Accounting for Managers: Interpreting accounting information for decision-making

STRATEGIC INVESTMENT DECISIONS 191

Table 12.9 NPV for Goliath Co.

AB

Year 0

C

Year 1

D

Year 2

E

Year 3

F

Year 4

G

Year 5

Cash flows 45,000 50,000 55,000 50,000 35,000

Present value 179,437

−200,000

NPV −20,563

Initial
investment

=+NPV (10%, C36:G36)

The payback period is the end of year 4 when £200,000 of cash flows has
been recovered.
Net present value of the cash flows:

Year Cash flow Factor Present value

1 45,000 .9091 40,910

2 50,000 .8264 41,320

3 55,000 .7513 41,321

4 50,000 .6830 34,150

5 35,000 .6209 21,731

Present value of net cash flows 179,432

Cash outflow −200,000

Net present value −20,568

Using the spreadsheet NPV function, the answer is calculated in Table 12.9 (the
difference is due to rounding).
Although the ROI is 7% and the payback is four years, the discounted cash
flow shows that the net present value is negative. Therefore the project should be
rejected, as the returns are insufficient to recover the company’s cost of capital.

Conclusion: a critical perspective............................

In this chapter we have introduced strategy and the role of investment appraisal in
capital investment decisions. In particular, we have described the main methods
of capital investment appraisal. Often, however, decisions are made subjectively
and then justified after the event by the application of financial techniques. This is
particularly so for emergent strategy, described earlier in this chapter. Despite the
usefulness of these techniques, the assumption has been that future cash flows can
be predicted with some accuracy. This is, however, one of the main difficulties in
accounting,aswewillseeinChapter14.
Shank (1996) used a case study to show how the conventional NPV approach
was limited in high-technology situations as it did not capture the ‘richness’
of the investment evaluation problem. Shank saw NPV more as a constraint