LECTURE 3

INVESTMENT APPRAISAL

EBENEZER YEN (CA)

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 Introduction
• Before capital expenditure projects are undertaken, they should be
assessed and evaluated. As a general rule, projects should not be
undertaken unless:
üthey are expected to provide a suitable financial return, and
üthe investment risk is acceptable.
• Investment appraisal is the evaluation of proposed investment projects
involving capital expenditure. The purpose of investment appraisal is to
make a decision about whether the capital expenditure is worthwhile and
whether the investment project should be undertaken

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 Investment Appraisal Process
Investment appraisal therefore takes place within the framework of a capital
budget and strategic planning. It involves:
1. Generating capital investment proposals in line with the company’s
strategic objectives.
2. Forecasting relevant cash flows relating to the project
3. Evaluating the projects
4. Implementing projects which satisfy the company’s criteria for deciding
whether the project will earn a satisfactory return on investment
5. Monitoring the performance of investment projects to ensure that they
perform in line with expectations.
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 Inputs in Investment Appraisal
• All the available methods employed in appraising investment uses two major
indicators (inputs):
ØAccounting profit
ØNet (free) Cash flows
• What is accounting profit? This is usually the expected “profits after tax” from
project/asset to be undertaken or purchased. Thus this figure is what is revealed by
a company’s proforma financial income statement on a particular asset or project.
• The use of the word “expected” emphasizes that in investment appraisal, our
inputs for analysis are future figures rather than past figures. Thus in going to set
up a branch in Techiman for instance in September this year, our assessment as to
whether it will be a good investment or otherwise should be based on cash flows
from say October 2023 to say October 2028.

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 Inputs in Investment Appraisal
• What is (free) cash flows? This represents the expected “residue” of a company’s
expected cash receipts from its revenues after relevant expected expenditures have
been deducted.
• Whereas profit does not necessarily look at cash we are receiving or expenses we are
paying, cash flow looks purely at only items that will increase or reduce cash.
• In using profits or cash flows, the Finance Manager has to be aware that the figures
relate to future years and hence has risk associated with them. Thus the concept of
time value of money needs to be upheld, if really he wants to maximize shareholders’
wealth.
• The methods used in investment appraisal can thus be grouped into:
ØNon-discounted cash flow techniques
ØDiscounted cash flow techniques

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 Profit versus Cash
In capital investment appraisal it is more appropriate to evaluate future cash
flows than accounting profits, because:
Ø Profits cannot be spent
Ø Profits are subjective
Ø Cash is required to pay dividends

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 Relevant Cash Flows in Investment Decision
• The only cash flows that should be taken into consideration in capital
investment appraisal (with the exception of ROCE) are the relevant cash flows.
• Relevant cash flows are future cash flows arising as a direct consequence of the
decision under consideration. Relevant cash flows exhibit the following features:
ØThey are direct costs
ØThey are incremental costs
ØThey are differential costs
ØThey are opportunity costs
ØThey are controllable costs
ØThey are avoidable costs

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 Irrelevant Costs in Investment Decision
• Any cost that does not satisfy the basic features of relevant cost, as outlined
above, is said to be irrelevant cost. The following are examples of irrelevant
costs:
1. Sunk (past) cost
2. Non-cash items like depreciation
3. Indirect costs like General overheads and Central Office overheads
4. Absorbed fixed cost

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 Assumptions of Cashflows
• If cashflows arise during the period, then it is assumed as it arises at the end of
that period
• If cashflows arise at the start of the period then it is assumed as if it arises at the
end of the preceding period.
• Period ‘0’ is not a period, instead it represents start of period ‘1’

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 Investment Appraisal Techniques/Methods
• Non-discounted cash flow techniques are the methods in appraising investment that do not take
into consideration time value of money. i.e the profit or cash flows are not discounted before they
are used for analysis. The include:
ØPayback method
ØAccounting Rate of Return (ARR)/Return on Capital Employed (ROCE)

• Discounted cash flow techniques are the methods in appraising investments that take into
consideration time value of money. i.e the profit or cash flows are discounted before they are used
for analysis.
ØDiscounted payback method
ØNet present Value (NPV)
ØInternal Rate of Return (IRR)
ØProfitability Index

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 Payback Period Method
• This method chooses investment by looking at the number of years or months it will
take for the monies invested to be recouped.
• Generally investors want to recover their investments early. Hence a shorter payback
period is desirable.
• Payback period is the time it takes for an investment expenditure to be recovered or
recouped.
• Investors having a target payback period, choose a particular investment only if the
expected payback period of the prospective investment is equal to or lower than the
target.
• The payback method uses net cash flows.
• Net Cash flows is the difference between cash receipts and cash payments (i.e
monies paid and monies received). In investment analysis we use forecast cash flows
and hence net cash flows refer to monies to be received less monies to be paid.
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 Payback Period Method
• For two mutually exclusive projects/investments (i.e investments you can only do
one at a time, because of cash constraints, etc)
• Where expected net cash inflows subsequent to the investment is constant (the
same), we can simply calculate the payback period as follows:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑎𝑚𝑜𝑢𝑛𝑡
(𝑎𝑛𝑛𝑢𝑎𝑙) 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠

• Decision rule
If Payback Period < Target Payback Period, Accept the Project. Else, Reject the
Project.

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Illustration: Payback Period -Expected Constant
Cash Inflows
• Example 1
An expenditure of GH₵2 million is expected to generate net cash inflows of
GH₵500,000 each year for the next seven years. What is the payback period for the
project?
Solution
GH₵2,000,000
Payback period = ––––––––– = 4 years
GH₵500,000
• A payback period may not be for an exact number of years. To calculate the payback
in years and months you should multiply the decimal fraction of a year by 12 to the
number of months
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 Payback Period With Diverse Cash Flows
• Where the expected annual cash flows are not the same or differ as given in the example below, we cannot
use the preceding approach we adopted.
• We must rather find the cumulative cash flows and pick the year whose cumulative cash flow corresponds to
the investment. Where an exact figure corresponding to the investment cannot be found, you pick the closest
figure. The next is thing is to estimate the approximate years for the difference between this figure and the
investment amount.
• The payback period is therefore the sum of:
Ø The year corresponding to the closest cumulative sum;
Ø approximate year (months) of the difference between closest cumulative sum and investment amount
• so for instance if at the end of the fifth year, the cumulative cash flow is GHS10,000 and at the end of sixth
year, the cumulative cash flow is GHS15,000, to find the number of years it takes to recover investment
amount of GHS12,000, clearly it will be 5years and some months.
• It takes one year to make GHS5,000 (15,000 less 10,000) so how many years will it take to add GHS2,000, the
remaining value of investment to be recovered? It will be approximately 5 months (2000/5000 *12). The
payback period is thus 5 years and 5 months.

