Chapter 5

Investment decision-making

Expenditure Types
Asset (“capital”) expenditure – incurred in the acquisition or improvement of
non-current assets.
Expenses (“revenue expenditure) – incurred to maintain non-current assets
(e.g. Repairs).

Investment decision-making process

Capital investment projects involve the outlay of large sums of money in the
expectation of benefits that may take several years to accrue.
The decision whether to proceed with a capital investment project is normally
made by a capital expenditure committee overseeing a process that includes the
following phases:
(a) Idea Creation (b) Screening (c) Financial (d) Review
analysis
Proposals can be To screen out A detailed A post-completion
stimulated by a unsuitable appraisal of the review (or audit)
regular review of proposals by project's risk and aims to learn from
the company’s looking at the return, how it will mistakes that
competitive impact of the be financed, any have arisen in the
environment and project on alternatives to it project appraisal
can be stakeholders and and the process.
encouraged by whether they implications of not
incentive schemes support the accepting the
organization’s project.
strategy
Important Terms
Relevant cash flow: A future incremental cash flow caused by a decision (e.g. to
invest in a project)
Opportunity cost: A cost incurred from diverting existing resources from their best
use.
Illustration 1: Opportunity cost
If a team of workers, costing $300,000 per year, is diverted to work on a new
project then they will stop work on existing products which earn contribution (i.e.
sales revenue less variable cost) of $500,000, this contribution will therefore be
lost (note that this assumes that labor is a variable cost).
Required
Calculate the relevant cost associated with using the team of workers on the new
project.
Solution
The relevant cost is the opportunity cost i.e. the $500,000 of lost contribution plus
the cost of the workers. This gives a total relevant cost of $800,000.
Non-relevant costs examples
Questions will expect you to be able to identify costs that are not relevant to
decision-making. Some examples are included in the following table.

Examples Explanation
Depreciation and apportioned overheads
Non-cash flows (i.e. overheads that are not directly
attributable to a project) are not cash flows.
A cost incurred in the past (i.e. sunk), or
committed to, will not change whether a
Sunk and committed costs project goes ahead or not and is therefore
not a relevant cash flow (market research is
often an example).
If materials that are used by a project need
to be replaced, the relevant cost of the
material is the replacement cost of the
material—not the price originally paid to
Historic cost of materials acquire the material (i.e. the historic cost). If
such materials do not need to be replaced,
the relevant cost is zero (unless there is an
opportunity cost from lost revenue if the
material could have been sold as scrap).

Examples Explanation
If labour used by a project is: (a) Idle, then
the relevant cost of using that labour is zero.
Cost of labour (b) At full capacity, then the cost is wages
paid + contribution lost on the work that they
had to stop doing.
Any finance costs (e.g. dividend payments,
interest payments) should not be considered
Finance costs as a cash flow because they are included in
the cost of capital used to discount a project
(covered in section 3).
Illustration 2
Brenda and Eddie are considering expanding their restaurant business through
an investment in anew. restaurant, the Parkway Diner. Brenda and Eddie have
analyzed the profit made in the first year and are concerned that the project could
be loss making.
Their Year 1 costs and revenues are forecast as follows:
Year 1 $
Revenue 200,000
Depreciation 25,000
Materials (note 1) 49,000.
Labor (note 2) 100,000
Overheads (note 3) 100,000.
Profit / (Loss) (74,000)
Notes.
1. The materials include $10,000 of surplus inventory that Brenda and Eddie have
in their existing restaurants. This inventory has a scrap value of $1,000.
2. Labor includes 20% of the $50,000 salary of a manager of an existing branch,
who will assist the existing manager of the restaurant in its first year of operation.
3. This is an allocation of corporate overheads

Required
Assess the relevant cash flows of the project in the first year to Brenda and Eddie
and advise Brenda and Eddie whether they are right to be concerned.
Solution
Year 1 $
Revenue 200,000
Depreciation 0
Materials (49,000 – 10,000 not relevant + 1,000
40,000
scrap value)
Labour (100,000 – 10,000 not relevant) 90,000
Overheads (not a cash flow) 0
Cash flow 70,000
This is less concerning than the losses figure of $74,000 that we
started with but requires further analysis to see if the project is worth
pursuing (e.g., analysis of later time periods).

