Capital investment appraisal 2 DCF and decision making FDM10 Capital investment appraisal 2

Capital investment appraisal 2 Different types of decision using NPV: Is a project worthwhile? Choosing between two options Continuing with a project Prioritising projects when capital is limited Other discounted cash flow methods: Internal rate of return Discounted payback Non-financial considerations Reading: Management Accounting for Business chapter 6 FDM10 Capital investment appraisal 2

Is a project worthwhile? Simple decision Go ahead or not? Will the project increase wealth? Go ahead if NPV>0 Return greater than opportunity cost of capital FDM10 Capital investment appraisal 2

Choosing between two projects Focus on relevant cash flows Choose project with higher NPV Can use differential cash flows instead Applies when projects are of equal length Otherwise have to consider annual equivalents FDM10 Capital investment appraisal 2

Continuing with a project Decision whether to abandon a project which is already started Relevant incremental cash flows Expenses so far are sunk costs Make decision based on future cash flows from today May be other significant non-financial factors FDM10 Capital investment appraisal 2

Prioritising projects when capital is limited Maximise return per £ invested Rank according to profitability index PV of future inflows / PV of future outflows Applies when projects are divisible (can be done in part) If not, need to calculate NPV for all possible combinations up to available capital FDM10 Capital investment appraisal 2

Internal rate of return Method which takes account of time value of money Represents interest rate earned by investment over its life Advantage: gives % measure managers can relate to Rate at which present values of outflows = present value of inflows Rate at which NPV = 0 FDM10 Capital investment appraisal 2

Estimating and using IRR Calculate NPV at different discount rates Then can use alternative methods to find point at which NPV = 0: Using a graph Interpolation (calculate based on two points) Trial and error Project is profitable if IRR > opportunity cost of capital With choice of projects choose higher IRR FDM10 Capital investment appraisal 2

FDM10 Capital investment appraisal 2 Estimating the IRR (2) £ Discount Rate Straight line – mathematically calculated – gives estimate of IRR True NPV – gives actual IRR FDM10 Capital investment appraisal 2

FDM10 Capital investment appraisal 2 IRR – the main issues Does consider time value of money but: Ignores the scale of the project Assumes interim cash flows reinvested at same return as the project ie at the IRR Problematic with unconventional cash flows such as net outflows in later years can lead to more than one possible IRR: NPV Cost of capital FDM10 Capital investment appraisal 2

Discounted payback method Calculate payback period after discounting cash flows Gives better indication than simple payback period Shares other disadvantages with simple payback period Does not take account of cash flows after payback period ends FDM10 Capital investment appraisal 2

Non-financial considerations How does this project fit with the organisation’s strategy Is it mandatory? What non-financial resources are required? How risky is it? Possible alternatives? Will it lead to other opportunities? Ethical issues Other impacts? On employees On the community On the environment FDM10 Capital investment appraisal 2