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Illustration :Payback Period with Diverse Cash
Flows
• Find the payback of a project with following cash flows
Year Cash flows
0 (20,000)
1 8,000
2 5,500
3 7,500

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 Advantages of the Payback Period Method
ØIt is easy and simple to apply and the concept is easy to understand
ØIt is based on cash flows, not accounting profit (which is subjective)
ØIt can be used as a first screening device in eliminating obviously
inappropriate projects prior to more detailed evaluation.
ØThe fact that it tends to bias in favour of short-term projects means that
it tends to minimize both financial and business risk.
ØIt can be used when there is a capital rationing situation to identify those
projects which generate additional cash for investment quickly.

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 Disadvantages of the Payback Period Method
ØIt ignores all cash flows after the payback period, and so ignores the total
cash returns from the project.
ØIt ignores the time value of money, so that it gives equal weight to cash flows
whenever they occur within the payback period.
ØPayback is unable to distinguish between projects with the same payback
period.
ØThe choice of any cut-off payback period by an organization is arbitrary.
ØIt may lead to excessive investment in short-term projects.
ØIt does not give a measure of return, as such it can only be used in addition
to other investment appraisal methods.
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 Return on Capital Employed/ARR
• The Return on Capital Employed compares a company’s capital with its earnings to measure
how efficiently capital has been used to generate earnings.
• This uses accounting ratio to make investment decisions. A predetermined target is used and
if the computed ratio is equal or greater than the target, the project is viable (i.e for
independent projects);
• For mutually exclusive projects, the higher is chosen.
• There are several different definitions of return on capital employed (ROCE), which is also
called return on investment (ROI) and accounting rate of return (ARR).
• It is important to remember that return on capital employed is calculated using accounting
profits, which are operating cash flows adjusted to take account of depreciation. Accounting
profits are not cash flows, since depreciation is an accounting adjustment which does not
correspond to an annual movement of cash.
• Given net cash flows, accounting profit is computed as follows:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
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 Return on Capital Employed
• Total profit over the life of the project can simply be computed as follows:
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 ! 𝑠 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
• Total depreciation is the called the depreciable amount of the asset.
• Depreciable amount is the difference between the cost of the asset and the
residual value.
• ROCE is computed as a ratio of profit to investment. The formula is as follows:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑓𝑖𝑡
= 𝑥100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

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 Return on Capital Employed
• Average profit is simply calculated as the sum of profits over the
project life divided by the project life/years.
• Average investment is calculated as follows:
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 (𝑠𝑐𝑟𝑎𝑝) 𝑣𝑎𝑙𝑢𝑒
=
2
• Alternatively we can also use the initial investment only as the
denominator as follows in calculating the ROCE:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑓𝑖𝑡
𝑥100
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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 Illustrations-ROCE
• Example 1
A project involves the immediate purchase of an item of plant costing
GH₵110,000. It would generate annual cash flows of GH₵24,400 for five years,
starting in Year 1. The plant purchased would have a scrap value of GH₵10,000 in
five years, when the project terminates. Depreciation is on a straight line basis.
• Determine the project's ROCE using:
• (a) Initial capital costs
• (b) Average capital investment

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 Illustrations-ROCE
• Solution
• Annual cash flows are taken to be profit before depreciation.
Depreciation
= (GH₵110,000 – GH₵10,000) ÷ 5
= GH₵20,000
Average annual profit
= GH₵24,400 – GH₵20,000
= GH₵4,400

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 Illustrations-ROCE
• Using initial cost:
Average annual profit
ROCE = ––––––––––––––––– × 100%
Initial capital cost
GH₵4,400
= –––––––––––– × 100% = 4%
GH₵110,000

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 Illustrations-ROCE
• Using average capital investment:

Average annual profit

ROCE = ––––––––––––––––– × 100%
Average capital cost

• Average capital investment is calculated as:

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 Illustrations-ROCE
Initial cost + Final scrap
= –––––––––––––––––
2
GH₵110,000 + GH₵10,000
= –––––––––––– = GH₵60,000
2

GH₵4,400
= –––––––––––– × 100% = 7.33%
GH₵60,000

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 Advantages of ROCE
• It gives a value in percentage terms, a familiar measure of return, which can be
compared with the existing ROCE of a company, the primary accounting ratio
used by financial analysts in assessing company performance.
• It is also a reasonably simple method to apply and can be used to compare
mutually exclusive projects.
• Unlike the payback method, it considers all cash flows arising during the life of
an investment project.

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 Disadvantages of ROCE
• It is not based on cash, but uses accounting profit, which is open to manipulation and
is not linked to the fundamental objective of maximizing shareholder wealth.
• Because the method uses average profits, it also ignores the timing of profits.
• A more serious drawback is that the return on capital employed method does not
consider the time value of money and so gives equal weight to profits whenever they
occur.
• It also fails to take into account the length of the project life.
• Since it is expressed in percentage terms and is therefore a relative measure, it
ignores the size of the investment made.
• There is no definite investment signal. The decision to invest or not remains
subjective in view of the lack of an objectively set target ROCE.
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 Trial 1 - ROCE
A company is considering a project which requires an investment of GHC120,000 in
machinery. The machinery will last four years after which it will have scrap value of
GHC20,000. The investment in additional working capital will be GHC15,000. The
expected annual profits before depreciation are:
Year
1 GHC45,000
2 GHC45,000
3 GHC40,000
4 GHC25,000
The company requires a minimum accounting rate of return of 15% from projects of
this type. ARR is measured as average annual profits as a percentage of the average
investment. Should the project be undertaken?

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 Trial 2 - ROCE
A capital project would involve the purchase of an item of equipment costing
GHC240,000. The equipment will have a useful life of six years and would generate
cash flows of GHC66,000 each year for the first three years and GHC42,000 each
year for the final three years. The scrap value of the equipment is expected to be
GHC24,000 after six years. An additional investment of GHC40,000 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 ROCE of the project, using the initial cost of the equipment to
calculate capital employed.
b) Calculate the ROCE of the project, using the average cost of the equipment to
calculate capital employed.

