Lecture notes

Introduction & Investment Appraisal

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Module
Financial strategy

Institution
University Of Derby (UoD)

The introduction section of a financial analysis or investment appraisal provides an overview of the purpose and scope of the analysis. It serves as an opening statement that sets the context and importance of the investment appraisal and provides a brief summary of the key points that will be cove...

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Uploaded on June 9, 2023
Number of pages 12
Written in 2022/2023
Type Lecture notes
Professor(s) Liz
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6AG503/6AG518 Financial Strategy Week 1 Lecture Handout

ARR – Worked Example

A project involves the immediate purchase of an item of plant costing £550,000. It would
generate cash flows of £122,000 for five years, starting in year 1. At the end of the project,
after five years, it would have a scrap value of £50,000. Depreciation is on a straight-line
basis. The company has a policy to accept projects with ARR over 10% using:

Estimated average annual accounting profits x 100%
Estimated average investment

Where
Average investment = Capital cost + Residual Value
2
Guide:

TOTAL CASH INFLOWS
= 122,000 x 5 = 610,000

TOTAL DEP’N:
= (550,000 – 50,000) = 500,000

TOTAL PROFIT AFTER DEPRECIATION:
= 110,000

PER YEAR:
= 110, = 22,000

Average Investment:
= (550,000 + 50,000)/2 = 300,000

ARR:
= 22,000/300,000 x 100 = 7.33%

DECISION:
Reject as 7.33% < 10%

Sensitivity: Internal

, 6AG503/6AG518 Financial Strategy Week 1 Lecture Handout

Question 1 – ARR
A project requires an initial investment of £900,000 and earns net cash inflows as follows:

Year 1 2 3 4 5 6 7
Cash Inflows
100 250 350 450 350 200 150
(£’000)

At the end of the project, the assets will be sold for £100,000.

Required
Determine the project’s ARR using:
Estimated average annual accounting profits x 100%
Estimated average investment

Where
Average investment = Capital cost + Residual Value
2
And state if the company would accept with a required return of 25%

TOTAL CASH INFLOWS = 1,850,000
TOTAL DEP’N = (900,000 – 100,000) = 800,000
TOTAL PROFIT AFTER DEPRECIATION = 1,050,000
PER YEAR = 1,050, = 150,000

Average Investment = (900,000 + 100,000)/2 = 500,000

ARR = 150,000/500,000 x 100 = 30%

Accept as 30% > 25% requirement.

Sensitivity: Internal

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