Time Value of Money and Capital

Budgeting Techniques
By: Waqas Siddique Samma. ACCA
 Agenda:

• Time Value of Money

• Compounding and Discounting
• Net Present Value
• Internal rate of return (IRR) method
• Annuities and perpetuities
• Layout of NPV calculations basic
• Payback Period
The time value of money
The idea that money available at the present time is worth
more than the same amount in the future due to its
potential earning capacity. This core principle of finance
holds that, provided money can earn interest, any amount
of money is worth more the sooner it is received. .
Money received now is more valuable than the same
amount in the future.
Terminal values (TVs) are the amounts that will receive
at the end of the project.
Instead of comparing terminal values, it is more normal to
compare present values.
3
 Concept of Time Line

$10,000
0 1 2 3 4 5
10%

Now

4
Simple interest
• Interest may be simple interest, but is usually compound
interest
• Simple interest is calculated on the original investment
• Investment $100,000 for 3 years, 10% simple interest
• Interest after three years = $100,000 x 10% x 3 years = $30,000
• Value of investment after 3 years = $100,000 + $30,000 =
$130,000

5
Compound interest
• Compound interest: Interest is calculated for each period
on the original investment plus the accumulated interest at
the start of the period
Year Investment Interest
0 Investment 100,000
End of Year Interest (10%) 10,000 10,000
1
110,000
End of Year Interest (10%) 11,000 11,000
2
121,000
End of Year Interest (10%) 12,100 12,100
3
End of Year 133,100 33,100
3 6
Compounding/ Future value
Compounding-The process of determining the final value of a
cash flow or series of cash flows when compound interest is
applied.
Future Value (FV) The amount to which a cash flow or series of
cash flows will grow over a given period of time when
compounded at a given interest rate.
FV = PV (1 + r)n
where
FV = future value at the end of period n
PV = present value (= original investment)
r = interest rate each period (10% = 0.10, 5% = 0.05)
n = number of time periods
• When PV = $100,000, n = 3 and r = 10%
• FV at end of Year 3 = $100,000 x (1.10)3 = $133,100
7
0 1 2 3 n-1 n
i% . . .
R R R R R

FV

8
9
10
11
12
PV table

Annuity table

13
You have following investment plan for next fifteen years.

Time of investment Amount invested

0 10,000
2 25,000
3 30,000
5 50,000

Return on investment is expected to be 10%. How much you

will receive at the end of fifteen years.
 Discounting
The process of finding the present value of a cash flow or a series
of cash flows.
Discounting is the reverse of compounding. The present value of a
future sum tells us what a future sum is worth today
- Compounding: Calculate a FV from a PV

- Discounting: Calculate a PV from a FV

FV = PV (1 + r)n

PV = FV x [1/ (1 + r)n]

PV = FV (1 + r)-n

(1/ (1 + r)n is the discount factor)

15
 Cash flows occur at the end of the period

0 1 2 n
i% . . .
R R R

R = Periodic
Cash Flow

16
Annuity
An annuity is a series of equal payments made at fixed intervals for a specified
number of periods.
Ordinary Annuity.
If the payments occur at the end of each period the annuity is called an ordinary or
deferred annuity. For example $ 500 is received at the end of each year for next
five years.
T1-5
Annuity Due
If payments are made at the beginning of each period, the annuity is an annuity
due annuity. For example $ 500 is received at the beginning of each year for next
five years.
Delayed Annuity
An annuity in which the first payment is paid at a later date in the future.
Alternatively we can say annuity starting other than t 1or 0 is annuity delayed.
What is the present value of $500 per annum receivable for
ten years if the first payment is due
(i) in a year’s time (i) 500 × 5.019 = $2,510
(ii) in two years’ time (ii) 500 × (5.019 × 0.870) =$2,183
(iii) immediately? (iii) 500 × (4.772 + 1) = $2,886
The discount rate is 15%.

What is the present value of $1,500 per annum receivable

for fifteen years if the first payment is due
(i) in a year’s time
(ii) in two years’ time
(iii) immediately?
The discount rate is 20%.
A perpetuity is an annuity that has no definite end, or a
stream of cash payments that continues forever.
PV = P/I
If perpetuity is growing at constant rate its PV can be
calculated as follows
P
PV =
i-g

Delayed Perpetuity.
What is the present value of $1,500 per annum due in
perpetuity at a 10% discount rate if the first payment is due
(i) in one year’s time
(ii) in five years’ time?

