Investment Analysis
Core tools
Investment analysis centres on incremental cash flows discounted at an opportunity cost of capital. A candidate must be fluent with NPV, IRR, modified IRR, payback and discounted payback, the profitability index, and the annuity and perpetuity formulas used to shortcut them. Only incremental, after-tax, cash (not accounting) flows belong in the appraisal: exclude sunk costs and allocated fixed overhead, include working capital and its later recovery, and treat finance costs as captured in the discount rate rather than in the cash flows.
Discount nominal cash flows at a nominal rate and real flows at a real rate; mixing the two is a perennial exam favourite. For mutually exclusive projects, rank by NPV: IRR can mislead when projects differ in scale or timing, and it can take multiple values when cash-flow signs flip more than once. Check whether annuities are ordinary (end of year) or due (start of year).
Worked example
A machine costs KES 1,000,000 and generates KES 400,000 a year for four years; the cost of capital is 10%. The four-year annuity factor at 10% is 3.170, so PV of inflows = KES 1,268,000 and NPV = +KES 268,000: accept. The IRR solves an annuity factor of 2.5 (= 1,000,000/400,000), which sits near 22%, well above 10%, so IRR and NPV agree here. Rule of thumb: when NPV and IRR conflict, follow NPV.