Summary — What This Chapter Covers
- Appraisal uses future net cash flows caused by the project: cash in less cash out each year. Depreciation is not a cash flow; past (sunk) costs are ignored.
- Payback: the time taken for cumulative net cash inflows to repay the initial cost, in years and months.
- ARR = average profit ÷ average investment × 100, where profit is after depreciation.
- NPV: discount each year’s net cash flow, add them and subtract the outlay. Positive NPV: accept.
- IRR: the discount rate at which NPV = 0, found by interpolation between a rate with a positive NPV and a rate with a negative NPV. Accept if IRR is above the cost of capital.
- Each method has strengths and limits, so a recommendation uses several of them plus non-financial factors.
1. Net Cash Inflows and Outflows
Syllabus 4.4.1 · A Level · Paper 4
Cash, not profit
Investment appraisal looks at the extra cash a project brings in and pays out over its life. Outflows include the initial cost of the asset, installation, extra working capital and running costs. Inflows include extra sales receipts and cost savings.
- Depreciation is not a cash flow: it spreads the cost that has already been counted as the Year 0 outflow. Counting it again would deduct the cost twice.
- Sunk costs (money already spent, such as a market survey last year) are ignored because the decision cannot change them.
- Only relevant costs count: those that change because of the decision. A share of existing head office costs that will be paid anyway is ignored.
From profit to cash flow
Net cash flow = Profit + Depreciation (when the only non-cash item is depreciation)
Practice Question 1
A project is forecast to make a profit of $18,000 a year after charging depreciation of $24,000. A consultant’s report on the project last year cost $5,000. Calculate the annual net cash inflow and state how the consultant’s fee is treated.
2. Payback
Syllabus 4.4.1 · A Level · Paper 4
How quickly is the money back?
Tamarind Print Ltd must choose between two printing machines. Each costs $120,000 and lasts 5 years with no residual value. The company’s cost of capital is 10%. Forecast net cash inflows:
| Year | Machine A $ | Machine B $ |
|---|
| 1 | 40,000 | 20,000 |
| 2 | 45,000 | 30,000 |
| 3 | 42,000 | 40,000 |
| 4 | 30,000 | 60,000 |
| 5 | 20,000 | 50,000 |
| Total | 177,000 | 200,000 |
Worked example
Calculate the payback period for each machine.
| Machine A |
|---|
| Year | Net cash flow $ | Cumulative cash flow $ |
|---|
| 0 | (120,000) | (120,000) |
| 1 | 40,000 | (80,000) |
| 2 | 45,000 | (35,000) |
| 3 | 42,000 | 7,000 |
| 4 | 30,000 | 37,000 |
| 5 | 20,000 | 57,000 |
| Machine B |
|---|
| Year | Net cash flow $ | Cumulative cash flow $ |
|---|
| 0 | (120,000) | (120,000) |
| 1 | 20,000 | (100,000) |
| 2 | 30,000 | (70,000) |
| 3 | 40,000 | (30,000) |
| 4 | 60,000 | 30,000 |
| 5 | 50,000 | 80,000 |
Machine A: after 2 years $35,000 is still to be recovered; Year 3 brings $42,000. Payback = 2 years + 35,000/42,000 × 12 months = 2 years 10 months.
3 years 6 months
The calculation assumes cash flows arise evenly through the year.