AQA A-Level Accounting: Capital investment appraisal (7127) – Revision Notes

These notes condense section 3.13, Capital investment appraisal, of the AQA A-level Accounting (7127) specification, version 1.1 (October 2026), for A-level exams from June 2019 onwards. The course is untiered; section 3.13 is assessed on Paper 2. For full explanations and longer worked examples, use the study guide. All figures are invented.

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3.13 at a glance

Specification content	Recall
Calculation and use of cash flows	Future, incremental cash only; add back depreciation; ignore sunk and unchanged costs
Payback and NPV	Terms: payback period, net present value, discount factor, cost of capital
Benefits and limitations	Payback is simple but short-sighted; NPV is thorough but depends on the cost of capital
Evaluation of projects	Financial and non-financial factors, then a clear decision

Key definitions

• Capital investment appraisal: using accounting techniques to decide whether a capital project is worthwhile, or which of several projects to choose.
• Net cash flow: cash received minus cash paid because of the project, for one year.
• Payback period: the time the project’s net cash inflows take to repay the initial outlay.
• Cost of capital: the rate of return the business must pay to providers of finance; the minimum return a project must earn, used as the discount rate.
• Discount factor: the multiplier that turns a future cash flow into its present value.
• Present value: what a future cash flow is worth in today’s money.
• Net present value (NPV): the total of the present values of all a project’s cash flows, with the initial outlay as a negative.
• Residual value: cash received from selling or scrapping the asset at the end of the project.
• Sunk cost: money already spent that the decision cannot change.

Formulas

What	Formula
Payback (equal inflows)	initial outlay ÷ annual net cash inflow
Months into the payback year	(amount still to recover ÷ that year’s net cash inflow) × 12
Discount factor, year n, rate r	1 ÷ (1 + r)ⁿ
Present value	cash flow × discount factor
NPV	total present value of inflows − initial outlay
Cash flow from forecast profit	profit + depreciation (+ any unchanged apportioned costs charged)
Straight-line depreciation	(cost − residual value) ÷ useful life

If discount factors are given in a question, use them as given. Otherwise calculate them; these notes round factors to three decimal places.

Relevant cash flows: in or out?

Item	Include?	Reason
Purchase and installation cost	Yes, year 0	Cash paid because of the project
Extra sales receipts or cost savings	Yes	Incremental inflows
Extra running costs, wages, maintenance	Yes	Incremental outflows
Residual value	Yes, final year	Cash received on disposal
Depreciation	No	Non-cash; cost already in the outlay
Market research or feasibility study already paid	No	Sunk cost
Share of existing rent or head-office costs	No	Paid whether or not the project goes ahead

Method in steps

Cash flows

1. Start from cash, or from profit with depreciation added back.
2. Remove sunk costs and unchanged apportioned overheads.
3. Put the outlay in year 0 and the residual value in the final year.

Payback

1. Write the cash flows in a table with a cumulative column, starting at the negative outlay.
2. Find the year in which the cumulative figure turns positive.
3. Months = (amount outstanding at the start of that year ÷ that year’s inflow) × 12.
4. State the answer in years and months, rounded as the question asks.

NPV

1. List each year’s net cash flow, outlay in year 0.
2. Multiply each by its discount factor (year 0 factor = 1.000).
3. Add the present values; the outlay is negative.
4. State the result with its sign, then the decision: positive accept, negative reject.

Worked reminders

Equal inflows. A van costs £60 000 and saves £16 000 cash a year. Payback = 60 000 ÷ 16 000 = 3.75 years. 0.75 × 12 = 9 months, so 3 years 9 months.

Small NPV. Outlay £50 000; net inflows £22 000 a year for 3 years; cost of capital 12%; factors 0.893, 0.797, 0.712.

Year	Cash flow (£)	Factor	Present value (£)
0	(50 000)	1.000	(50 000)
1	22 000	0.893	19 646
2	22 000	0.797	17 534
3	22 000	0.712	15 664
		NPV	2 844

Positive, so accept on financial grounds, though the margin is small. With equal inflows you can also add the factors (0.893 + 0.797 + 0.712 = 2.402) and multiply: 22 000 × 2.402 = 52 844.

