Cambridge International A2
Accounting
Prepared by :
Udayanga Wijekoon.Sc.
B.Sc. Accounting (Special)
University of Sri Jayewardenepura,
Chartered Accountancy (S-I), CIMA (ML)
OKI International School
Investment Appraisal
Investment Appraisal is the process of assessing whether it is worthwhile to invest funds into a
particular project.
These projects involve making choices ;
− whether or not to proceed with the project
− which new products to be introduced
− a promotional campaign
− relocation of a factory
− acquiring or replacing an asset
Investment Appraisal Techniques
1.
2.
3.
4.
Accounting rate of return (ARR)
Payback period
Net present value (NPV)
Internal rate of return (IRR)
Following things should be considered when estimating cash for a project
•
Only the cash inflows and cash outflows are considered. Non-cash items are not considered.
•
Taxes should be considered as cash outflows.
•
When it relates to an existing cash flow, only the changes (increases/decreases) in cash flows
are considered. If the change is favourable, it is considered as a cash inflow. If the change is
unfavourable, it is considered as a cash outflow.
•
Sunk cost (cost that has been already incurred) is not considered.
•
Initial investment is considered as a cash out flow in year 0.
•
Any proceeds from selling the old assets are considered as a cash inflow in year 0.
•
Residual value is considered as a cash inflow at the end of the project.
•
Working capital is considered as a cash outflow in year 0 and cash inflow at the end of the
project.
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Accounting Rate of Return (ARR)
Accounting rate of return is the average profit from an investment expressed as a percentage of the
average capital of the investment.
The steps to calculate the ARR
Step 1 Calculate the expected profit over the life of the investment.
Step 2 Calculate the expected average annual profit from the life of the investment.
Average Profit = Total profit over the life of the investment
Life of the investment
Step 3 Calculate the average investment using the formula.
Average Investment = Cost of the initial investment + Residual value of the investment
2
Step 4 Calculate the ARR.
ARR =
Average Profit
× 100%
Average Investment
A business can compare the ARR of a potential investment with the return on capital employed
(ROCE) to decide whether the investment will be worthwhile.
− If the ARR more than ROCE, the project is acceptable.
− If the ARR less than ROCE, the project is not acceptable.
Question 01
Planners Limited is considering investing in a new machine that will increase the profit of the
business. The machine will cost $ 130 000 and have a life of five years. After that time, it will be
scrapped at $ 20 000.
The company policy is to depreciate the non-current assets by 20% using the straight-line method.
Expected cash flows from the new machine are:
Year
Cash inflow
Cash outflow
1
$ 70 000
$ 30 000
2
$ 75 000
$ 29 000
3
$ 78 000
$ 30 000
4
$ 80 000
$ 31 000
5
$ 84 000
$ 34 000
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Planners Limited currently earns a ROCE of 20% and requires any new investments to earn at least
the same percentage.
Required,
(a) Calculate the ARR for the new machine
(b) State, with reasons, whether the business should buy the new machine
Question 02
A manufacturer is proposing to introduce a new product that is expected to produce the following
incremental profits over a period of four years:
Year 1
$ 30 000
Year 2
$ 36 000
Year 3
$ 38 000
Year 4
$ 40 000
The project will require the use of a new machine that will have to be bought for $150 000.
Required, Calculate the accounting rate of return that will be earned from the new product.
Advantages of ARR
• The expected profitability of a project can be compared with the present profitability (ROCE) of
the business.
• ARR is straight forward to calculate.
Disadvantages of ARR
• The average annual profit used to calculate ARR is unlikely to be the profit earned in any year of
the life of the project.
• The method does not take into account the timing of cash flows. The initial outlay on the
project is at risk until the flow of cash into the business has covered the initial cost.
• ARR ignores the time value of money. Every dollar received now is more useful to a business
than a dollar received at a later date.
• No consideration is taken of the actual life expectancy of a project.
• Profit is subjective and depends on variable policies such as provisions for depreciation,
valuation of inventory, etc.
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Payback Period
Payback period is the period of time it takes for the net cash receipts from a project to pay back or
equal the total of the funds invested in the project.
Projects with shorter payback periods are preferred than the projects with longer payback periods.
The steps to calculate payback
Step 1 Calculate the net cash flows for the project.
Step 2 Calculate the cumulative net cash flows from the investment to find out the year that
payback occurs.
Step 3 Calculate the portion of the year that will be needed to achieve payback.
Question 03
ABC Limited is proposing the manufacture of a new product that will involve the purchase of new
plant costing $ 100 000.
