F2-17 Capital Budgeting and Discounted Cash Flows PDF

Session 17
Capital Budgeting and

Discounted Cash Flows
FOCUS
This session covers the following content from the ACCA Study Guide.
C. Budgeting
5. Capital budgeting and discounted cash flows
a) Discuss the importance of capital investment planning and control.
b) Define and distinguish between capital and revenue expenditure.
c) Outline the issues to consider and the steps involved in the preparation of
a capital expenditure budget.
d) Explain and illustrate the difference between simple and compound
interest, and between nominal and effective interest rates.
e) Explain and illustrate compounding and discounting.
f) Explain the distinction between cash flow and profit and the relevance of
cash flow to capital investment appraisal.
g) Identify and evaluate relevant cash flows for individual investment
decisions.
h) Explain and illustrate the net present value (NPV) and internal rate of
return (IRR) methods of discounted cash flow.
i) Calculate present value using annuity and perpetuity formulae.
j) Calculate NPV, IRR and payback (discounted and non-discounted).
k) Interpret the results of NPV, IRR and payback calculations of investment
viability.
Session 17 Guidance
Read section 1, which sets out a basic scenario for this session.
Work Examples 1 and 2 and Illustration 3 to appreciate the mechanics of the computations of simple
interest, compound interest and annuities. Pay attention to formulae used for calculations.
Read carefully sections 2.4 and 2.5 on nominal versus effective rates of interest.
Understand discounting (s.3), which is used to calculate a "present value" of a cash flow, and how to
apply discounted cash flow (DCF) techniques which focus on the time value of money (s.4.1).
(continued on next page)

F2 Management Accounting Becker Professional Education | ACCA Study System
Sadia sadia Afzal - [email protected]

VISUAL OVERVIEW
Objective: To introduce budgeting for capital expenditures and to describe methods for
assessing the viability of capital investments.
CAPITAL BUDGETING
• Capital v Revenue Expenditure
• Planning and Control
INTEREST
• Simple
• Compound
• Annuities
• Nominal Rates
• Effective Rates
DISCOUNTING DISCOUNTED CASH PAYBACK PERIOD

FLOW (DCF) TECHNIQUES
• "Compounding in • Advantages
Reverse" • Time Value of Money • Disadvantages
• Points to Note • Profit v Cash • Discounted Payback
• Relevant Cash Flows Period
• Investment Appraisal
NET PRESENT VALUE INTERNAL RATE OF

(NPV) RETURN (IRR)
• Procedure • Decision Rule
• Meaning • Perpetuities
• Pro Forma • Annuities
Calculations • Uneven Cash Flows
• Annuities • Comparison With NPV
• Perpetuities
Session 17 Guidance
Use Illustrations 6 and 7 and Example 4 to test your understanding of the difference between
profit and cash (s.4.2) and the identification of relevant cash flows (s.4.3) when assessing
an investment.
Learn the concepts of net present value (NPV) (s.5) and internal rate of return (IRR) (s.6), and
note how to apply the payback technique (s.7). Work Illustration 13 and Example 11.
Familiarise yourself with the discount factor and annuity tables that will be provided in the exam.
© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 17-1

Session 17 • Capital Budgeting and Discounted Cash Flows F2 Management Accounting
1 Capital Budgeting
1.1 Capital v Revenue Expenditure Capital expenditure

("CAPEX")—the
In financial reporting: acquisition of non-
Capital expenditure is initially recognised as an asset in the current assets or their
statement of financial position (i.e. "capitalised"). It is expensed improvement.
to the income statement over its useful life (through depreciation Revenue expenditure
or amortisation). —is recognised as an
expense in the income
Revenue expenditure is recognised as an expense in the statement in the period
income statement in the period in which it occurs. in which it occurs.
1.2 Capital Investment Planning and Control

1.2.1 Types of Capital Investment
Expenditure of a capital nature may be incurred in acquiring or
constructing both tangible and intangible non-current assets.
Therefore, expenditure on research and development is regarded
as capital.*
*For management
Capital expenditures may arise through: purposes, an
 asset replacement; expenditure such as
research is considered
 modernisation; capital even if it cannot
 investment in new projects; be recognised as an
asset in the financial
 expansion of existing business;
statements because it
 diversification into new business; does not meet asset
 welfare or other statutory requirements; and/or recognition criteria.
 cost reduction programs.
1.2.2 Stages in Capital Investment Planning and Control

