# 20 Capital investment appraisal

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```					Chapter 20: Capital investment appraisal

   On completion of this topic you should be able to
Explain the purpose of capital investment appraisal
Calculate and interpret the payback period for an
investment project
Calculate and interpret the accounting rate of return for
an investment project
techniques
   Independent study
Study Chapter 20
Progress test and practice question(s) as set
Capital investment appraisal

 Whilst cost accounting provides information to
management for making short-term decisions
about revenue expenditure, this topic provides
information for long-term decisions about capital
expenditure
 Capital investment appraisal is ‘the evaluation of
proposed investment projects, with a view to
determining which is likely to give the highest
financial return’ (Collis and Hussey, 2007, p. 335)

Characteristics of capital investment decisions

Time span            2+ years
Nature               Strategic (eg whether to build or buy a
new factory)
Level of             Medium – high
expenditure
External factors     Very important (eg interest rates and
rates of inflation)
Typical techniques   Payback period
Accounting rate of return
Discounted cash flow techniques
Adapted from Jones, 2002, p. 452
The capital investment decision

 Capital investment appraisal techniques are used
for making decisions concerning the investment of
large amount of capital in a long-term project
 Management needs to know that the investment
project will be worthwhile
Either it will generate more cash than the initial amount
invested or it will provide cost savings over the life of the
project that will exceed the capital invested
   At the very least, management needs to know that
the business will get its money back

Exercise 1
Capital investment decisions

 Cotswold Coolers is doing well and has £100,000 to invest in
new bottling machines
 Ros has a choice of 3 machines. Each will cost £100,000 and
have an expected life of 3 years, but the net cash inflows vary
Year Machine 1 Machine 2 Machine 3
£            £             £
1     60,000       20,000        10,000
2     40,000       40,000        20,000
3     20,000       60,000        95,000
 Required
- Complete the pro forma and decide which machine is the
better investment

Exercise 1
Capital investment decisions

Year   Machine 1 Machine 2 Machine 3
£         £         £
Cash outflow        0      (100,000) (100,000) (100,000)
Net cash inflows    1         60,000    20,000  10,000?
2         40,000    40,000  20,000?
3         20,000    60,000  95,000?
Subtotal                  ________? ________? ________?
Net cash flow             ________? ________? ________?

Solution 1
Capital investment decisions
Year Machine 1 Machine 2 Machine 3
£         £         £
Cash outflow       (A)  0   (100,000) (100,000) (100,000)
Net cash inflows        1          60,000          20,000    10,000
2          40,000          40,000    20,000
3          20,000          60,000    95,000
Subtotal        (B)               120,000         120,000   125,000
Net cash flow (B-A)                20,000          20,000    25,000

 Is it simply a question of choosing the investment
that gives the highest positive net cash flow?
 What other factors should be considered?

Solution 1
Capital investment decisions (continued)

   Machine 3 looks best as the net cash inflow is
£25,000 (£5,000 higher than for Machines 1 or 2)
But waiting until Year 3 to get most of the cash increases
risk – the annual net cash flows are estimates and the
further ahead the forecast, the more unreliable it is
 Machines 1 & 2 both give the same total net cash
inflow, so either is worth considering, but Machine 1
is the more favourable because the cash comes in
sooner
 It’s difficult to decide - we need a technique to help

Capital investment appraisal techniques

Capital investment
appraisal

Accounting            Discounted
Payback period
rate of return          cash flow

Payback period

   The payback period is ‘the time required for the
predicted net cash flows to equal the capital
invested in a proposed investment project’ (Collis
and Hussey, 2007, p. 338)
The project that repays the capital invested in the
shortest time is considered to be the most favourable
   The following estimates are needed
The amount of capital required
The amount and timing of the net cash flows
generated by the investment project

Conventions and assumptions

   Year 0 is a conventional way of referring to the start
of Year 1
   Year 1, 2, 3 etc means the end of Year 1, 2, 3, etc
   It is assumed that the cash outflow from the initial
investment of capital will take place at Year 0
   It is assumed that the net cash inflows during a
year will be received evenly throughout the year
   Negative cash flows are shown in brackets