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 Trial 3 - ROCE
Yen Ltd. is considering the purchase of a new machine and has found two which
meet its specification. Each machine has an expected life of five years. Machine1
would generate annual cash flows(receipts less payments)of GHC210,000 and
would cost GHC570,000. Its scrap value at the end of five years would be
GHC70000. Machine 2 would generate annual cash flows of GHC510,000 and
would cost GHC1,616,000.The scrap value of this machine at the end of five years
would be GHC301,000. Carbon plc uses the straight-line method of depreciation
and has a target return on capital employed of 20 percent. Calculate the return
on capital employed for both Machine 1 and Machine 2 on an average
investment basis and state which machine you would recommend, giving
reasons.

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 Trial 4 - ROCE
Find the Accounting rate of return of an investment in a fixed asset of GHC20,000
which is expected to yield an annual constant profit of GHC5,000 for five years.
The fixed asset is expected to have a nil residual value.

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 Discounted Cash flow Techniques
• These methods take into consideration time value of money. This is done
through discounting;
• Hence in applying these methods, students must be mindful that there is
always going to be discounting of cash flows. In discounting you require
appropriate discount rate (or cost of capital).
• DCF techniques include:
ØNet present Value (NPV)
ØProfitability Index (PI)
ØInternal Rate of Return (IRR)
ØDiscounted Payback method
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 Net Present Value (NPV)
• NPV is the difference between the present value of cash inflows and the present value of
cash outflows for a project. The present value aspect is useful for projects that last several
years, since it takes into account elements such as inflation.
• The difference between the present value of cash inflows and the the present value of cash
outflows can be positive, negative or zero
ØPositive (sum of PVs > investment). This represents “gain position” and shareholders
wealth will increase if the investment is undertaken. The investment is viable. Invest!
ØNegative (Investment > Sum of PVs). This represents “loss position” and hence
shareholders’ wealth will decrease if the investment is undertaken. The investment is not
viable. DON’T invest!;
ØZero (Investment=Sum of PVs). This represents a “break-even point” and shareholders
maintain their wealth position if the investment is undertaken. You are NOT losing or
gaining, so you can invest or reject it (an indifferent point).

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 Residual Value
• Note that in NPV and all the techniques that use cash flows that the residual
value becomes part of the cash flows at the end of the useful life of the asset.
Hence always add it!
• If the asset has five years useful life and the cash flow in the fifth year is
GHS1,000 but the residual value of the asset is GHS500, the total cash flow in
year 5 becomes GHS1,500 (1000 +500).

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 Illustration- Finding NPV

Find the NPV of an investment in a fixed asset which costs GHS10,000 and
expected to generate cash flows as follows:
Years cash flows
1 5,000
2 1,000
3 4,800
Assume a discount rate of 10%

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 Computation of NPV
YEARS CASH FLOWS DCF@10% PV

0 (10,000) 1.000 (10,000)

1 5,000 0.909 4,545

2 1,000 0.826 826

3 6,000 0.751 4,506

NPV = (123)

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 Computation of NPV
The residual value of the fixed asset at the end of its useful life is
estimated at GHS1,200. Assume cost of capital of 10%.
Soln
• In the solution note that the investment amount is deducted from the
sum of the PVs to give NPV. The present value of the investment is
the same since it is paid now.
• Also note that the residual value of GHS1,200 is added to the
GHS4,800 cash flow at the end of the asset’s life.

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 Advantages of NPV method
ØNPV takes account of the time value of money by calculating the present
value for each cash flow at the investor’s cost of capital
Ø The NPV method provides a decision rule which is consistent with
objective of maximisation of shareholders’ wealth. If the cost of capital
reflects the investors required return then the NPV reflects the theoretical
increases in shareholder wealth maximization.
ØNPV considers the whole life of the project by considering all relevant cash
flows over the life of an investment project.
ØIt is an absolute measure of return not a relative measure
Ø It is based on cash flows not profits and therefore an objective measure.
ØWhere there are no constraints on capital, the net present value decision
rule offers sound investment advice.

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 Disadvantages of NPV Method
ØThe time value of money and present value are concepts that are not easily
understood and difficult to explain to managers.
ØThere might be some uncertainty about what the appropriate cost of capital
or discount rate should be for applying to any project
Ø It is usually difficult to estimate the cash flows and outflows over the life of
the project.
ØNPV assumes that there is a perfect capital market in which there is no
restrictions on capital availability for which reason all projects with positive
NPV should be accepted. This limits the applicability of the NPV’s decision
rule.
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 Trial 1 - NPV
An organization with a cost of capital of 14% is considering investing in a project
costing GHC500,000. The project would yield nothing in Year 1, but from Year 2
would yield cash inflows of GHC100,000 per annum in perpetuity.

Required
Assess whether the project should be undertaken.

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 Trial 2 - NPV
A company is considering an investment in equipment costing GHC70,000. Working capital of
GHC5,000 will also be required early in Year 1. The equipment will have a resale value of
GHC7,000 at the end of Year 5. The operating profits from the investment, in cash flows, will
be:
Year Cash flows (GHC)
1 25,000
2 20,000
3 30,000
4 20,000
5 3,000

Using discount tables for the discount factors, calculate the NPV of the project if the cost of
capital is:
(a) 12% and
(b) 8%
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 Trial 3 - NPV
Kwadonto Ltd is evaluating three investment projects, whose expected cash flows are given in
Table below.
Period Project A (GHC000) Project B (GHC000) Project C (GHC000)
0 (5,000) (5,000) (5,000)
1 1,100 800 2,000
2 1,100 900 2,000
3 1,100 1,200 2,000
4 1,100 1,400 100
5 1,100 1,600 100
6 1,100 1,300 100
7 1,100 1,100 100
Required
Calculate the net present value for each project if Kwadonto’s cost of capital is 10 per cent.
Which project should be selected?

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 Trial 4 - NPV
Calculate the NPV of an investment with the following estimated cash flows,
assuming a cost of capital of 8%:
Years Annual cash flow
GHC
0 (3,000,000)
1–4 500,000
5–8 400,000
9 – 10 300,000
11 onwards in perpetuity (per year). 100,000

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 Profitability Index (PI)
• This finds the relative factor of the present value of cash flows from the project
to the present value of the investment made. There are three (3) possible
results:
PI=1 (PV of inflows=PV of investment outlay)
PI>1 (PV of inflows > PV of investment outlay)
PI<1 (PV of inflows < PV of investment outlay)
• PI is calculated as follows:
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠
=
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑢𝑡𝑙𝑎𝑦
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 Profitability Index (PI)
• The PI has a huge advantage over the NPV as it is applied to make the best of
shareholders’ decision where there is capital rationing (capital constraint).
• In instances of capital rationing, the NPV does not always give the best
shareholders’ decision.
• It is applied in choosing divisible projects.