 Identify investment opportunities (e.g. to invest in new
technologies) which will assist in achieving the organisational
objectives.
 Develop forecasts of expected costs and benefits. Cash flow
estimates will be made in quantitative terms. Some benefits,
in particular, may not be quantifiable so the final decision to
make the investment may also consider qualitative aspects of
the decision (e.g. urgency, health and safety, environmental
impacts).
 Evaluate net benefits and determine which offer the most
attractive opportunities to achieve organisational objectives
(e.g. to increase shareholder wealth).
 Approve capital investment (e.g. authorisation by the board
of directors for large sums). Approval of authority may be
delegated for certain types of investment.
 Monitor and control capital projects to ensure that expenditure
is controlled and the expected results are being achieved. *Investment
appraisal concerns
 Review the investment planning process ("post–completion the techniques used
audit") to determine if there were errors which can be avoided in making capital
in the future and to provide guidance for future project investment decisions.
evaluations.*
17-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

F2 Management Accounting Session 17 • Capital Budgeting and Discounted Cash Flows
2 Interest
2.1 Simple Interest

Simple interest accrues only on the initial amount invested.
A single principal sum (P) invested for n years at an annual rate of
interest (r as a decimal) will amount to a future value (FV).
Where FV = P (1 + nr)
Illustration 1 Simple Interest
If $100 is invested at 10% per annum (pa) simple interest:
Year Amount on Deposit Interest Amount on Deposit

(year beginning) (year end)
1 $100 0.1 × 100 = 10 $110
2 $110 0.1 × 100 = 10 $120
3 $120 0.1 × 100 = 10 $130
2.2 Compound Interest

Compound interest is re-invested alongside the principal (so that
interest is "compounded" on interest).
A sum (P) invested for n years earning compound interest at an
annual rate of interest (r as a decimal) will amount to a future
value (FV).
Where FV = P (1 + r) n
Illustration 2 Compound Interest
If Zarosa placed $100 in the bank today (t0) earning 10% interest
per annum, what would this sum amount to in three years' time?
Solution *Conversely, the

present value of
In 1 year's time, $100 would have increased by 10% to $110.
$133.10 receivable in
In 2 years' time, $110 would have grown by 10% to $121. three years' time is
In 3 years' time, $121 would have grown by 10% to $133.10.* $100.

Example 1 7% Simple and

Compound Interest
$500 is invested in a fund on 1 January 2013.
Required:
Calculate the amount on deposit by 31 December 2016 if the
interest rate is:
(a) 7% per annum simple
(b) 7% per annum compound.
Solution
(a) Simple interest FV = P (1 + nr)
FV =
FV = $
(b) Compound interest FV = P (1 + r)n
FV =
FV = $
Example 2 5% Compound Interest
$1,000 is invested in a fund earning 5% per annum on 1 January 2012. $500 is added to this
fund a year later and a further $700 is added a year after that.
Required:
Calculate the amount that will be on deposit on 31 December 2014.
Solution
Date Amount Compound Compounded

× =
Invested Interest Factor Cash Flow
$ $
1 Jan 2012 1,000 ×
1 Jan 2013 500 ×
1 Jan 2014 700 ×
Amount on deposit =

2.3 Annuities
Many investment-saving schemes involve the same amount being
invested annually.
There are two formulae for the future value of an annuity. Which
to use depends on whether the investment is made at the end of
each year or at the start of each year.
1. First sum paid/received at 2. First sum paid/received at

the end of each year: the beginning of each year:
 (1 + r )n − 1    1 + r n +1 − 1  
a   a   ( )  − 1 
FV = FV =
 r    r  
    
where a = annuity (i.e. annual sum)

r = interest rate (interest payable annually in arrears)
n = number of years annuity is paid/invested You do not need to
learn these formulae –
if asked for, you will be
able to work out future
Illustration 3 Annuity values "long-hand".
However, for the
Andrew invests $3,000 at the start of each year in a high-interest purpose of discounting
account offering 7% per year. How much will he have after a fixed annuities (later in this
five-year term? Session), you must
understand that the
Solution   1.07 5+1 − 1   exam formulae and
FV = $3,000 ×  
( )  − 1  = $3,000 × 6.153 = $18,460 annuity tables remove
  0.07   the need for long-hand
   calculations.
2.4 Nominal Interest Rates

These are quoted rates of interest, for example:
 Annual interest rate of 12% on a bank overdraft facility.
 Quarterly interest rate of 3% on a reward savings account.
 Monthly interest at 1.5% on a credit card.
2.5 Effective Annual Interest Rates (EAIR)
Where interest is charged on a non-annual basis it is useful to
know the effective annual rate.*
 For example, interest on bank overdrafts (and credit cards) is
often charged on a monthly basis. *The term APR
 To compare the cost of finance to other sources it is necessary (annual percentage
to know the EAIR. rate) is widely used
in offering credit.
Formula
1 + R = (1 + r)n
R = annual rate
r = rate per period (month/quarter)
n = number of periods in year

