Investment Appraisal/capital Investment: Page 1 of 20

Investment appraisal/Capital investment
Business expenditures for acquiring assets to be used for more than one year are called capital investments.
Examples may include investment in properties, plant, equipment, vehicles, research and development projects
and other noncurrent assets.
The ultimate objective for making capital expenditure or investment is to improve or maintain the overall
profitability and net worth of the enterprise over the long run.
Types of investment appraisal techniques:
Non-DCF methods
1. Payback
2. Accounting Rate of Return (ARR) method
DCF methods
3. Net present value (discounted cash flow)
4. Discounted payback period
5. Internal Rate of Return (IRR) method
Note: only ARR uses profit and all other technique use cash.
1. Payback
The Payback Period method is perhaps the simplest and easiest method of appraising capital projects. As the
name implies, the Payback period method the period of time a capital investment will take to generate cash
flows that cover or payback the original investment in the project.
When business has a choice between mutually exclusive projects, then the project with the shorter payback
period is preferred provided other things being equal. The shorter payback period represents greater liquidity
and low risk.
If the payback period is within the duration of the project, it is acceptable but if the initial investment is
not recover within the duration, the project is not acceptable.
Advantages of payback method Disadvantages of payback method

It is easy to calculate and understand Overall profitability is ignored.
It is based on cash flows which are more objective The time value of money is ignored.
than profits
Choosing projects with the shorted payback period Ignores total cash flow generated by the project
will tend to minimize risk which are related to time
It allowed proper planning since the company In case of only one project, it may be difficult to
knows when it will recover its investment determine the maximum acceptable payback period
Eg 1
A project with an estimated useful life of five years involves an initial outlay of $24 000. The project is
expected to generate annual cash inflows of $8 000 in each year of its life. Calculate payback period.
Eg 2
A project with an estimated useful life of five years involves an initial outlay of $240 000. The following
information is available.
Page 1 of 20
Year Inflow Outflow

1 150 000 (60 000)
2 150 000 (70 000)
3 160 000 (70 000)
4 140 000 (50 000)
5 160 000 (50 000)
Calculate the payback period.
Eg 3
A firm is considering two project to invest. Project A initial investment is $300 000 and project B is $500 000
The following information is available.
Project A Project B
Year Inflow Outflow Year Inflow Outflow
1 150 000 (60 000) 1 250 000 (60 000)
2 120 000 (80 000) 2 300 000 (70 000)
3 160 000 (80 000) 3 460 000 (80 000)
4 140 000 (90 000) 4 440 000 (90 000)
5 160 000 (60 000) 5 460 000 (100 000)
Calculate the payback period for project A and B to decide which project is better.
2. Accounting rate of return(ARR)
It is also called as the return on capital employed. It is defined as the ratio of average net profit to average
investment.
i. The net profit must be after depreciation and tax

ii. Average investment = initial investment/ 2
iii. ARR = Average net profit / average investment X 100
ARR is the only investment appraisal technique which considers depreciation that is we need profit.
Net profit = NCF – Depreciation

NCF = Net profit + depreciation
NCF = Inflow – Outflows
NCF = NPV / discounting Factor
Advantages of ARR Disadvantages of ARR

Simple to calculate and understand Ignored time value of money
Consider the overall profitability of the project No universal accepted method of calculating ARR
Management can compare the profitability with Ignored risk related to time by not considering the
different project investment time recovery period.
It takes into calculation all the profits expected over Average annual profits used in the ratio may not
the project life represent actual profits for any year
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Example 1
The firms intend to invest in one of the following projects.
Project A Project B
Cost of investment 5000 5000
Net profit Year 1 750 1200
Calculate ARR,
Example 2
The firms intend to buy machine A or B .Both machines are expected to be used for 5 years.
Project A Project B
Cost of machine 300000 300000
Calculate ARR
Ex 3
Victor and Victor want to make an investment in a project which is expected to yield annual cash inflows of
$28 000. The project requires an initial investment of $63 000. It is assumed that business uses straight line
method of depreciation. Calculate ARR
Ex 4
The firms intend to buy machine A or B .Both machines are expected to be used for 5 years.
Project A Project B
Cash inflow Year 1 142000 106000
Project A has an annual depreciation of $10 000. Project B has an annual depreciation of $5 000
Calculate ARR
Ex 5
The firms intend to buy machine A or B. Both machines are expected to be used for 5 years.
Project A Project B
Project A has an annual depreciation of $10 000. Project B has an annual depreciation of $5 000
Calculate ARR
Page 3 of 20
3. Net present value (discounted cash flow)
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.
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.
Definition: 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.
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 cost of capital is the rate by which money can be made available now, that is the lending rate of the bank.
Cost of capital = 1 / (1+ r) a
r = discount rate
a = year
Advantages and disadvantages of NPV
Advantages Disadvantages
it take into account time value of money Ignores total cash flow generated by the project
It is based on cash flows which are more objective Difficult to estimate discount rate that is cost of
than profits capital
It is easy to understand Cash flow are assumed to occur at the end of each
year.
ITEMS not included in NPV