Investment decision-making Methods

Payback period: A measure of how long it takes for the cash flows affected by
the decision to invest to repay the cost of the original investment.
KEY TERM
Payback period: A measure of how long it takes for the cash flows affected by the
decision to invest repay the cost of the original investment.
Payback is often used as part of an initial screening of projects. If a project gets
through the payback test it should be evaluated using a more sophisticated
project appraisal technique.
A project with a long payback period is uncertain because it relies on cash flows
that are in the distant future and are therefore highly uncertain.
A company will reject a project with a payback period that is above the company's
target payback period. Payback is especially useful if a company has cash flow
concerns because it focusses on shorter term investments. Payback is based on
relevant cash flows so any non-cash flow cost items (e.g. depreciation) should be
ignored.
Illustration 3: Payback period
Brenda and Eddie are worried about the length of time it will take for the cash
flows from the Parkway.
Diner to repay their total investment of $500,000 ($350,000 to take over the
business and $150,000 to refurbish it).
Cash flow projections from the project are estimated as:
Operating cash flows
Year $
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
After the sixth year, Brenda and Eddie confidently expect that they could sell the
business for $350,000.
Required
Calculate the payback period for the project.

Solution
Year Cumulative Cash Flow ($) Workings
0 (500,000) Calculated as (500,000) + 70,000
1 (430,000) Calculated as (430,000) + 70,000
2 (360,000) Calculated as (360,000) + 80,000
3 (280,000) Calculated as (280,000) + 100,000
4 (180,000) Calculated as (180,000) + 100,000
5 (80,000) Calculated as (80,000) + 120,000
General problems with payback
(a) It ignores the timing of cash flows within the payback period (e.g. ignores that
a project is more uncertain if most of the cash is received at the end of the
payback period).
(b) It ignores the cash flows after the end of the payback period and therefore the
total project return.
(c) It ignores the time value of money (a concept incorporated into more
sophisticated appraisal methods). This means that it does not take into account
that the value of money is lower the further into the future that the money is
received.
(d) The choice of any cut-off payback period by an organization is arbitrary.
(e) It may lead to excessive investment in short-term projects.
Because of these drawbacks, a project should not be evaluated using payback
alone.

2. Return on capital employed

Return on capital employed (ROCE) is also called accounting rate of return
(ARR) and return on investment (ROI). ROCE is another simple, traditional,
approach to evaluating investments.
ROCE compares the profit from an investment project to the amount invested in
the project, expressing the result as a percentage.
Using this method, a company will accept a project if it has a ROCE above the
company's target.
Calculation (formulae are not given and need to be learnt)
Profit is calculated after depreciation which we have seen is not a relevant cash
flow, this failure to distinguish between relevant and non-relevant cash flows is
one of the many drawbacks of this technique
 Formula Description
ROCE = Average annual profit / Initial investment
or
ROCE = Average annual profit / Average investment
Where Average Investment = (Initial outlay + Scrap value) / 2

Illustration 4
An asset costing $120,000 is to be depreciated over 5 years to a nil residual
value. Profits after depreciation for the 5 years of the project are as follows.

