ADVANCED INVESTMENT APPRAISAL
Investment appraisal is one of the key financial data that may be tested with the case study. The
methods of investment appraisal are payback, accounting rate of return and the discounted cash flow
methods of net present value (NPV) and internal rate of return (IRR). For each of these methods
students must ensure that they can define it, make the necessary calculations and discuss both the
advantages and disadvantages.
The aim of this article is to briefly discuss these potential problem areas and then work a
comprehensive example which builds them all in. Technically the example is probably harder than any
exam question is likely to be. However, it demonstrates as many of the issues that students might face
as is possible. Exam questions, on the other hand, will be in a scenario format and hence finding the
information required may be more difficult than in the example shown.
The problem areas Inflation Students must be aware of the two different methods of dealing with
inflation and when they should be used. The money method is where inflation is included in both the
cash flow forecast and the discount rate used while the real method is where inflation is ignored in both
the cash flow forecast and the discount rate. The money method should be used as soon as a question
has cash flows inflating at different rates or where a question involves both tax and inflation. Because of
this the money method is commonly required. Students must ensure that they can use the Fisher
formula provided to calculate a money cost of capital or indeed a real cost of capital for discounting
purposes. They must also be able to distinguish between a general inflation rate which will impact on
the money cost of capital and potentially some cash flows and a specific inflation rate which only applies
to particular cash flows.
Taxation Building taxation into a discounted cash flow answer involves dealing with ‘the good the bad
and the ugly’! The good news with taxation is that tax relief is often granted on the investment in assets
which leads to tax saving cash flows. The bad news is that where a project makes net revenue cash
inflows the tax authorities will want to take a share of them. The ugly issue is the timing of these cash
flows as this is an area which often causes confusion.
Working capital
The key issue that must be remembered here is that an increase in working capital is a cash outflow. If a
company needs to buy more inventories, for example, there will be a cash cost. Equally a decrease in
working capital is a cash inflow. Hence at the end of a project when the working capital invested in that
project is no longer required a cash inflow will arise. Students must recognise that it is the change in
working capital that is the cash flow. There is often concern amongst students that the inventories
purchased last year will have been sold and hence must be replaced. However, to the extent the items
have been sold their cost will be reflected elsewhere in the cash flow table.
Relevant/irrelevant cash flows
This problem is rarely a big issue in case study as students have been examined on this topic previously.
However students should remember the ‘Golden Rule’ which states that to be included in a cash flow
table an item must be a future, incremental cash flow. Irrelevant items to look out for are sunk costs
such as amounts already spent on research and apportioned or allocated fixed costs. Equally all
financing costs should be ignored as the cost of financing is accounted for in the discount rate used.
Question
CBS Co CBS Co is considering a new investment which would start immediately and last four years. The
company has gathered the following information: Asset cost – N160,000 Annual sales are expected to be
30,000 units in Years 1 and 2 and will then fall by 5,000 units per year in both Years 3 and 4. The selling
price in first-year terms is expected to be N4.40 per unit and this is then expected to inflate by 3% per
annum. The variable costs are expected to be N0.70 per unit in current terms and the incremental fixed
costs in the first year are expected to be N0.30 per unit in current terms. Both of these costs are
expected to inflate at 5% per annum.
The asset is expected to have a residual value (RV) of N40,000 in money terms. The project will require
working capital investment equal to 10% of the expected sales revenue. This investment must be in
place at the start of each year. Corporation tax is 30% per annum and is paid one year in arrears. 25%
reducing balance writing-down allowances are available on the asset cost. General inflation is 4% and
the real cost of capital is 7.7% N12, 000 has already been spent on initial research.
Required:
Calculate the NPV of the proposed investment.
