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Lecture 2- Capital Investment Appraisal: Appraisal process and methods. Objectives: Describe the nature of capital investment appraisal Apply the main investment appraisal techniques Recognise the limitations of investment appraisal technique. Definition of Investment .
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Payback method - length of time it takes to repay the cost of initial investment
Lecture Example 2.1
LBS Ltd uses the payback period as its sole investment appraisal method. LBS invests £30,000 to replace its computers and this investment returns £9,000 annually for the five years. From the information above evaluate the investment using the payback. Assume that £9,000 accrues evenly throughout the year.
Year Yearly cash flow cumulative net cash flow
0 (30,000) (30,000)
Therefore 3years = 27,000 then 3000/9000 x 12 = 4
Payback period = 3 years 4months
For A = 4 years
For B = 5 years
For A, payback is outside the project’s life
For B payback is 6.25 yeas (how?)
Read on page 13
Average Accounting Profit
(- 250 +1000 + 1000 + 20,750) / 4 = 5625
Average investment = 45,000 / 2 = 22500
ARR = (5625/22,500 x 100 = 25%
Advantages and disadvantages (page 14)
A company can purchase a machine at the price of £2200. The machine has a productive life of three years and the net additions to cash inflows at the end of each of the three years are £770, £968 and £1331. The company can buy the machine without having to borrow and the best alternative is investment elsewhere at an interest rate of 10%.
Evaluate the project using the
Lecture Example 2.5
A firm invest £180,000 in a project that will give a net cash inflow of 50,000 in real terms in each of the next six years. Its real pre-tax cost of capital is 13%.
Use the annuity table
Year Cash flow DF @13% PV
0 (180,000) 1 (180,000)
1-6 50,000 3.998 199,900
Using Lecture example 2.4 (above), calculate the internal rate of return for the project.
Solution to 2.6
Please read more on the advantages and disadvantages of these techniques
Why is the NPV considered superior over the other methods, even the IRR?
Any question please?