1. Past cost/ sunk cost.
2. Item which have occurred before the project.
Example 1
A firm intends to introduce a new product which requires the immediate purchase of a new machine costing
$50 000. The machine is expected to be used for 5 years.
The machine will require a special check up at the beginning of the third year costing $5000. The expected
production and sale volume is as following:
Year Units Sold and produce

2010 100 00
2011 12 000
2012 11 000
2013 9 000
2014 12 000
Page 4 of 20
Details per units

Direct material $3
Direct labour $2
Selling price $10
Additional info:
Fixed cost per annum $35000
Cost of capital 12%
Calculate net present value, Payback, ARR
Ex2 May 2012 P43 Q3

The directors of a clothing company are proposing to manufacture coats. They anticipate that the coats would
stay in fashion for the next 4 years. This would require the purchase of additional equipment at a cost of $250
000 which would be scrapped after 4 years.
Sales are expected to be 4000 coats in year 1. In years 2 and 3 the expected number of coats sold will increase
by 10% on the previous year but will fall to 3500 in year 4. The selling price of the coats will be $80 in year 1,
$90 in years 2 and 3 and $75 in the final year. Variable costs will be $65 per coat for years 1 and 2, rising to
$70 for years 3 and 4.
The company’s cost of capital is 10%. The discount factors are:

Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
REQUIRED
(a) Calculate the net cash flows for each year. [13]
(b) Payback period in term of years
(c) Calculate the accounting rate of return. [7]
(d) Calculate the net present value of the proposal. [11]
4. Internal Rate of Return (IRR) method
The internal rate of return technique is a discounting rate which when apply to the project yields zero NPV.
There is no direct method of calculating the IRR of a project. It is found by trial and error.
The usual way is to find 2 rates (1 giving a positive NPV and the other one giving a negative NPV).
Note: Take a higher rate to obtain a negative NPV.
Formula=
IRR = +ve discount rate + +ve NPV X difference between

+ve NPV – (-ve NPV) Two rates
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.
Principles
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1. If the IRR of a project is less than the minimum rate set in the question, the project is not acceptable.
2. If the IRR of a project is more than the minimum rate set in the question, the project is acceptable.
3. If there is no minimum rate; and the IRR is greater than the cost of capital, it is acceptable. However, if
the IRR is less than the cost of capital, the project is not acceptable.
Take the previous example to work a calculation.

Takes into account time value of money Involve large volume of calculations
It is based on cash flows which are more objective Cash flow are assumed to occur at the end of each year.
than profits
Example 1MPLE 11
A project is forecast to cost $300 000 with varying annual cash inflows. The net present value has been
calculated at
two discount rates as shown
Discount rate NPV ($)
10% 4 200
14% (1 400)
Calculate internal rate of return for this project.
Different scenarios
1. Annual cash flow – annual outflow
2. Annual revenue – annual income – annual expenditure
3. Annual profit + annual depreciation + scrap value.
4. Incremental revenue – annual incremental cost
Usually in such question you will be given two options : with or without
5. Annual cost saving – any new annual expenditure
Ex 1
Mr Ben is a photographer. He currently sends his work to be printed by a specialist printer. The cost of printing
is actually $10 000 and is expected to increase by $1000 each year. He is considering buying a machine that
will enable him to process his work instead of sending it to the specialist printer. The cost of the machine is $25
000. The cost of operating the machine will be as follows:
Summary for NPV, IRR

