Chapter 4 Capital Budgeting and Basic Investment Appraisal

Techniques

1. Objectives

1.1 Describe the capital budgeting process.

1.2 Explain the role of investment appraisal in the capital budgeting process.
1.3 Calculate the payback and discounted payback period as an investment
appraisal method.
1.4 Calculate the net present value (NPV) and use it to appraise the proposal.
1.5 Calculate the internal rate of return (IRR) and use it to appraise the proposal.
1.6 Calculate accounting rate of return (ARR) and use it to appraise an investment.
1.7 Define a relevant cash flow.

2. Capital Investment

2.1 When a business spends money on new non-current assets it is known as

capital investment or capital expenditure. Spending may be for:
(a) Maintenance – spending to replace worn-out or obsolete assets, or to
improve safety and security of existing non-current assets.
(b) Profitability – spending to achieve cost savings, quality improvements,
improvements to productivity, etc.
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 (c) Expansion – spending to grow the business, make new products, open
new outlets, invest in research and development (R&D), etc.
(d) Indirect purposes – spending which is necessary for the smooth
running of the business but not directly related to operations, e.g.
renovating office buildings.
2.2 A capital budget:
(a) is a program of capital expenditure covering several years
(b) includes authorized future projects and projects currently under
consideration.
2.3 The capital budgeting process consists of a number of stages:

2.4 The process of appraising the potential projects (stage 3 above) is known as
investment appraisal. This appraisal has the following features:
(a) assessment of the level of expected returns earned for the level of
expenditure made
(b) estimates of future costs and benefits over the project’s life.

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3. Investment Appraisal Techniques

A. Payback method

3.1 The payback period is the time a project will take to pay back the money
spent on it. It is based on expected cash flows and provides a measure of
liquidity.
3.2 Decision rule:
(a) only select projects which pay back within the specified time period
(b) choose between options on the basis of the fastest payback
(c) provides a measure of liquidity.

3.3 EXAMPLE 1
A project is expected to have the following cash flows:
Year Cash flow ($000)
0 (2,000)
1 500
2 500
3 400
4 600
5 300
6 200

What is the expected payback period?

Solution:
Year Cash flow Cumulative cash flow
($000) ($000)
0 (2,000) (2,000)
1 500 (1,500)
2 500 (1,000)
3 400 (600)
4 600 0
5 300 300
6 200 500

The payback period is exactly 4 years.

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 In the table above a column is added for cumulative cash flows for the
project to date. Figures in brackets are negative cash flows.

Each year’s cumulative figure is simply the cumulative figure at the start of
the year plus the figure for the current year. The cumulative figure each year
is therefore the expected position as at the end of that year.

3.3 Test your understanding 1

A project is expected to have the following cash flows:
Year Cash flow ($000)
0 (1,900)
1 300
2 500
3 600
4 800
5 500

What is the expected payback period?

Solution:

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3.3 Advantages and disadvantages of payback

Advantages Disadvantages
 It is simple  It ignores returns after the
 It is useful in certain situations: payback period
 Rapidly changing technology  It ignores time value of money
 Improving investment  It is subjective – no definitive
conditions investment signal
 It favours quick return:  It ignores project profitability.
 Helps company growth
 Minimizes risk
 Maximizes liquidity
 It uses cash flows, not accounting
profit.

B. Discounted payback

3.4 With discounted payback the future cash flows are discounted prior to
calculating the payback period. This is an improvement on the simple payback
method in that it takes into account the time value of money.

3.5 EXAMPLE 2
A project is expected to have the following cash flows. The discount rate is
10%.
Year Cash flow ($000)
0 (2,000)
1 600
2 500
3 600
4 600
5 300
6 200

What is the discounted payback period?

Solution:

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 Year Cash flow Discounted Cumulative
($000) Cash flow @10% cash flow
($000) ($000)
0 (2,000) (2,000) (2,000)
1 600 545 (1,455)
2 500 413 (1,042)
3 600 451 (591)
4 600 410 (181)
5 300 186 5
6 200 113 118

The payback period is about 6 years.

C. Net present value (NPV)

3.6 To appraise the overall impact of a project using discounted cash flow (DCF)
techniques involves discounting all the relevant cash flows associated with the
project back to their PV.
3.7 If we treat outflows of the project as negative and inflows as positive, the NPV
of the project is the sum of the PVs of all flows that arise as a result of doing the
project.

3.8 Decision Rule

The NPV represents the surplus funds (after funding the investment)
earned on the project, therefore:

 If the NPV > 0 – the project is financially viable, i.e. accepted.

 If the NPV = 0 – the project breaks even.
 If the NPV < 0 – the project is not financially viable, i.e. rejected.

