Fundamentals of Management Accounting

Investment Appraisal Techniques

Fundamentals of Management Accounting

Class Slides Ian Wilson



Explain the process of long term investments

Calculate the Net Present Value (NPV),
Internal Rate of Return(IRR) & Payback for an
Investment

In the course to date, we have focused on

COSTS & CASH FLOWS that relate to normal
& typical BUSINESS COSTS & EXPENSES.
This is called REVENUE Expenditure
Typically, Materials, Labour, Rent, Rates,
Insurance etc fall into this category.
A business will also need to purchase & fund
ASSETS TANGIBLE ASSETS, typically items
such as:
Computers, Machinery, Premises & Vehicles

This is called:

CAPITAL EXPENDITURE

A business will have to decide IF it can afford
to purchase ASSETS & what benefit &
Financial Return those Assets will create

As such, Managers have to:
1. PLAN buy the asset
2. MAKE a DECISION is it the right asset
3. CONTROL against that Decision will it give
an actual return as we expect?

This process is called:

PROJECT APPRAISAL

Management accountants are involved heavily
in this process, guiding managers to the
right outcome:

Techniques used could be:
be
1. Net Present Value (NPV)
2. Internal rate of Return (IRR)
3. Payback

Before a Company can look at a specific

asset, it has to consider the relevant costs
associated with the project.
To do this, it must understand the FUTURE
CASH FLOWS associated with the life time of
the asset:
The purchase cost today year 0
The following years income generated by the
Asset:
Year 1, Year 2 etc & at the end of the term
and disposal proceeds

We can now see an important aspect of this

process developing:
Cash Flows take place over a longer time
period, often 3 years, 5 years or even longer
Premises may be used for 20+ years, a
vehicle for 10 years and so on
Over time money changes in value
You will have to consider the Time Value of
Money



What is this?
this
Based on the concept that money received
now is worth more than the same sum
received in one years time or at another time
in the future.
When capital expenditure projects are
evaluated, it is appropriate to decide whether
the investment will make enough profit to
allow for the time value of money as capital
is tied up over time.

$1000 received NOW is worth MORE than

$1000 received in say, 2 years time.

Why?
Why
1. Inflation
2. Uncertainty & Risk
3. Opportunities to Invest

You need to learn some key terms also:



Simple Interest:
Interest
Simple interest involves adding interest to an
invested capital sum of money, whereby the
interest that is added each period is added to
the capital sum only and not to the interest
earned in previous periods.
Simple interest formula :FV = PV (1 + rn)
You need to understand the Key:
See the next slide:

Simple interest formula FV = PV (1 + rn)

Where:
Where
1. FV = Future Value after n periods
2. PV = Present or Initial Value
3. r = Rate of Interest per period
4. n = Number of periods

$1,000 is invested at the start of year 1 and

simple interest is added each year at 10% per
annum.

How much income will the investment
generate by the end of Year 2?

Answer:
1. Initial investment $1,000
2. Interest year 1 $1,000 x 10% $100
3. Interest year 2 $1,000 x 10% $100
4. Value at end of year 2 $1,200

Compound interest is a system that adds

interest each year to both the original capital
PLUS any interest added to date.

Compound interest formula :FV = PV (1 + r)n

Where:
Where
1. FV = Future Value after n periods
2. PV = Present or Initial Value
3. r = Rate of Interest per period
4. n = Number of periods

$1,000 is invested at the start of year 1 and

compound interest is added each year at 10%
per annum.
Calculate the value of the investment at the
end of Year 3.
Answer on next Slide:



Initial investment
$1,000
Interest year 1 $1,000 x 10% $100
Value end of year 1
$1,100
Interest year 2 $1,100 x 10% $110
Value end of year 2
$1,210
Interest year 3 $1,210 x 10% $121
Value end of year 3
$1,331



Yes! Apply the formula:

formula
Remember:
FV = PV (1 + r)n
FV = $1000 x (1+0.10)3
FV = $1331



Present Values (PVs):

(PVs):
This calculates the present value (at year 0)
of all cash flows, & sums them to give the
NPV. If this value is positive, the investment
goes ahead.