Illustration 4 EAIR
Borrow $100 at a cost of 2% per month. How much (principal plus

interest) will be owed after a year and what is the effective annual
interest rate?
Solution
Using FV = P (1 + r)n
= $100 x (1.02)12
= $100 x 1.2682* = $126.82
EAIR = 1.2682 ‒ 1 = 26.82%
3 Discounting
3.1 Compounding in Reverse

Discounting calculates the sum which must be invested now (at a
fixed interest rate) in order to receive a given sum in the future.*
The discounting formulae are based on the compounding formula:
The formula for compounding is: FV = P (1 + r)n *Discounting is
1 a very important
Rearranging this: P = FV x technical concept
(1 + r)n not only for decision-
making but also for
1
or alternatively PV = CF x financial reporting
(1 + r)n purposes (you will
see it again in papers
Where PV = the present value of a future cash flow (CF) F5, F7 and P2).
R = annual rate of interest/discount rate
n = number of years before the cash flow arises
Illustration 5 Discounting
If Zarosa needed to receive $251.94 in three years' time (t3), what

sum would she have to invest today (t0) at an interest rate of 8%
per annum?
Solution
1
PV = $251.94 x = $200
(1.08)3
The present value of $251.94 receivable in three years' time is $200.
3.2 Simple Discount Factor

1
 is known as the "simple discount factor" and gives
(1 + r)n
the present value of $1 receivable at the end of n years at a The formula for
discount rate, r. simple discount
factors is provided at
 For a cash flow arising now (at t0), the discount factor will the top of the present
always be 1 (whatever the discount rate). value table in the
 t1 is defined as a point in time exactly one year after t0. exam as (1 + r)-n.

Always assume that cash flows arise at the end of the year to which
they relate (unless told otherwise).
Example 3 Present Value
Find the present value of:

(a) $250 received or paid in 5 years' time, r = 6%
per year.
(b) $30,000 received or paid in 15 years' time, r = 9%
per year.
Solution
(a)
From the tables: r = 6%, n = 5, discount factor =
Present value =
(b)
From the tables: r = 9%, n = 15, discount factor =
Present value =
4 Discounted Cash Flow (DCF) Techniques
4.1 Time Value of Money

Investors prefer to receive $1 today rather than $1 in one year.
 This concept is referred to as the "time value of money" (or DCF techniques take
"time preference for money"). account of the time
 There are several possible reasons for this: value of money by
 Liquidity preference—if money is received today it can either restating each future
be spent or reinvested to earn more in the future. Hence, cash flow in terms of
its equivalent value
investors have a preference for having cash/liquidity today.
today.
 Risk—cash received today is safe; future cash receipts may
be uncertain.
 Inflation—cash today can be spent at today's prices, but the
value of future cash flows may be eroded by inflation.
4.2 Profit v Cash

*If income and
 Over the entire life of a business, total profits earned must expenditure are
equate to net cash income. accounted for on a
 Both profit and cash are measures of performance, but a cash basis (e.g. as
business can be profitable and lack cash. This is because: might be the case
 a cash asset (or liability) is the difference between physical for a "club" or small
charity), profit (or
cash inflows and cash outflows; and
loss) would be the
 profit for a period is the difference between revenues same as cash surplus
earned and expenses incurred as recognised in accordance (or deficit).
with accounting principles.*

 The main reasons for differences between profit and cash are:
 cash items which do not affect profit;
 profit items which do not affect cash; and/or
 items which affect cash and profit but by differing amounts
(e.g. in different accounting periods).
Cash items which do not Profit items which Items which affect profit
affect profit do not affect cash and cash differently
Contributions to share capital Increases/decreases in Sales/purchases on credit

inventory (increase/ decrease (i.e. recognised as revenue/
profit) expense on accruals basis)
Bank loans received Allowances for and write-off Prepayments and accruals of
of irrecoverable debts expenses
Loan repayments Depreciation and write-down

of non-current asset values
Payments and refunds of

general sales tax (e.g. VAT)
4.3 Relevant Cash Flows

For the entire life of a project, its total profit (or loss) will equate
to its net cash inflow (or net outflow). However, profit and cash
flow will rarely, if ever, otherwise be the same in any one period.
Financing cash flows

Illustration 6 Profit and Cash are ignored because
Flows the cost of finance
is measured in the
ABC purchases an item of equipment for $95,000 which it leases discount rate and
to a customer for three years for $3,000 a month, paid monthly in taken into account
advance. At the end of the lease term the equipment is expected to by the discounting
be sold for scrap for $5,000. process itself. If
you include interest
Cash Flow Profit payments in a DCF
calculation, then the
$000 $000
finance cost will be
Initial outlay (95) double counted.
Year 1 Revenue 36 36
Cost (depreciation) (30)
Cost (30)
Cost (30)
Sale proceeds 5
18 18
Note: Straight-line depreciation is calculated taking account of the

expected residual value and there is therefore no profit on disposal.

