An example of an investment appraisalDiscounting
Tax on Capital Net Discounted
Initial Working Operating operating allowance cash Discount cash
Year investment capital profit profit tax relief flows factor flows
£000 £000 £000 £000 £000 £000 @ 12% £000
0 (1,200) (100) (1,300) 1.000 (1,300)
1 (5) 294 (88) 90 291 0.893 260
2 (5) 309 (93) 68 279 0.797 222
3 (6) 556 (167) 51 434 0.712 309
4 (6) 583 (175) 38 440 0.636 280
5 122 613 (184) 114 665 0.567 377
Net present value 148
See note 2345 6 7
As the NPV is positive and significant, from a financial viewpoint, the production of the
Rapido should be undertaken.
Notes
1 The costs of developing the product and of the market survey will not vary with the pre-
sent decision and must therefore be ignored. They exist irrespective of the decision.
2 Treating the working capital commitment in the way shown takes account, in a broadly
correct way, of the timing difference between operating cash flows and accounting flows.
In ‘money’ terms, the investment in working capital will increase as inflation increases the
inventories and sales prices. Each of the outflows of years 1 to 4 (inclusive) comprises
the additional amount necessary to invest to bring the working capital up to the higher
level. In each case the figure is 5 per cent of the previous year’s working capital figure.
3 The operating profits are simply the ‘real’ figures, adjusted for inflation at 5 per cent, for
as many years into the future as is relevant.
4 The tax figures are simply the operating profits multiplied by 30 per cent (the CT rate).
5 The CA tax reliefs are taken directly from the table showing capital allowances on the
initial investment. (See page 124.)
6 The discount factor reflects the ‘money’ cost of capital. Quite how the discount rate is
established (that is, where the 12 per cent came from) is a question that we shall con-
sider in some detail later in the book, particularly in Chapter 10.
7 Note that the NPV using ‘real’ cash flows would be identical to the NPV using ‘money’
cash flows. Note as well that the present value of each year’s net cash flow would also
have been identical, no matter whether ‘real’ or ‘money’ cash flows were used.
8 All the calculations in this example have been rounded to the nearest £1,000. While this
is not strictly correct, the accuracy to which cash flows, timings and discount rates can
be predicted is such that this rounding is not out of place. It could be argued that doing
other than this in such calculations would give the result an air of precision not justified
given the levels of probable inaccuracy of the input data.
9 This example (except to the extent of the rounding mentioned in point 8 above) has com-
pletely ignored the question of risk.
How reliable are the predictions of labour costs? What if the bottom fell out of the
domestic food mixer market? Would the increased level of activity that this project
engenders prove too much for the competence of management?
These and many other matters are present with this project, and similar ones with any
other project. These risks should be formally assessed and their effect built into the deci-
sion-making process. How this can be done will be addressed in the next two chapters.
10 The net cash flow figures in the example could be used as the basis of an IRR or a PBP
assessment of the project without modification. IRR and PBP would simply use them
differently.