Exercise 2
Mr Cornetto’s ice cream van project
Mr Cornetto is considering investing in an ice cream van that will
cost £12,000 and last 4 years. Estimated annual cash flows are:
£          £
Cash inflows
Sales                      20,000
Cash outflows
Purchases         5,000
Wages             9,000
Expenses          2,000 (16,000)
Net cash flow                  4,000
 Required
- Calculate the payback period in years using the formula:
Initial capital investment
Annual net cash flow

Solution 2
Mr Cornetto’s ice cream van project

   The payback period for the ice cream van project is

Initial capital investment = £12,000
Annual net cash flow       £4,000
= 3 years exactly

   We have been able to use this formula because Mr
Cornetto expects the net cash flows to be the same
every year over the life of the project, but we can’t
use it if the projected annual net cash flows are
expected to differ…
Exercise 3
Mr Cornetto’s pasta van project

 An alternative project is to invest in a pasta van that
will also cost £12,000 and last 4 years
 Because take-away pasta may take some time to
catch on, the annual net cash flows are expected to
be £2,000 in year 1, rising to £3,000 in year 2,
£5,000 in year 3 and £6,000 in year 4
 Required
Using the pro forma, calculate the payback period in
years and months for the pasta van project

Pro forma
Mr Cornetto’s pasta van project

Year   Net cash flow Cumulative net cash flow
£                        £
0          (12,000)                 (12,000)
1             2,000                        ?
2             3,000                        ?
3             5,000                        ?
4             6,000                        ?

Payback period …………………………? (years and months)

Solution 3
Mr Cornetto’s pasta van project
Year     Net cash flow          Cumulative net cash flow
£                                 £
0           (12,000)                          (12,000)
1              2,000                          (10,000)
2              3,000                           (7,000)
3              5,000                           (2,000)
4              6,000                             4,000
 The payback period is somewhere between 3 - 4 years where
the cumulative net cash flow changes from a deficit to a surplus
 3 years +         Deficit £2,000            = 0.33 = 3 yrs 4 mths
Deficit £2,000 + Surplus £4,000
 So Mr Cornetto should choose the ice cream van project, as it
takes only 3 years to pay back the initial investment

Simple to calculate and easy to understand
Useful for risky projects where prediction of future cash
flows beyond first few years is difficult (eg IT)
Useful if short-term cash flows are more important to
survival of the business than long-term cash flows
Useful if borrowing or gearing is a concern
Does not take account of the time value of money (cash
now is worth more than cash received later)
Ignores cash flows after the payback period

Accounting rate of return

 The payback period focuses on cash flows, but the
accounting rate of return (ARR) focuses on profit
 The accounting rate of return ‘measures the
predicted average profit before interest and tax as
a percentage of the average capital employed in a
proposed investment project’ (Collis and Hussey,
2007, p. 342)
 When comparing ratios from different sources, care
must be taken that the same definition of profit and
capital employed have been used

Exercise 4
Fresh Farm Foods ARR
 The owners of Fresh Farm Foods are planning to open either
a farm shop or a café. Estimates for the two projects are:
Farm shop        Café
£          £
Average sales                         62,000 109,000
Average costs and expenses            43,400 82,000
Average capital employed             100,000 180,000
 Required
- Using the pro forma, calculate the average profit for each
project and the ARR using the following formula and decide
which is the better of the two investments
Average profit      100
Average capital employed
Pro forma
Fresh Farm Foods ARR

Farm shop                Café
£                  £
Average sales                                  ?                  ?
Average costs and expenses          (         )?        (        )?
Average profit                                 ?                  ?

Average PBIT  100                            ?  100       ?  100
Average CE                                    ?             ?

ARR =                       ?%            ?%

Solution 4
Fresh Farm Foods ARR

Farm shop         Café
£          £
Average sales                             62,000   109,000
Average costs and expenses              (43,400)   (82,000)
Therefore, average profit                 18,600     27,000

Average PBIT  100               8,600  100 27,000  100
Average CE                     100,000         180,000
ARR =           18.6%             15%
 The Farm Shop gives a higher ARR than the Café, but should
the owners base their decision purely on this?
period as well
Conclusions

Simple to calculate and easy to understand
Takes account of the entire life of the project
Compatible with the performance ratio, ROCE
Does not take account of the time value of money
Ignores the timing of profits (eg benefit of earning a larger
proportion of profit in early years) and timing of cash flows
No standard definition of terms (limits comparisons)
Averages can be misleading (actual figure may be ↑ or ↓)
No guidance on what is an acceptable rate of return