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

This guide covers 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, and section 3.13 is assessed on Paper 2, which draws on sections 1–3, 8–13 and 17–18. Every business and figure below is invented.

Useful links: AQA A-level Accounting hub, printable checklist, revision notes for this topic, practice questions and the free 10-minute diagnostics. Investment appraisal uses the same idea of relevant costs as marginal costing, and its cash flows often feed a cash budget.

What this section covers

Specification content (3.13)	What you must be able to do
The calculation and use of cash flows in capital investment appraisal	Work out the net cash flow of a project for each year; leave out non-cash and irrelevant items
Payback and net present value (discounted cash flow) of a capital project	Use the terms payback period, net present value, discount factor and cost of capital; calculate payback and NPV
Benefits and limitations of the payback and net present value methods	Explain the strengths and weaknesses of each method
Use of capital appraisal measures in the evaluation of projects	Make a reasoned recommendation using financial and non-financial factors

1. What capital investment appraisal is

Capital expenditure buys or improves non-current assets used for more than one year, such as a new machine or a shop extension. The money is spent now, but the benefits arrive over several years, so a poor choice ties up funds and is hard to reverse.

Capital investment appraisal uses accounting techniques to judge whether a capital project is worth undertaking, or which competing project to choose. The specification names two methods: payback and net present value (NPV). Both work with cash flows, not profit.

2. Calculating the cash flows

Why cash, not profit

Profit uses accruals and includes non-cash items. Investment appraisal asks how much cash goes out, how much comes back, and when. So you use the net cash flow for each year: cash received because of the project minus cash paid because of the project.

Which cash flows are relevant

Include only cash flows that are future and incremental (they happen only because the project goes ahead):

• the initial outlay: purchase price, delivery and installation, paid at the start;
• cash inflows: extra sales receipts, or cost savings such as lower wages or lower running costs;
• cash outflows: extra materials, wages, maintenance and other running costs;
• the residual value (scrap or sale value) received when the asset is disposed of at the end.

Leave out:

• depreciation, a non-cash expense; the asset’s cost is already in the initial outlay, so counting depreciation too would count the cost twice;
• sunk costs, money already spent (for example a feasibility study paid last month), because the decision cannot change it;
• apportioned fixed overheads that will be paid whether or not the project goes ahead.

If you are given a forecast profit that has been calculated after charging depreciation, convert it back to cash flow by adding the depreciation back.

Timing convention

The start of the project is called year 0 (“now”). Unless a question says otherwise, NPV calculations assume each year’s cash flows arrive at the end of that year. Payback calculations assume cash flows arrive evenly through the year, which is what allows a payback period in months.

Worked example 1: from forecast profit to cash flows

Kestrel Print is considering a new press costing £120 000, paid now. It will last 4 years and then be sold for £20 000. Depreciation is straight-line. The forecast profit from the press for each year is shown below, after charging depreciation and a £5 000 share of existing head-office costs, which will not change if the press is bought. Kestrel has already paid £3 000 for a market survey.

Step 1: depreciation. (120 000 − 20 000) ÷ 4 = £25 000 a year.

Step 2: add back the non-cash and non-incremental items.

Year	Forecast profit	+ Depreciation	+ Apportioned head-office costs	Net cash flow
1	10 000	25 000	5 000	40 000
2	16 000	25 000	5 000	46 000
3	22 000	25 000	5 000	52 000
4	12 000	25 000	5 000	42 000

Step 3: add the residual value to year 4: 42 000 + 20 000 = £62 000.

Step 4: ignore the market survey. The £3 000 is a sunk cost. Year 0 is the (120 000) outlay; brackets show an outflow.

3. Payback

The payback period is the time a project’s net cash inflows take to repay the initial outlay. Shorter is preferred, and a business may reject projects beyond a maximum (say three years).

Equal annual cash inflows: payback = initial outlay ÷ annual net cash inflow.

Unequal cash inflows: build a cumulative cash flow column. Payback falls in the year in which the cumulative figure turns from negative to positive. Then:

months into that year = (amount still to recover at the start of the year ÷ that year's cash inflow) × 12

Worked example 2: payback for Kestrel Print

Year	Net cash flow (£)	Cumulative (£)
0	(120 000)	(120 000)
1	40 000	(80 000)
2	46 000	(34 000)
3	52 000	18 000
4	62 000	80 000

At the end of year 2, £34 000 is still to be recovered. Year 3 brings in £52 000.

(34 000 ÷ 52 000) × 12 = 7.8 months, so payback is 2 years 8 months to the nearest month.

The year-4 residual value plays no part: payback ignores everything after the outlay is repaid.

4. Net present value

The time value of money

£1 today is worth more than £1 in three years’ time: it can be invested to earn a return, inflation has not eroded it, and there is no risk it never arrives. So each future cash flow is converted to its present value, its worth in today’s money.