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 Internal Rate of Return (IRR)
• The IRR is another project appraisal method using DCF techniques.
• The IRR represents the discount rate at which the NPV of an investment is
zero. As such it represents a breakeven cost of capital.
• The IRR is computed using the formula below:
𝑵𝑷𝑽𝑳
=𝑳+ 𝒙 (𝑯 − 𝑳)
𝑵𝑷𝑽𝑳 − 𝑵𝑷𝑽𝑯
• Where:
𝑵𝑷𝑽𝑳 =NPV given by the lower rate
𝑵𝑷𝑽𝑯 =NPV given by the higher rate
𝑳= Lower cost of capital
𝑯= Higher cost of capital
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 Internal Rate of Return (IRR)
• The above uses the idea of interpolation-finding middle number on a
line given two values, positive and negative at the right and left sides
respectively.
• Since IRR finds a discount rate at which NPV is equal to zero, given a
line of cost of capital against NPVs, we can use interpolation formula
to find where the line cuts the x-axis (cost of capital line).
• Decision rule:
• projects should be accepted if their IRR is greater than the cost of
capital.

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 Calculating the IRR using linear interpolation
• The steps in linear interpolation are:
(1) Calculate two NPVs for the project at two different costs of capital (ideally
the two cost of capital should give positive and negative NPVs)
(2) Use the formula (given in the previous slides-61) to find the IRR.
• Where a project’s cash flows qualify as annuity, we can simply use a
mathematical equation and given the annuity discounting table, we can
find an approximate IRR.
• The IRR of a perpetuity can also be calculated simply using a mathematical
equation as follows:
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑓𝑙𝑜𝑤
= 𝑥100
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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 Illustration – Finding IRR
1. 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.

2. Find the IRR of an investment of $50,000 if the inflows are:

(a) $5,000 in perpetuity
(b) $8,060 for eight years.

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 Illustration – Finding IRR
3. A business undertakes high-risk investments and requires a minimum
expected rate of return of 17% pa on its investment. A proposed capital
investment has the following expected cash flows:
Year GHS
0 (50,000)
1 18,000
2 25,000
3 20,000
4 10,000
State, on financial grounds alone (based IRR), whether this project should go
ahead.
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 Advantages of IRR
• Considers the time value of money
• IRR is a percentage measure and therefore easily understood.
• IRR uses cash flows not profits. Cashflows are less subjective compared to
profits
• Considers the whole life of the project rather than ignoring cashflows
(which will occur with payback period).
• The IRR can be calculated when the cost of capital is unknown (say, if
finance for a project has yet to be determined. It therefore may provide a
useful benchmark for appraising potential sources of capital.
• A firm selecting projects where the IRR exceeds the cost of capital should
increase shareholders' wealth
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 Disadvantages of IRR
• It is not a measure of absolute profitability.
• Interpolation only provides an estimate and an accurate estimate
requires the use of a spreadsheet programme.
• It is fairly complicated to calculate.
• Non-conventional cash flows may give rise to multiple IRRs which
means the interpolation method can't be used.

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 NPV versus IRR
• NPV and IRR method look similar though the NPV produces results in cedi or dollar
whiles the IRR produces result in percentage.
• However, the two can yield contrasting results. In such instance which method
should be used in making the investment decision. NPV is considered superior to
the IRR for the following reasons:
ØIt chooses better for mutually exclusive projects. If A and B have IRR of 15% and
12% respectively as against the cost of capital of 11%. On the basis of IRR, A is
better. However, if the computed NPVs of A and B are GHS1,800 and GHS2,000
respectively for A and B, B is better using the NPV. However since NPV tells
however much additional wealth shareholders will get when the investment is
made as opposed to IRR that tells us the minimum returns we would get in order to
break-even, we use the NPV and not the IRR to make the decision.
ØNPV method handles better changes in cost of capital/discount rate over the
project’s life.

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 NPV versus IRR
ØNPV method handles better project with unconventional cash flows since the
IRR method can lead to multiple IRRs and in this instance making decisions
becomes difficult. If an investment project has cash flows of different signs in
successive periods (e.g. a cash inflow followed by a cash outflow, followed by
a further cash inflow), it may have more than one internal rate of return.
Such cash flows are called non-conventional cash flows.
ØThe re-investment assumption under NPV is superior to that of the IRR. NPV
assumes that cash flows can be reinvested at the company’s cost of capital
(required rate of return) of investors whiles IRR assumes it can be reinvested
at the IRR. This becomes impractical especially where the IRR varies hugely
from the cost of capital.

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Discounted cash flow methods:
Profitability index and NPV
1. Calculate the NPV of a project with initial investment of GHS50,000
which is expected to generate net cash inflows of GHS17,000 for
three years. Assume cost of capital of 15%. Calculate the PI of this
project also.
2. Calculate the NPV of a project with initial investment in one year
from now of GHS15,000, but expected to have annual constant net
cash inflows in subsequent years of GHS3,500 for three years.
Assume cost of capital of 10%. Calculate also the PI of this project.
3. Calculate the NPV and PI of a project with an initial investment of
GHS10,000 and cash inflows of GHS3,000, GHS5,500 and GHS1,000
respectively in year 1, year 2 and year 3.
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 Investment Appraisal and Taxation
• Taxation may have a significant impact on the viability of capital investment
project. Taxation payments and savings in tax payments are clearly cash flows
associated. These are relevant and should be included in investment appraisal.
• There are two tax effects that we need to deal with in investment appraisal,
which are the effects of corporation tax, and the impact of tax depreciation
(also known as capital allowance).
• Typical assumptions are that the taxable profits will be the net cash flows from
the project less any tax depreciation (capital allowance).
• Unless otherwise specified, taxes in Ghana are paid one year in arrears.

