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9609 · 10.3.1

The concept of investment appraisal — practice questions

Practice and worked examples for 9609 The concept of investment appraisal. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

A firm spent $50,000 last year on a feasibility study for a new warehouse. It now considers building the warehouse for $400,000 with forecast net cash inflows of $120,000 per year. Should the $50,000 study cost be included in appraisal?

Show solution outline

No — the $50,000 is a sunk cost. It is already spent whether or not the warehouse proceeds.

Relevant flows: initial $400,000 outlay and incremental $120,000 annual net cash inflows (plus any terminal value). The feasibility study is useful background but not part of the calculation.

Worked example 2

EcoPack Ltd. is appraising a new bio-plastic moulding machine. The financial controller has gathered the following data:

  • Machine purchase price: $250,000
  • Delivery & Installation cost: $20,000
  • One-off staff training in Year 0: $10,000
  • Expected annual revenue increase from new products: $150,000
  • Expected annual raw material & operating cost increase: $60,000
  • Annual share of existing factory rent to be allocated to the project: $15,000
  • Annual depreciation charge for the machine: $50,000

Calculate the relevant cash flows for Year 0 (initial investment) and Year 1 (first year of operation).

Show solution outline

The key is to identify only the future, incremental, cash-based flows.

Step 1: Calculate the Initial Outlay (Year 0 Cash Flow) This includes all cash payments required to get the project started.

  • Machine Purchase: -$250,000
  • Installation Cost: -$20,000
  • Staff Training: -$10,000 (This is a direct, incremental cash cost for the project)

Year 0 Total Cash Flow = -$250,000 - $20,000 - $10,000 = -$280,000

Step 2: Calculate the Net Operating Cash Flow (Year 1) This includes the incremental cash inflows and outflows generated by the project's operations.

  • Incremental Revenue: +$150,000
  • Incremental Costs: -$60,000

Items to Exclude:

  • Allocated Rent ($15,000): This is not an incremental cost. The factory rent is paid regardless of this project. It is an allocated overhead, not a new cash outflow caused by the project.
  • Depreciation ($50,000): This is a non-cash accounting entry used to calculate profit, not an actual cash flow.

Year 1 Net Cash Flow = Incremental Revenue - Incremental Costs Year 1 Net Cash Flow = $150,000 - $60,000 = +$90,000

Final Answer: The relevant cash flow for Year 0 is an outlay of $280,000. The relevant net cash flow for Year 1 is an inflow of $90,000.

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