Benefits and limitations

Payback

• Benefits: quick and easy to understand; favours early cash returns, helping liquidity; relies on the nearer, more reliable forecasts; suits industries with fast-changing technology.
• Limitations: ignores cash flows after payback; ignores the time value of money; does not measure overall value added; the cut-off period is a judgement.

NPV

• Benefits: allows for the time value of money; uses all the cash flows; gives a clear decision rule tied to the cost of capital; shows the value a project adds in £.
• Limitations: harder to calculate and explain; the cost of capital is hard to estimate and changes the answer; assumes year-end cash flows; does not show return per £ invested when outlays differ.

Both: depend entirely on forecasts, which are least reliable in later years.

Must-know distinctions

• Cash flow vs profit: appraisal uses cash. Profit includes depreciation and accruals.
• Payback vs NPV: payback measures speed of return (liquidity and risk); NPV measures value added. They can rank two projects differently.
• Timing: payback assumes cash arrives evenly through the year (so months make sense); NPV assumes each year’s cash arrives at the year end.
• Higher cost of capital, lower NPV: discount factors get smaller as the rate rises, so present values fall.
• Financial vs non-financial factors: figures first, then staff, customers, quality, suppliers, environment, legal and strategic fit.

Quick self-test

1. A machine costs £45 000 and generates £12 000 net cash a year. Calculate payback in years and months.
2. Calculate the discount factor for year 2 at a cost of capital of 6%, to three decimal places.
3. A cash inflow of £25 000 arises at the end of year 3. The discount factor is 0.751. Calculate its present value.
4. Forecast profit is £14 000 after charging depreciation of £9 000. What is the net cash flow?
5. A business has spent £2 500 on a survey for a proposed project. Is this a relevant cash flow?
6. The present values of a project’s inflows total £63 400 and the outlay is £65 000. State the NPV and the decision.
7. Outlay £70 000; inflows £30 000, £25 000, £20 000 in years 1 to 3. Calculate payback.
8. Explain why a project’s NPV falls when the cost of capital rises.
9. State two non-financial factors a business might consider before buying new machinery.
10. Which method ignores cash flows that arise after the outlay has been recovered?
11. Project P has a shorter payback than project Q, but Q has the higher positive NPV. Which does each method favour, and give one reason a business might still choose P.

Answers

1. 45 000 ÷ 12 000 = 3.75 years = 3 years 9 months.
2. 1 ÷ 1.06² = 0.890.
3. 25 000 × 0.751 = £18 775.
4. 14 000 + 9 000 = £23 000; depreciation is non-cash, so add it back.
5. No. It is a sunk cost; it has been paid whatever is decided.
6. 63 400 − 65 000 = −£1 600. Negative, so reject on financial grounds.
7. Cumulative: (40 000), (15 000), +5 000 in year 3. 2 years + (15 000 ÷ 20 000) × 12 = 2 years 9 months.
8. A higher rate gives smaller discount factors, so every future inflow has a lower present value while the year-0 outlay is unchanged.
9. Any two: effect on staff morale or jobs; training needed; product quality; supplier reliability and servicing; environmental impact; health and safety.
10. Payback.
11. Payback favours P; NPV favours Q, as it adds more value. A business might still choose P if it is short of cash, or if Q’s later forecasts look unreliable, because P recovers the outlay sooner.

Where marks are usually lost

• Treating depreciation as a cash outflow, or not adding it back to a profit forecast.
• Including sunk costs such as a survey already paid for.
• Including apportioned fixed overheads that do not change.
• Forgetting the residual value, or putting it in year 1 instead of the final year.
• Using the wrong year’s inflow in the months calculation.
• Discounting the year-0 outlay, or forgetting to subtract it.
• Quoting an NPV without its sign, or with no accept or reject decision.
• Listing benefits and limitations without explaining why each matters.
• Ending an evaluation with no clear recommendation.

Official syllabus

AQA A-level Accounting (7127) specification, version 1.1, October 2026, for A-level exams June 2019 onwards (AQA). Section 3.13 Capital investment appraisal.