Takes into account time value of money Involve large volume of calculations
it is based on cash flows which are more objective Ignored cash flow pattern during the payback period
than profits
Difficult to estimate discount rate that is cost of capital
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11
Question 6
Source B2
The directors of W Limited plan to buy a new machine costing $220 000 for making a new product. The
machine will have a useful life of 4 years with no scrap value.
The cash inflows and cash outflows from the new product for four years are expected to be as follows:
Inflows Outflows
$ $
Year 1 100 000 36 000
Year 2 132 000 50 000
Year 3 160 000 68 000
Year 4 92 000 50 000
The cost of capital is 8%.
The following discount factors are given:
8% 12%
Year 1 0.926 0.893
Year 2 0.857 0.797
Year 3 0.794 0.712
Year 4 0.735 0.636
Answer the following questions in the question paper. Questions are printed here for reference
only.
(a) Calculate for the new machine:
(i) the accounting rate of return (ARR) [5]
(ii) the net present value (NPV) [3]
(iii) the internal rate of return (IRR) [4]
(b) Advise the directors whether or not they should buy the new machine. Justify your answer.
[3]
Additional information
The directors are of the view that the NPV method should be used to make decisions on
investment.
(c) State three advantages of using the NPV method. [3]
Due to a change in economic conditions, the directors consider that the cost of capital should
be 12%.
(d) Explain the effect on the directors’ decision on investment of the change in the cost of capital.
[2]
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The directors also consider that the negative impact from the increase of cost of capital can be
offset by increasing the revenue. Additional advertising costing $20 000 incurred in year 1 can
help increase the sales revenue in years 2 and 3. Year 2 sales revenue is expected to increase by
$24 000.
(e) Calculate the minimum increase in sales revenue in year 3 to justify the directors deciding to
buy the new machine. [5]
[Total: 25]
Permission to reproduce items where third-party owned material protected by copyright is included has been sought and cleared where possible. Every
reasonable effort has been made by the publisher (UCLES) to trace copyright holders, but if any items requiring clearance have unwittingly been included, the
publisher will be pleased to make amends at the earliest possible opportunity.
To avoid the issue of disclosure of answer-related information to candidates, all copyright acknowledgements are reproduced online in the Cambridge
Assessment International Education Copyright Acknowledgements Booklet. This is produced for each series of examinations and is freely available to download
at www.cambridgeinternational.org after the live examination series.
Cambridge Assessment International Education is part of the Cambridge Assessment Group. Cambridge Assessment is the brand name of the University of
Cambridge Local Examinations Syndicate (UCLES), which itself is a department of the University of Cambridge.
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Section B: Cost and Management Accounting
Question 5
Source B1
The directors of P Limited plan to launch a new product which has an expected life of 4 years. A new
machine is required for this and the directors are considering buying Machine X.
Details of Machine X are as follows.
Year 0 Year 1 Year 2 Year 3 Year 4

$ $ $ $ $
Cost 400 000
Annual receipts 390 000 420 000 460 000 370 000
Annual payments 280 000 280 000 270 000 250 000
The machine has a useful life of 4 years with no residual value. It will be depreciated using the
straight-line method.
Answer the following questions in the Question Paper. Questions are printed here for
reference only.
(a) Calculate the accounting rate of return (ARR) of Machine X. [5]
(b) State two advantages and two disadvantages of using ARR. [4]
P Limited’s cost of capital is 10%.
The following are the discount factors for 10%.
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
(c) Calculate the net present value (NPV) of Machine X. [5]
P Limited requires an internal rate of return (IRR) of 13% on any capital investment.
If a discount factor of 16% is used, Machine X will have a negative NPV of $13 130.
(d) Calculate the IRR of Machine X. [3]
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A similar machine, Machine Y, is available. It also has a useful life of 4 years. The following
information for Machine Y is available.
Initial cost $480 000

NPV $33 200
ARR 25%
IRR 13.5%
(e) Advise the directors of P Limited which machine they should buy. Justify your answer. [5]
The directors are also considering buying another machine, Machine Z, at a cost of $110 000.
This will be used to produce another product which has an expected life of 3 years. The annual
receipts from the sale of the product will be $100 000. Annual payments will be $45 000. This will
remain constant for each of the 3 years. P Limited’s cost of capital remains at 10%.
The directors are confident about the accuracy of their forecast for annual payments. They are
not confident about their forecast for annual receipts.
(f) Calculate the annual receipts which give a zero NPV for Machine Z. [3]
[Total: 25]
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Section B: Cost and Management Accounting
Question 5
Source B1
Gerry manufactures a product using Machine B. The following budgeted information is available in
respect of this for the year ending 31 December 2019.
$
Total annual cash inflows from sales 800 000
Total annual cash outflows for cost of sales 416 000
Gerry has decided to purchase a new machine, Machine X, at a cost of $600 000, to replace Machine
B on 1 January 2020. The new machine will have a useful life of 3 years with no residual value. It is
expected that Machine X will produce the following results:
1 Each year sales will be 5% more than the sales in the previous year.
2 Gross margin will increase by 2% in 2020 and this gross margin will then remain constant.
3 Machine maintenance costs will be:

$
2020 10 000
2021 20 000
2022 30 000
4 Other operating costs (excluding depreciation) will be $120 000 per year.
reference only.
(a) Calculate for Machine X:
(i) the net cash flow for each year [5]
(ii) the payback period [3]
(iii) the accounting rate of return to two decimal places. [5]
(b) State two advantages and two disadvantages of using the payback method of investment
appraisal. [4]
Gerry’s cost of capital is 10%. The relevant discount factors are:
Year 1 0.909
Year 2 0.826
Year 3 0.751
(c) Calculate the net present value (NPV) of Machine X. [3]
(d) Advise Gerry whether or not he should purchase Machine X. Justify your answer using two
financial and two non-financial factors. [5]
[Total: 25]
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Question 6
Source B2
Samir has a business in the leisure industry. He is purchasing a boat and plans to start luxury river
cruises. In his original plan, which had a positive net present value (NPV), he anticipated the following
revenue.
number of tickets price per ticket

sold per year $
year 1 8000 100
year 2 8300 110
He is now considering a revised plan, employing local historians to accompany the cruises and give
lectures on the history of the area. He thinks that this will result in 20% more tickets being sold each
year. The selling price of the tickets would be $10 higher than under the original plan.
only.
(a) Calculate the total revenue for each year for:
(i) the original plan [1]
(ii) the revised plan. [1]
The majority of the running costs of the cruises will be fixed. Variable costs are expected to amount
to $30 for each ticket sold.
(b) Calculate the total variable cost for each year for:
(i) the original plan [2]
(ii) the revised plan. [2]
1 The cost of employing the historians will add $125 000 per annum to the total fixed costs of
running the cruises.
2 The capacity of the boat restricts the total number of tickets which can be sold each year to
10 000.
3 Samir uses a cost of capital of 10% per annum. The discount factors for this rate are as
follows.
year 1 0.909
year 2 0.826
(c) Calculate the increase in NPV which would arise if the revised plan was used instead of the
original. [8]
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Question 6
Source B2
The directors of M Limited plan to buy a machine for a new product at the cost of $160 000. It has a
useful life of four years with no residual value.
The number of units produced and sold are expected to be as follows.
Year 1 Year 2 Year 3 Year 4 Total

5000 7500 8500 4200 25 200
The unit selling price is $28 and the variable cost is $10 per unit. Annual fixed costs including
depreciation are $90 000 up to the level of 6500 units. The fixed costs will increase by $10 000 each
time the production level increases by up to 1500 units.
only.
(a) Calculate the net cash flows for each year throughout the life of the machine. [4]
The cost of capital is 10%. Relevant discount factors are:
10% 16%
Year 1 0.909 0.862
Year 2 0.826 0.743
Year 3 0.751 0.641
Year 4 0.683 0.552
(b) Calculate for the proposed purchase:
(i) the net present value (NPV) [4]
(ii) the internal rate of return (IRR). [4]
(c) Advise the directors whether or not the machine should be purchased. Justify your answer.
[3]
The directors decide that the NPV method should be adopted. One of the directors has concerns
about the total sales target. To achieve the total sales of 25 200 units, he has the following
suggestion.
1 The selling price should be reduced by $1.
2 Advertising costs of $8000 should be incurred in both Year 1 and Year 3.
3 The units produced and sold for each year should be the same. This would also keep the
fixed cost to its minimum.
(d) Explain what is meant by the term ‘sensitivity analysis’ for investment appraisal.
[3]
(e) Assess the impact of the director’s suggestion on the decision to buy the new machine.
Support your answer with calculations.
[7]
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Source A for Question 1
Barry has performed a survey of a farmer’s field which is on the site of an ancient settlement. He has
government permission to dig up items from that settlement and sell them to museums around the
world as long as he pays a percentage of the proceeds to the government.
The following information is available.
Payment to the farmer for the right to dig $100 000, all paid before the dig starts
in the field for 4 years
Estimated sales proceeds from museums $500 000 over 4 years
Proceeds are expected to be received

in line with the progress of the dig
Payment to government 10% of proceeds, paid in the year in
which the proceeds are received
The progress of the dig, with regard to the removal of the ancient items, and the additional associated
costs are expected to be as follows:
Year Progress of the dig Costs

$
1 45% 116 500
2 25% 98 500
3 20% 67 000
4 10% 23 000
Barry uses a cost of capital of 10%. The discount factors for this rate are as follows:
Year Discount factor