Required
What is the average accounting rate of return for this project? (Give your answer
to the nearest percentage.)
Solution
Average investment = [$120,000 (start) + $0 (end)] + 2 = $60,000
Average profits = [12,000 + 17,000 + 28,000 + 37,000 + 8,000] + 5 (years) =
$20,400
ARR = $20,400 + $60,000 = 34% (this can also be referred to as ROI or ROCE)
Illustration 5

Brenda and Eddie are considering expanding their restaurant business through
purchase of the Parkway Diner, which will cost $350,000 to take over the
business and a further $150,000 to refurbish the premises with new equipment.
Cash flow projections for this project are as for the previous activity.
The equipment will be depreciated to a zero-resale value over the same period
and, after the sixth year, Brenda and Eddie confidently expect that they could sell
the business for $350,000.
Required
What is the ROCE of this investment (using the average investment method)?
A. 13.0%
B. 15.3%
C. 18.0%
D. 21.2%

Calculation $
Total cash flows from
540,000
operations
Total depreciation (500,000 –
(150,000)
350,000)
Total profits 390,000
Average profits (÷ 6) 65,000 p.a.

Investment Calculation Formula

Average Investment (500,000 + 350,000) / 2
ARR 65 / 425 = 15.3%
Benefits of using ROCE/ARR
ROCE method is a quick and simple calculation that involves the familiar concept
of a percentage return. Unlike payback period it does consider the whole of a
project's life. The fact that it gives a percentage measure means that ROCE
makes it easy to compare two investment options even if they are of different
sizes.
General problems with ROCE/ARR
(a) It is based on accounting profits and not relevant cash flows. ROCE is the
only investment appraisal technique not based on relevant cash flows.
(b) It is a relative measure (i.e. a percentage) rather than an absolute measure
and therefore takes
no account of the size of the investment.
(c) Like the payback method, ROCE ignores the time value of money.

ROCE/ARR is the only project appraisal technique that is based on profit instead
of cash flow. So, in this technique (only) you will need to include depreciation in
your calculations.

Time value of money and discounting

A key problem with both payback and ROCE is that they both ignore the time
value of money; this is an important concept that is used in the more
sophisticated investment appraisal techniques that are covered in the remainder
of this chapter.
Time value of money
The idea that receiving $100 in the future is worth less than having $100 today is
an example of the concept of money having a 'time value.’
Several possible reasons underlie this assumption:
Liquidity preference: money received today can be spent or reinvested to earn
more. Therefore, investors have a preference for having cash/liquidity 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
Illustration 6: Time value
If a project involved the outlay of $20,000 today and provided a definite return of
$21,000 in one year's time.
Required
Would you accept it if you could get a return of 6% on investments of similar risk?
Solution
We can look at this in two ways:
Firstly, if you had $20,000 today and invested it for one year in a project of similar
risk at 6% then you would have $20,000 x 1.06 = $21,200 (this approach is called
compounding).
This is more than is generated by the project, so the project is not acceptable.
Alternatively, we can reduce the future cash flow of $21,000 to reflect its worth if it
was received today:
$21,000 x 1/1.06 = $19,811
This approach is called discounting.
$19,811 is the value today, or the present value, of receiving $21,000 in one
year's time to reflect the return available to investors.
Again, we can see that the project is unacceptable because this present value is
below the cost(today) of the project of $20,000.

Discounting and present values

The process of discounting future cash flows back to their present value is often
called discounted cash flow (DCF) analysis. It is important in project appraisal
because many projects involve investing money now and receiving returns in
many different time periods in the future.
DCF analysis is an important tool in allowing the value of future cash flows to be
compared against money invested today.

Present value: The cash equivalent now of money received (or paid) in the future.
Discount factors.
In the previous illustration, a future cash flow received in 1 year was discounted
back to a present value by multiplying by 1/1.06.
This is the same as multiplying the cash flows by 0.943 (i.e. 1/1.06 = 0.943), and
this figure is an example of a discount factor.
This discount factor reflects the investor's required return (also referred to as a
cost of capital) of 6% and the timing of the future cash flow (in one year's time).
In the exam you are provided with a table of discount factors to apply depending
on the rate of return expected and the timing of the future cash flow.
These are shown as an Appendix at the back of this book as a present value
table.

