Why is "Using cash flows instead of profit for ARR" a common mistake in Application of capital investment appraisal techniques?

Why it happens: Confusing ARR with the cash methods. How to avoid it: ARR uses average PROFIT (after depreciation); payback, NPV and IRR use cash flows. Source: 9706 Examiner Reports

Why is "Not interpolating the payback period" a common mistake in Application of capital investment appraisal techniques?

Why it happens: Rounding to whole years. How to avoid it: Interpolate part-years: amount still to recover ÷ that year's inflow × 12. Source: 9706 Examiner Reports

Why is "Forgetting to deduct the initial investment from NPV" a common mistake in Application of capital investment appraisal techniques?

Why it happens: Stopping at the discounted inflows. How to avoid it: NPV = total PV of inflows − initial investment. Source: 9706 Examiner Reports

Why is "Discounting the Year 0 outflow" a common mistake in Application of capital investment appraisal techniques?

Why it happens: Applying a discount factor to today's cash. How to avoid it: The Year 0 outflow is already at present value (discount factor 1); don't discount it. Source: 9706 Examiner Reports

Why is "Comparing IRR with the wrong benchmark" a common mistake in Application of capital investment appraisal techniques?

Why it happens: Forgetting the decision rule. How to avoid it: Accept if IRR > the COST OF CAPITAL (required return), not an arbitrary figure. Source: 9706 Examiner Reports

Why is "Calculating without stating the decision" a common mistake in Application of capital investment appraisal techniques?

Why it happens: Stopping at the number. How to avoid it: State the decision: accept positive NPV / IRR > cost of capital / shortest payback / highest ARR. Source: 9706 Examiner Reports

Cambridge International A Levels Accounting (9706)

Application of capital investment appraisal techniques

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Detailed Study Notes

Detailed notes on Investment appraisal for Cambridge International A Levels Accounting, covering key concepts, explanations, examples, and exam-focused revision points.

Capital Investment Appraisal Techniques — Cambridge AS & A Level Accounting 9706 Study Notes (2026-2028)

The four appraisal methods. Master payback period, accounting rate of return (ARR), net present value (NPV) and internal rate of return (IRR) — how to calculate each, what each tells you, and the decision rule and strengths/weaknesses of each.

At a glance

Four techniques: payback, ARR, NPV, IRR — applied to a project's net cash flows.
Payback: time to recover the initial investment; choose the shortest.
ARR = average annual profit ÷ average investment × 100; choose the highest (vs target).
NPV: discount future cash flows to today; accept if NPV is positive.
IRR: the discount rate giving NPV = 0; accept if IRR exceeds the cost of capital.
NPV and IRR allow for the time value of money; payback and ARR do not.
Each method has strengths and weaknesses — often used together.

What you’ll learn

Mapped to the Cambridge International A Level 9706 syllabus (2026-2028).

2.2.7 — Calculate and interpret the payback period and accounting rate of return.
2.2.7 — Calculate and interpret the net present value (NPV).
2.2.7 — Understand the internal rate of return (IRR) and the strengths/weaknesses of each method.

Payback period

How long to recover the initial investment from the net cash inflows.

The payback period is the time taken to recover the initial investment from the project's net cash inflows:

add up the cumulative net cash inflows until they equal the initial outflow;
where it falls mid-year, interpolate: $\text{months} = \frac{\text{amount still to recover}}{\text{that year's cash inflow}} \times 12$ .

Example. Investment $100,000; inflows $40,000 a year → after 2 years $80,000 recovered, $20,000 left → 20,000 ÷ 40,000 × 12 = 6 months → payback = 2 years 6 months.

Decision rule: choose the project with the shortest payback (or one within a target).

Strengths: simple, focuses on liquidity and risk (faster payback = lower risk). Weaknesses: ignores cash flows after payback and the time value of money; not a measure of overall profitability.

Payback = time to recover the initial investment.
Interpolate for part-years (amount left ÷ year's inflow × 12).
Rule: choose the shortest payback (or within a target).
Simple; ignores later cash flows and the time value of money.