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 Investment Appraisal and Taxation cont’
• In practice, the effects of taxation are more complex, and are influenced by a
number of factors including the following:
üthe taxable profits and tax rates
üthe company’s accounting period and tax payment dates.
üwhether assets qualify for tax depreciation
ülosses available for set-off.
• Detailed knowledge of tax is not required for this paper. Assumptions and
simplifications will be made. These will usually be set out in each examination
question.
• In examination, tax depreciation is generally allowed on the cost of plant and
machinery or any other capital asset, using either straight line method or
reducing balance method.
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 Investment Appraisal and Taxation cont’
• There will be associated tax savings on tax-allowable depreciation which will
included for the purpose of appraising the project. The timing of the tax
savings is important depending on whether tax is paid in arrears or in the
same year in which profits arises.
• When an asset reaches the end of its useful life, it will be scrapped or
disposed of. On disposal, there might be a balancing charge or a balancing
allowance. This is the difference between:
üthe written-down value of the asset for tax purposes (TWDV), and
üits disposal value (if any).
• If the written-down value of the asset for tax purposes is higher than the
disposal value, the difference is a balancing allowance.
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 Investment Appraisal and Taxation cont’
• There will be associated tax savings on tax-allowable depreciation which will
included for the purpose of appraising the project. The timing of the tax savings is
important depending on whether tax is paid in arrears or in the same year in which
profits arises.
• When an asset reaches the end of its useful life, it will be scrapped or disposed of.
On disposal, there might be a balancing charge or a balancing allowance. This is the
difference between:
üthe written-down value of the asset for tax purposes (TWDV), and
üits disposal value (if any).
• The effect of a balance allowance or balance charge is to ensure that over the life of
the asset:
Total amount of capital allowances claimed = Cost of the asset – Residual value
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 Investment Appraisal and Taxation cont’
• If the written-down value of the asset for tax purposes is higher than the
disposal value, the difference is a balancing allowance.
• The balancing allowance is set against taxable profits, and so it will result in a
reduction in tax payments of:
Balancing allowance × Tax rate = Cash saving
• If the written-down value of the asset for tax purposes is lower than the
disposal value, the difference is a balancing charge. The balancing charge is a
taxable amount, and will result in an increase in tax payments of:
Balancing charge × Tax rate = Cash payment.

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 Illustration 1: Taxation and Capital Allowance
An asset is purchased for GHS72,500 by Capon Ltd. At the end of the
fourth year it will be sold for GHS10,000. Tax depreciation is available
at 25% percent reducing balance and corporation tax is payable in
arrears at the rate of 30%.
Required:
Calculate the tax depreciation each year, associated corporate tax
savings, and illustrate the timing of the tax savings

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 Illustration 2: Taxation and Capital Allowance
An asset is bought by Placer Ltd for a project at a cost of GHS25,000.
The asset will be used for four years before being disposed of for
GHS5,000. Tax-allowable depreciation is available at 25% reducing
balance and the tax rate is 30%.
(a) Calculate the tax allowable depreciation and hence the tax savings
for each year if tax is paid (and saved) a year in arrears.
(b) How would your answer to the part (a) change if the sales
proceeds for the asset at the end of the project had been
GHS15,000
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 Investment Appraisal and Inflation
• Inflation can have a serious effect on capital investment decisions, both by reducing the
real value of future cash flows and by increasing their uncertainty.
• Future cash flows must be adjusted to take account of any expected inflation in the prices
of goods and services in order to express them in nominal (or money) terms ,i.e in terms
of the actual cash amounts to be received or paid in the future.
• Nominal cash flows are discounted by a nominal cost of capital using the net present
value method of investment appraisal.
• As an alternative to the nominal approach to dealing with inflation in investment
appraisal, it is possible to deflate nominal cash flows by the general rate of inflation in
order to obtain cash flows expressed in real terms, i.e. with inflation stripped out.
• These real cash flows can then be discounted by a real cost of capital to determine the
net present value of the investment project. Whichever method is used, whether
nominal terms or real terms, care must be taken to determine and apply the correct rates
of inflation to the correct cash flows.
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 Investment Appraisal and Inflation cont’
• Where cash flows have not been increased for expected inflation they are
described as being in current prices, or today's prices.
• Where cash flows have been increased to take account of expected inflation
they are known as money cash flows, or nominal cash flows.
• Remember, if they do take inflation into account, they represent expected
flows of money, hence the term ‘money cash flows’.
• You can assume that cash flows you are given in the exam are the money cash
flows unless told otherwise

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 Real and Nominal Costs of Capital
• The real cost of capital is obtained from the nominal (or money) cost
of capital by removing the effect of inflation.
• This is obtained by using the Fisher equation:
• 1+Nominal Rate= (1+Real rate)(1+Inflation rate)
• Rerranging the equation gives:
𝟏#𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝒓𝒂𝒕𝒆
• 𝑹𝒆𝒂𝒍 𝒓𝒂𝒕𝒆 = −𝟏
(𝟏#𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒆)

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 General and Specific Inflation
• It is likely that individual costs and prices will inflate at different rates and so
individual cash flows will need to be inflated by specific rates of inflation. These
specific rates will need to be forecast as part of the investment appraisal process.
• There will also be an expected general rate of inflation, calculated for example by
reference to the consumer price index (CPI), which represents the average
increase in consumer prices.
• In situations where you are given a number of specific inflation rates, the real
cost of capital cannot be used. Use the nominal cost of capital or money cost of
capital to appraise the project.
• If a question contains both tax and inflation, it is advisable to use the money
method. Although it is theoretically possible to use the real method in questions
incorporating tax, it is extremely complex.
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 Illustration - Inflation
A company is considering a cost-saving project. This involves purchasing a machine
costing GHC7,000, which will result in annual savings (in real terms) on wage costs
of GHC1,000 and on material costs of GHC400. The following forecasts are made of
the rates of inflation each year for the next five years:
Wage costs 10%
Material costs 5%
General prices 6%
The cost of capital of the company, in real terms, is 8.5%.
Evaluate the project, using NPV, assuming that the machine has a life of five years
and no scrap value.

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 Inflation and Working Capital
• Working capital recovered at the end of a project will not have the same
nominal value as the working capital invested at the start. The nominal value of
the investment in working capital needs to be inflated each year in order to
maintain its value in real terms.
• If the inflation rate applicable to working capital is known, we can include in
the investment appraisal an annual capital investment equal to the incremental
annual increase in the nominal value of working capital.
• At the end of the project, the full nominal value of the investment in working
capital is recovered.

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 Incorporating Working Capital
• Investment in a new project often requires an additional investment in working
capital, i.e. the difference between short-term assets and liabilities.
• The treatment of working capital is as follows:
Øinitial investment is a cost at the start of the project
Øif the investment is increased during the project, the increase is a relevant cash
outflow
Ø at the end of the project all the working capital is ‘released’ and treated as a
cash inflow.