Formula

Discount tables are provided in the exam, but they cover only integer values of r
and up to 15years ahead. If you need to calculate a discount rate that is not an
integer (e.g. 10.5%) or is not in the range of values covered by the tables, you will
need to use the discounting formula provided.

Conventions used in DCF.

• Time 0 is today, it is usual to assume that time 0 is the first day of a project, i.e.
the start of its first year.
• Time 1 is the last day of the first period (normally a year).
• A cash flow which occurs during a time is assumed to occur all at once at the
end of the time (at the end of the year).
• A cash flow which occurs at the start of a time is taken to occur at the end of the
previous time e.g. a cash outlay of $5,000 at the start of time 2 is taken to occur
at the end of time period 1.
Illustration 7

Calculate the present value of $100,000 received in seven years' time, if the cost
of capital is 12%. (Give your answer to the nearest $100.)

Solution
Calculation Method Result ($)
45,234 (or 45,200
Formula: 100,000/ (1+0.12)7100,000 / (1 + 0.12) ^7 rounded to the nearest
$100)
Using tables: 100,000×0.452100,000 \times 0.452
(discount factor from the 12% column and the time 7 45,200
row)

Annuities
Annuity: A series of equal cash flows.
If a project involves equal annual cash flows (or annuities) then each future cash
flow can be discounted separately back to a present value, but it is quicker to use
a single discount factor (Called an annuity factor or a cumulative discount factor)
Formula
Illustration 8
If a project involved the outlay of $20,000 today and provided a definite return of
$8,000 per year for three years, would you accept the project?
Assume that you could get a return of 6% on investments of similar risk.
Solution
This can be analyzed as a series of individual calculations, obtaining the discount
factors from the present value table (from the 6% column for time periods 1, 2
and 3)

Time 0 1 2 3
Cash Flow ($) (20,000) 8,000 8,000 8,000
Discount Factors 1.000 0.943 0.890 0.840
Present Value ($) (20,000) 7,544 7,120 6,720
Net Present Value +1,384

Alternatively, this could be analyzed more quickly by using a single discount

factor provided in the annuity table given in the Appendix to this book (here using
the 6% column and time 3).
The figure obtained is 2.673: this is called an annuity (or cumulative discount)
factor.
Time 0 1 to 3
Cash Flow ($) (20,000) 8,000
Annuity Factor 2.673
Present Value ($) (20,000) 21,384
Net Present Value +1,384

The annuity factor of 2.673 represents the addition of the individual discount
factors used in the first method (0.943 + 0.890 + 0.840)
Annuity tables are provided in the exam, but again only cover integer values of r
and up to 15years ahead. If you need to calculate a discount rate that is not an
integer or is not in the range of values covered by the tables, you will need to use
the formula provided.

Illustration 9
A firm has arranged a 10-year lease at an annual rent of $17,264. Each rental
payment is to be made at the start of the year. Required What is the present
value of the lease at 12%? (Give your answer to the nearest $.
Solution
Details Values
Result $109,247
Cash flows arise at the end of the year. Payments at the start
of years 1–10 are treated as one payment at time zero, and
Assumption
nine payments at the end of years 1–9. Using the annuity table
corresponds to time periods 1–9.
Rate (r) 12%
Number of
9 (1st payment now, 10th payment at the end of time 9)
periods (n)
Annuity Factor 5.328 (for time periods 1–9 at 12%)
Present Value PV=17,264PV = 17,264 (the first payment is not discounted
Calculation because it is paid in advance)
17264+(5.328×17,264) =109,247
Perpetuities
Perpetuity: An annuity that occurs for the foreseeable future.
If the series of cash flows does not have an end date (i.e. it is expected for the
foreseeable future) then this is called a perpetuity. This can be dealt with by
applying a single discount factor, but this requires the use of a formula which you
will need to learn:
The formula for discounting a perpetuity is:
I/R

Illustration 10
If a project involved the outlay of $20,000 today and provided a definite return of
$3,000 per year for the foreseeable future.
Required
Would you accept the project?
(Again, assume that you could get a return of 6% on investments of similar risk.)
Solution
The perpetuity factor here is.
:1/0.06
So, the present value of the future cash flows is $3,000 x 1/0.06 =$50,000
And the present value of the inflows exceeds the cost of the project, so the
project is acceptable.