See the full worked example for application of capital investment appraisal techniques →

Accounting rate of return (ARR)

Average annual profit as a percentage of the average investment.

The accounting rate of return (ARR) measures the average annual profit as a percentage of the investment:

$\text{ARR} = \frac{\text{Average annual profit}}{\text{Average investment}} \times 100$

Average annual profit = total profits over the life ÷ number of years (profit is after depreciation, not cash).
Average investment = (initial cost + scrap value) ÷ 2 (or sometimes the initial cost — follow the question).

Example. Average profit $24,000; average investment $120,000 → ARR = 20%.

Decision rule: accept if ARR exceeds a target; choose the highest ARR.

Strengths: simple, uses profit (familiar), considers the whole life. Weaknesses: uses accounting profit (not cash); ignores the time value of money and the timing of returns.

ARR = average annual profit ÷ average investment × 100.
Average investment = (cost + scrap) ÷ 2 (per the question).
Rule: accept if above target; choose the highest.
Uses profit and the whole life; ignores the time value of money.

See the full worked example for application of capital investment appraisal techniques →

Net present value (NPV)

Discount future cash flows to today; accept if NPV is positive.

Net present value (NPV) recognises the time value of money — $1 today is worth more than $1 in the future. It discounts each future net cash flow to its present value using a discount factor at the cost of capital, then nets them against the initial outflow:

$\text{NPV} = \sum (\text{Net cash flow} \times \text{Discount factor}) - \text{Initial investment}$

(Discount factor for year n at rate r = $1/(1+r)^n$ , usually read from tables.)

Example. If the discounted inflows total $112,000 and the investment is $100,000, NPV = +$12,000.

Decision rule: accept if NPV is positive (it adds value); choose the highest NPV.

Strengths: allows for the time value of money, uses cash flows, considers the whole life, gives a $ value of the gain. Weaknesses: complex; depends on choosing the right discount rate and on uncertain future cash flows.

NPV discounts future cash flows to present value at the cost of capital.
NPV = Σ(cash flow × discount factor) − initial investment.
Rule: accept if NPV positive; choose the highest.
Best method (time value, cash, whole life) but complex and rate-dependent.

See the full worked example for application of capital investment appraisal techniques →

Internal rate of return (IRR)

The discount rate at which NPV = 0; accept if it beats the cost of capital.

The internal rate of return (IRR) is the discount rate at which the NPV equals zero — the project's break-even rate of return. It is usually estimated by interpolation between a rate giving a positive NPV and one giving a negative NPV:

$\text{IRR} \approx L + \frac{\text{NPV}_L}{\text{NPV}_L - \text{NPV}_H} \times (H - L)$

(where L and H are the lower/higher rates).

Example. At 10% NPV = +$8,000; at 15% NPV = −$2,000 → IRR ≈ 10 + 8,000/(8,000+2,000) × 5 = 14%.

Decision rule: accept if IRR exceeds the cost of capital (the required return); choose the highest IRR.

Strengths: allows for the time value of money, uses cash flows, gives a rate (easy to compare with the cost of capital). Weaknesses: complex (interpolation is an estimate); can give misleading results with unconventional cash flows; assumes reinvestment at the IRR.

IRR = the discount rate at which NPV = 0.
Estimate by interpolation between a + and − NPV.
Rule: accept if IRR > cost of capital; choose the highest.
Uses time value/cash; complex and an estimate.

Quick recap

Payback = time to recover the investment; choose the shortest; ignores later flows and time value.
ARR = average profit ÷ average investment × 100; uses profit; ignores time value.
NPV discounts cash flows; accept if positive; the best method but complex.
IRR = the rate where NPV = 0; accept if it beats the cost of capital.
NPV and IRR allow for the time value of money; payback and ARR do not.
Each has strengths and weaknesses; often used together.

Memorise this

Verbatim phrases and definitions Cambridge mark schemes credit.