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 Incorporating Working Capital cont’
• To calculate the working capital cash flows you should:
Step 1: Calculate the absolute amounts of working capital needed in each period.
Step 2: Work out the incremental cash flows required each year

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 Illustration on Working Capital
1. A company expects sales for a new project to be $225,000 in the first year growing at 5% pa. The
project is expected to last for 4 years. Working capital equal to 10% of annual sales is required and
needs to be in place at the start of each year.
Calculate the working capital flows for incorporation into the NPV calculation.
Solution:
Step1: Estimate working capital for each year (computed on the basis of sales). Sales for the years
are as follows:
Sales working capital at 10%
GHS GHS
Year 0 - 22.500
Year 1 = 225,000 23,625
Year 2 = 225000 x1.05 236,250 24,806
Year 3 = 236,250 x 1.05 248,062.50 26,047
Year 4 = 248,062.50 x 1.05 260,465.63 -
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 Illustration on Working Capital
• Step 2: work out the incremental working capital for each year. This
becomes the relevant cash flow for year.
Year 0 1 2 3 4
cash flow (22,500) (1,125) (1,181) (1,241) -
• Step 3: The value of the working capital at the end of the project is
‘released or recovered. This becomes an inflow in the last year.
Relevant cash flows to be used in NPV calculation is as follows:
Year 0 1 2 3 4
cash flow (GHS) (22,500) (1,125) (1,181) (1,241) 26,047
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 Layout – Long NPV Questions
Year 0 Year 1 Year 2 Year 3 Year 4
Sales receipts - X X X -
Costs - (X) (X) (X) -
Sales less costs X X X -
Taxation on profits - (X) (X) (X) (X)
Tax benefit of tax dep'n - X X X X
Initial investment (X) - - - -
Scrap value - - - X -
Working capital (X) - - X -
(X) X X X (X)
Discount factors @
post-tax cost of capital X X X X X
Present value (X) X X X (X)

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 Investment Appraisal and Capital Rationing
• Shareholder wealth is maximised if a company undertakes all possible
positive NPV projects.
• Capital rationing occurs where there are insufficient funds available to
invest in all projects that have a positive NPV. This implies that where
investment capital is rationed, shareholder wealth is not being maximised.
• There are two types of capital rationing
• Hard capital rationing: This occurs when the shortage of capital is imposed
by external factors, such as the refusal by a bank to advance any more
money or an inability to raise more capital by issuing new shares or bonds.
• Soft capital rationing: This occurs when the shortage of capital is imposed
internally by management decision, such as setting limits to the capital
budget for the year.

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 Reasons for Hard and Soft Capital Rationing
• Hard capital rationing:
ØInability to meet borrowing requirements due to low reported profits
ØLack of asset security for a loan
ØA depressed stock market making share issues difficult
ØTemporary recessions in the economy or set because of setbacks for a particular industry.
ØThe cost associated with capital may be too great
Soft-capital rationing:
ØLimited management skills available
ØCompany reluctant to raise equity to avoid dilution of control
ØLimited exposure to external finance
ØDesire to manage returns of limited range of investments
ØEncourages acceptance of only substantially profitable business.

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Single and Multi-Period Capital Rationing
• Single-period capital rationing: Shortage of funds for this period only.
• Multi-period capital rationing: Shortage of funds in more than one
period.
• The method for dealing with single-period capital rationing is similar
to the limiting factor analysis used elsewhere in decision making. The
profitability index (PI) is used to make decision in single-period
capital rationing.
• The PI cannot however be used in a multi-period period capital
rationing, a different technique known as Linear programming is used
in multi-period capital rationing.
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 The Profitability Index (PI) and Divisible Projects
• Divisible project-If a project is divisible, any fraction of the project may be undertaken
and the returns from the project are expected to be generated in exact proportion to the
amount of investment undertaken. Projects cannot however be undertaken more than
once.
• The aim when managing capital rationing is to maximise the NPV earned per GHS1
invested in projects.
• Where the projects are divisible:
ØIt means they can be done in part
Ø earn corresponding returns to scale
• It is achieved by:
(1) calculating a PI for each project
(2) ranking the projects according to their PI
(3) allocating funds according to the projects’ rankings until they are used up.

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The Profitability Index (PI) and Divisible Projects

• The formula for PI that is usually used is:

𝑁𝑃𝑉
=
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

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 Illustration-Divisible Projects
A company has GHS100,000 available for investment and has identified the
following 5 investments in which to invest. All investments must be started now
(year 0).
Project Initial Investment NPV
C 40 20
D 100 35
E 50 24
F 60 18
G 50 (10)
Required:
Determine which projects should be chosen to maximize the return to the business
(if the projects are divisible)
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 Indivisible Projects -Trial and Error
• If a project is indivisible it must be done in its entirety or not at all.
• Where projects cannot be done in part, the optimal combination can
only be found by trial and error
• Using the same illustration in the previous slides, we can find an
optimal combination of the projects that their investments will not
exceed GHS100,000 and at the same time give us the highest
aggregate NPV.

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 Mutually-Exclusive Projects

• Sometimes the taking on of projects will preclude the taking on of

another, e.g. they may both require use of the same asset.
• In these circumstances, each combination of investments is tried to
identify which earns the higher level of returns.
• We can consider mutually exclusive projects within the choice of
divisible projects as well as that of indivisible projects.

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Illustration-divisible project (including mutually
exclusive projects)
A company has GHS100,000 available for investment and has identified the
following 5 investments in which to invest. All investments must be started now
(year 0).
Project Initial Investment NPV
C 40 20
D 100 35
E 50 24
F 60 18
G 50 (10)
Required:
Determine which projects should be chosen to maximize the return to the business
(if the projects are divisible) and projects C and E are mutually exclusive.
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Trial – Capital Rationing
AKOMA co has identified 4 positive NPV projects as follows:
Project Initial Investment NPV
A 60 9
B 40 12
C 35 6
D 20 4
AKOMA co can only raise GHS12m to invest now
Required:
Advise the company which project (s) to accept if the projects are:
(i) Independent and divisible
(ii) Independent and indivisible
(iii) Mutually exclusive
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 Multi-Period Capital Rationing-Linear
Programming (LP)
• Linear programming is applied in solving capital rationing in more than one
period (a single constraint).
• Where there are more than one constraint we need the principles of LP to help us
determine optimal investments to be made.
• LP expresses real problem into mathematical equations/inequalities and makes
graphical representations of these inequalities, and from them an optimal
solution is determined at where the various lines meet.
• The principles of LP are as follows:
ØFormulation of objective function
ØDefining the unknowns
ØIdentification of constraints and forming inequalities for the constraints
(constraint function), including the non-negativity constraint.
ØThe inequalities are graphed and the optimal solution is found on the graph.
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 Example-LP
A company makes two products , brooms and mops. Each product passes through two departments,
manufacture and packaging. The time spent in each department is as follows:
Departmental time (hours)
Manufacture Packaging
Brooms 3 2
Mops 4 6
There are 4,800 hours available in the manufacturing department and 3,600 hours available in the
packaging department. Production of brooms must not exceed 1,100 units.
The contribution earned from one broom is GHS15 and from a mop is GHS10.
Required:
1.Formulate the linear programme needed to identify the optimum use of the scarce labour resource.
2. Determine optimal production of broom and mop