(i) 1,500 ÷ 0.10 = $15,000

(ii) (1,500 ÷ 0.10) × 0.683=$10,245
An investment pays you $100 at the end of each of the next
3 years. The investment will then pay you $200 at the end
of Year 4, $300 at the end of Year 5, and $500 at the endof
Year 6. If the interest rate earned on the investment is 8
percent, what is its present value? What is its future value?

PV $923.98; FV $1,466.24.

21
You are in the process of negotiating your first contract.
The team’s general manager has offered you three
possible contracts. Each of the contracts lasts for 4 years.
All of the money is guaranteed and is paid at the end of
each year. The terms of each of the contracts are listed
below:
CONTRACT 1 CONTRACT 2 CONTRACT 3
PAYMENTS PAYMENTS PAYMENTS
Year 1 $3 million $2 million $7 million
Year 2 3 million 3 million 1 million
Year 3 3 million 4 million 1 million
Year 4 3 million 5 million 1 million
You should discounts all cash flows at 10 percent. Which of
the three contracts offers you the most value?

Contract 2; PV $10,717,847.14. 22
The difference between the present value of cash inflows and
the present value of cash outflows. NPV is used in capital
budgeting to analyze the profitability of an investment or
project. 

NPV analysis is sensitive to the reliability of future cash inflows

that an investment or project will yield. 

NPV may be positive or negative, depending on the size of the

cash inflows and outflows and the discount rate
Positive NPV: the project will provide a higher return than the
cost of capital. Therefore financially worthwhile
Negative NPV: expected returns are less than the cost of
capital. Do not invest in the project.

23
For example, if a retail clothing business wants to purchase
an existing store, it would first estimate the future cash flows
that store would generate, and then discount those cash
flows into one lump-sum present value amount, say
$565,000. If the owner of the store was willing to sell his
business for less than $565,000, the purchasing company
would likely accept the offer as it presents a positive NPV
investment. Conversely, if the owner would not sell for less
than $565,000, the purchaser would not buy the store, as the
investment would present a negative NPV at that time and
would, therefore, reduce the overall value of the clothing
company.  

24
Decision rule
Accept all projects with a positive NPV (ie NPV > 0) at
the company’s discount rate (cost of capital).
The NPV of a project is the addition to shareholder
wealth from undertaking that project.

Assumptions about the timing of cash flows

All cash flows for the investment are assumed to occur
at the end of the year
If a cash flow will occur early during a particular year, it
is assumed that it will occur at the end of the previous
year.

25
Advantages of NPV method
NPV takes account of the timing of the cash flows by calculating the
present value for each cash flow at the investor's cost of capital
DCF is based on cash flows, not accounting profits. It is therefore
much more suitable than the ARR method for investment appraisal
it evaluates all cash flows from the project, unlike the payback
method which considers only those cash flows in the payback period
It gives a single figure, the NPV, which can be used assess the value
of the investment project
The NPV method provides a' decision rule which is consistent with
objective of maximisation of shareholders' wealth. In theory, a
company ought to increase in value by the NPV of an investment
project (assuming that the NPV is positive).

Disadvantages of NPV method.

The time value of money and present value are concepts that are not
easily understood
There might be some uncertainty about the appropriate cost of
capital or discount rate to apply to any project. 26
An organisation is considering a capital investment in new
equipment.
The estimated cash flows are as follows.
Year Cash flow $
0 (240,000)
1 80,000
2 120,000
3 70,000
4 40,000
5 20,000
The company’s cost of capital is 10%.
Calculate the NPV of the project to assess whether it should
be undertaken.

27
A company is considering whether to undertake an
investment. The cost of capital is 10%. The cost of the
investment would be $50,000 and the expected annual cash
flaws from the project, would be:
Year Revenue Costs Net cash flow
1 40,000 30,000 10,000
2 55,000 35,000 20,000
3 82,000 40,000 42,000
Required
(a) Use compounding arithmetic to calculate what the
investment should be worth at the end of Year 3.
(b) Using discounting, calculate the NPV of the project.
(c) Reconcile the future value of the investment (calculated
by compounding) with the NPV.