 Investment appraisal is a decision-making process that

concerns:
 only those revenues and expenditures (both capital and
revenue) which are affected by the decision; and
 the cash flow impacts of those revenues and expenditures.
 Relevant cash flows are those which are:*

 in the future;
 incremental (i.e. the amount by which a revenue or cost
changes); and *Financing cash flows
 generated from operating the project (e.g. cash from sales are ignored because
less payments for materials, etc.). the cost of finance
is measured in the
 The following items are also specifically excluded:
discount rate and
 Sunk costs (i.e. money already spent for example on taken into account
research) by the discounting
 Non-cash items (e.g. depreciation or amortisation) process itself.
 Book values (e.g. FIFO/LIFO values of inventory)
 Unavoidable (i.e. money will be spent regardless)
 Committed costs (e.g. contract rental or lease payments)
 Shared costs (e.g. apportionments of fixed costs).
 The following items are specifically included:

 Avoidable costs and revenues (i.e. those which would be
avoided if a particular course of action is taken).
 "Opportunity costs"—in simple terms, this is the cost of
forgoing an opportunity.
Illustration 7 Opportunity Cost
ZiZi is considering an investment opportunity which could make use

of an item of equipment which has a book value of $5,000. The
equipment has no current use within the business but could be sold
for an estimated $7,000.
The book value (historic cost less accumulated depreciation) is
irrelevant. If the equipment is used in the project there will be no
actual cash flow, but the sales proceeds forgone will be a relevant
cash flow. The opportunity cost of using the equipment in the project
rather than selling it is $7,000.

Example 4 Relevant Cash Flows

A research project, which to date has cost the company $150,000, is under review.
If the project is allowed to proceed, it will be completed in approximately one year,
when the results would be sold to a government agency for $200,000.
The managing director estimates that the following resources are necessary to
complete the project:
Materials: These have just been purchased at a cost of $60,000. The materials
are toxic and, if not used in this project, must be disposed of at a cost of $5,000.
Skilled labour: Four skilled workers are paid $35,000 per year each for 230
working days a year. They are currently working at 85% capacity. The project is
expected to require an additional 115 days to complete it.
Overheads: Company policy is to absorb overheads at 120% of labour cost.
Research staff: The decision already has been made that, when work on this
project ceases, the research department will be closed. Research wages for the
year are $60,000, and redundancy and severance pay has been estimated at
$15,000 now or $35,000 in one year's time.
Equipment: The project utilises a special microscope, which cost $18,000 three
years ago. It has a residual value of $3,000 in another two years and a current
disposal value of $8,000. If used in the project it is estimated that the disposal
value in a year's time will be $6,000.
Share of general building services: The project is to be charged with $35,000
per year to cover general building expenses. If the project is discontinued, the
space occupied could be sub-let for an annual rental of $7,000.
Required:
Advise the managing director whether the project should be allowed
to proceed, explaining the reasons for the treatment of each item.
(Ignore the time value of money.)
Solution
Cash flows for costs if the project is allowed to proceed:
1. Costs to date
2. Materials
3. Skilled labour
4. Overheads
5. Research staff
6. Equipment
7. General building services
Total relevant costs
Less sales value of project
Increased contribution from project
Advice:

4.4 Investment Appraisal

DCF techniques can be used to evaluate business projects for
investment appraisal. Two methods are available:
1. Net Present Value or NPV (see section 5)
2. Internal Rate of Return or IRR (see section 6)
5 Net Present Value (NPV)
5.1 Procedure
The steps to find a project's net present value are:
1. Forecast the relevant cash flows from the project (see s.4.3).
2. Estimate the required return on the investment (i.e. the
discount rate).*
3. Discount each cash flow (receipt or payment) to its present
value (PV).
*The primary objective
4. Sum all present values to give the NPV of the project. of most companies is to
maximise shareholders'
Once the NPV is found, the decision rule is: wealth and the required
 If NPV is positive, then accept the project as it provides a return of its investors
higher return than the firm's cost of capital. (i.e. shareholders)
represents a company’s
 If NPV is negative, then reject. cost of finance, also
referred to as its "cost
5.2 Meaning of capital".
 NPV shows the theoretical change in the dollar value of the
company as a result of making the investment.
 It shows the change in shareholders' wealth arising from
taking on the project.
 The assumed key objective of financial management is to
maximise shareholder wealth.
 Therefore, NPV must be considered a key technique in
business decision-making.
5.3 Pro Forma Calculations Understanding how

There are three methods of presenting calculations: to use the present
value and annuity
1. Single line—for very small NPV calculations. tables provided in
2. Cash budget—for short projects for which cash flows change the examination is
from year to year. vital to being able to
tackle questions most
3. Tabular layout—for longer projects or those with more uneven efficiently.
annual cash flows.

