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Challenges in advanced management accounting
Challenges in advanced management accounting

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3 Principles of project appraisal

At the end of this section you should:

  • be able to distinguish between relevant and non-relevant cash flows
  • be able to explain the time value of money, and why discounting is carried out
  • know how to use a company’s WACC as a discount rate and discuss its drawbacks
  • be able to calculate an appropriate discount rate by using the CAPM and discuss its drawbacks
  • be able to use a spreadsheet to model a discounted cash flow analysis.

Before we examine specific appraisal techniques, we shall review and expand on some of the principles underlying them. At this more advanced level it is important that you not only know how to perform techniques, but also why they are carried out in the way they are, and how this affects which technique is most appropriate for a task. This will help you to explain them to other people if necessary, and deepen your understanding of the techniques themselves, allowing you to recognise their strengths and limitations too.

We review the type of costs that are included in an appraisal; how to decide if costs are relevant or not; why we should ignore sunk costs; and also whether there are opportunity costs incurred which would not normally be identified on an accounting budget of a project’s financial costs. People have a tendency to take sunk costs into account; however, doing so means that irrelevant information may be influencing a decision, so the optimal decision may not be made.

We look in depth at the related concepts of discounting, the time value of money, and present value (of future cash flows). These are the foundation of discounted cash flow (DCF) techniques, which is based around the idea that £1 received or paid today does not have the same economic value as £1 received or paid at some point in the future. We will discuss the causes of the time value of money.

Discounted cash flow techniques such as net present value and internal rate of return require us not only to take account of the time value of money, but to estimate what it is by using a discount rate. We show how the weighted average cost of capital, discussed in the previous course, can be used as a discount rate to take account of the time value of money, and also review the potential problems with this technique. If we decide that the WACC is not an appropriate discount rate, the capital asset pricing model (CAPM) is another method to calculate a discount rate. We review how this can be used, and look at the potential problems with this method too.