Payback = time to recover the initial investment (shortest is best).
ARR = average annual profit ÷ average investment × 100.
NPV = Σ(cash flow × discount factor) − initial investment; accept if positive.
IRR = the discount rate where NPV = 0; accept if IRR > cost of capital.

How it’s examined

Tested on Paper 4 (A Level): calculate the payback, ARR and NPV (and estimate IRR) of a project, and compare the methods (commonly [8-16] marks). Examiner reports note candidates using cash flows for ARR (should be profit), and not interpolating the payback/IRR.

Sources: Cambridge International AS & A Level Accounting 9706 syllabus (2026-2028); 9706 Paper 4 past papers & mark schemes, 2022-2024; 9706 Examiner Reports, 2022-2024. Last reviewed 2026-06-19.

Take this whole topic with you

Step-by-step worked examples — Application of capital investment appraisal techniques

Step-by-step solutions to past-paper-style questions on application of capital investment appraisal techniques, written exactly the way a tutor would explain them at the board.

Question type:

1Payback period (4 marks)
Getting startedMulti-step problem• 9706 Paper 4 style• payback, AO2
Question
Investment $120,000; net cash inflows$ 40,000 per year. Calculate the payback period. (4 marks)
Step-by-step solution
1. Step 1
  After 3 years, cumulative inflow = 3 × 40,000 = $120,000.
2. Step 2
  This exactly equals the investment.
3. Step 3
  Payback period = 3 years.
Answer
3 years.
Examiner tip
Add inflows until they equal the investment.
2Payback with interpolation (5 marks)
Building confidenceMulti-step problem• payback, AO2
Question
Investment $100,000; net cash inflows$ 40,000 per year. Calculate the payback period in years and months. (5 marks)
Step-by-step solution
1. Step 1
  After 2 years: 2 × 40,000 = 80,000 recovered; $20,000 still to recover.
2. Step 2
  Months into year 3 = 20,000 ÷ 40,000 × 12 = 6 months.
3. Step 3
  Payback = 2 years 6 months.
Answer
2 years 6 months.
Examiner tip
Interpolate: amount left ÷ that year's inflow × 12.
3Accounting rate of return (5 marks)
Building confidenceMulti-step problem• ARR, AO2
Question
Total profit over 5 years $150,000; initial investment$ 200,000; scrap value $20,000. Calculate the ARR using the average investment. (5 marks)
Step-by-step solution
1. Step 1
  Average annual profit = 150,000 ÷ 5 = $30,000.
2. Step 2
  Average investment = (200,000 + 20,000) ÷ 2 = $110,000.
3. Step 3
  ARR = 30,000 ÷ 110,000 × 100 = 27.3%.
Answer
27.3%.
Examiner tip
ARR uses PROFIT and the average investment.
4Net present value (6 marks)
StretchMulti-step problem• NPV, AO2
Question
Investment $100,000; net cash inflows$ 45,000 (year 1), $50,000 (year 2),$ 40,000 (year 3). Discount factors at 10%: 0.909, 0.826, 0.751. Calculate the NPV. (6 marks)
Step-by-step solution
1. Step 1
  Year 1 PV = 45,000 × 0.909 = 40,905.
2. Step 2
  Year 2 PV = 50,000 × 0.826 = 41,300.
3. Step 3
  Year 3 PV = 40,000 × 0.751 = 30,040.
4. Step 4
  Total PV = 40,905 + 41,300 + 30,040 = 112,245.
5. Step 5
  NPV = 112,245 − 100,000 = +$12,245.
Answer
NPV = +$12,245 (accept the project).
Examiner tip
Discount each inflow, total, then deduct the investment.
5NPV decision (3 marks)
Getting startedWord problem• NPV, AO2
Question
A project has an NPV of −$4,000 at the company's cost of capital. State and explain the decision. (3 marks)
Step-by-step solution
1. Step 1
  A negative NPV means the project does not cover the cost of capital.
2. Step 2