In other words:
words
The value at time 0 of a future cash flow,
having taken account of the time value of
money. In investment appraisal, it represents
the maximum an investor would be willing to
invest for a future cash inflow given a
specified required return



Discounted Cash Flow(DCF):

Flow(DCF)
DCF is a technique that takes into account the
timing of cash flows & allows comparison
between cash flows arising at different points
in time.



Compounding ReRe-cap:
cap
Compounding calculates the future value of a
given sum of money
FV = PV (1 + r)n
where FV = Future Value after n periods
PV = Present or Initial Value
r = Rate of Interest per period
n = Number of periods



Final rere-cap:
cap
Compounding: we move from a present
value to a future value by adding compound
interest each year



Discounting:
Discounting:
Discounting is the reverse of compounding
we start at the future value and work back to
the present value.
PV = FV (1 + r)n
Where:
Where
PV = present value
FV = future value
r = rate of interest
n = number of periods

YEAR 0

YEAR 1
Compounding:

Discounting:



What do they contain?

contain
Periods n for 15 years, by single year
Discount rate r, r = a %, 1 to 20%
Read off the years/periods & discount rate &
you get a factor, something to multiply your
cash flow by to get the:
PRESENT VALUE, ie the value in todays terms
for a cash flow in the future

You can calculate your own factors with a

formula:
1
1+r^n
Say r = 10%, substitute 0.10 into the formula
in your calculator:
1
1+ 0.1^n
= 0.909 = the same answer as your tables

How do we deal with timescales of many

years, ie n=2, or n=3 etc?.
You have to use to the power of for each
year.
2 years = power of 2, n=2
3 years = power of 3, n=3
Your calculator has a ^ key for you to do this
10% on 2 years would be:
1
1 + 0.1 power 2 = 0.826

See page 132:

find the present value of
$80,000 at the end of year 5
Remember your formula for
FV = PV (1 + r)n
Substitute into the formula:
FV = $80,000, r = 10%
FV = 80000
(1+.10)5
= $49674 invested today to get $80000 in 5
years time



The answer again:

PV = FV/(1 + r)n
PV = 80,000 / (1 + 0.1)5
PV = 80,000 / 1.61051 = $49,674

NPV looks at the comparison of how much

cash will an investor get back from an
investment compared to how much cash they
have had to pay for the investment.
Everything is compared in present value
terms.
The techniques is used to evaluate whether or
not a project should be accepted.
There are Three steps to follow:

1.

2.

3.

Step 1: sort out the numbering of the years

between the investment & each future value
Step 2: decide what Cost of capital to use &
find discount factors
Step 3: multiply each future value by the
relevant discount factor to give the present
values



Decision Criteria:
Criteria
If the investment has a positive NPV then the
project should be accepted (negative rejected).
A positive NPV means that the project will
increase the wealth of the company by the
amount of the NPV at the current cost of
capital

A company is evaluating a project that has

the following cash flows:
Machine to be purchased on January 1 2011:
for $50,000
You are given Net Cash Flows for 2011 to
2014.
The Company can borrow money at 10%
Is the project worthwhile?
Use the template on page 133

Year

Cash Flow

Discount Factor
@ 10%

Present Value

($50,000)

1.000

($50,000)

$20,000

0.909

$18,180

$10,000

0.826

$8,260

$20,000

0.751

$15,020

$15,000

0.683

$10,245

Net Present Value:

$1,705

The rate of interest (discount) at which the

NPV = 0

If the IRR is greater than the cost of capital

the project should be accepted, because this
suggests that the NPV is positive at the cost
of capital
Look at Exercise 3
You will need the linear interpolation
formula:

Lets look at this example:



What is it?
The length of time it takes for cash inflows
from trading to pay back the initial
Investment in Year 0
Is your payback period right or wrong?
The answer is you dont know unless you
have a Target.
What is the Target?, measure against that.
It depends!



How do we calculate it?

This is the length of time it takes for cash
inflows from trading to pay back the
initial investment.
Payback period = Initial investment / Annual
inflow

A company invests in a project with an initial

cash outflow of $100,000. Cash inflows
resulting from the project are $40,000 per
annum.
Calculate the payback period.



Payback period = $100,000 / $40,000 =

2.5 years

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