Objectives 1. Explain what is meant by term ‘Capital Investment’ and how a business decides which project to invest in 2. State the two main methods that you need to be able to calculate and use for appraising Capital Investment 3. Calculate Payback Periods and list the advantages and disadvantages of this method 4. Explain what is meant by the ‘time value of money’. Evaluate Capital Investments using the DCF method, making appropriate recommendations and list the advantages and disadvantages of using DCF 5. Discuss what is meant by a Perpetuity and an Annuity 6. Make recommendations on a proposed Capital Investment using IRR 7. Estimate IRR 8. Access Blackboard (off site) and complete a quiz to test your knowledge and understanding of this topic area

AAT Level 3 Capital Investment Appraisal (CIA)

What is Capital Investment?

Project proposal

Example – buying a new machine.... What do we need to consider before investing in new assets? Funding? Cost of Capital Expected Costs of Project Timescales Tax Implications Economy Objective – Profit Maximisation 5 minutes

Methods of CIA Payback Period Discounted Cash-flow Internal Rate of Return To discuss To use and discuss

Payback Period (Activity 1) Machine C costs £100,000 Scrap Value? Year 1 Spend (£100,000) Expected Income £40,000 (£60,000) (£30,000) 0 £30,000 £55,000

Payback Period (Activity 1) Machine D costs £75,000 Scrap Value? Year 1 Spend (£75,000) Expected Income £20,000 (£55,000) (£35,000) (£15,000) £5,000 £25,000 £45,000 £65,000 £85,000 £60,000 repaid years 1-3 Balance£15,000 due Year 4 ÷£20, or ¾ of 1 year (12 months) So Payback is 3 years & 9 months

Assumes cash flows occur equally through out the period Advantages Uses earlier cash flows – less affected by uncertainty Disadvantages Ignores cash flows outside the payback period

Try these... Activity 2 & 3

Activity 2 - Answer

Activity 3 - Answer Cumulative Cash flow Cumulative Cash flow Payback is > 3 years so not recommended

Discounted Cash Flow Time Value of Money Cash flows Income - Expenditure Discounted

£10 Investment Preference – If you have money now you can invest it which means your money will be worth more in future than it is now. Consumption Preference – You are likely to be able to but more with £10 today than with £10 in a years time Risk Preference – Receiving your money back sooner rather than later reduces the risk of default on the loan Time Value of Money Our preference to have the money NOW rather than wait and receive it at a later date

Activity 4 Machine A costs £100,000 Scrap Value? £25,000 (100,000) 27,270 30,000 x ,780 30,040 13,660 21,735 17,485 *This includes £10,000 cash inflow PLUS the scrap value on sale

(£60,000) Use table (P4) (60,000) 22,725 20,650 11,265 10,245 6,210 11,095

Notes on NPV Only considers ACTUAL cash-flows Depreciation Resale value at end of period Net Cash flow = Inflows - Outflows

Advantages Based on cash flows over entire lifetime Disadvantages Makes various assumptions which may not be accurate -Cost of capital -Prediction of cash flows More complicated to calculate

Activity 5

Try these.... Activity 6 - 9

Activity 6 - Answer

Activity 7 - Answer

Activity 8 & 9 Check with Kate

Activity 10 Net Present Costs (NPC) (100,000)(37,040)(35,994)(36,206)(36,015) (245,255)

(340,000)(148,160)(154,260)(150,860)(147,000) (940,280) Activity 10 Net Present Costs (NPC)

Try Activity 11

Internal Rate of Return Definition The discount rate which, when applied to project cash flows gives a zero net present value

How it works.... IRR is the % rate which gives a ZERO NPV

Question 13 You have been asked to evaluate a proposed project with capital expenditure totalling £ using a PV factor (rate of interest) of 8%. You have calculated that the NPV for that project is What is likely to be the IRR? a) 6% b) 8% c) 10% d) 14% Top tip! Give a higher IRR where you have a positive NPV, and a lower one where you have a negative

Try Activity 13 b & c