28
Compounding $
Investment in Year 0 (50,000)
Interest required (10%), Year 1 (5,000)
Return required, end of Year 1 (55,000)
Net cash flow, Year 1 10,000
(45,000)
Intent required (10%), Year 2 (4,500)
Return required, end of Year 2 (49,500)
Net cash flow, Year 2 20,000
(29,500)
Interest required (10%), Year 3 (2,950)
Return required, end Year 3 (32,450)
Not cash flow, Year 3 42,000
Future value, end at Year 3 9,550
29
Discounting: NPV method
Year Cash flow Discount factor Present value
@ 10%
0 (50,000) 1.0 (50,000)
1 10,000 1/(1.10)¹ 9,091
2 20,000 1/(1.10)² 16,529
3 42,000 1/(1.10)³ 31,555
Net present value +7,175

Reconciliation. of present value-and future value

NPV x (1 + r)n = Future value; $7,175 x (1.10)3 = $9,550

30
Cash flows and working capital
(NPV method)
• Some investment projects require an investment in working
capital. Allow for this in cash flow estimates.
• When working capital increases, cash flows are less than
cash profits by the amount of the increase
• Working capital increases: treat as a cash outflow/payment
(often in Year 0)
• Working capital reductions: treat as a cash inflow/receipt
(often in the last year of the project)

31
NPV method: example
(NPV method)
Year Cash flow item Cash flow Discount PV
factor
$ 10% $
0 Buy equipment (100,000) 1.000 (100,000)
1 Cash profit 20,000 1/(1.10)1 18,182
2 Cash profit 30,000 1/(1.10)2 24,793
3 Cash profit 50,000 1/(1.10)3 37,566
4 Cash profit 40,000 1/(1.10)4 27,321
5 Cash profit 20,000 1/(1.10)5 12,418
NPV = + 20,280
32
NPV method: discount tables
(NPV method)
• Discount tables can be used to obtain discount factors for
each year, at different discount rates
Year Cash flow Cash flow PV factor PV
item
$ at 10% $
0 Buy equipment (100,000) 1.000 (100,000)
1 Cash profit 20,000 0.909 18,180
2 Cash profit 30,000 0.826 24,780
3 Cash profit 50,000 0.751 37,550
4 Cash profit 40,000 0.683 27,320
5 Cash profit 20,000 0.621 12,420
NPV = + 20,250
33
NPV method: example 2
(NPV method)
• Use discount tables for any cost of capital up to 20% (if a
whole number) and any year up to Year 20

Year Cash flow DCF factor Present value

$ 8% $
0 (160,000) 1.000 (160,000)
1 (20,000) 0.926 (18,520)
2 60,000 0.857 51,420
3 140,000 0.794 111,160
4 70,000 0.735 51,450
+ 35,510
34
Significance of an NPV
(NPV method)
• NPV is a money amount, not a percentage yield
• If a company calculates an NPV using its cost of capital as
the discount rate, the NPV is an estimate of the change that
might be expected in the total market value of the company,
if the investment goes ahead
• The theoretical argument is outside the scope of the
examination syllabus

35
Internal rate of return (IRR) method
• NPV method – discount all future cash flows at the cost of
capital
• IRR method – calculate the discount rate at which the NPV =
0. This is the investment yield from the project.
• IRR ‘rule’: Undertake the project if its IRR exceeds a
minimum target yield, or exceeds the company’s cost of
capital
• Do not undertake the project if its IRR is lower than the
minimum acceptable yield or cost of capital

36
Calculating the IRR
(IRR method)
• Approximate IRR can be calculated using interpolation
• Calculate two NPVs, one positive and the other negative, at a
higher discount rate.
• The choice of discount rates is arbitrary
• However, both NPVs should be close to 0 if possible, to
reduce the estimation error
• The IRR, where the NPV is 0, must be somewhere between
the discount rates for the two NPVs

37
Calculating the IRR: interpolation
(IRR method)
IRR = R1+NPV1 (R2-R1)
(NPV1-NPV2)
0 (100,000)
1 75,000
2 25,000
• Formula for interpolation
3 30,000
NPV at a discount rate of A% = + $P (positive)
NPV at a discount rate of B% = - $N (negative)
IRR = A% + [P/(P + N)] x (B – A)%
(ignore the minus sign for the negative NPV)