5.3.1 Cash Budget Pro Forma
Time 0 1 2 3
$000 $000 $000 $000
Capital expenditure (x) – – x
Cash from sales – x x x
Materials (x) (x) (x) –
Labour – (x) (x) (x)
Overheads – (x) (x) (x)
Advertising (x) – (x) –
Grant – x – –
Net cash flow (x) x x x
1 1 1
r% discount factor 1
1+r (1 + r) (1 + r)3
2
Present value (x) x x x

NPV = ∑X (sum of the Xs)
5.3.2 Tabular Layout*
Time Cash Flow Discount Present

Factor Value
$000 @ r% $000
0 Capital expenditure (x) 1 (x)
*The tabular layout
1–10 Cash from sales x x x will mostly be used
0–9 Materials (x) x (x) for this paper as that
is more appropriate
1–10 Labour and overheads (x) x (x) for consideration of
0 Advertising (x) x (x) the annuities and
perpetuities which
2 Advertising (x) x (x) are examined at this
1 Grant x x x level. In later papers,
the cash budget pro
10 Scrap value x x x forma will be used
extensively.
Net present value x

Example 5 Net Present Value
Elgar has $10,000 to invest for a five-year period. He could

deposit it in a bank earning 8% per year compound interest.
He has been offered an alternative: investment in a low-risk
project that is expected to produce net cash inflows of $3,000 for
each of the first three years, $5,000 in the fourth year and $1,000
in the fifth year.
Required:
Calculate the net present value of the project.
Solution
Time Description Cash Flow 8% DF PV
$ $
0 Investment (10,000)
1 Net inflow 3,000
2 Net inflow 3,000
3 Net inflow 3,000
4 Net inflow 5,000
5 Net inflow 1,000
NPV =
5.4 Annuities
An annuity is a stream of identical cash flows arising each year for
a finite period of time.
 The present value of an annuity is given as:
1 1 
CF x 1 − 
r  (1+r)n 
where CF is the cash flow received each year commencing
at t1v
 The "annuity factor" or "cumulative discount factor" is known
1 1  Both the formula and
as: 1 −  tables give an annuity
r  (1+r)n 
factor for an annuity
It is simply the sum of a geometric progression. which starts at t1.
The formula is given in the exam at the top of the annuity factor
tables as: −n
1 − (1 + r )
r

Illustration 8 3-Year Annuity
Calculate the present value of $1,000 receivable each year for three
years if interest rates are 10%.
Time Description Cash Flow 10% Annuity Factor PV

$ $
1  1 
t1–3 Annuity 1,000 1−  = 2.487 2.487
0.1  1.13 
Note: An annuity received for the next three years is written as t1–3
and its annuity or cumulative discount factor as Cdf1–3.
Example 6 Annuity
Calculate the present value of $2,000 receivable for each of 10

years commencing three years from now. Assume interest at 7%.
Solution

$ $
t3-12 Annuity 2,000 (W)
Working
Cdf3-12 @ 7% =
=
=
5.5 Perpetuities
A perpetuity is a stream of identical cash flows arising each year
to infinity (i.e. "in perpetuity").
 As n → ∞ (i.e. infinity)
(1 + r)n → ∞
This formula applies
1 when the first cash
Therefore →0
(1 + r)n flow arises at t1.
1 1  1
Hence 1 −  → .
r n r
(1 + r) 
This is known as the "perpetuity factor".
1
 The present value of a perpetuity is given as CF x
where CF is the cash flow received each year. r

Illustration 9 Perpetuity at 10%
Calculate the present value of $1,000 receivable each year in

perpetuity if interest rates are 10%.
Solution

$ $
1
t1–∞ Perpetuity 1,000 = 10 10,000
0.1
Example 7 Perpetuity
Calculate the present value of $2,000 receivable in perpetuity

commencing in 10 years' time. Assume interest at 7%.
Solution

$ $
t10–∞ Perpetuity 2,000 (W)
Working
Cdf10-∞ @ 7%
=
=
6 Internal Rate of Return (IRR)
6.1 Decision Rule

Internal rate of return represents the average annual
percentage return from a project Internal rate of
return (IRR)—the
 It shows the highest finance cost that can be accepted for the rate of return inherent
project (i.e. a "breakeven" discount rate). in a project and this
 Once the IRR is found, the decision rule is: rate is the discount
rate at which the NPV
 If IRR > cost of capital, accept the project. is zero.
 If IRR < cost of capital, reject the project.