  It would reduce the company's value.
3. Step 3
  Decision: reject the project.
Answer
Reject — a negative NPV reduces value.
Examiner tip
Accept positive NPV; reject negative NPV.
6Internal rate of return (6 marks)
StretchMulti-step problem• IRR, AO2
Question
At 10%, a project's NPV is + $9,000; at 16%, its NPV is −$ 3,000. Estimate the IRR by interpolation. (6 marks)
Step-by-step solution
1. Step 1
  IRR ≈ L + [NPV_L ÷ (NPV_L − NPV_H)] × (H − L).
2. Step 2
  = 10 + [9,000 ÷ (9,000 − (−3,000))] × (16 − 10).
3. Step 3
  = 10 + (9,000 ÷ 12,000) × 6.
4. Step 4
  = 10 + 0.75 × 6 = 10 + 4.5 = 14.5%.
Answer
IRR ≈ 14.5%.
Examiner tip
Interpolate between the + and − NPV rates.
7IRR decision (3 marks)
Building confidenceWord problem• IRR, AO2
Question
A project's IRR is 14.5% and the company's cost of capital is 10%. State and explain the decision. (3 marks)
Step-by-step solution
1. Step 1
  The IRR (14.5%) exceeds the cost of capital (10%).
2. Step 2
  The project earns more than the required return.
3. Step 3
  Decision: accept the project.
Answer
Accept — IRR (14.5%) exceeds the cost of capital (10%).
Examiner tip
Accept if IRR > cost of capital.
8Strength/weakness of payback (4 marks)
StretchWord problem• evaluation, AO3
Question
State one strength and one weakness of the payback method. (4 marks)
Step-by-step solution
1. Step 1
  Strength: simple to calculate and understand; focuses on liquidity and risk (faster payback = lower risk).
2. Step 2
  Weakness: ignores cash flows after the payback period.
3. Step 3
  It also ignores the time value of money and is not a measure of total profitability.
Answer
Strength: simple, shows liquidity/risk. Weakness: ignores later cash flows and the time value of money.
Examiner tip
Know one strength and one weakness of each method.
9Why NPV is preferred (4 marks)
StretchWord problem• evaluation, AO3
Question
Explain why NPV is generally regarded as the best appraisal method. (4 marks)
Step-by-step solution
1. Step 1
  It allows for the time value of money (discounts future cash flows).
2. Step 2
  It uses cash flows (not profit) and the whole life of the project.
3. Step 3
  It gives a clear $ value of the gain and a simple accept-if-positive rule.
4. Step 4
  So it directly measures the value added to the business.
Answer
It uses the time value of money and cash flows over the whole life, giving the $ value added.
Examiner tip
NPV's time-value and clear value measure make it superior.
10Time value of money (4 marks)
StretchWord problem• discounting, AO3
Question
Explain what is meant by the time value of money and why NPV and IRR allow for it but payback and ARR do not. (4 marks)
Step-by-step solution
1. Step 1
  The time value of money means $1 today is worth more than $1 in the future (it could be invested/earn interest).
2. Step 2
  NPV and IRR discount future cash flows to present values, allowing for this.
3. Step 3
  Payback and ARR treat $1 in any year as equal, ignoring timing.
4. Step 4
  So the discounted methods give a more accurate view of value.
Answer
$1 now >$ 1 later; NPV/IRR discount future flows; payback/ARR treat all years equally.
Examiner tip
Discounting is what handles the time value of money.

Model Answers — Application of capital investment appraisal techniques

High-scoring sample answers for application of capital investment appraisal techniques on the Cambridge IGCSE paper, with examiner-style notes mapping each response to the mark scheme and assessment objectives.