38
Calculating the IRR: example 1
(IRR method)
• NPV at 10% discount rate = + 500
• NPV at 13% discount rate = - 100

So approximate IRR =
10% + [500/(500 + 100)] x (13 – 10)%
= 10% + [500/600] x 3%
= 10% + 2.5%
= 12.5%
39
Calculating the IRR: example 2
(IRR method)
Year Cash Try 15% Try 10%
flow Factor PV Factor PV
0 (240,000) 1.000 (240,000) 1.000 (240,000)
1 50,000 0.870 43,500 0.909 45,450
2 80,000 0.756 60,480 0.826 66,080
3 120,000 0.658 78,960 0.751 90,120
4 90,000 0.572 51,480 0.683 61,470
NPV (5,580) NPV + 23,120

IRR = 10% + [23,120/(23,120 + 5,580)] x (15 – 10)% = 14%

40
NPV or IRR method?
(IRR method)
• The NPV method is better. It gives a money value to projects
• IRR weaknesses
• IRR does not indicate the size of the investment (nor its
value)
• mutually exclusive projects: choose the one with the
higher NPV, even if its IRR is lower
• IRR advantage
• IRR yield: easier to understand a yield than an NPV

41
Summary
(Discounted cash flow)
• Methods of investment appraisal
• ARR method and payback method. Ignore the time value of
money. Never use these on their own
• NPV and IRR method. Both are DCF methods, but the NPV
method is better. NPV estimates a value for an investment
• In practice, companies may use several methods and
compare the results from each
• In the exam, the NPV method is more common

42
Annuities
(Investment arithmetic)

• An annuity = a constant cash flow for a given number of time

periods
• PV of an annuity =
• the amount that has to be invested now
• to earn an annual income of A each year
• for the next n years, starting in Year 1
• when the investment rate is r
PV = (A/r) x [1 – 1/(1 + r)n]
43
 What is the difference between an ordinary annuity and
an annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

44
PV of an annuity: example
(Investment arithmetic)
• Annuity = $10,000, years 1 – 6
• Investment rate (discount rate) = 5%
PV = ($10,000/0.05) x [1 – 1/(1.05)6]
= $200,000 x 0.253785
= $50,757

45
Annuity factors
(NPV method)
Year Cash flow PV factor 12% PV
0 (75,000) x 1.000 = (75,000)
1 20,000 x 0.893 = 17,860
2 20,000 x 0.797 = 15,940
3 20,000 x 0.712 = 14,240
4 20,000 x 0.636 = 12,720
5 20,000 x 0.567 = 11,340
NPV = (2,900)

46
Annuity factors
(NPV method)
Year Cash flow PV factor 12% PV
0 (75,000) x 1.000 = (75,000)
1 20,000 0.893
2 20,000 0.797
3 20,000 0.712
4 20,000 0.636
5 20,000 0.567
1-5 20,000 x 3.605 = 72,100
NPV = (2,900)
47
Annuity factors
(NPV method)
• Annuity factor for annual cash flows beginning later
than Year 1
• Subtract one annuity factor from another
Year Cash flow Annuity factor PV
at 9%
1 – 10 6.418
1–4 3.240
5 – 10 10,000 x 3.178 = 31,780

48
Perpetuities
• A perpetuity is a constant cash flow each period which continues for
a very long period.

PV = C/r where C = constant annual cash flow

r = cost of capital

Example
The present value of a perpetuity of $1,000 at a cost of capital of 8%
= $1,000/0.08 = $12,500
49
Layout of NPV calculations

For a simple calculation the following layout can be used;

Year Description Cash Flow Discount PV

$ Factor (7%) $
0 Equipment (10,000) 1 (10,000)
1-5 Cash profit 5,000 4.1 20,500
Net present value 10,500

50
 What is the PV of this uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
51
Layout of NPV calculations
For a more complex calculation the following layout is recommended;
Year 0 1 2 3
(All figs ‘000)
Investment (150)
Working capital (20)
Incremental contribution 80 80 80
Incremental cost (10) (15) (20)
Total cash flow (170) 70 65 60
Discount factor (7%) 1 0.935 0.873 0.816
PV (170) 65.45 56.75 48.96
Net present value = $1,160

52
Which rule is preferred/Superior?

There is no doubt about the theoretical superiority of the NPV

There are two reasons for preferring the NPV rule.

