forecast cash flows from
going ahead with the project and the forecast cash flows from not accepting the project.
 Incremental Cash Flow Analysis
Remember Opportunity Costs

Capital projects frequently give rise to opportunity costs.

For example, a company has developed a patent to produce a new type of

lawnmower. If it makes the product, the expected NPV is Rs 70,000. However,
this ignores the alternative course of action: to sell the patent to another
company for Rs 90,000. This opportunity cost is a fundamental element in the
investment decision to manufacture the product and should be deducted
from the Rs 70,000, giving a negative NPV of Rs 20,000
 Incremental Cash Flow Analysis
Remember Opportunity Costs
An existing machine can be replaced by an improved model costing £50,000,
which generates cash savings of £20,000 each year for five years, after which
it will have a £5,000 scrap value. The equipment manufacturers are prepared to
give an allowance on the existing machine of £15,000, making a net initial
cash outlay of £35,000. But in pursuing this course of action, we terminate the
existing machine’s life, preventing it from yielding £3,000 scrap value in three
years. The prospective scrap value denied is the opportunity cost of replacing
the existing machine. The cash flows associated with the replacement decision
are therefore:
Year 0 Net cost (£35,000)
Years 1–5 Annual cash savings (£20,000)
Year 3 Opportunity cost (scrap value forgone on old machine) (£3,000)
Year 5 Scrap value on new machine £5,000
 Incremental Cash Flow Analysis
Ignore sunk costs
Any costs incurred or revenues received prior to a decision are not relevant
cash flows; they are sunk costs

Look for associated cash flows

Decision to produce and launch a new product may influence the demand for
other products within the product range. Similarly, the decision to invest in a
new manufacturing plant in Eastern Europe, or to take over existing facilities,
may have an adverse effect on the company’s exports to such countries.

Include additional fixed overheads

 Incremental Cash Flow Analysis
Assessment
Waxo plc has developed a new wonder earache drug. The management is
currently putting together an investment proposal to produce and sell the drug,
but is not sure whether to include the following:
1 The original cost of developing the drug.
2 Production of the new product will have an adverse effect on the sale of
related products in another division of Waxo.
3 Instead of producing the drug internally, the patent could be sold for £10
million.
 Incremental Cash Flow Analysis
Include working capital changes
Normally, a capital project gives rise to increased stocks and debtors to support
the increase in sales. This increase in working capital forms part of the
investment outlay and should be included in project appraisal.
Separate investment and financing decisions
Capital projects must be financed. Involves borrowing, which requires a series
of cash outflows in the form of interest payments. Interest charges should not
be included in the cash flows because they relate to the financing rather than
the investment decision.
Were interest payments to be deducted from the cash flows, it would amount to
double-counting, since the discounting process already considers the cost of
capital in the form of the discount rate.
To include interest charges as a cash outflow could therefore result in seriously
understating the true NPV.
INFLATION CANNOT BE IGNORED
We can adopt one of two approaches:

• Forecast cash flows in money terms and discount at the nominal or money cost of
capital including inflation, or

• Forecast cash flows in constant (i.e. current) money terms and discount at the real
cost of capital.
Appropriate discount rate - WACC
Major plc has 20 million £0.50 ordinary shares and irredeemable loan capital with a
nominal value of £40 million in issue. The ordinary shares have a current market
value of £2.40 per share and the loan capital is quoted at £80 per £100 nominal
value. The cost of ordinary shares is estimated at 11% and the cost of loan capital is
calculated to be 8%. The rate of corporation tax is 25%. What is the weighted average
cost of capital for the company?
End of chapter