Examples of Justifying Decisions Made and Techniques Used:
Example:
ABC Company is considering investing in a new production line for one of its products. The initial cost of the production line is £500,000. The expected cash flows from the investment are as follows:
| Year | Cash Inflows | Cash Outflows |
| 1 | £100,000 | £50,000 |
| 2 | £150,000 | £50,000 |
| 3 | £200,000 | £50,000 |
| 4 | £250,000 | £50,000 |
| 5 | £300,000 | £50,000 |
Capital Investment Appraisal Techniques Used:
- Payback Period:
The payback period is the time it takes for the initial investment to be recovered. In this Example, the payback period can be calculated as follows:
Year 1: £500,000 – £100,000 = £400,000 remaining
Year 2: £400,000 – £150,000 = £250,000 remaining
Year 3: £250,000 – £200,000 = £50,000 remaining
Based on the payback period, the investment will be recovered in 3 years.
- Accounting Rate of Return (ARR):
The accounting rate of return is the average annual profit as a percentage of the initial investment. In this Example, the ARR can be calculated as follows:
Average Annual Profit = (Sum of Cash Inflows – Sum of Cash Outflows) / Number of Years
Average Annual Profit = (£100,000 + £150,000 + £200,000 + £250,000 + £300,000 – £50,000 – £50,000 – £50,000 – £50,000 – £50,000) / 5
Average Annual Profit = £700,000 / 5 = £140,000
ARR = (Average Annual Profit / Initial Investment) * 100
ARR = (£140,000 / £500,000) * 100 = 28%
- Net Present Value (NPV):
The net present value is the difference between the present value of cash inflows and the present value of cash outflows. In this Example, the NPV can be calculated using a discount rate of 10%:
Year 1: £100,000 / (1 + 0.10) = £90,909
Year 2: £150,000 / (1 + 0.10)^2 = £121,900
Year 3: £200,000 / (1 + 0.10)^3 = £166,116
Year 4: £250,000 / (1 + 0.10)^4 = £206,611
Year 5: £300,000 / (1 + 0.10)^5 = £248,680
NPV = Sum of Present Values of Cash Inflows – Initial Investment
NPV = £90,909 + £121,900 + £166,116 + £206,611 + £248,680 – £500,000 = £273,216
- Internal Rate of Return (IRR):
The internal rate of return is the discount rate that makes the NPV equal to zero. In this Example, the IRR can be calculated using a financial calculator or Excel:
IRR = 18.7%
Justification of Decisions Made:
Based on the investment appraisal techniques used, the following decisions can be justified:
- Payback Period: The investment will be recovered in 3 years, which is within the company’s desired payback period. Therefore, this investment is financially viable.
- Accounting Rate of Return (ARR): The ARR is 28%, which is higher than the company’s required rate of return. Therefore, this investment is financially attractive.
- Net Present Value (NPV): The NPV is £273,216, which is positive. A positive NPV indicates that the investment will generate more cash inflows than outflows, resulting in increased shareholder wealth. Therefore, this investment is financially beneficial.
- Internal Rate of Return (IRR): The IRR is 18.7%, which is higher than the company’s required rate of return. Therefore, this investment is financially viable.
Overall, based on the results of the investment appraisal techniques, it can be concluded that the investment in the new production line is financially viable, attractive, beneficial, and meets the company’s investment criteria. Therefore, it is recommended to proceed with the investment.