Delayed annuities and perpetuities

The approaches demonstrated in the previous sections for annuities and
perpetuities assume that the cash flows begin in time 1 and value these annuities
or perpetuities from the perspective of the preceding time period to when the
cash flows begin (i.e. time 0, a present value).Where the first cash flow in an
annuity is not received from time 1 this is called a delayed annuity. Where this is
the case, the approach to valuing an annuity or perpetuity must be slightly
adjusted.
Illustration 11: Delayed Perpetuity
If a project involved the outlay of $20,000 today and provided a definite return of
$3,000 per year for the foreseeable future starting in three years' time.
Required
Would you accept the project? (Again, assume that you could get a return of 6%
on investments of similar risk.)
Solution
As before, the perpetuity factor here is: 1/0.06.
So, the value of the future cash flows is $50,000, as before.
However, this value is from the perspective of the preceding time to when the
cash flows begin and here the cash flows begin at time 3 so the value is from the
perspective of time 2 (the preceding time).

This can be adjusted to a time 0 present value by treating the $50,000 as a one-
off cash flow received in time 2 and multiplying it by the discount factor from the
present value table for period2 at 6% of 0.890.
$50,000 x 0.890 = $44,500
This is now a present value and because this is higher than the cash outflow of
$20,000, the project is acceptable
Illustration 12
An annuity of $3,000 per annum for eight years starts at the end of the third year
and finishes at the end of the tenth year.
Required
What is the present value of the annuity if the discount rate is 6%? (Give your
answer to the nearest $.)
Solution
$16,581
Annuity factor for 8 years at 6%= 6.210
Present Value = 3,000 x 6.210 = $18,630
This is a value from the perspective of the preceding time to the annuity (i.e. a
present value at time 2).
Discounting at time 2 discount factor of 0.890 gives a present value at time 0 of
18,630 x 0.890 =$16,581.
There is an alternative approach which you can use if preferred which is to
subtract the annuity factor for times 1-2 (when the cash flow is not received) from
the annuity factor for times 1-10(time 10 is the final year of the cash flow).
Annuity factor for time 3-10 = (annuity factor for time 1-10) - (annuity factor for
time 1-2)
= 7.360 - 1.833 = 5.527
Present value = 3,000 x 5.527 = $16,581
Constant growth
If a series of cash flows does not have an end date (i.e. it is expected for the
foreseeable future) and is growing at a constant rate, then this can be converted
into present value terms by applying a single discount factor and is known as a
growing perpetuity.

The formula for discounting a constantly growing cash flow is.

1/r-g

[Link] present value (NPV)

The NPV method uses the concept of discounting and recognizes the time value
of money.
This method compares the present value of all the cash inflows from a project
with the present value of all the cash outflows from a project. The difference, the
NPV, represents the change in wealth of the investor because of investing in the
project.

NPV Value Explanation

NPV Return from investment’s cash inflows more than cost of capital
positive (undertake project)
NPV Return from investment’s cash inflows below cost of capital (don’t
negative undertake project)
Return from investment’s cash inflows same as cost of capital (the
NPV = 0
project will be only just worth undertaking)

Note. We assume that the cost of capital is the organization’s target rate of return
for proposed investment projects. One of the advantages of NPV is that it gives a
clear and objective decision rule which is that a project is acceptable if its NPV is
zero or above.
Illustration 13: NPV
LCH manufactures product X which it sells for $5 per unit. Variable costs of
production are currently $3 per unit. Sales of product X are estimated to be
75,000 units per annum. A new machine is available which would cost $90,000
but which could be used to make product X for a variable cost of only $2.50 per
unit. Fixed costs, however, would increase by $7,500 per annum as a direct result
of purchasing the machine. The machine would have an expected life of four
years and a disposal value of $10,000. LCH expects to earn at least 12% per
annum from its investments.
Required
Using NPV analysis, should LCH acquire the machine?
Solution
The correct answer is: $7,470.
Savings are 75,000 x ($3 - $2.50) = $37,500 per annum.
Additional costs are $7,500 per annum.
Net cash savings are therefore $30,000 per annum. (Remember, depreciation is
not a cash flow and must be ignored as a 'cost’.)