1 0.909
2 0.826
3 0.751
4 0.683
(i) the net present value (NPV) of the dig
(ii) the payback period

(iii) the accounting rate of return (ARR).
(b) Advise Barry whether or not he should go ahead with the dig in the farmer’s field. Justify your
answer.
(c) State two disadvantages of using ARR for investment decisions.
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Source A for Question 1
Beachside is a village with 320 houses, the continued existence of which is threatened by rising sea
levels. The residents approached Hiram, a building contractor, to suggest a project for building a sea
wall to protect their village.
The cost to Hiram of building the wall would be $400 000 payable at the start of the project. The local
government was prepared to make a grant of $142 000 in year 1.
The residents had together decided that each household would pay Hiram a fee of $200 per annum,
for each of the years 1 to 4.
The residents believed that the village would become a more desirable place to live if the wall was
in place. They therefore told Hiram that they expected that 80 new houses would be built in each of
the years 2, 3 and 4, and that the new households would pay the same fee per year as the existing
households.
There would be no cash flows after the end of year 4.
(i) the net cash flow for each year and in total for the project
(ii) the accounting rate of return (ARR) to two decimal places.
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Hiram’s cost of capital was 10%. The relevant discount factors were as follows:
Year Discount factors

1 0.909
2 0.826
3 0.751
4 0.683
(b) Calculate the net present value (NPV) of the project.
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
............................................................................................................................................. [4]
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As Hiram remained undecided as to whether he should proceed, the residents made a further
suggestion.
In addition to the sea wall, Hiram could build an extension to enable local fishermen to land their
catches more easily. This would add $20 000 to the building cost.
The residents believed that if the extension was built, it would result in a further increase of
another 20 new houses being built in each of the years 2, 3 and 4.
(c) Calculate the change in NPV which would arise if the extension was also built. Your answer
should indicate whether the change is an increase or a decrease.
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
...................................................................................................................................................
............................................................................................................................................. [7]
(d) Advise Hiram whether or not he should agree to build the sea wall and the extension. Justify
your answer.
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2 The directors of Ragley Limited are considering a new business opportunity. This involves the
purchase of machinery costing $600 000.
Units produced by the machine are expected to have a selling price of $50 each and the variable
costs of production are expected to be $31.10 per unit. Fixed costs are expected to be $120 000
per annum excluding depreciation.
The machinery is expected to lose its value evenly over four years and then be scrapped.
The directors expect to produce and sell 20 000 units a year.
REQUIRED
(a) Calculate the following expected annual values. Label each answer.
(i) Total contribution
(ii) Net cash flow
(iii) Profit [6]
(b) Calculate the expected annual breakeven level of production, both in units and sales
revenue. [5]
Ragley Limited has a cost of capital of 10%. Discount factors are as follows.
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
3.169
The directors provide the following incorrect net present value calculation as an aid to decision
making.
Annual surplus $108 000

x Discount factor for four years 3.169
Net present value $342 252
REQUIRED
(c) Explain why the directors’ net present value calculation is incorrect. [4]
(d) Calculate the correct net present value of the machinery. [6]
(e) Calculate the sensitivity of the project to changes in the cost of the machinery. [4]
(f) Calculate the sensitivity of the project to changes in the selling price. [9]
(g) State the IAS which deals with property, plant and equipment and identify five items which a
company can add to the cost price of an asset. [6]
[Total: 40]
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Question 6
Source B2
Ronaldo is considering introducing a new product which will require the purchase of a new machine.
There are two machines available, Machine A and Machine B, but only one may be acquired. Both
machines will be scrapped after five years with no residual value.
The following information is available for Machine A.
$
Cost 225 000
Revenue generated in year 1 80 000
Direct costs in year 1 20 000
Revenues are expected to increase by 10% every year to year 4 and then decrease by 25% in
year 5.
Direct costs are expected to increase by 5% in year 3 and by a further 6% in year 5.
reference only.
(a) Calculate the accounting rate of return (ARR) for Machine A to two decimal places. [10]
Ronaldo has a cost of capital of 10%. Discount factors are as follows:
Year 1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
(b) Calculate the net present value (NPV) of Machine A. [4]
The payback period for Machine A is 3 years and 3 months.
(c) State three advantages and three disadvantages of using the payback method of investment
appraisal. [6]
The following data are available for Machine B.
Payback period 2 years and 10 months