The first is that it is closely linked to the assumed objective.

Everything we do in FM is based on the belief that the object
of the exercise is the maximisation of shareholder wealth.
Since the NPV is the immediate increase in wealth as a result
of accepting a project .
The second reason for preferring the NPV is technical
limitations of the IRR rule. There are three.
1) Like many percentage measures the IRR is unable to deal
with different sized projects.
2) Under certain circumstances projects may have more than
one IRR. This problem may arise when the project has non-
standard cash flows. 53
3) The IRR rule is based on an unrealistic re-investment
assumption. Both the NPV rule and the IRR rule have implicit
assumptions about the re-investment of intermediate
cash flows. The NPV rule assumes that all intermediate cash
flows can be reinvested, on receipt, to earn a return equal to
the company's cost of capital. The IRR rule assumes that all
intermediate cash flows can be re-invested, on receipt, to earn
a return equal to the IRR of the project under consideration.
Both re-investment assumptions are limiting but of the two that
of the NPV is the more realistic. The
company's cost of capital is at least a market interest rate and
it may not be unreasonable to assume we can invest at that
rate. The IRR is not a market interest rate, it is simply a
number with a mathematical property. It would be by the most
amazing coincidence if we were to find another project that
paid exactly the same return as the IRR of the project that
54
we
are evaluating.
Capital Budgeting Techniques
Capital expenditure
• Companies invest in capital assets and new business
ventures

• The investment decision

• Should we invest or not?
• With alternative investments, which one should we
choose?

• Capital investment appraisal = financial evaluation of

proposed investments
Features of investment projects
• Long-term investments
• They provide returns over several years
• ‘Long term’ = more than one year
• ‘Classic’ project = Investment now, followed by a return each
year over the life of the project
• Investment appraisal: consider costs and revenues over the
full life of the project
Accounting rate of return method
The accounting rate of return from an investment project is
the accounting profit, usually before interest and tax, as a
percentage of the capital invested. It is similar to Return on
Capital Employed (ROCE). The essential feature of ARR is
that it is based on accounting profits, and the accounting
value of assets employed.
Decision rule for the ARR method
The decision rule for capital investment appraisal using the
ARR method is:
 Accept projects with an ARR that is higher than the target
ARR or minimum acceptable ARR. Alternatively, the
decision rule might be.
 Accept a project if the ARR or ROCE of the company as a
whole will increase as a result of undertaking the project.
 Return on capital employed (ROCE)
A traditional approach to evaluating investments is to
evaluate the profit from the investment as a % of the
amount invested. ROCE is also called accounting rate of
return (ARR) and return on investment (ROI).

ROCE = Average annual profit from investment X 100

Initial investment or Average investment

Initial outlay + scrap value

Average Investment =
2
Note: profit is after depreciation but before interest and
tax
Unfortunately, a standard definition of accounting rate of
return does not exist. There are two main definitions:
Average annual profit as a percentage of the average
investment in the project
Average annual profit as a percentage of the initial
investment.
Advantages of ROCE
Consistent with methods used to evaluate the company as
a whole
Relative score (%) is easy to understand
Considers the whole life of the project
Disadvantages of ROCE
Ignores the timing of the cash flows
Worsens if a small amount of extra cash is earned in an
extra year of the project
Profits can be affected by costs that are not relevant costs
Brenda and Eddie are considering expanding their restaurant
business through purchase of the Parkway Diner, which will cost
$350,000 to take-over the business and a further $150,000 to
refurbish the premises with new equipment. Cash flow projections
from the project show the
following profits over the next six years.
Year Net Cash Profits ($)
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
The equipment will be depreciated to a zero resale value over the
same period and, after the sixth year, Brenda and Eddie
confidently expect that they could sell the business for
$350,000.Calculate the ROCE of this investment (using the
average investment method)
Profit calculation:
$
Total cash flows from operations 540,000
Total depreciation (500,000 – 350,000) (150,000)
Total profits 390,000
Average profits (÷ 6) = $65,000 p.a.
Investment calculation 425,000
(500,000 +350,000) / 2

