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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: 250,000250,000
  • Delivery & Installation cost: 20,00020,000
  • One-off staff training in Year 0: 10,00010,000
  • Expected annual revenue increase from new products: 150,000150,000
  • Expected annual raw material & operating cost increase: 60,00060,000
  • Annual share of existing factory rent to be allocated to the project: 15,00015,000
  • Annual depreciation charge for the machine: 50,00050,000

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: -250,000250,000
  • Installation Cost: -20,00020,000
  • Staff Training: -$10,000 (This is a direct, incremental cash cost for the project)

Year 0 Total Cash Flow = -250,000−250,000 - 20,000 - 10,000=−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: +150,000150,000
  • Incremental Costs: -60,00060,000

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 = 150,000−150,000 - 60,000 = +90,000∗∗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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