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 Example of LP in capital rationing
A company has identified the following independent investment projects all of
which are divisible and exhibit constant returns to scale. No project can be
delayed or done more than once.
Cash flows
Project at time 0 1 2 3 4
GHS000 GHS000 GHS000 GHS000 GHS000

A (10) (20) 10 20 20

B (10) (10) 30 - -

C (5) 2 2 2 2

D - (15) (15) 20 20

E (20) 10 (20) 20 20

F (8) (4) 15 10 -

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 Example of LP in Capital Rationing
• There is only GHS20,000 available now and GHS5,000 in year 1 plus
the cash inflows from projects undertaken at time T0 in each time
period thereafter, capital is freely available. The appropriate discount
rate is 10%.

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 Investment Appraisal and Risk
• While the words risk and uncertainty tend to be used interchangeably, they do have different meanings.
• Risk refers to sets of circumstances which can be quantified and to which probabilities can be assigned. Uncertainty
implies that probabilities cannot be assigned to sets of circumstances.
• In the context of investment appraisal, risk refers to the business risk of an investment, which increases with the
variability of expected returns, rather than to financial risk, which since it derives from a company’s capital structure is
reflected in its weighted average cost of capital.
• There are several methods of assessing project risk and of incorporating risk into the decision-making process. major
methods used are:
Ø Sensitivity analysis.
Ø Probability Analysis and expected net present values
Ø Discounted Payback method
Ø Adjusted Payback
Ø Capital Asset Pricing Model (CAPM)
Ø Risk-adjusted discount rates using different classes
Ø Simulation models
Ø Decision trees

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 Sensitivity Analysis
• Sensitivity analysis is a useful but simple technique for assessing investment risk
in a capital expenditure project when there is uncertainty about the estimates of
future cash flows.
• Sensitivity analysis assesses how responsive the project's NPV is to changes in the
variables used to calculate that NPV. Sensitivity analysis typically involves posing
‘what if?’ questions.
• For example, what if demand fell by 10% compared to our original forecasts?
Would the project still be viable?
• Sensitivity margin = NPV × 100%
Present value of project variable

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 Sensitivity Analysis cont
• Sensitivity analysis is a useful but simple technique for assessing investment risk
in a capital expenditure project when there is uncertainty about the estimates of
future cash flows.
• Sensitivity analysis assesses how responsive the project's NPV is to changes in the
variables used to calculate that NPV. Sensitivity analysis typically involves posing
‘what if?’ questions.
• For example, what if demand fell by 10% compared to our original forecasts?
Would the project still be viable?
• Sensitivity margin = NPV × 100%
Present value of project variable

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 Illustration 1 – Sensitivity Analysis
An investment of GHC40,000 today is expected to give rise to annual contribution of
GHC25,000. This is based on selling one product, with a sales volume of 10,000 units,
selling price of GHC12.50 and variable costs per unit of GHC10. Annual fixed cost of
GHC10,000 will be incurred for the next four years; the discount rate is 10%.
Required:
a. Calculate the NPV of this investment
b. Calculate the sensitivity of the NPV to the following
i. Initial investment
ii. Selling price per unit
iii. Variable cost per unit
iv. Sales volume
v. Fixed costs
vi. Discount rate
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 Trial 1 – Sensitivity Analysis
Yen Plc is considering investing GHC500,000 in equipment to produce a new type of ball.
Sales of the product are expected to continue for three years, at the end of which the
equipment will have a scrap value of GHC80,000. Sales revenue of GHC600,000 pa will be
generated at a variable cost of GHC350,000. Annual fixed costs will increase by
GHC40,000.
Required:
a. Using a cost of capital of 15%, compute the NPV of the investment
b. Calculate the sensitivity of the NPV to the following
i. Initial investment
ii. Selling price per unit
iii. Variable cost per unit
iv. Sales volume
v. Fixed costs
vi. Discount rate
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 Advantages and Disadvantages of Sensitivity Analysis
Advantages
• Provides more information to allow management to make subjective judgements
• Identifies areas which are crucial to the success of the project. If the project is
chosen, those areas can be carefully monitored.
• Indicates just how critical are some of the forecasts which are considered to be
uncertain.
Disadvantages
• Does not directly identify a correct decision
• Assumes that variables change independently of each other
• Does not assess the likelihood of a variable changing
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 Discounted Payback Period
Instead of using the ordinary payback to decide whether a project is acceptable,
discounted payback might be used as an alternative. A maximum discounted
payback period is established and projects should not be undertaken unless they
pay back within this time.
A discounted payback period is calculated in the same way as the ‘ordinary’
payback period, with the exception that the cash flows of the project are converted
to their present value. The discounted payback period is the number of years
before the cumulative NPV of the project reaches GHC0.
The discounted payback method has the same advantages and disadvantages as
for the traditional payback method except that the shortcoming of failing to
account for the time value of money has been overcome.

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 Illustration Discounted Payback Period
A project with the following cash flows is under consideration:
Y0 Y1 Y2 Y3 Y4
(20,000) 8,000 12,000 4,000 2,000
Cost of capital 8%.
Required:
Calculate the Discounted Payback Period.

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 Illustration Discounted Payback Period
Solution
Year Working Discounted cash flow Cumulative discounted cash flow
GHC GHC
0 (20,000) (20,000)
1 8,000/(1.08) = 7,407 (12,593)
2 12,000/(1.08)2 = 10,288 (2,305)
3 4,000/(1.08)3 = 3,175 870
Hence discounted payback period = 2 years + (2,305/3,175) = 2.73 years

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 Risk-adjusted Discount Rate
(Project Specific Cost of Capital)
• Risk-adjusted discount rates might be used to evaluate projects with different risk
characteristics. The broad principle is to increase the minimum required return (in other
words, increase the discount rate or cost of capital) to compensate for the higher risk
involved.
• This is a key concept in investment appraisal. Applying the existing discount rate or cost
of capital to an investment assumes that the existing business and gearing risk of the
company will remain unchanged. If the project is significant in size and likely to result in
additional risks then a project specific or risk-adjusted discount rate should be used.
• The application of an increased discount rate is often successful in eliminating marginal
projects. The addition to the usual discount rate is called the risk premium. The method
used is examined further in the cost of capital lecture.