6.2 IRR for Perpetuities

If a project has equal annual cash flows receivable in perpetuity,
Annual cash inflows $140
then IRR = × 100% = × 100% = 14%
Initial investment $10, 000
Illustration 10 IRR for Perpetuity
An investment of $1,000 gives income of $140 per annum

indefinitely, the return on the investment is given by
Annual cash inflows $140

IRR = × 100% = × 100% = 14%
Initial investment $10, 000
Example 8 IRR (Perpetuity)

An investment of $15,000 today will provide $2,400 each year
to perpetuity.
Required:
Calculate the internal rate of return inherent for the
investment.
Solution
IRR= =
6.3 IRR for Annuities

To give an NPV of zero, the present value of the cash inflows
must equal the initial cash outflow. This means that the following
formulae apply for annuities:
Annuity cash inflow × Annuity factor = Cash outflow
Cash outflow
Annuity factor =
Cash inflow
Once the annuity factor is known, the discount rate can be
established from the appropriate table.

Illustration 11 IRR for Annuity
An investment of $6,340 will yield an income of $2,000 for four years.

Calculate the internal rate of return of the investment.
Solution
Year Description CF DF PV
0 Initial investment (6,340) 1 (6,340)
1-4 Annuity 2,000 AF1-4 years 6,340
NPV Nil
$6, 340
AF1-4 years = = 3.17
$2, 000
From the annuity table, the rate with a four-year annuity factor closest to 3.17
is 10% and this is therefore the approximate IRR for this investment.
Example 9 IRR (Annuity)

An immediate investment of $10,000 will give an annuity of
$1,000 for the next 15 years.
Required:
Calculate the internal rate of return of the investment.
Solution
Time Description Cash Flow Discount Factor PV
$ $
0 Investment (10,000)
1-15 Annuity 1,000
NPV
The IRR is between and percent.
6.4 Uneven Cash Flows

The steps to find IRR for a project which has uneven cash flows are:
1. Calculate the NPV of the project at a chosen discount rate.
2. If NPV is positive, recalculate NPV at a higher discount rate
(i.e. to get closer to IRR).
3. If NPV is negative, recalculate at a lower discount rate.
4. The IRR can be estimated using the formula:*
NA *The IRR formula is

IRR ~ A + (B − A)
NA − NB not provided in the
exam so it must be
learnt. However, as
Where A = Lower discount rate Illustration 12 shows,
B = Higher discount rate it is simply a pro rata
calculation of the
NA = NPV at rate A difference between the
NB = NPV at rate B two discount rates.

This method is known as "linear interpolation".*
*The formula always works but take care with + and − signs. When
both discount rates used give rise to positive NPVs, the IRR is being
extrapolated rather than interpolated.
Illustration 12 IRR With Uneven

Cash Flows
The NPVs of a project with uneven cash flows are as follows:
Estimate the IRR of the investment.
Discount rate NPV

$
10% 64,237
20% (5,213)
Solution*
64, 237
IRR ~ 10% + (20 – 10)%
64, 237 − (−5, 213)
*The IRR should always
IRR ~ 19%
be shown as a rounded
approximation due to
the inherent inaccuracy
The linear interpolation method of calculating the IRR is based
of this method.
on the simplifying assumption that there is a linear relationship
between NPV of a project and discount rate. However, this is not
so and the following diagram illustrates the true situation.
NPV
IRR using formula

(interpolated)
NA
Discount rate
A B
NB
Actual NPV as
discount rate varies
Actual IRR

Example 10 IRR (Uneven

Cash Flows)
An investment opportunity with uneven cash flows has the
following net present values:
$
at 10% 71,530
at 15% 4,370
Required:
Estimate the IRR of the investment.
Solution
NA
IRR ~ A+ (B – A)
NA – NB
IRR ~
Graphically:
6.5 NPV versus IRR
NPV IRR
 An absolute measure ($).  A relative measure (%).
 If NPV > 0, accept.  If IRR > target %, accept.
 If NPV ≤ 0, reject.  If IRR ≤ target %, reject.
 Shows $ change in value  Does not show absolute

of company/wealth of change in wealth.
shareholders.
 A unique solution (i.e. a  May be a multiple solution

project has only one NPV). (although this is outside
the scope of the syllabus).
 Always reliable for  Not always reliable.

decision-making.

7 Payback Period
Payback period is the time it takes for the operating cash flows
from a project to pay back the initial investment.
Once the IRR is found, the decision rule is:
 If payback period < target period, accept the project
 If payback period > target period, reject the project
Illustration 13 Payback Period
Investment $1.4m
Annual cash flows (before depreciation, but after tax) $0.3m
Project life 10 yrs
Calculate the payback period.
Solution
1.4
Payback period = = 4.7 years
0.3
(or five years if cash flows are assumed to arise at year ends.)
Example 11 Payback
A project being considered requires a machine costing $80,000.

