Financial Management - Investment Appraisal Notes

Capital Expenditure

  • Investments in long-term projects (e.g., buying machinery, developing products).

  • Irregular and often large expenditures for long-term benefits.

Revenue Expenditure

  • Day-to-day expenditures consumed quickly (within one accounting period).

  • Includes working capital expenditure for short-term net assets.

Importance of Capital Expenditure

  • Can impact a company's success or failure.

  • Poor decisions can lead to collapse.

  • Companies use formal capital budgeting processes.

Capital Budgeting Process

  1. Generate ideas for suitable projects.

  2. Appraise potential projects.

  3. Select and approve the best project(s).

  4. Implement the decision.

  5. Monitor and evaluate outcomes.

Investment Appraisal Techniques

  • Used to determine which projects meet company objectives.

  • Techniques include:

    • Payback Period

    • Discounted Payback Period

    • Accounting Rate of Return (ARR)

    • Net Present Value (NPV)

    • Internal Rate of Return (IRR)

Payback Period

  • Time required to recover initial investment.

  • Decision rule: accept if it meets a predetermined figure; choose the fastest payback.

Payback Period Example

  • Initial cash outflow:

    • Year 0: (120,000)

    • Year 1: 50,000

    • Year 2: 60,000

    • Year 3: 80,000

    • Year 4: 40,000

  • Cumulative cash flow at end of Year 2 is (10,000), payback occurs between Years 2 & 3.

Payback Period - Pros & Cons

  • Pros: Simple, uses cash flows, minimizes risk and maximizes liquidity.

  • Cons: Ignores time value of money, does not consider cash flows after payback and profitability.

Accounting Rate of Return (ARR)

  • Measures return on capital employed.

  • Calculation includes average annual accounting profit, decision rule: accept if ARR > target figure, choose highest ARR.

Time Value of Money (TVM)

  • £1 today is worth more than £1 in the future due to factors like inflation and risk.

Net Present Value (NPV)

  • Sum of present values of cash flows discounted at the opportunity cost of capital.

  • Decision rule: accept projects with positive NPV, reject negative.

NPV Example

  • Cash flows and calculations for NPV consideration.

NPV - Pros and Cons

  • Pros: Linked to shareholder wealth, considers TVM, includes all cash flows.

  • Cons: Complex to explain, requires cost of capital calculation.