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Chapter 5 • Practical aspects of investment appraisal

One way to do this is by trial and error. We could try to find an amount such that

the NPV of three payments of that amount, one at the end of each of the next three

years, equals £6,712. Fortunately there is a quicker way, using the annuity table

(Appendix 2 of this book).

You may care to look back to page 85 for an explanation of the annuity table.

Looking at the annuity table for 15 per cent and 3 years we find an annuity factor of 2.283.

This means that the present value of £1 payable (or receivable) at the end of this year and of

the next two years totals £2.283. Thus the amount payable at the end of this year and of the

next two years, which has an NPV of £6,712, is £6,712/2.283 =£2,940.

The four-year annuity factor (from the table) is 2.855. Thus the equivalent annual cost of

replacing the vehicle after four years is £7,713/2.855 =£2,702.

Again we find that the four-year replacement cycle is the less costly option. Note that the

equivalent annual cost approach gives the same result as the LCM approach because they

follow exactly the same principles, even though they seem quite different. (£15,935 is 8.8 per

cent higher than £14,644 (LCM), and £2,940 is 8.8 per cent higher than £2,702 (equivalent

annual cost).

Helpful and

practical

solution

The example we have used is a very basic one. In reality there would probably be

a tax aspect, different running costs of the vehicle in each of the four years and the

effects of inflation. All these can be incorporated without any great difficulty. There

may well also be non-quantifiable factors such as the effect on the image of the busi-

ness of having its staff driving relatively new vehicles.

5.10 Routines for identifying, assessing, implementing

and reviewing investment projects

In Chapter 2 we saw how the decision-making process involves six steps. These are:

1 Identifying the business’s objectives

2 Identifying possible courses of action

3 Assembling data relevant to the decision

4 Assessing the data and reaching a decision

5 Implementing the decision

6 Monitoring the effects of decisions.

Accepting that wealth maximisation is the principal financial objective for all deci-

sions, we can now look at the other five of these in the context of investment decisions.

Identifying possible investment opportunities

The assessment of possible investment projects is only one step in a process of the

search for opportunities. This process should not be regarded as one that should be

undertaken at, say, five-yearly intervals, but as one that should be part of the routine

of the business. Good investment opportunities do not tend to beat a path to the

business’s door; they must be sought out. Business tends to be highly competitive, so