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Tuesday 19 July 2011

Management Accountancy : Investment Appraisal

 Investing in a project is judged financially using “investment appraisal” techniques, as there is little point in investing in a project for financial if the saving/return will not cover the initial investment.

Methods
  •          Payback Period (PP) & Discounted Payback period 
  •          Accounting Rate of return (ARR)
  •          Net Present Value (NPV)
  •          Internal Rate of Return (IRR)

Payback Period (PP)
The PP is in simplicity terms the length of time that it will take to recoup the initial investment.  Discounted payback method simply makes use of a discount table (see NPV).

Accounting Rate of Return (ARR)
ARR is the average capital employed expressed as a percentage of the profit that it will turn over the life of the investment.
ARR =
Profit
ARR (10%) =
£10,000 (Profit)

Average Investment *
£1,000 (Average investment)

* Average Investment  =
Cost of investment + Disposal Value

Length of investment

Net Present Value (NPV)
NPV looks at the cost/returns of an investment and considers the timing of cash flows, i.e. would the capital spent on a five year project return the same amount as if the capitol was attracting interest in the bank.
NPV makes use of a “discount table” to discount future cash flows, as cash (in the form of savings) received in 5 years time is worth less than (i.e. it would discount more a cash flow in year 5 than year 2).
Years
3.00%
3.50%
4.00%
4.50%
1
£0.97
£0.97
£0.96
£0.96
2
£0.94
£0.93
£0.92
£0.92
3
£0.92
£0.90
£0.89
£0.88
4
£0.89
£0.87
£0.85
£0.84
5
£0.86
£0.84
£0.82
£0.80
Example of a NPV discount table



Internal Rate of Return (IRR)
IRR is the discount rate that when applied to the cash flows of a project cause it to have a zero NPV. 
Carry out NPV against a project and do so with two discount rates (i.e. once at 10% and one at 15%), using the values and percentage discounts carryout the following formula.
IRR =
L% +
L(#)
* (H(%) – L(%))


( L(#) + H(#)

L% = Lowest discount percentage
L# = Lowest discounted value
H% = Highest discount percentage
H# = Highest discount value



IRR is used to evaluate at which level of discount a project would break even and at which level.

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