If the company has two or more mutually exclusive projects under

consideration it should choose the one with the highest NPV.

The NPV gives the impact of the project on shareholder wealth.

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3.9 EXAMPLE 3
An organization is considering a capital investment in the 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 9%.

Calculate the NPV of the project to assess whether it should be undertaken.

Solution:
Year Cash flow ($0 Discounted factor PV ($)
at 9%
0 (240,000) 1.000 (240,000)
1 80,000 0.917 73,360
2 120,000 0.842 101,040
3 70,000 0.772 54,040
4 40,000 0.708 28,320
5 20,000 0.708 13,000
NPV = 29,760

The PV of cash inflows exceeds the PV of cash outflows by $29,760, which

means that the project will earn a DCF return in excess of 9%, i.e. it will
earn a surplus of $29,760 after paying the cost of financing. It should
therefore be undertaken.

3.10 Advantages and disadvantages of NPV

Advantages Disadvantages
 Considers the time value of  It is difficult to explain to

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 money managers
 Is an absolute measure of return  It requires knowledge of the cost
 Is based on cash flows not profits of capital
 Considers the whole life of the  It is relatively complex.
project
 Should lead to maximization of
shareholder wealth.

D. Internal rate of return (IRR)

3.11 The IRR is the rate of return which equates the present value of future cash
flows with the outlay:

Outlays = Future cash flows discounted at rate r

Thus:

The IRR (r) is the discount rate at which the NPV is zero.

3.12 Decision Rule

Projects should be accepted if their IRR is greater than the cost of
capital.

3.13 Steps in calculating the IRR using linear interpolation

1. Calculate two NPVs for the project at two different costs of capital.
One NPV must be negative, and another one is positive.
2. Using the following formula to find the IRR:

IRR = L +

where:
L = Lower rate of interest
H = Higher rate of interest

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 NL = NPV at lower rate of interest
NH = NPV at higher rate of interest

The diagram below shows the IRR as estimated by the formula.

3.14 EXAMPLE 4
A potential project’s predicted cash flows give a NPV of $50,000 at a
discount rate of 10% and – $10,000 at a rate of 15%.

Calculate the IRR.

Solution:

IRR = 10% + = 14.17%

3.15 Test your understanding 2 – IRR with even cash flows

Find the IRR of a project with an initial investment of $1.5 million and
three years of inflows of $700,000 starting in one year.

Solution:

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3.16 Test your understanding 3 – IRR with perpetual cash flows
Find the IRR of an investment that costs $20,000 and generates $1,600 for
an indefinitely long period.

Solution:

3.17 Advantages and disadvantages of IRR

Advantages Disadvantages
 Considers the time value of  It is not a measure of absolute
money profitability.
 Is a percentage and therefore  Interpolation only provides an
easily understood estimate and an accurate estimate
 Uses cash flows not profits requires the use of a spreadsheet
 Considers the whole life of the program
project  It is fairly complicated to
 Means a firm selecting projects calculate
where the IRR exceeds the cost  Non-conventional cash flows may
of capital should increase give rise to multiple IRRs.
shareholders’ wealth.

E. Accounting rate of return (ARR)

3.18 This is also known as return on capital employed (ROCE) or return on

investment (ROI).

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3.19 Decision rule
If the expected ARR for the investment is greater than the target or
hurdle rate then the project should be accepted.

3.20 This ratio can be calculated in a number of ways. There are three alternative
versions of ARR can be used. It should be noted that these are just three of all
the possible ways of calculating ARR, there are many more.

3.21 EXAMPLE 5

ARR = = 33.33%

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 If we now make the example slightly more sophisticated by assuming that
the machinery has a scrap value of $8,000 at the end of year 3, then the
average capital invested figure becomes:
(30,000 + 8,000) ÷ 2 = 19,000

3.22 Test your understanding 4

Arrow wants to buy a new item of equipment which will be used to provide
a service to customers of the company. Two models of equipment are
available, one with a slightly higher capacity and greater reliability than the
other. The expected costs and profits of each item are as follows.

Equipment Item X Equipment Item Y

Capital cost $80,000 $150,000
Life 5 years 5 years
Profits before depreciation
Year 1 50,000 50,000
Year 2 50,000 50,000
Year 3 30,000 60,000
Year 4 20,000 60,000
Year 5 10,000 60,000
Disposal value 0 0

ROCE is measured as the average annual profit after depreciation, divided

by the average net book value of the asset. You are required to decide which
item of equipment should be selected, if any, if the company’s target ROCE
is 30%.

