Investment Appraisal and Capital Budgeting
What the domain tests
Investment appraisal tests whether you can select projects that add value using incremental, after-tax cash flows and a risk-adjusted discount rate. Questions often combine NPV with sensitivity, capital rationing or replacement decisions.
Core rules and concepts
- Relevant cash flows are incremental, future and cash-based. Exclude sunk costs, allocated head-office overhead and financing flows (interest and dividends) because these are captured in the discount rate.
- Include capital expenditure, tax allowable depreciation or capital allowances, working capital investment and its recovery, opportunity costs and inflation.
- NPV is the preferred rule: NPV = PV of cash inflows − initial outlay. IRR is the rate at which NPV = 0; it can mislead with non-conventional flows or mutually exclusive projects of different scale.
- Use nominal cash flows with a nominal discount rate, or real flows with a real rate. For capital rationing, rank by profitability index when projects are divisible.
Worked example
A machine costs N1,000,000 and generates N400,000 annual net cash savings for four years. WACC is 10%. The four-year annuity factor is 3.170. PV of savings = N400,000 × 3.170 = N1,268,000. NPV = N1,268,000 − N1,000,000 = N268,000. Accept if capital is available and the cash-flow estimates are sound. The IRR is above 10% because NPV is positive, but IRR alone would not show the N268,000 absolute gain.
Traps that cost marks
Common errors are deducting interest in project cash flows, forgetting working-capital recovery, mixing real and nominal rates, using accounting profit instead of cash flow, and ranking mutually exclusive projects by IRR rather than NPV. Sensitivity analysis changes one variable at a time; it does not create a probability distribution.