Investment Appraisal
Investment appraisal
This domain tests the selection of long-term projects using discounted and non-discounted methods, relevant cash flows and capital rationing.
Core rules
- NPV is the primary criterion: discount incremental after-tax cash flows at the opportunity cost of capital.
- IRR is the discount rate making NPV zero; it can mislead with non-conventional flows or scale differences.
- MIRR assumes reinvestment at the cost of capital and gives one answer.
- Payback and discounted payback measure liquidity and risk, not value.
- Include opportunity costs; exclude sunk costs; include working capital and its recovery; treat tax and inflation consistently.
Worked example
A machine costs LKR 100,000 and generates LKR 40,000 a year for four years. At 10%, the four-year annuity factor is 3.170. PV of inflows = 40,000 times 3.170 = LKR 126,800; NPV = LKR 26,800. Profitability index = 126,800/100,000 = 1.27. Payback = 100,000/40,000 = 2.5 years. IRR is about 21.9%, above 10%. All methods point the same way here; with a capital constraint, rank by profitability index, not by absolute NPV alone.
Traps
Do not include interest payments in project cash flows when the discount rate already reflects financing; do not ignore working capital recovery; do not compare IRRs of projects with different scales; and do not use accounting profit instead of cash flow.