Key terms

• Cost of capital: the rate of return a business must pay to the providers of its finance (interest on loans, the return expected by owners or shareholders). It is the minimum return a project must earn, and it is used as the discount rate.
• Discount factor: the number you multiply a future cash flow by to find its present value. For a cost of capital r (as a decimal) and a cash flow at the end of year n: discount factor = 1 ÷ (1 + r)ⁿ. The year-0 factor is always 1.000. If a question supplies discount factors, use them exactly as given. This page rounds them to three decimal places.
• Present value = cash flow × discount factor.
• Net present value (NPV) = total present value of all the cash flows, with the initial outlay entered as a negative. Equivalently, total present value of inflows − initial outlay.

Decision rule

• Positive NPV: the project earns more than the cost of capital and adds value. Accept on financial grounds.
• Negative NPV: the project earns less than the cost of capital. Reject on financial grounds.
• Choosing between projects: prefer the one with the higher positive NPV.

Worked example 3: NPV for Kestrel Print at 10%

Discount factors at 10%: year 1 0.909, year 2 0.826, year 3 0.751, year 4 0.683.

Year	Net cash flow (£)	Discount factor (10%)	Present value (£)
0	(120 000)	1.000	(120 000)
1	40 000	0.909	36 360
2	46 000	0.826	37 996
3	52 000	0.751	39 052
4	62 000	0.683	42 346
		NPV	35 754

Total present value of inflows = 36 360 + 37 996 + 39 052 + 42 346 = £155 754. NPV = 155 754 − 120 000 = £35 754 positive, so on financial grounds Kestrel should buy the press.

Note that the residual value is included in year 4 here, because NPV uses all the project’s cash flows.

5. Benefits and limitations of each method

	Payback	Net present value
Benefits	Simple to calculate and easy for non-accountants to understand	Allows for the time value of money
	Favours projects that return cash quickly, which helps liquidity	Uses all the cash flows over the whole life of the project
	Near-term forecasts are more reliable, so it reduces exposure to uncertain later years	Gives a clear decision rule linked to the cost of capital
	Useful when technology changes fast	Shows the money value a project adds
Limitations	Ignores all cash flows after the payback point	Harder to calculate and explain to non-accountants
	Ignores the time value of money	Depends on choosing the right cost of capital, which is hard to estimate
	Does not measure overall profitability or value added	Assumes cash flows arrive at year ends and that forecasts are accurate
	The maximum acceptable payback is a judgement	NPV alone does not show the return per £ invested

Both methods are only as reliable as the cash flow forecasts, and later years are the least certain.

6. Using the measures to evaluate projects

A recommendation should combine the calculations with wider judgement.

Financial factors include: the NPV and payback figures; how reliable the forecasts are (what if sales were 10% lower?); whether finance can be raised and at what cost; the effect on liquidity; and the opportunity cost of the funds.

Non-financial factors include: effects on staff (training, redundancies, morale); product quality and customer reaction; supplier reliability and servicing; environmental impact and reputation; legal requirements such as health and safety; and fit with long-term aims.

Worked example 4: choosing between two projects

Fenwick Packaging can afford one of two machines, each costing £90 000. Its cost of capital is 8%. Discount factors: 0.926, 0.857, 0.794, 0.735, 0.681 for years 1 to 5.

Year	Alder net cash flow (£)	Birch net cash flow (£)
1	40 000	15 000
2	35 000	20 000
3	30 000	30 000
4	10 000	30 000
5	5 000	45 000

Payback. Alder cumulative: (50 000), (15 000), +15 000 in year 3, so 2 years + (15 000 ÷ 30 000) × 12 = 2 years 6 months. Birch cumulative: (75 000), (55 000), (25 000), +5 000 in year 4, so 3 years + (25 000 ÷ 30 000) × 12 = 3 years 10 months.

NPV. Alder present values: 37 040 + 29 995 + 23 820 + 7 350 + 3 405 = 101 610, NPV = £11 610. Birch present values: 13 890 + 17 140 + 23 820 + 22 050 + 30 645 = 107 545, NPV = £17 545.

Evaluation. Both NPVs are positive, so both earn more than 8%. NPV favours Birch, which adds £5 935 more value; payback favours Alder, which pays back 16 months sooner. Birch relies on large inflows in years 4 and 5, the least certain forecasts. If Fenwick is short of cash or its market changes quickly, Alder’s earlier return may matter more. If the later forecasts are reliable, Birch is better because it adds more value. A strong answer adds a non-financial point, such as which supplier offers better servicing, and ends with a clear recommendation.

Common errors

• Including depreciation as a cash outflow, or forgetting to add it back to a profit figure.
• Including sunk costs or unchanged apportioned overheads.
• Leaving the residual value out of the NPV, or adding it to the wrong year.
• Converting a decimal of a year into months incorrectly (0.65 years is not 6.5 months).
• Using the cash inflow of the wrong year as the divisor in the months calculation.
• Discounting the year-0 outlay, or forgetting to subtract it.
• Saying “accept” for a negative NPV because total inflows exceed the outlay before discounting.
• Listing factors with no final decision.

Next steps

Try the practice questions, recap with the revision notes, and see the exam preparation guide.

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.