Solution:

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3.23 Advantages and disadvantages of ARR

Advantages Disadvantages
 It is a quick and simple  It is based on accounting profit
calculation and not cash flows. Accounting
 It involves the familiar concept of profits are subject to a number of
a percentage return different accounting treatments.
 It looks at the entire project life  It is a relative measure rather than
an absolute measure and hence
takes no account of the size of the
investment
 It takes no account of the length
of the project.
 Like the payback method, it
ignores the time value of money.

4. Relevant Cash Flows

4.1 Only relevant cash flows should be considered. These are:

(a) Future
(b) Incremental / Changes
(c) Cash-based.
4.2 We should ignore the following costs:
(a) sunk costs
(b) committed costs
(c) non-cash items
(d) allocated costs.
4.3 On the other hand, in capital investment appraisal it is more appropriate to
evaluate future cash flows than accounting profits, because:

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(a) profits cannot be spent
(b) profits are subjective
(c) cash is required to pay dividends.

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 Exercise

Question 1 - NPV
Silly Filly Ltd is a recently established company specialising in the manufacture of
talking toy horses for children. The Silly Filly range currently comprises three key
products – all of which are toy horses – plus approximately thirty accessories to
complement the range, from stables to grooming kits.

The Silly Filly range has been such a success in the last year that the management is
considering producing an animated film to accompany the range. This is in
accordance with the company’s long-term expansion plans, culminating in a stock
exchange flotation in three year’s time.

The film will take one year to make. In the year following that, sales of the film will
commence.

You, an accounting technician for the company, have been asked to assist in
appraising the project to decide whether it should go ahead. The following
information is relevant to your calculations.

(i) Market research has already been carried out at a cost of £1·2 million.
(ii) The services of a company specialising in animation will be required at a total
cost of £520,000. 50% of these costs will be paid immediately with the
remainder being paid in one year’s time.
(iii) Two producers will be employed throughout the first year of the project. They
will each be paid salaries of £120,000.
(iv) Other production costs during the year are expected to be £650,000.
(v) A film director will be employed immediately on a one-year contract at a cost of
£160,000.
(vi) The animated film is expected to generate revenues of £1·2 million in the first
year of sales, £2·2 million in the second year, and £1·6 million in the third year.
(vii) The two producers and the director will each be paid royalties from the film.
These will be paid at the rate of 1·5% of gross revenues for EACH of the
producers and 2% for the director. They will always be payable one year in
arrears.
(viii) Specialist equipment will need to be purchased immediately for the film
production. This will cost £2·3 million but can be sold at the end of the year for
£1·7 million.
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(ix) A loan for £1 million will be taken out to assist in financing the project. The
loan will be repayable in two year’s time, with interest of 8% per annum being
payable for its duration.
(x) The company’s cost of capital is 10% per annum.
(xi) Assume that all cash flows occur at the end of each year, unless otherwise
stated.

Required:

(a) Calculate the project’s net present value (NPV) at the company’s cost of capital.
Conclude as to whether the company should proceed with the project, giving a
reason for your conclusion. (10 marks)

Question 2 – NPV and IRR

Paradise Ltd is a large company specialising in luxury holidays for the rich and
famous. It has recently purchased an uninhabited island, close to the popular resort of
Luca, at a cost of £2 million. The company has already spent £1·5 million on
preparing the land for construction work. Over the next year it plans to develop the
island extensively, with the aim of making it one of the most exclusive holiday
locations in the region.

An offer has just been made to buy the land for £5 million. Paradise Ltd has therefore
decided to reappraise the project in order to decide whether they should still proceed
with the project, or should instead accept the offer. If they decide to accept the offer,
the sale will take place immediately, incurring legal fees of £20,000. If they reject the
offer, development will continue and accommodation will be available for rent in one
year’s time.

The company’s project accountant has provided estimates of costs and revenues for
the next five years as set out below.

1. Total construction costs for the seven hotels on the island are £37 million. Of the
total, £2 million has already been spent in the form of down payments to several
construction firms. These down payments are irrecoverable.
2. Total construction costs for the forty luxury self-catering lodges that will be
attached to the hotels are £24 million. A down payment of £4 million is required
immediately.
3. The cost of furnishing the hotels and lodges is estimated at £3·2 million.
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4. Each lodge will have its own private swimming pool. The cost of each pool is
expected to be £12,000.
5. Six restaurants will be built on the island at a cost of £15 million. Paradise Ltd
has already had to commit to £3 million of these costs in order to attract the
chefs it requires. Although these monies have not yet been paid over, Paradise
Ltd is contractually bound to pay them, irrespective of whether the project now
proceeds.
6. A small parade of shops will be developed at a cost of £4 million.
7. Annual cash overheads are expected to be £2 million for the hotels. Revenues
for the hotels are estimated at £13 million per annum.
8. Maintenance costs for each of the lodges will be £7,000 per annum, compared to
rental income of £390,000 per annum, per lodge.
9. Depreciation totalling £1·5 million per annum will be charged in Paradise Ltd’s
accounts for the hotels, lodges, restaurants and shops.
10. The restaurant and shops are expected to generate net income of £4·73 million
per annum, in total.
11. Interest on money borrowed to finance the project will be £2·5 million per
annum.