Question 1
9706 Paper 4 style5 marks
Q (5 marks). An investment of $90,000 generates net cash inflows of$ 30,000 in year 1, $30,000 in year 2 and$ 40,000 in year 3. Calculate the payback period in years and months.
Model answer
Cumulative: end of year 1 = 30,000; end of year 2 = 60,000; still to recover = 90,000 − 60,000 = $30,000. Year 3 inflow = $40,000, so months = 30,000 ÷ 40,000 × 12 = 9 months. Payback = 2 years 9 months.
Why this scores
Marking (point-based, 5). Cumulative to year 2 $60,000 (2);$ 30,000 left ÷ $40,000 × 12 = 9 months (2); 2 yrs 9 mths (1).
Question 2
9706 Paper 4 style5 marks
Q (5 marks). A project costs $250,000 with a scrap value of$ 30,000 and generates total profits of $200,000 over 4 years. Calculate the accounting rate of return using the average investment.
Model answer
Average annual profit = 200,000 ÷ 4 = $50,000. Average investment = (250,000 + 30,000) ÷ 2 = $140,000. ARR = 50,000 ÷ 140,000 × 100 = 35.7%.
Why this scores
Marking (point-based, 5). Average profit $50,000 (1.5); average investment$ 140,000 (2); ARR 35.7% (1.5).
Question 3
9706 Paper 4 style8 marks
Q (8 marks). An investment of $150,000 generates net cash inflows of$ 60,000 (year 1), $70,000 (year 2) and$ 55,000 (year 3). Discount factors at 12%: 0.893, 0.797, 0.712. Calculate the NPV and state the decision.
Model answer
Year 1 PV = 60,000 × 0.893 = 53,580. Year 2 PV = 70,000 × 0.797 = 55,790. Year 3 PV = 55,000 × 0.712 = 39,160. Total PV = 53,580 + 55,790 + 39,160 = 148,530. NPV = 148,530 − 150,000 = −$1,470. Decision: reject — the NPV is negative, so the project does not cover the 12% cost of capital and would reduce value.
Why this scores
Marking (point-based, 8). Three PVs (4.5); total PV $148,530 (1); NPV −$ 1,470 (1.5); reject (1).
Question 4
9706 Paper 4 style6 marks
Q (6 marks). A project's NPV is + $12,000 at a discount rate of 8% and −$ 4,000 at 14%. Estimate the internal rate of return by interpolation and state the decision if the cost of capital is 10%.
Model answer
IRR ≈ L + [NPV_L ÷ (NPV_L − NPV_H)] × (H − L) = 8 + [12,000 ÷ (12,000 − (−4,000))] × (14 − 8) = 8 + (12,000 ÷ 16,000) × 6 = 8 + 0.75 × 6 = 8 + 4.5 = 12.5%. Decision: accept — the IRR (12.5%) exceeds the cost of capital (10%), so the project earns more than the required return.
Why this scores
Marking (point-based, 6). Interpolation set-up (2); 12.5% (2); accept as IRR > 10% (2).
Question 5
9706 Paper 4 style6 marks
Q (6 marks). Compare the payback method and the net present value method, explaining the strengths and weaknesses of each.
Model answer
Payback measures the time taken to recover the initial investment. Its strengths are that it is simple to calculate and understand, and it focuses on liquidity and risk — a shorter payback means the cash is recovered sooner, reducing exposure to uncertainty. Its weaknesses are that it ignores all cash flows after the payback period (so it ignores overall profitability) and ignores the time value of money (it treats $1 in any year as equal).

Net present value (NPV) discounts all the future cash flows to their present value at the cost of capital and nets them against the investment. Its strengths are that it allows for the time value of money, uses cash flows over the whole life of the project, and gives a clear $ value of the gain with a simple accept-if-positive rule — so it directly measures the value added. Its weaknesses are that it is more complex, it depends on choosing an appropriate discount rate, and it relies on uncertain forecast cash flows.

