Investment Appraisal Part1

ACCA P5 Advance Performance Management


Managers Incentive is directly linked to project performance. So, a good understanding of investment appraisal helps in choosing right project that aligns with organisation’s goal and strategy, matches organisational risk and manager’s attitude to cope with risk under uncertainty.

NPV: NPV is the residual amount calculating by deducting total cash outflows at present term from total discounted future cash inflows for the operation under consideration.

Drawback of NPV:

Shareholder’s wealth maximization	What about other stakeholders?
Use discount rate	Is it appropriate discount rate?
Consider cash flow at period end	Cash flow is actually spread over period.
Account whole life of project	What about short term position?
Accounts financial information only	What about non-financial information?
Does not account for change in performance	Not linked to performance incentive
Does not account for technological change	What about future technological development?

Sensitivity analysis: Sensitivity incorporates uncertainty into the project and informs decision maker on the impact of independent variable to the dependent variable. In investment appraisal it calculates percent change in each independent variables separately that would have to occur before NPV (dependent variable) changes to 0. E.g. required percentage change in sales volume (contribution margin) to give a NPV of 0, or required percentage increase in tax to give 0 NPV.

Mathematically, Sensitivity = (NPV/ PV of cash flows under consideration)*100

Drawback of Sensitivity analysis:

Each independent variable is considered separately. However they could be interrelated. E.g. sales volume may affect cost, price, tax and finance needed.

It is a relative measure.

It inherits the drawback of NPV which is fundamental element in calculating sensitivity.

Payback period: Time over which cash input (cash outflow) into system is fully recovered or the time when the project will be breakeven.  For even cash inflows payback period can be calculated using the formula Payback Period = Cost of project (Total cash outflow)/ Annual cash inflow. Where cash inflow is uneven cumulative approach is used. It is an absolute measure.

Drawback of Payback Period:

It ignores time value of money

It ignores benefit after full recovery of inputs (ignores profitability)

Focus on short time period and quick recovery and ignores long term prospects of business