Investment appraisal form major part of the ACCA FM examinations. Candidates are normally asked to calculate various Investment appraisal techniques and comment on their acceptability in to the particular project which will be discussed here in this article.
The major investment appraisal techniques examined in paper FM are Net present value (NPV), Internal rate of return (IRR), Discounted payback period and Accounting rate of return (ARR)/ Return on capital employed (ROCE).
Investment appraisal is done to look at the project where it is financially viable to the company or not. If the project is financially viable, a company will accept the project as the primary objective of company is to maximize shareholders wealth.
First, the superior appraisal method is NPV which discounts the relevant Free cash flows of the project to present values and check whether it is financially acceptable. Normally, the project is financially acceptable if the NPV is positive and hence company accept the project as this will increase shareholder wealth.
Here, you have to know RELEVANT CASH FLOWS and FREE CASH FLOWS. Relevant cash flows is future incremental cash flows as a result of the project i.e., those cash flows which arise as a result of project. For example, Variable costs incurred in the project is as a result of project so is relevant as it is not incurred if project will not be undertaken however, head office rent is not relevant to the project being appraised.
Free cash flows is a cash flow that is ready for discounting. For example, you cannot directly discount operating profit from project to present value as operating profit is not always the cash flows.
Advantages of NPV
-NPV consider the cash flows and not accounting profit which may be subject to management manipulation.
-NPV consider the time value of money in its calculations hence is more relevant for user understanding of what the
cash flows will be from project in today’s terms.
-NPV consider the whole life of project hence relevant than other method such as Discounted pay back which consider
cash flows only up to period of recovery of investment.
Disadvantages/limitations of NPV
-Projected discount rate used in NPV calculation may be wrong as it is based on estimates and many other factors.
If discount rate is wrong, NPV will be wrong.
-The projected cash flows may not happen in reality.
The company primary objective is to maximize shareholders wealth but also they have secondary objective towards
other stakeholders such as employees, public, government. So the stakeholder non-financial consideration should
also be taken in to account when appraising the project. For example, a investment in heavy machinery will create
lots of noise and it is financially acceptable and increase shareholder wealth but other non-financial considerations such as affecting the local school children and residents due to noise must be taken into account.
NPV Calculation in CBE exam
In the exam, you have to calculate the free cash flows and for discounting to present value, you can take two method –
1. You can use discount factor given in the PV table and apply it individually in relevant free cash flows in all years to arrive at present value.
2. You can use NPV formula directly in excel without having to do above. Use “=NPV(discount rate,range of free cash flows from year 1 to year Y)+Initial Investment(Year 0)”. For example, if project life is 2 years and discount rate is 10% and free cash flows in Year 0 is 200000 and in year 1 is 30000, year 2 is 40000. We can calculate NPV in excel as “=NPV(10%,year 1:year2)+ 200000 Initial Investment(Year 0)”.
The FM examining team has said that they will accept both method of NPV calculations in excel sheet.
You can try the NPV calculation question from FM CBE Specimen Exam Question number 31 in CBE format.
Written by a member of BOD Team for CCA.