ARR = 15.3%
 ARR method: example

• Invest in buying a machine, cost $100,000

• Project life: 5 years
• Expected residual value: $30,000 at end of Year 5
• Working capital required: $20,000
• Depreciation method: Straight-line
• Expected cash profits:
• Years 1 and 2: $30,000 each year
• Years 3 and 4: $40,000 each year
• Year 5: $10,000
• Minimum required accounting rate of return = 15%
ARR method: example
Total cash profits (In 000s, 150,000
30 + 30 + 40 + 40 + 10)
Less depreciation (100,000 – 30,000) 70,000

Total profits (5 years) 80,000

Average annual profit = 80,000/5 = 16,000

Average capital employed (100,000 + 30,000) + 20,000

2
= 85,000

ARR = 16,000/85,000 = 18.8%

Weaknesses of the ARR method
Project A Project B
Year $ $
0 Cost (200,000) (200,000)
1 Profit before dep’n 20,000 200,000
2 Profit before dep’n 20,000 50,000
3 Profit before dep’n 220,000 10,000
Total profits 60,000 60,000
Average profit 20,000 20,000
ARR 20% 20%
(20,000/100,000)
 Exercise 1
A capital project would involve the purchase of an item of
equipment costing £240,000. The equipment will have a useful
life of six years and would generate cash flows of £66,000 each
year for the first three years and £42,000 each year for the final
three years. The scrap value of the equipment is expected to be
£24,000 after six years. An additional investment of £40,000 in
working capital would be required. The business currently
achieves a return on capital employed, as measured from the
data in its financial statements, of 10%.
Required
a) Calculate the ARR of the project, using the initial cost of the
equipment to calculate capital employed.
b) Calculate the ARR of the project, using the average cost of the
equipment to calculate capital employed.
c) Suggest whether or not the project should be undertaken, on
the basis of its expected ARR.
The payback method
• This is a measure of how many years it takes for the cash flows
affected by the decision to invest to repay the cost of the original
investment. A long payback period is considered risky because it
relies on cash flows that are in the distant future.
• Unlike the ARR method, the payback method considers:
• cash flows of the investment, not accounting profits
• the timing of cash returns

• Payback = the length of time before an investment will pay back

the cash invested
• Company sets a maximum payback period for investments
• Don’t invest unless the investment will pay back within the
maximum time allowed
Brenda and Eddie are worried about the length of time it will
take for the cash flows from the Parkway Diner to repay their
total investment of $500,000 ($350,000 to take-over the
business and $150,000 to refurbish it). Cash flow projections
from the project are reproduced below.
Year Net Cash Profits ($)
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
After the sixth year, Brenda and Eddie confidently expect
that they could sell the business for $350,000.
Required
Calculate the payback period for the project, and advise
Brenda & Eddie whether they are right to be concerned.
 Time Cumulative cash flow
$
0 (500,000)
1 (430,000)
2 (360,000)
3 (280,000)
4 (180,000)
5 (80,000)
6 40,000
Payback = 5 + (80/120) years
= 5 years 8 months
This is a long payback period and means that if there is no
buyer for the business in 6 years time, then they will only just
have recouped their costs. This project is beginning to look
risky, but we might not be rejected because this analysis has
not considered the total cash flows of the project.
Payback method: example
(Payback method)