The expected cash flows from the project are as follows:
Year
Cash Receipts
Cash Payments
1
$ 78 000
$ 48 000
2
$ 82 000
$ 42 000
3
$ 94 000
$ 64 000
4
$ 98 000
$ 54 000
Required, Calculate the payback period for the new plant
Question 04
Jeneric Limited is planning to install a new specialist computer system into the business. It has two
choices of replacements: system A or system B, each costing $ 50 000 and both expected to have a
useful life of three years. Jeneric Limited is concerned about the risk of the investment and is
aiming for a quick recovery of the cost of the original investment.
System A
System B
Cash Inflow
Cash Outflow
Cash Inflow
Cash Outflow
Year 1
$ 80 000
$ 60 000
$ 60 000
$ 30 000
Year 2
$ 90 000
$ 70 000
$ 80 000
$ 60 000
Year 3
$ 70 000
$30 000
$ 70 000
$ 45 000
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Required,
(a) Calculate the payback periods for each of the computer systems
(b) State with reasons which computer system Jeneric Limited should purchase
Advantages of Payback Period
•
•
•
•
•
Payback is straightforward to calculate.
Payback can compare the relative risks of different projects.
Cash flow is less subjective than profitability.
Payback highlights the timing and size of cash flows.
Short payback periods result in increased liquidity and enable businesses to grow more quickly.
Disadvantages of Payback Period
•
•
The life expectancy of the project is ignored. Once the payback period has been evaluated, the
net cash inflows after this time are ignored.
Projects with the same payback period may have different cash flows.
Net Present Value (NPV)
Net present value is the present value of future receipts from a project, less the present value of
future payments in respect of the same project.
A positive NPV would mean that the net receipts in present day terms would cover the initial outlay
and the project should be undertaken.
A negative NPV would mean that the net receipts in present day terms would not cover the initial
outlay and the project should not be undertaken.
If two or more projects are being considered, the one with the highest positive NPV would be
preferred to the others.
The steps to calculate NPV
Step 1 Calculate the net cash flows for the project for each year.
Step 2 Calculate the discounted cash flows by multiplying the net cash inflow for the year by the
discount factor for the year.
Step 3 Calculate the net present value by adding up all the discounted cash flows.
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Question 05
Lees Limited is considering a project with an initial cost of $ 100 000. The company accountant has
estimated its net cash receipts from the project for the next five years to be as follows:
Year 1
$ 30 000
Year 2
$ 40 000
Year 3
$ 40 000
Year 4
$ 46 000
Year 5
$ 42 000
Lees Limited’s cost of capital is 10%. The discount factors for the present value of 10% are:
Year
Discount factor at 10%
0
1.000
1
0.909
2
0.826
3
0.751
4
0.683
5
0.621
Required, Calculate the net present value of the project.
Question 06
Maya Limited is considering investing in one of two possible projects; project X or project Y. Each
project costs $ 130 000 and will have a five-year life with no residual value at the end of that time.
The net receipts for each project over the five-year period are as follows:
Project X
Project Y
Year 1
$ 50 000
$ 35 000
Year 2
$ 50 000
$ 35 000
Year 3
$ 30 000
$ 35 000
Year 4
$ 25 000
$ 35 000
Year 5
$ 20 000
$ 35 000
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Maya Limited’s cost of capital is 12%.
The discount factors at 12% are:
Year
Discount factor at 12%
0
1.000
1
0.893
2
0.797
3
0.712
4
0.636
5
0.567
Required,
(a) Calculate the net present value of each option
(b) State which project Maya Limited should choose and why
Advantages of NPV
•
•
•
Takes into consideration the time value of money.
Uses cash flows that are less subjective than profitability.
All the cash flows of the project are considered, unlike payback.
Disadvantages of NPV
•
•
Estimating the most appropriate discount factor can be difficult.
Managers may not fully understand the concept of present value.
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Internal Rate of Rerturn (IRR)
Internal rate of Return is the discount rate at which the net present value of all the cash flows from
the project equal zero.
The steps to calculate IRR
Step 1 Select two discounting rates sufficiently wide apart to give positive and negative net present
values.
Step 2 Calculate the net present value for each of the two discount rates chosen in Step 1.
Step 3 Interpolate to find the percentage that will give a nil net present value. (Interpolation means
finding an intermediate value between the two discounting rates.)