Overall: NPV is theoretically superior because it considers the whole life and the time value of money, whereas payback is a useful supplementary measure of risk/liquidity. Many businesses therefore use both together.
Why this scores
Marking (point-based, 6). Payback strengths/weaknesses (~2.5); NPV strengths/weaknesses (~2.5); overall — NPV superior / use together (~1).
Question 6
9706 Paper 4 style3 marks
Q (3 marks). A project has a net present value of +$18,000 at the company's cost of capital. State the decision and explain it.
Model answer
Decision: accept the project. A positive NPV (+$18,000) means that, after allowing for the time value of money, the project's discounted cash inflows exceed the initial investment by $18,000 — so it earns more than the cost of capital and adds $18,000 of value to the business.
Why this scores
Marking (point-based, 3). Accept (1); positive NPV exceeds investment / adds value (2).
Question 7
9706 Paper 4 style4 marks
Q (4 marks). Explain why the accounting rate of return might lead to a different decision from the net present value method.
Model answer
The ARR is based on average accounting profit and ignores the time value of money and the timing of returns — it treats profit earned in a later year as equally valuable as profit earned now, and uses profit rather than cash flow. The NPV discounts the cash flows to present value at the cost of capital, so it favours projects whose returns come sooner and reflects the actual cash generated. Because they use different bases (profit vs discounted cash flow), two projects could be ranked differently — for example, ARR might prefer a project with high later profits, while NPV prefers one with high early cash flows. NPV is generally regarded as more reliable because it allows for the time value of money.
Why this scores
Marking (point-based, 4). ARR profit/ignores time value (2); NPV discounts cash / favours early flows (1.5); can rank differently (0.5).
Question 8
9706 Paper 4 style4 marks
Q (4 marks). Explain what is meant by the 'time value of money' and how the NPV method allows for it.
Model answer
The time value of money is the principle that $1 received today is worth more than $1 received in the future, because money received now can be invested to earn a return (and is also more certain). The NPV method allows for this by discounting each future net cash flow to its present value using a discount factor based on the cost of capital — cash flows further in the future are multiplied by smaller discount factors, so they are worth less in today's terms. By summing these present values and deducting the initial investment, NPV expresses the project's worth in today's money, properly reflecting the timing of the cash flows.
Why this scores
Marking (point-based, 4). $1 now >$ 1 later / can be invested (2); NPV discounts future flows by smaller factors (2).
Question 9
9706 Paper 4 style4 marks
Q (4 marks). State one strength and one weakness each of the payback method and the accounting rate of return.
Model answer
Payback — strength: simple to calculate and understand, and it highlights liquidity/risk (faster recovery = lower risk). Payback — weakness: it ignores cash flows after the payback period and the time value of money. ARR — strength: it uses profit (familiar to managers) and considers the whole life of the project. ARR — weakness: it uses accounting profit (not cash) and ignores the time value of money / timing of returns.
Why this scores
Marking (point-based, 4). Payback strength + weakness (2); ARR strength + weakness (2).
Question 10
9706 Paper 4 style3 marks
Q (3 marks). State which two of the four appraisal methods allow for the time value of money, and which two do not.
Model answer
The two methods that allow for the time value of money are net present value (NPV) and the internal rate of return (IRR), because they discount future cash flows to their present value. The two that do not are the payback period and the accounting rate of return (ARR), which treat $1 received in any year as equal in value.
Why this scores
Marking (point-based, 3). NPV & IRR discounted (1.5); payback & ARR not (1.5).

Key Formulae — Application of capital investment appraisal techniques

The formulae you need to memorise for application of capital investment appraisal techniques on the Cambridge IGCSE paper, with every variable defined in plain English and a note on when to use it.

Accounting rate of return (ARR)
$ARR = \frac{Average\ annual\ profit}{Average\ investment} \times 100$
$Average annual profit$
total profit ÷ years (profit, not cash)
$Average investment$
(initial cost + scrap value) ÷ 2
When to use
To measure average profitability as a % of investment.
Example
30,000 ÷ 110,000 × 100 = 27.3%.
Net present value (NPV)
$NPV = \sum (Net\ cash\ flow \times Discount\ factor) - Initial\ investment$
$Discount factor$
1/(1+r)^n at the cost of capital r (from tables)
$Initial investment$
the Year 0 outflow
When to use
To find the present value of a project; accept if positive.
Example
112,245 − 100,000 = +$12,245.
IRR (interpolation)
$IRR \approx L + \frac{NPV_L}{NPV_L - NPV_H} \times (H - L)$
$L, H$
lower and higher discount rates
$NPV_L, NPV_H$
NPV at the lower (positive) and higher (negative) rates
When to use
To estimate the rate at which NPV = 0.
Example
10 + 9,000/12,000 × 6 = 14.5%.
Payback (part-year)
$Months = \frac{Amount\ still\ to\ recover}{That\ year's\ cash\ inflow} \times 12$
$Amount still to recover$
investment − cumulative inflows so far
When to use
To find the months into the year payback occurs.
Example
20,000 ÷ 40,000 × 12 = 6 months.

