Capital Investment Appraisal and Long-Term Decision Making
Capital investment appraisal and long-term decision making tests discounted and non-discounted methods and the identification of project cash flows. ICSAN questions commonly require NPV, payback, ARR or IRR, plus a recommendation.
Core rules
- Relevant project cash flows are incremental, after tax, and include working capital and disposal proceeds. Depreciation is not a cash flow, but tax relief on depreciation is.
- Payback ignores time value and cash flows after payback; ARR uses accounting profit and average investment.
- NPV discounts at the cost of capital; accept positive NPV. IRR is the rate where NPV is zero; accept if IRR exceeds the cost of capital.
- For mutually exclusive projects, NPV is preferred because it measures absolute value added. Profitability index = PV of inflows / initial investment.
- Inflation: discount nominal cash flows at a nominal rate or real cash flows at a real rate; do not mix.
Worked example
A machine costs ₦100,000 and generates ₦30,000 net cash inflow annually for five years. The cost of capital is 10%. The five-year annuity factor at 10% is 3.791, so PV of inflows = 30,000×3.791=₦113,730 and NPV = ₦13,730. The project is acceptable. Payback is 100,000/30,000=3.33 years. The reasoning: NPV recognises that later cash flows are worth less; the positive NPV adds value after charging for capital.
Traps
Discounting profit instead of cash flow; deducting depreciation but forgetting tax relief; including interest payments in project cash flows when the discount rate already captures financing; using IRR for mutually exclusive projects; mixing real cash flows with a nominal discount rate.