Market research of $8,000 has already been carried out and has
been capitalised. The project is expected to last six years and
produce net cash earnings of $20,000 for each of the first three
years, then $15,000 for each of the last three years. (Assume
that cash flows arise evenly during the year.)
Required:
Evaluate the project using the payback period.
Solution
Time Flow Cumulative Flow
0 (88,000)
1 20,000
2 20,000
3 20,000
4 15,000
5 15,000
6 15,000
Payback period =

7.1 Advantages of Payback Period

Simple to calculate.
Easy to understand.
*Identifying quick
Widely used in practice as an initial screening method.
cash-generating
Concentrates on the more certain, earlier cash flows.* projects will be
important if the
7.2 Disadvantages of Payback Period organisation has
liquidity concerns.
Ignores cash flows after the end of the payback period.
Target period is subjective.
Ignores time value of money.
Gives no information about the change in shareholder wealth
(total profitability is ignored).
7.3 Discounted Payback Period

 An improvement on the payback model is to first discount the
cash flows to present value and then calculate the payback
period.
 This takes account of the time value of money of cash flows in
the payback period.

Summary
 Investment appraisal concerns the techniques used in making capital investment decisions.
 Investment decisions should be based on cash flows, not profit.
 Relevant cash flows are future, incremental and operating.
 Exam formulae are provided only for simple discount and annuity factors.
 The annuity formula and tables (and perpetuity formula) assume the first cash flow to be at t0.
 NPV decision rule: if NPV > $0 accept; if ≤ $0 reject.
 IRR decision rule: if IRR > target % accept; otherwise reject.
 Payback rule: if payback period < target period accept; otherwise reject.
Session 17 Quiz
Estimated time: 15 minutes
1. Define capital expenditure and revenue expenditure. (1.1)

2. State the major difference between simple and compound interest. (2.1, 2.2)
3. True or false? The effective annual interest rate is not affected by the number of compounding
periods throughout the year. (2.5)
4. Explain the relationship between compounding and discounting. (3.1)
5. Describe TWO cash items that do not affect profit and TWO profit items that do not affect
cash. (4.2)
6. True or false? Cash flows incurred before a project is accepted are relevant in DCF appraisal
methods. (4.3)
7. State the THREE methods for presenting NPV calculations and state the circumstances in
which each will be most appropriate. (5.3)
8. State whether NPV or IRR is the more reliable for investment appraisal and describe why. (6.5)
Study Question Bank

Estimated time: 105 minutes
Priority Estimated Time Completed
Q75 Alternative machines 25 minutes
Q76 Net present value 20 minutes
Q77 Internal rate of return 20 minutes
Q80 MCQs 40 minutes

Additional
Q73 Compounding and

discounting
Q74 Despatch
Q78 Gerrard
Q79 Elvira

Session 17
EXAMPLE SOLUTIONS
Solution 1—7% Simple and Compound Interest

The $500 is invested for a total of 4 years:
(a) Simple interest FV = P (1 + nr)

FV = 500 (1 + 4 × 0.07)
= 500 × 1.28 = $640.00
(b) Compound interest FV = P (1 + r)n
FV = 500 (1 + 0.07)4
= 500 × 1.3108 = $655.40
Solution 2—5% Compound Interest
Date Amount Compound Compounded

× =
Invested Interest Factor Cash Flow
$ $
1 Jan 2012 1,000 × (1.05)3 1,157.63
1 Jan 2013 500 × (1.05)2 551.25
1 Jan 2014 700 × (1.05)1 735.00
Amount on deposit = 2,443.88
Solution 3—Present Value
(a) From the tables: r = 6%, n = 5, discount factor = 0.747
Present value = $250 × 0.747 = $186.75
(b) From the tables: r = 9%, n = 15, discount factor = 0.275
Present value = $30,000 × 0.275 = $8,250

Solution 4—Relevant Cash Flows
Cash flows for costs if the project is allowed to proceed:
$
1. Costs to date of $150,000 are sunk—therefore ignore. –
2. Materials—purchase price of $60,000 is also sunk. 5,000
Opportunity benefit is disposal costs saved.
3. Skilled labour—four workers each have 230 × 15% days –
of spare capacity = 138 days available. As there appears
to be a year in which to complete the project, no overtime
working or other incremental cost will be incurred.
4. Overheads—absorption is irrelevant as it is merely an –
apportionment of existing costs.
5. Research staff
Wages for the year (60,000)
Redundancy pay increase ($35,000—$15,000) (20,000)
6. Equipment
Proceeds foregone if used in the project = disposal value (8,000)
Disposal proceeds in one year 6,000
7. General building services
Apportioned costs irrelevant –
Opportunity costs rental forgone (7,000)
Total relevant costs (84,000)
Sales value of project 200,000
Increased contribution from project 116,000
Advice: Proceed with the project.
Solution 5—Net Present Value