The first step in calculating an NPV is to establish the relevant costs year by year.
All future cashflows arising as a direct consequence of the decision should be
taken into account. It is assumed that the machine will be sold for $10,000 at the
end of year 4.
It is quicker to use an annuity approach for the net cash savings in time 1-4. D
Time 0 1 to 4 4
Cash Flow ($) (90,000) 30,000 10,000
Discount Factors 1.0 3.037 0.636
Present Value ($) (90,000) 91,110 6,360

Net Present Value (NPV):

NPV= (−90,000) +91,110+6,360=7,470

 Time 0 1 2 3 4
Cash Flow ($) (90,000) 30,000 30,000 30,000 40,000
Discount Factors 1.0 0.893 0.797 0.712 0.636
Present Value ($) (90,000) 26,790 23,910 21,360 25,440

Net present Value = (90,000) + 91,110 + 6,360 = $7,500 (difference due to

rounding). The NPV is positive and so the project is expected to earn more than
12% per annum and is therefore acceptable.
4. Internal rate of return (IRR)
The IRR method also uses the concept of discounting and recognizes the time
value of money.
Internal rate of return (IRR): A discounted cash flow technique that calculates the
percentage return given by a project. If this return is used to discount a project's
cash flows, it would deliver an NPV of zero.

IRR Condition Explanation

IRR is greater than Return from the investment is above that which is
the required return required (undertake project)
IRR is less than the Return from the investment is below that which is
required return required (don’t undertake project)
Return from the investment is the same as cost of
IRR is equal to the
capital (the project will be only just worth
required return
undertaking)
 Calculating IRR
▪ Computer based exam method
In a computer-based exam you can use the =IRR function to calculate the
project's IRR.
Example:
From the previous activity the project cash flows for the NPV calculation could be
shown on a spreadsheet as follows:

Row A B C D E F
1 Time 0 1 2 3 4
2 Cash flow ($) (90,000) 30,000 30,000 30,000 40,000
3 Discount factors 1.0 0.893 0.797 0.712 0.636
4 Present value ($) (90,000) 26,790 23,910 21,360 25,440

To calculate the IRR the correct instruction would be = IRR (B2:F2)

In this example, this would give an IRR of 15.7%.
Note. The undiscounted cash flows are used for the IRR calculation. Also, the
spreadsheet IRR formula does not work if the cash flows are set up as annuities
(e.g. one cash flow of $30,000 for time 1-3 in the previous illustration)
Interpolation
If a question provides two project NPVs then these can be used to estimate the
internal rate of a project. This approach is sometimes called interpolation.

Where a is the lower discount rate giving NPVa and b is the higher discount rate
giving NVPb

This approach to IRR is more likely to be tested in an OT question.

Example:
From the previous activity if you had been told that NPV of the project cashflows
was +$7,500 at a cost of capital of 12% and -$540 at 16% then the IRR can be
estimated as:
Step Formula/Calculation Result
IRR=a%+NPV×(b%−a%)
IRR Formula
/NPVa−NPVb
IRR=12+7500 × (16−12) /
Substitute values
(7500+540)