Year Cash flow Cumulative cash

flow
0 = ‘now’ Investment (160,000) (160,000)
1 Cash profit 30,000 (130,000)
2 Cash profit 50,000 (80,000)
3 Cash profit 50,000 (30,000)
4 Cash profit 80,000 50,000
Payback in Year 4, or
3 years + (30/80) x 12 months = 3 years 5 months
Decision rule
Accept all projects with a payback period within the
company's target payback period.
Advantages of payback
 A simple way of screening out projects that look too risky
 The method analyses cash flows, not accounting profits. Investments are
about investing cash to earn cash returns. In this respect,, the payback
method is better than the ARR method.
 Useful when a company has cash flow problems
Weaknesses
The payback method of investment appraisal has some major
limitations and weaknesses, and it should never be used on
its own to decide whether or not an investment should be
undertaken.
 It looks at the timing of cash flows but ignores the time value of money
 It ignores returns after payback, so it ignores the total expected returns
from the investment
 A company must choose between two investments, Project A and
Project B. It cannot undertake both invests. The expected cash
flows for each project are:
Year Project A Project B
0 (80,000) (80,000)
1 20,000 60,000
2 36,000 24,000
3 36,000 2,000
4 17,000. -
The maximum permissible payback period for an investment is three
years as per company policy. If a choice has to be made between,
two projects, the project with the earlier payback will be chosen.
Required
Calculate the payback period for each project:
(a)assuming that cash flows occur at that year end
(b)assuming that cash flows after Year 0 occur at a constant rate
throughout each year Are the projects acceptable, according to the
company's payback rule?
Which project should be selected?
Do you agree that this is the most appropriate invest decision?
Discounted payback period
The figures used for the payback period procedure are
simply discounted first and the time to reach a net present
value is calculated.
Bail-out factor
The project is evaluated for different durations, taking into
account any scrap values receivable.
A project being considered would require a machine costing
£80,000. Market research of £8,000 has already been carried
out and has been capitalised. The result is that the
project is expected to last for six years and produce net cash
earnings of £20,000 for each of the first three years and then
£15,000 for each of the last three years. The anticipated scrap
proceeds of the machine at various stages in its life are as
follows:
After year 1 £40,000 After year 2 £30,000
After year 3 £20,000 After year 4 £13,000
After year 5 £10,000 After year 6 £4,000
Required:
Evaluate the project using
ROCE
ROCE using the average investment approach
payback period
payback period incorporating the bail-out factor.
You may assume that cash flows arise evenly during the year.
Solution
(a)ROCE
Average annual earnings =
Average annual depreciation =
ROCE =
(b)Average investment =
ROCE =
 Net
Cumulative
Time Flow Scrap cumulative
flow
flow
0 (88,000)
1 20,000 40,000
2 20,000 30,000
3 20,000 20,000
4 15,000 13,000
5 15,000 10,000
6 15,000 4,000

Payback period =
Payback period with bail-out =
EXAMPLE SOLUTION

Solution 1 – ARR and payback

(a) ROCE

Average annual earnings = (3 x 20,000 + 3 x 15,000)

= ₤17,500
6

Average annual deprecation = 80,000 + 8,000 – 4,000

= ₤14,000
6

ROCE = 17,500 – 4,000

= 4%
88,000
(b) Average investment = 88,000 + 4,000
= ₤46,000
2
ROCE = 17,500 – 14,000
= 7.6%
46,000
Time Flow Cumulative Scrap Net cumulative
flow flow
0 (88,000) (88,000) (88,000)
1 20,000 (68,000) 40,000 (28,000)
2 20,000 (48,000) 30,000 (18,000)
3 20,000 (28,000) 20,000 (8,000)
4 15,000 (13,000) 13,000 -
5 15,000 2,000 10,000 12,000
6 15,000 17,000 4,000 21,000

Payback peroid = 413/15 years

Payback peroid with bail-uut = 4 years

Weaknesses of the payback method

Year Project A Cumulative Project B Cumulative

Cash Flow Cash Flow
0 (80,000) (80,000) (80,000) (80,000)
1 70,000 (10,000) 0 (80,000)
2 4,000 (6,000) 0 (80,000)
3 3,000 (3,000) 10,000 (70,000)
4 3,000 0 70,000 0
Weaknesses of the payback method

Year Project A Cumulative Project C Cumulative

Cash Flow Cash Flow
0 (80,000) (80,000) (80,000) (80,000)
1 70,000 (10,000) 20,000 (60,000)
2 4,000 (6,000) 20,000 (40,000)
3 3,000 (3,000) 20,000 (20,000)
4 3,000 0 20,000 0
5 0 0 20,000 20,000
6 0 0 20,000 40,000
In capital investment appraisal it is more appropriate to
evaluate future cash flows than accounting profits, because:
• profits cannot be spent
• profits are subjective
• cash is required to pay dividends.
Only relevant cash flows should be used.
Consider:
• future
• incremental
• cash based.
Ignore:
• sunk costs
• committed costs
• noncash items
• allocated costs.
Relevant costs in investment decisions
• Payback and DCF techniques use cash flow to evaluate
investments
• Cash flows used should be relevant costs and revenues
• Relevant means future costs or revenues which arise as a
result of the investment
• Never include sunk costs in an investment appraisal based
on cash flows as these are not relevant.
• Never include depreciation as a cash flow