L5 FINANCIAL MANAGEMENT

INVESTMENT APPRAISAL (1)

Question 1.

Project A NPV:

Year Project A 12 % discount Present Value

(£) factor
0 (10 000) 1.000 (10 000)
1 5 000 0.893 4 465
2 5 000 0.797 3 985
3 2 000 0.712 1 424
4 1 000 0.636 636
NPV 510

Project B NPV:

Year Project A 12 % discount Present Value

(£) factor
0 (15 000) 1.000 (15 000)
1 5 000 0.893 4 465
2 5 000 0.797 3 985
3 5 000 0.712 3 560
4 10 000 0.636 6 360
5 5 000 0.567 2 835
NPV 6 205

Project C NPV:

Year Project A 12 % discount Present Value

(£) factor
0 (20 000) 1.000 (20 000)
1 10 000 0.893 8 930
2 10 000 0.797 7 970
3 4 000 0.712 2 848
4 2 000 0.636 1 272
NPV 1 020

All 3 projects produce a positive NPV at 12% so all 3 should be accepted if the
company can afford the total capital outlay.

Question 2.

Project A:
Average annual accounting profit = (5,000+5,000+2,000+1,000-10,000)/4 = 750
Average investment = 10,000/2 = 5,000
ROCE/ARR = 750/5,000 = 0.15 x 100 = 15%

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 L5 FINANCIAL MANAGEMENT
INVESTMENT APPRAISAL (1)

Project B:
Ave annual accounting profit = (5,000+5,000+5,000+10000+5000-15,000)/5=3000
Average investment = 15,000/2 = 7500
ROCE/ARR = 3,000/7,500 = 0.40 x 100 = 40%

Project C:
Average annual accounting profit = (10,000+8,000+4,000+2,000-20,000)/4 = 1,000
Average investment = 20000/2 = 10,000
ROCE/ARR = 1,000/10,000 = 0.10 x 100 = 10%

Project A and Project B exceed the target ROCE of 12% and therefore would be
accepted. Project C falls to achieve the required hurdle rate and would be rejected.

Question 3.

Project A: = 4 years
Project B: 3 years + 300/400 = 3.75 years
Project C: 3 years + 500/1000 = 3.5 years
Project D = 4 years
Project E: 3 years + 250/400 = 3.63 years

Project ranking:

1. C
2. E
3. B
4. A/D

Question 4.

Project 1:

Year Cashflow Discount Present

factor@ Value
15%
0 (556,000) 1.00 (556,000)
1 200,000 0.870 174,000
2 200,000 0.756 151,200
3 200,000 0.658 131,600
4 200,000 0.572 114,400
5 256,000 0.497 127,232
NPV 142,432

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 L5 FINANCIAL MANAGEMENT
INVESTMENT APPRAISAL (1)

Project 2:

Year Cashflow Discount Present

factor Value
@ 15%
0 (1,616,000) 1.00 (1,616,000)
1 500,000 0.870 435,000
2 500,000 0.756 378,000
3 500,000 0.658 329,000
4 500,000 0.572 286,000
5 801,000 0.497 398,097
NPV 210,097

Project 2 should be accepted over project 1, given they are mutually exclusive.

Question 5.

(1) Variable costs = £400,000 per year

Annual net cash income = 600,000 - 400,000 = £200,000 per year
Payback period = 900,000/ 200,000 = 4.5 years

(2) Average annual accounting profit = ((200,000 x 8) – 800,000)/ 8 = £100,000

Average investment = (800,000/2 + 100,000) = £500,000
Accounting rate of return = (100,000/ 500,000) x 100 = 20%

(3) NPV at 11%:

(200,000 x 5.146) + (100,000 x 0.434) - 900,000 = £172,600

(4) IRR – here we need a negative NPV so discount at a higher discount rate:
NPV at 20%:
(200,000 x 3.837) + (100,000 x 0.233) - 900,000 = -£109,300

IRR = R1 + (R2 – R1) x (NPV1/(NPV1 – NPV2)

= 11% + (20% - 11%) x (172,600/(172,600 + 109,300)
= 16.5%

Notes:

 no comment can be made on investment acceptability from an ARR point

of view, since a hurdle rate on capital employed or target ARR is needed
with which to compare the calculated ARR.
 the same comment can be made with respect to payback period, since a
target payback period is needed with which to make an evaluative
comparison.
 as the NPV is positive, the project is acceptable, since the NPV decision
rule is to accept all projects with a positive NPV.
 With IRR, the IRR of 16.5% is higher than the discount rate of 11%, so the
project is acceptable using this investment appraisal technique.

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 L5 FINANCIAL MANAGEMENT
INVESTMENT APPRAISAL (1)

Phase Test Preparation:

Q1. C (2) and (3) are correct

Statement (1) is the only incorrect one of the three. Internal Rate of Return can lead
to the incorrect decision as there is a zone of error compared to NPV.

Q2. A Decrease No change

Here the IRR would be lower as the NPV would also be lower
In terms of the Payback Period, the t4 cash flow falls outside of the payback period
of 2 years 8 years, hence it will be unaffected.

Q3. C 20.6%
The best estimate will be to use 15% and 20%:
IRR = R1 + (R2 – R1) x (NPV1/(NPV1 – NPV2)
= 15% + (20% - 15%) x (18,000/(18,000 – 2,000)
= 20.6%

Q4. C 3.5 years

Here the Payback Period is given by 3.5 years

Q5. D 24%
No info on the scrap value so assumed to be zero.
All figures below in £000’s.
Total cash flows = £1,440
Total profit = £1,440 - £900 = £540
Average cash flows = £540/5 = £108
Average investment = £900/2 = £450
ARR/ROCE = £108/£450 = 24%

Q6. A (1) and (2)

Only (3) should not be included when calculating the NPV of a project. That is
because it is a sunk cost and has already been incurred and hence will not be
affected if the company takes or doesn’t take the project.

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