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 Lease or Buy Decision
• Once the decision has been made to acquire an asset for an investment project, a
decision still needs to be made as to how to finance it. The choices that we will
consider are whether to lease the asset or buy the asset.
• The NPVs of the financing cash flows for both options are found and compared
and the lowest cost option selected.
• The finance decision is considered separately from the investment decision. The
operating costs and revenues from the investment will be common in each case.
• Only the relevant cash flows arising as a result of the type of finance are included
in the NPV calculation.

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 Lease or Buy Decision cont’
Leasing Implications
• The asset is never ‘owned’ by the user company from the perspective of the
taxman.
• The finance company receives the tax-allowable depreciation as the owner of the
asset.
• The user receives no tax-allowable depreciation but is able to offset the full rental
payment against tax.
• The relevant cash flows would thus be:
üthe lease payments
ütax relief on the lease payments.

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 Lease or Buy Decision cont’
Buying Implications
• The assumption is that buying requires the use of a bank loan (for the sake of
comparability). The user is the owner of the asset.
• The user will receive tax-allowable depreciation on the asset and tax relief for the
interest payable on the loan.
• As the interest payments attract tax relief we must use the post-tax cost of borrowing
as our discount rate.
• Post-tax cost of borrowing = Cost of borrowing × (1 – Tax rate).
• If the company is not paying tax the pre-tax cost of borrowing is used.
• As all financing cash flows are considered to be risk-free, this rate is used for both
leasing and buying.
• Note: Don’t use the company’s cost of capital as the discount rate.
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 Lease or Buy Decision cont’
Buying Implications cont’
• The relevant cash flows would be:
üthe purchase cost
üRepairs and maintenance costs if any
üany residual value
üany associated tax implications due to tax-allowable depreciation and repairs and
maintenance costs.

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 Illustration 1 - Lease or Buy Decision
A firm has decided to acquire a new machine to neutralise the toxic waste produced by
its refining plant. The machine would cost GHC6.4 million and would have an economic
life of five years. Tax-allowable depreciation of 25% pa on a reducing balance basis is
available for the investment. Taxation of 30% is payable on operating cash flows, one year
in arrears. The firm intends to finance the new plant by means of a five-year fixed
interest loan at a pre-tax cost of 11.4% pa, principal repayable in five years’ time.
As an alternative, a leasing company has proposed a lease over five years at GHC1.42
million pa payable in advance. Scrap value of the machine under each financing
alternative will be zero.
Required:
Evaluate the two options for acquiring the machine and advise the company on the best
alternative.
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 Trial - Lease or Buy Decision
Mannasseh is considering a project requiring a new machine. The machine costs
GHC3 million and it would have a useful life of three years and no residual value at
the end of that time.
The machine will produce cash operating surpluses of GHC1.6 million each year.
Tax allowable depreciation is 15% on a straight-line basis. Tax is 30% on operating
cash flows and is payable one year in arrears. Mannasseh has an after-tax cost of
capital of 20%. It is considering either borrowing from the bank at the pre-tax
interest rate of 14% and buying the asset outright,or leasing it at a cost of GHC1.3
million each year for three years, with the lease payments payable in advance at
the beginning of each year.
Required:
Evaluate the project. Should the asset be acquired, and if so which financing
method should be used?
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 Asset Replacement Decision
• Once the decision has been made to acquire an asset for a long-term project, it is
quite likely that the asset will need to be replaced periodically throughout the life
of the project.
• Asset replacement decision involves deciding how frequently a non-current asset
should be replaced, when it is in regular use. So, the decision we are concerned
with here is – how often should the asset be replaced.
• Where there are competing replacements for a particular asset we must compare
the possible replacement strategies available.
• A problem arises where:
üequivalent assets available are likely to last for different lengths of time or
üan asset, once bought, must be replaced at regular intervals.

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 Asset Replacement Decision cont’
• In order to deal with the different time-scales, the NPV of each option is
converted into an annuity or an Equivalent Annual Cost (EAC).
• The EAC is the equal annual cash flow (annuity) to which a series of uneven cash
flows is equivalent in PV terms.
• The formula used is:
EAC = PV of cost
Annuity factor
• The optimum replacement period (cycle) will be the period that has the lowest
EAC, although in practice other factors may influence the final decision.

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 Illustration - Asset Replacement Decision
A machine costs GHC20,000. The following information is also available:
Running costs (payable at the end of the year):
Year 1 GHC5,000
Year 2 GHC5,500
Trade-in allowance:
Disposal after 1 year: GHC16,000
Disposal after 2 years: GHC13,000
Required:
Calculate the optimal replacement cycle if the cost of capital is 10%.

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 Trial - Asset Replacement Decision
A decision has to be made on replacement policy for vans. A van costs GHC12,000 and
the following additional information applies:
Asset sold at end of year Trade-in allowance Asset kept for Maint’ cost at end of year
GHC GHC
1 9,000 1 year 0
2 7,500 2 years 1,500 in 1st year
3 7,000 3 years 2,700 in 2nd year
Required:
Calculate the optimal replacement policy at a cost of capital of 15%.
Note that the asset is only maintained at the end of the year if it is to be kept for a
further year, i.e. there are no maintenance costs in the year of replacement.
Ignore taxation and inflation.

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 Asset Replacement Decision –
Equivalent Annual Benefit (EAB)
The equivalent annual benefit (EAB) is the annual annuity with the same value as
the net present value of an investment project. It can be calculated using a similar
formula to that used for the equivalent annual cost:
EAB = NPV
Annuity factor
Calculating the EAB is particularly useful when trying to compare projects with
unequal lives. The project with the highest EAB would be preferred.

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 Limitations - Asset Replacement Decision
• The model assumes that when an asset is replaced, the replacement is in all
practical respects identical to the last one and that this process will continue for
the foreseeable future. However in practice this will not hold true owing to:
1. changing technology
2. Inflation
3. changes in production plans.

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THANK YOU FOR YOUR ATTENTION

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