Simplify numerator and

denominator
Final IRR IRR=15.7% = 15.7\% 15.7%

Note. If NPVb is a negative number, then NPVa-NPVb becomes NPVa+NPVb

since subtracting a negative is the same as an addition. Although the
interpolation method is slower than the formula method, it does allow some marks
to be scored if a minor error is made (follow-through marks) whereas the formula
approach will either be 100% correct or will score 0. So, if you are at all unsure
about the formula approach then the interpolation method would be better to use
in the exam.
Illustration 13
A project has a positive NPV of $15,000 when discounted at 6% and a negative
NPV of $3,000when discounted at 12%. Required
Calculate the internal rate of return.
Solution
11%
IRR = 6 + (15/ (15 + 3) × 6) = 11%
Exam Tip:
It is easy to confuse internal rate of return (IRR) and accounting rate of return
(ARR). One way of remembering the difference is that accounting rate of return is
based on accounting profits (whereas IRR is based on relevant cash flows).

Advantage of DCF method (NPV and IRR)

Both NPV and IRR are superior methods for appraising investments compared to
the simpler techniques covered in section 2 because:
(a)They are DCF methods i.e. they account for the time value of money (unlike
non-DCF methods like ROCE and payback)
(b)They focus on relevant cash flows (unlike ROCE)
(c)They look at the cash flows over the whole life of the project (unlike payback)
Disadvantage of DCF method
• The potentially complex and time-consuming process of calculating NPV or
IRR (see later in this chapter).
• Difficulty in explaining DCF methods to non-financial managers.
• The complexity of estimating an appropriate discount rate (i.e. the
applicable interest rate), particularly for unquoted companies.
• Managers may feel little connection between DCF methods and their
reported performance and bonus systems.

Given that there are two methods of using DCF, the NPV method and the IRR
method, the relative merits of each method must be considered.

Advantage of IRR over NPV

IRR gives the percentage return of a project; this concept is easy for non-financial
managers to understand
Advantages of NPV over IRR
Example: Projects of different sizes
If a company had to choose between project A and project B, then it would
choose project A which is 10 times bigger (as reflected in the NPV). But if the
only information on which the projects were judged were to be their IRR of 18%,
project B would be made to seem just as beneficial as project A, which is not the
case.
[Link]-conventional cash flows
The projects we have considered so far have had conventional cash flows (an
initial cash outflow followed by a series of inflows). When flows vary from this they
are termed 'non-conventional’.
In general, if the sign of the net cash flow changes in successive periods (inflow
to outflow or vice versa), it is possible for the calculations to produce as many
IRRs as there are sign changes.
This can make IRR difficult to interpret.
There are no issues with NPV and non-conventional cash flows.
3. Re-investment assumption
An assumption underlying the NPV method is that any net cash inflows generated
during the life of the project will be reinvested elsewhere at the cost of capital
(that is, the discount rate).
The IRR method, on the other hand, assumes these cash flows can be reinvested
elsewhere to earn a return equal to the IRR of the original project. Assuming that
the project is attractive, so that the IRR is above the cost of capital then if this
assumption is not valid, the IRR method overestimates the project's actual return.
Conclusion
There is a consensus that NPV is the superior technique from a technical
viewpoint.
However, IRR is still extremely useful for explaining the appraisal of an
investment to non-financial managers. This is why both NPV and IRR are both
widely used in practice.
This is not to say that NPV is perfect; like any financial technique, there is the
danger that the nonfinancial benefits of an investment are ignored or that the
financial estimates are inaccurate.
Assignment
Question 1
DEF Co has a cost of capital of 12%.
Project A has a positive NPV of $5,000 when discounted at 12% and a positive
NPV of $3,600 when discounted at 16%.
Project B has a positive NPV of $8,000 when discounted at 12% and a negative
NPV of $1,000 when discounted at 16%.
The projects are mutually exclusive.
Required
1 What is the internal rate of return for projects A and B?
A. Project A has an IRR of 26.3% and B an IRR of 16.5%.
B. Project A has an IRR of 26.3% and B an IRR of 15.6%.
C. Project A has an IRR of 14.3% and B an IRR of 16.5%.
D. Project A has an IRR of 14.3% and B an IRR of 15.6%.
2 Which of the following statements is correct?
A. Both NPV and IRR indicate that Project A is the more financially viable
project.
B. To maximize shareholder wealth Project A is the better project.
C. Neither Project A nor Project B should be accepted from a financial
perspective.
D. Project B will increase shareholder wealth more than Project A at the
current cost of capital.
Solution
1. The correct answer is: Project A has an IRR of 26.3% and B an IRR of 15.6%.
IRR (A) = 12 + 5,000/ (5,000 - 3,600) x (16 - 12) = 26.3%
IRR (B) = 12 + 8,000/ (8,000 + 1,000) x (16 - 12) = 15.6%
2. The correct answer is: Project B will increase shareholder wealth more than
Project A at the current cost of capital.
The NPV at the current cost of capital will be the movement in shareholder wealth
because of the project being accepted. Project B (not A) will generate more
shareholder wealth. NPV suggests that Project B is better, but the IRR is better
for Project A.
Question 2
Calculate the present value of $2,000 receivable for each of 10 years
commencing three years from now. Assume interest at 7%.
A.12270
B.10000
C.17270
D.8900
Solution

