This paper builds on knowledge from the Basic Costing unit at Level 2. It is assessed by a 150 minute computer based assessment containing ten tasks. The first five tasks cover the short term costing of direct costs, revenues and overheads and is generally well done by students.
In this article we will look at techniques used for decision making. Questions on Capital investment appraisal will commonly include:
Payback
Net Present Value (NPV)
Net Present Cost (NPC)
Internal Rate of Return (IRR)
Capital investment appraisal techniques help us to decide whether it is worth spending an amount now in the hope that it generates cash in the future. The issues surrounding capital investment appraisal are that the expenditure tends to be large and the amount and timing of the potential cash it may generate is often unknown.
1. Payback
Here we look at how long it will take us to ‘payback’ our initial investment. If I purchase a machine today for £100,000 and expect that it will generate additional cashflows of £40,000 in both of the next two years and then £20,000 per annum for another two years, after which it will be scrapped, how long is the payback?
£
Today- cash out (100,000)
End of year 1- cash in 40,000
(60,000)
End of year 2- cash in 40,000
(20,000)
End of year 3- cash in 20,000
Nil
So by the end of year three I will have ‘paid back’ the initial cost of £100,000.
Common assessment errors:
• Not using actual ‘cash’, instead using discounted amounts.
• Making generalised statements i.e. ‘should accept as paid back in three years’. Before decisions can be made, we would need to know what the organisations target payback period is. If their target is that projects must be paid back within two years then we would reject this investment.
ASSESSMENT TIP: Check to see what the Organisations payback policy is. If it is not given then you cannot make a decision on the capital investment appraisal using payback alone. You could use one of the investment appraisal techniques which take into consideration the time value of money.
Time value of money:
The basic principle here is that we would rather have £10,000 today than be given £10,000 in two years time. This is because there is a risk that we may not get the amount in the two years time and if we had it now then we could invest it so it would be worth more than £10,000 in two years time.
2. Net Present Value (NPV)
Taking the example we used for payback, and assuming a present value (discount) factor of 5%:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
| Cash outflow (a) | (100,000) | ||||
| Cash inflow | 40,000 | 40,000 | 20,000 | 20,000 | |
| PV factor 5% (b) | 1.000 | 0.952 | 0.907 | 0.864 | 0.823 |
| Discounted cash flow(a) x (b) | (100,000) | 38,080 | 36,280 | 17,280 | 16,460 |
The NPV is the sum of the discounted cashflows: £8,100
As this is positive then the project should be accepted.
Common assessment errors:
• Including the initial investment in year one rather than year 0, or forgetting the initial investment altogether.
• Ignoring any residual/scrap value for the item, if you were told in the above example that the machine could be sold for scrap of £5,000 at the end of the project then your cash inflow for year four would be £25,000 rather than £20,000.
3. Net Present Cost (NPC)
This is similar to NPV, however it excludes cash inflows, and instead the PV factor is applied to cash outflows.
4. Internal Rate of Return (IRR)
The IRR is the discount factor that will give you a NPV of £0. In the above example we saw that a discount factor of 5% gave a positive NPV of £8,100. If we re-performed the calculation using a discount factor of 10% we would have got a negative NPV of £1,920. The IRR is somewhere between 5% (£8,100) and 10% (-£1,920) so a 5% increase in discount factor causes a change of £8100+£1,920 i.e. £10,020 in NPV. We can estimate that a 1% change results in a £2,000 change in NPV so to get a value of 0 for NPV if we take the 10% (£1,920) deduct 1% (£2000) then we get close to 0 at 9%.
If the organisation has a target rate of 7% then the investment (9%) should be accepted.
Common assessment errors:
• Not being able to estimate the IRR, or to decide whether to accept or reject.