Cash
Time Description 8%* DF PV
Flow
$ x $
0 Investment (10,000) 1 = (10,000)
1
1 Net inflow 3,000 = 2,778
(1.08)
1
2 Net inflow 3,000 = 2,572
(1.08)2
1
3 Net inflow 3,000 = 2,381
(1.08)3
1
4 Net inflow 5,000 = 3,675
(1.08)4
1
5 Net inflow 1,000 = 681
(1.08)5
NPV = 2,087
*Alternative return he could earn

Solution 6—Annuity

$ $
t3-12 Annuity 2,000 X 6.135 (W) = 12,270
Working
Cdf3-12 @ 7% = CDF1-12 @ 7% – CDF1-2 @ 7%

= 7.943 – 1.808 (per tables)
= 6.135
Solution 7—Perpetuity
$ $
t10-∞ Perpetuity 2,000 x 7.771 (W) = 15,542
Working
Cdf10-∞ @ 7% = CDF1-∞ @ 7%—CDF1-9 @ 7%

= 1
– 6.515 (per tables)
0.07
= 14.286 – 6.515
= 7.771
Solution 8—IRR (Perpetuity)

$2, 400
IRR = × 100 = 16%
$15, 000
Solution 9—IRR (Annuity)
Time Description Cash Flow Discount Factor PV

$ $
0 Investment (10,000) 1 (10,000)
$10, 000
1-15 Annuity 1,000 Cdf1-15 = 10,000
$1, 000
= 10
NPV Nil
From the annuity table the rate with a 15-year annuity factor of
10 lies between 5% and 6%.
Therefore, if $10,000 could be otherwise invested for a return of
6% or more, this annuity is not worthwhile.

Solution 10—IRR (Uneven Cash Flows)*
Formula
NA
IRR ~ A + (B – A)
NA − NB
 71, 530  *The formula always

IRR ~ 10 +  71, 530 − 4, 370  (15 – 10) works but take care
  with + and – signs.
When both discount
rates used give rise
IRR ~ 10 + 5.325 say 15% (rounded)
to positive NPVs (as
here) the IRR is being
NPV
extrapolated rather
$ than interpolated.
Actual NPV
71,530
Actual IRR
4,370
Discount rate (%)
10 15
IRR using formula

(extrapolated)
Solution 11—Payback
Time Flow Cumulative Flow
0 (88,000) (88,000)
1 20,000 (68,000)
2 20,000 (48,000)
3 20,000 (28,000)
4 15,000 (13,000)
5 15,000 2,000
6 15,000 17,000
Payback period = 4 13
15
years

NOTES

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Session 17

Capital Budgeting and

(continued on next page)

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DISCOUNTING DISCOUNTED CASH PAYBACK PERIOD

NET PRESENT VALUE INTERNAL RATE OF

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1.1 Capital v Revenue Expenditure Capital expenditure

1.2 Capital Investment Planning and Control

1.2.2 Stages in Capital Investment Planning and Control

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2.1 Simple Interest

Illustration 1 Simple Interest

If $100 is invested at 10% per annum (pa) simple interest:

Year Amount on Deposit Interest Amount on Deposit

2.2 Compound Interest

Illustration 2 Compound Interest

Solution *Conversely, the

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Example 1 7% Simple and

(a) Simple interest FV = P (1 + nr)

Example 2 5% Compound Interest

Date Amount Compound Compounded

1 Jan 2012 1,000 ×

1 Jan 2013 500 ×

1 Jan 2014 700 ×

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1. First sum paid/received at 2. First sum paid/received at

where a = annuity (i.e. annual sum)

2.4 Nominal Interest Rates

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Borrow $100 at a cost of 2% per month. How much (principal plus

3.1 Compounding in Reverse

If Zarosa needed to receive $251.94 in three years' time (t3), what

The present value of $251.94 receivable in three years' time is $200.

3.2 Simple Discount Factor

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Example 3 Present Value

Find the present value of:

4 Discounted Cash Flow (DCF) Techniques

4.1 Time Value of Money

4.2 Profit v Cash

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Contributions to share capital Increases/decreases in Sales/purchases on credit

Loan repayments Depreciation and write-down

Payments and refunds of

4.3 Relevant Cash Flows

Financing cash flows

Note: Straight-line depreciation is calculated taking account of the

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 Investment appraisal is a decision-making process that