Time Description Cash flow 7% Annuity Factor PV

$ $

t3−12 Annuity 2,000 6.135 (W) 12,270

WORKING

Annuity factor3−12 @ 7% = Annuity factor1−12 @ 7% – Annuity factor1−2@ 7%

= 7.943 − 1.808 (per tables) = 6.135

Question 3
Calculate the present value of $2,000 receivable in perpetuity commencing 10
years from now. Assume interest at 7%.

Time Description Cash flow 7% Annuity Factor PV

$ $

t10 − ∞ Perpetuity 2,000 7.771 (W) 15,542

WORKING
Annuity factor10-∞ @ 7% = Annuity factor1-∞ @ 7% – Annuity factor1-9 @ 7%

= − 6.515 (per tables) = 14.286 − 6.515

• Annuity factor to use = 7.771

Question 4
An investment of $6,340 will yield an income of $2,000 for four years.

Required:

Calculate the internal rate of return of the investment.

A.20
B.15
C.10
D 25

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 0
AF1−4 years = dollar sign 6,340 over dollar sign 2,000 = 3.17
From the annuity table, the rate with a four-year annuity factor closest to 3.17 is
10% which is the approximate IRR for this investment.
Question 5
Difference between IRR and NPV?
--------------------------------------------------

Summary
• Payback period and return on capital employed (ROCE) are commonly
used in practice. However, neither method informs management of the
absolute change in shareholder wealth due to a particular project.
• Decision rule for payback period: Accept the project if payback period is
shorter than the target. Reject the project if payback period is longer than
the target.
• Discounted payback period (see Chapter 7) offers a potential improvement
over payback period.
• ROCE is also called the accounting rate of return (ARR) or return on
investment (ROI).
• Decision rule for ROCE: Accept the project if ROCE exceeds the target.
Reject the project if ROCE is less than the target.
• Because ROCE is a financial accounting measure based on amounts
reported in financial statements, it includes sunk costs, “book values” of
assets, depreciation and amortization and allocated fixed overheads.
• The time value of money concept assumes that investors prefer to receive
$1 today rather than $1 in one year.
• Net present value (NPV) is a DCF method used to determine whether a
project should be undertaken.
• A project should be undertaken if its NPV > $0.
• NPV is considered the superior decision-making technique as it is an
absolute measure that tells management the change in shareholder wealth
expected from a project.
• An annuity is an equal annual cash flow for more than one year.
• A perpetuity is a stream of identical cash flows arising each year to infinity.
• Internal rate of return shows the highest finance cost that can be accepted
for the [Link] IRR > cost of capital, accept the [Link] IRR < cost of
capital, reject the project.
• If cash flows are unconventional (the cash flows change signs more than
once), IRR will have two solutions (i.e. multiple IRRs will be found).