Key Definitions and Keywords — Application of capital investment appraisal techniques

Definitions to memorise and the exact keywords mark schemes credit for application of capital investment appraisal techniques answers — sharpened from recent examiner reports for the 2026 Cambridge IGCSE sitting.

Payback period
Examiner keyword
The time taken to recover the initial investment from the net cash inflows.
Accounting rate of return (ARR)
Examiner keyword
Average annual profit ÷ average investment × 100; the profit method.
Net present value (NPV)
Examiner keyword
The present value of future net cash flows less the initial investment; accept if positive.
Internal rate of return (IRR)
Examiner keyword
The discount rate at which NPV = 0; accept if it exceeds the cost of capital.
Discount factor
Examiner keyword
1/(1+r)^n; multiplies a future cash flow to give its present value.
Cost of capital
Examiner keyword
The required rate of return used to discount cash flows / compare with the IRR.
Time value of money
Examiner keyword
$1 today is worth more than$ 1 in the future; allowed for by discounting (NPV/IRR).

Common Mistakes and Misconceptions — Application of capital investment appraisal techniques

The traps other students keep falling into on application of capital investment appraisal techniques questions — taken from recent Cambridge IGCSE examiner reports and mark schemes — and how to avoid them.

✕Using cash flows instead of profit for ARR
9706 Examiner Reports
Why it happens
Confusing ARR with the cash methods.
How to avoid it
ARR uses average PROFIT (after depreciation); payback, NPV and IRR use cash flows.
✕Not interpolating the payback period
9706 Examiner Reports
Why it happens
Rounding to whole years.
How to avoid it
Interpolate part-years: amount still to recover ÷ that year's inflow × 12.
✕Forgetting to deduct the initial investment from NPV
9706 Examiner Reports
Why it happens
Stopping at the discounted inflows.
How to avoid it
NPV = total PV of inflows − initial investment.
✕Discounting the Year 0 outflow
9706 Examiner Reports
Why it happens
Applying a discount factor to today's cash.
How to avoid it
The Year 0 outflow is already at present value (discount factor 1); don't discount it.
✕Comparing IRR with the wrong benchmark
9706 Examiner Reports
Why it happens
Forgetting the decision rule.
How to avoid it
Accept if IRR > the COST OF CAPITAL (required return), not an arbitrary figure.
✕Calculating without stating the decision
9706 Examiner Reports
Why it happens
Stopping at the number.
How to avoid it
State the decision: accept positive NPV / IRR > cost of capital / shortest payback / highest ARR.

Application of capital investment appraisal techniques

Detailed Study Notes

At a glance

What you’ll learn

Quick recap

Memorise this

How it’s examined

Take this whole topic with you

1Payback period (4 marks)

2Payback with interpolation (5 marks)

3Accounting rate of return (5 marks)

4Net present value (6 marks)

5NPV decision (3 marks)

6Internal rate of return (6 marks)

7IRR decision (3 marks)

8Strength/weakness of payback (4 marks)

9Why NPV is preferred (4 marks)

10Time value of money (4 marks)

Accounting rate of return (ARR)

Net present value (NPV)

IRR (interpolation)

Payback (part-year)

Payback period

Accounting rate of return (ARR)

Net present value (NPV)

Internal rate of return (IRR)

Discount factor

Cost of capital

Time value of money

✕Using cash flows instead of profit for ARR

✕Not interpolating the payback period

✕Forgetting to deduct the initial investment from NPV

✕Discounting the Year 0 outflow

✕Comparing IRR with the wrong benchmark

✕Calculating without stating the decision