ARR 23.58%
NPV $24 858
(d) Advise Ronaldo which machine he should purchase. Justify your answer. [5]
[Total: 25]
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3 Bradley Ltd is considering investing in a project which requires an initial outlay of $800 000.
A net cash inflow of $235 000 is expected at the end of the first year and this is expected to rise by
10% annually until the end of year 4. The project is fully complete and has no residual value at the
end of year 5 and the anticipated net cash inflow at this time is just 20% of the initial investment.
The company’s cost of capital is 8%.
Extracts from present value tables for $1
Year 8% 15%
1 0.926 0.870
2 0.857 0.756
3 0.794 0.658
4 0.735 0.572
5 0.681 0.497
REQUIRED
(a) Calculate the net present value (NPV) of the project at the company’s cost of capital and
advise the directors whether the project is acceptable. [13]
(b) Determine the discounted payback period. [7]
(c) Explain briefly what you understand by the internal rate of return (IRR) of a project. [2]
(d) Calculate the IRR of the project. [14]
(e) Identify four other factors other than NPV which may be used to determine the acceptability
of the project. [4]
[Total: 40]
Permission to reproduce items where third-party owned material protected by copyright is included has been sought and cleared where possible. Every
reasonable effort has been made by the publisher (UCLES) to trace copyright holders, but if any items requiring clearance have unwittingly been included, the
publisher will be pleased to make amends at the earliest possible opportunity.
University of Cambridge International Examinations is part of the Cambridge Assessment Group. Cambridge Assessment is the brand name of University of
Cambridge Local Examinations Syndicate (UCLES), which is itself a department of the University of Cambridge.
© UCLES 2011 9706/43/O/N/11
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Investment Appraisal/capital Investment: Page 1 of 20

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Investment Appraisal/capital Investment: Page 1 of 20

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Investment appraisal/Capital investment

Types of investment appraisal techniques:

Advantages of payback method Disadvantages of payback method

Year Inflow Outflow

Calculate the payback period.

2. Accounting rate of return(ARR)

i. The net profit must be after depreciation and tax

iii. ARR = Average net profit / average investment X 100

Net profit = NCF – Depreciation

Advantages of ARR Disadvantages of ARR

3. Net present value (discounted cash flow)

Cost of capital = 1 / (1+ r) a

ITEMS not included in NPV

Year Units Sold and produce

Details per units

Calculate net present value, Payback, ARR

Ex2 May 2012 P43 Q3

The company’s cost of capital is 10%. The discount factors are:

4. Internal Rate of Return (IRR) method

IRR = +ve discount rate + +ve NPV X difference between

Take the previous example to work a calculation.

Discount rate NPV ($)

Calculate internal rate of return for this project.

5. Annual cost saving – any new annual expenditure

Summary for NPV, IRR

Difficult to estimate discount rate that is cost of capital

The cost of capital is 8%.

The following discount factors are given:

(a) Calculate for the new machine:

(i) the accounting rate of return (ARR) [5]

(ii) the net present value (NPV) [3]

(iii) the internal rate of return (IRR) [4]

(c) State three advantages of using the NPV method. [3]

© UCLES 2021 9706/33/INSERT/M/J/21

Section B: Cost and Management Accounting

Details of Machine X are as follows.

Year 0 Year 1 Year 2 Year 3 Year 4

(a) Calculate the accounting rate of return (ARR) of Machine X. [5]

P Limited’s cost of capital is 10%.

The following are the discount factors for 10%.

(c) Calculate the net present value (NPV) of Machine X. [5]

(d) Calculate the IRR of Machine X. [3]

© UCLES 2019 9706/31/INSERT/O/N/19

Initial cost $480 000

© UCLES 2019 9706/31/INSERT/O/N/19 [Turn over

Section B: Cost and Management Accounting

3 Machine maintenance costs will be:

(a) Calculate for Machine X:

(i) the net cash flow for each year [5]

(ii) the payback period [3]

(iii) the accounting rate of return to two decimal places. [5]

Gerry’s cost of capital is 10%. The relevant discount factors are:

(c) Calculate the net present value (NPV) of Machine X. [3]

© UCLES 2019 9706/32/INSERT/M/J/19

number of tickets price per ticket

(a) Calculate the total revenue for each year for:

(i) the original plan [1]

(ii) the revised plan. [1]

(i) the original plan [2]

(ii) the revised plan. [2]

© UCLES 2020 9706/31/INSERT/O/N/20

The number of units produced and sold are expected to be as follows.

Year 1 Year 2 Year 3 Year 4 Total