IRR = P + (N – P) ×
p
p+n
P - rate giving a positive net present value
N - rate giving a negative net present value
p - the positive net present value
n - the negative net present value
Question 07
Lees Limited is considering a project with an initial cost of $ 100 000. The company accountant has
estimated its net cash receipts from the project for the next five years to be as follows:
Year 1
$ 30 000
Year 2
$ 40 000
Year 3
$ 40 000
Year 4
$ 46 000
Year 5
$ 42 000
The discount factors for the present value of 10% and 40% are:
Year
0
1
2
3
4
5
Discount factor at 10%
1.000
0.909
0.826
0.751
0.683
0.621
Discount factor at 4%
1.000
0.714
0.510
0.364
0.260
0.186
Required, Calculate the net present value of the project.
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Question 08
Maya Limited is considering investing in one of two possible projects; project X or project Y. Each
project costs $ 130 000 and will have a five-year life with no residual value at the end of that time.
The net receipts for each project over the five-year period are as follows:
Project X
Project Y
Year 1
$ 50 000
$ 35 000
Year 2
$ 50 000
$ 35 000
Year 3
$ 30 000
$ 35 000
Year 4
$ 25 000
$ 35 000
Year 5
$ 20 000
$ 35 000
Year
Discount factor at 12%
Discount factor at 20%
0
1.000
1.000
1
0.893
0.833
2
0.797
0.694
3
0.712
0.579
4
0.636
0.482
5
0.567
0.402
Required, Calculate the internal rate of return for project X and project Y
Advantages of IRR
•
•
•
•
It takes into consideration the time value of money.
It uses cash flows which are less subjective than profitability.
All the cash flows of the project are considered, unlike payback.
It gives a rate of return that can be used to make comparisons.
Disadvantages of IRR
•
•
It needs to consider different discount rates and involves multiple calculations.
Calculating IRR as a percentage means that projects of differing sizes cannot be compared using
IRR alone.
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Capital Rationing
In some cases, a company may evaluate a number of projects. However, because of the limited
amount of capital it has, the company cannot invest in all the projects at the same time. It must
ration its capital in such a way that the projects it invests in maximize the net present value of the
company over a period of time.
Profitability Index can be used for capital rationing.
Question 09
Aarav has evaluated five projects with the following results.
Project
Capital cost
Net present value
A
$ 200 000
$ 100 000
B
$ 300 000
$ 80 000
C
$ 500 000
$ 270 000
D
$ 200 000
$ 180 000
E
$ 300 000
$ 100 000
However, he only has a maximum of $ 500 000 to spend. Aarav needs to decide which projects he
should invest in to maximize the net present value.
Required, Which projects should be chosen to maximize the overall net present value?
Question 10
Darsha’s business can only invest in any one of the following three projects at one time. Details of
the projects are as follows.
Project
Capital cost
Net present value
X
$ 200 000
$ 50 000
Y
$ 300 000
$ 60 000
Z
$ 400 000
$ 120 000
Which order should Darsha invest in the projects to maximize the overall net present value?
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Question 11
A business is proposing to purchase new equipment costing $ 130 000. The business depreciates
equipment at 25% per annum using the straight-line method.
The equipment will earn revenue of $ 100 000 per annum and involve additional expenditure of
$ 55 000 each year for four years. The company’s cost of capital is 10%.
The present value of $1 is as follows:
Year
10%
15%
1
0.909
0.870
2
0.826
0.756
3
0.751
0.658
4
0.683
0.572
Required, Calculate:
(a) Accounting rate of return
(b) Net present value
(c) Internal rate of return
Question 12
A company is planning to produce a new product. In order to make it, the company will have to
purchase machine A costing $ 100 000. This will last for four years, after which it will be scrapped.
The following information is available:
− Expected sales units will be 12 000 units for each of the four years.
− The selling price, unit costs and other costs are:
Selling price per unit
$ 20 (This will increase by $ 1 per annum over the life of the project)
Direct costs per unit
$ 16 (These will stay the same over the life of the project)
Annual fixed overheads $ 10 000 (These will increase by $ 1 000 per annum over the life of the
project)
(excluding depreciation)
The company accountant has also produced the following data for an alternative machine B that
could be used for the project. This is as follows:
Capital cost
$ 140 000
Payback
3 years
Accounting rate of return
30%
The directors can only invest in one project.
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Required,
(a) Prepare a table to show the expected annual net cash flows and profits arising from the project
purchasing machine A
(b) Calculate the following for the project purchasing machine A:
(i) Payback period
(ii) Accounting rate of return
(c) Advise the directors on which machine they should buy
Non-financial factors
Non-financial factors are those factors that affect the decision to undertake a project but are
difficult to quantify and are not considered in investment appraisal techniques. Non-financial
factors include the following:
•
Human resources : jobs, motivation, culture and the working environment can all be impacted
by new projects.
•
Environment : projects typically will have some impact on the environment
•
Social : projects may affect staff, customers or the general public.
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