Capital Investment Decisions: Appraisal Methods

By Jackie, Researcher

Topic: Education

Area of discussion: Management & Cost Accounting

Chapter: Capital investment decisions – appraisal methods

The objective of this posting is to share a ‘question & answer’ related to capital investment decision. A real past year question was taken from AAT Stage 3 Cost Accounting and Budgeting. I hope this posting will help more students to understand payback, accounting rate of return and net present value calculations better. Some parts of it might be tricky where it tries to confuse students. Besides, normally professional exams questions will ask a bit on its theoretical concepts or other qualitative measures. Hopefully, this posting will help students to eliminate the fear in exams and to score with flying colours.

Payback is defined as the length of time that is required for a stream of cash proceeds from an investment to recover the original cash outlay required by the investment. If the stream of cash flows from the investment is constant each year, the payback period can be calculated by dividing the total initial cash outlay by the amount of the expected annual cash proceeds. However, if the stream of expected proceeds is not constant from year to year, the payback period is determined by adding up the cash inflows expected in successive years until the total is equal to the original outlay (see below).

Accounting rate of return uses profits rather than cash flows. Therefore, to find out the profits, we have to take cash flows minus depreciation. Do not add the scrap value back to the final year’s cash flow. This is because scrap value is not profit. Remember, if all things are run accordingly, there will be no ‘gain or loss on disposal’, thus it will not affect the profits. The average investment under this assumption is one-half of the amount of the initial investment plus one-half of the scrap value at the end of the project’s life.

Net present value (NPV) is computed using net cash inflows less the project’s initial investment outlay. A positive NPV indicates that an investment should be accepted, while a negative value indicates that it should be rejected. A zero NPV calculation indicates that the firm should be indifferent to whether the project is accepted or rejected. 

Normally, for the last sub-question of the investment appraisal decisions, the examiners will frequently ask the students on which is the most favorable investment project. Sometimes, when there is a conflict in ranking between the few investment appraisal methods, NPV method will be the key decision factor.

Not all investment projects can be described completely in terms of monetary costs and benefits. There is also a danger that those aspects of a new investment that are difficult to quantify may be omitted from the financial appraisal.

Additional readings, related links and references:

Payback Period: Meaning, Calculation, Example, Usage and Consideration.

http://www.business-case-analysis.com/payback-period.html

Investment Appraisals: A guide to calculating ARR, the accounting rate of return.

http://suite101.com/article/investment-appraisals-how-to-calculate-arr-a297194

Net Present Value (NPV): Tutorials, Calculators, Android Apps, Excel Solutions & Tables for Finance

http://finance.thinkanddone.com/npv.html

Watch a short introduction video to Investment Appraisal Methods

http://www.youtube.com/watch?v=4arxW7nO8zc

Investment Appraisal Masterclass by Kaplan

http://www.youtube.com/watch?v=DGXxr1aZl84