Chapter 5 • Practical aspects of investment appraisal
the points relate equally well to the other techniques for assessing investment projects,
and particularly to IRR.5.2 Cash flows or accounting flows?
When assessing a particular business investment opportunity, should the business
identify and discount cash payments and receipts or should it discount profits arising
from the project? This is an important question, as it seems that many businesses use
projections of accounting figures as the starting point for an investment appraisal. As
we saw in Chapter 4, cash flows from a particular project, in a particular time period,
will rarely equal the accounting profit for the project during the same period.
If we go back to the principles on which the concept of NPV is based, we see that
discounting takes account of the opportunity cost of making the investment. It is not
until cash needs to be expended in the project that the opportunity for it to produce
income from some other source will be lost. Only when cash flows back from the pro-
ject can the business use it to pay dividends, repay borrowings, lend it or reinvest it in
another project.
Over the life of a project the accounting profits will equal the net cash flows
(undiscounted) in total; it is the timing that will be different. Why should this be
the case?The roles of financial accounting and investment appraisal
Financial accounting, as we saw in Chapter 3, sets out to assess profit (increase in
wealth) for a period, perhaps a year. In doing so it needs to treat each period as a self-
contained unit. This is despite the fact that most of the business’s investment projects
will not be self-contained within that same period. Non-current assets (for example, an
item of machinery), perhaps acquired in a previous period, may be used in the period
and continue to be owned and used in future periods. Inventories (stock in trade)
acquired in a previous period may be sold in the current one. Sales made (on credit)
in the current period may be paid for by customers in the following period. Financial
accounting tends to ignore the timing of payments and receipts of cash and concen-
trates on wealth generated and extinguished during the period. Costs, less anticipated
disposal proceeds, of certain non-current assets are spread in some equitable way
(depreciated) over their lives so that each period gets a share of the cost, irrespective
of whether or not any cash is actually paid out to suppliers of non-current assets in the
particular accounting period under consideration. Sales revenues are usually recog-
nised and credit taken for them by the selling business when the goods change hands
or the service is rendered even though the cash receipt may lag some weeks behind.
The reduction in wealth suffered by using up inventories in making sales is recognised
when the sale is made – and not when the inventories are purchased or when they are
paid for.
These points are not weaknesses of financial accounting. Its role is to seek to meas-
ure income (profit) over particular time periods so that interested parties can obtain
a periodic assessment of the business’s progress. As projects will not usually be self-
contained within time periods as short as a year, it is necessary for financial account-
ing to take some consistent approach as to how to deal with the problem; the approach
taken seems a very logical one.