All the set-up costs will occur within the next year, before the resort is open. The
annual revenues and overheads relate to the four years following this. Assume that all
cash flows occur at the end of each year, unless otherwise stated, and that there are no
terminal values to consider at the end of the four years.

The company’s cost of capital is 10% per annum.

Required:

(a) Explain the main principles used to differentiate between relevant and irrelevant
costs for investment appraisal, using the information in the question to illustrate
your points. (8 marks)
(b) Calculate the project’s net present value (NPV) at the company’s required rate of
return. Conclude as to whether the company should accept the offer or continue
with the project, giving a reason for your conclusion. (16 marks)
(c) Calculate the internal rate of return (IRR) for the project, using the discount
rates in the tables provided. (4 marks)
(d) State three advantages and three disadvantages of using the IRR as a method of
project appraisal. (6 marks)
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(e) Briefly outline each of the following stages involved in evaluating capital
projects:
(i) Initial investigation of the proposal;
(ii) Detailed evaluation;
(iii) Authorisation;
(iv) Implementation;
(v) Project monitoring;
(vi) Post-completion audit. (6 marks)
(40 marks)
(Workings should be in £’000, to the nearest £’000.)

Question 3 – NPV and Payback

Taxi Ltd is a long established company providing high quality transport for
customers. It currently owns and runs 350 cars and has a turnover of £10 million per
annum.

The current system for allocating jobs to drivers is very inefficient. Taxi Ltd is
considering the implementation of a new computerised tracking system called
‘Kwictrac’. This will make the allocation of jobs far more efficient.

You are an accounting technician for an accounting firm advising Taxi Ltd. You have
been asked to perform some calculations to help Taxi Ltd decide whether Kwictrac
should be implemented. The project is being appraised over five years.

The costs and benefits of the new system are set out below.

(i) The central tracking system costs £2,100,000 to implement. This amount will be
payable in three equal instalments: one immediately, the second in one year’s
time, and the third in two years’ time.
(ii) Depreciation on the new system will be provided at £420,000 per annum.
(iii) Staff will need to be trained how to use the new system. This will cost Taxi Ltd
£425,000 in the first year.
(iv) If Kwictrac is implemented, revenues will rise to an estimated £11 million this
year, thereafter increasing by 5% per annum (i.e. compounded). Even if
Kwictrac is not implemented, revenues will increase by an estimated £200,000
per annum, from their current level of £10 million per annum.
(v) Despite increased revenues, Kwictrac will still make overall savings in terms of
vehicle running costs. These cost savings are estimated at 1% of the post
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 Kwictrac revenues each year (i.e. the £11 million revenue, rising by 5%
thereafter, as referred to in note (iv)).
(vi) Six new staff operatives will be recruited to manage the Kwictrac system. Their
wages will cost the company £120,000 per annum in the first year, £200,000 in
the second year, thereafter increasing by 5% per annum (i.e. compounded).
(vii) Taxi Ltd will have to take out a maintenance contract for the Kwictrac system.
This will cost £75,000 per annum.
(viii) Interest on money borrowed to finance the project will cost £150,000 per
annum.
(ix) Taxi Ltd’s cost of capital is 10% per annum.

Required:

(a) Calculate the net present value of the new Kwictrac project to the nearest £000.
(10 marks)
(b) Calculate the simple payback period for the project and interpret the result.
(3 marks)
(c) Calculate the discounted payback period for the project and interpret the result.
(3 marks)
(d) Taxi Ltd wants to ensure that it has enough cash available to pay the second and
third instalments for the Kwictrac system, when they fall due. The company has
therefore decided to invest the cash on time deposits with its local bank. The
rates of interest paid by the bank are as follows:

6 month deposits 7% per annum

One year deposits 8% per annum
Two year deposits 9% per annum
Three year deposits 10% per annum

Interest is paid once a year, at the end of the year.

Calculate the total amount of cash that Taxi Ltd needs to put on deposit
immediately in order to meet the final two instalments for Kwictrac. (4 marks)

NOTE: You should assume that all cash flows occur at the end of the year,
unless otherwise stated.
(Total 20 marks)

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