Investment Appraisal Measures and Capital Allocation Decisions

This document discusses various investment appraisal measures such as NPV, IRR, ARR, and payback period and their impact on capital allocation decisions. It highlights the shortcomings and reliability of each measure and emphasizes the importance of considering qualitative aspects in addition to quantitative analysis. The document also argues against outsourcing capital allocation decisions to specialized firms.

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PART A
The requisite computations are shown below.
1) ARR Computation (Project 2)
Annual cash flows =£ 500,000
Annual depreciation = (1616000-301000)/5 = £263,000
Hence, annual accounting profits = Cash flow – Depreciation = 500,000 -263,000 = £237,000
Average book value = (Initial cost + Scrap value)/2 = (1616000 + 301000)/2 =£958,500
Hence, ARR for project 2 = (237000/958500)*100 = 25%
2) NPV Computation (Project 1)
Net cash inflow in year 0 = -£556,000
Net cash inflow in year 1 = £200,000
Net cash inflow in year 2 = £200,000
Net cash inflow in year 3 = £200,000
Net cash inflow in year 4 = £200,000
Net cash inflow in year 5 = £200,000 + £56,000 = £256,000
Cost of capital = 15% p.a.
Hence, NPV (Project 1) (£ 000’s) = -556 + (200/1.15) + (200/1.152) + (200/1.153) +
(200/1.154) + (256/1.155) = 142
3) IRR Computation (Project 2)
Net cash inflow in year 0 = -£1,616,000
Net cash inflow in year 1 = £500,000

Net cash inflow in year 2 = £500,000
Net cash inflow in year 3 = £500,000
Net cash inflow in year 4 = £500,000
Net cash inflow in year 5 = £500,000 + £301,000 = £801,000
IRR is defined as the discount rate for which NPV is zero. Let the IRR be X%.
Hence, 0 = -1616 + (500/(1+X)) + (500/(1+X)2) + (500/(1+X)3) + (500/(1+X)4) +
(801/(1+X)5)
Solving the above, we get X = 20%
Therefore, the IRR for project 2 is 20%.
4) Payback Period (Project 1)
Initial investment = £ 556,000
Cash inflows during the first two years = £200,000 + £200,000 = £400,000
Remaining investment to be recovered = £ 556,000 - £400,000 = £156,000
Time required in the third year to recover the remaining investment = (156000/200000)= 0.8
Hence, payback period for project 1 is 2.8 years
Based on the above computations, the completed table is shown below.
PARTICULARS Project 1 Project 2
ARR 33% 25%
NPV(£’000) 142 210
IRR 25 20
Payback period (years) 2.8 3.2
Based on NPV, Project 2 should be selected. Based on the other parameters, Project 1 should
be selected (Berk et. al.,2016)

PART B
 With regards to investment appraisals there are a host of measures such as NPV, IRR,
ARR, Profitability Index along with payback period. Even though capital budgeting
technqius such as NPV and IRR have become quite established, but there is a tendency on
the part of the business to use measures such as ARR and payback period which often do
not lead to prudent decision making (Brealey, Myers and Allen,2014). However, these are
still used owing to their simplicity of use which is not the case with IRR and NPV.
Clearly, this is an indication of poor resource management especially in a scenario where
there is technology to aid decision making which tends to simplify complex computations
and lead to superior forecasting of expected future cash flows. This could potentially lead
to loss of competitive advantage for the businesses and needs to be avoided for prudent
capital allocation decisions (Damodaran, 2015).
 There are potential issues with various alternative investment appraisals methodologies.
For instance consider payback period which tends to focus on the period required to
recoup the original investment. The key shortcoming with this method is that it does not
use the time value of money and also ignores the cash flows after the period when the
initial investment is recovered. Another investment appraisal technique is ARR or
Accounting Rate of Return. The key issue with this measure is that it does not consider the
time value of money and focuses on accounting profits rather than cash flows (Lasher,
2017). IRR is yet another method to carry out the investment appraisal which essentially
is the discount rate where NPV is zero and hence indicates the cutoff point. This is not a
reliable measure for mutually exclusive projects and multiple IRR values can be derived
which would distort prudent decision making. Finally, there is NPV which tends to
compute the sum total of the net project cashflows over the useful life in present value
terms. Despite the underlying complexity, it is considered to be the most reliable technique
(Petty et. al., 2016).
 Despite the poor decisions with regards to capital allocation made by firms, these
decisions should not be outsourced to specialised firms. This is because theses outside
firms would not have a sound understanding of the business which the company officials
would have. This would adversely impact the project estimates of future cash flows. Also,
it is essential to note that capital budgeting decisions are not only made considering the

quantitative analysis but qualitative aspects are also taken into cognisance. This cannot be
carried out by outside agencies that would have limited understanding of the business and
the surrounding ecosystem with an eye on the future (Ross et. al.,2015). Also, even if
capital budgeting decisions are made by an outside firm, but if the same is not supported
by the management and employees, then there would be implementation issues owing to
lack of requisite support and resources. Hence, the help of outside agencies can be taken as
consultants to guide in the process but not to make the decisions which ought to be taken
by the management of the company and no outsider (Damodaran, 2015).

References
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2016) Fundamentals
of corporate finance. London: Pearson Higher Education,pp. 107
Brealey, R. A., Myers, S. C., and Allen, F. (2014) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill Inc, pp. 198
Damodaran, A. (2015). Appl0ied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons, pp. 173
Lasher, W. R., (2017) Practical Financial Management. 5th ed. London: South- Western
College Publisher, pp.154
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H.
(2016). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education,
pp.176
Ross,S.A., Tryaler,R., Bird, R.,Westerfield, R.W. and Jorden,B.D. (2015) Essentials of
Corporate Finance. 2nd ed. New York City: McGraw-Hill,pp. 145