ACCA F9 Financial Management - 2010 - Study text

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Chapter 7: Introduction to investment appraisal and capital investment decisions

However, you might be expected to define capital employed as the total initial

investment (capital expenditure + working capital investment).

Profits will vary from one year to the next over the life of an investment project. As

indicated earlier, profit is defined as the accounting profit, after depreciation but

before interest and taxation. Since profits vary over the life of the project, it is

normal to use the average annual profit to calculate ARR.

Profit is calculated using normal accounting rules, and is after deduction of

depreciation on non-current assets.

Example

A company is considering a project which requires an investment of $120,000 in

machinery. The machinery will last four years after which it will have scrap value of

$20,000. The investment in additional working capital will be $15,000.

The expected annual profits before depreciation are:

Year

1 $45,000

2 $45,000

3 $40,000

4 $25,000

The company requires a minimum accounting rate of return of 15% from projects of

this type. ARR is measured as average annual profits as a percentage of the average

investment.

Should the project be undertaken?

Answer

Total project profits before depreciation = $45,000 + $45,000 + $40,000 + $25,000 =

$155,000.

Total depreciation = $120,000 - $20,000 = $100,000.

Total accounting profits after depreciation = $155,000 - $100,000 = $55,000.

Average annual accounting profits $55,000/4 years = $13,750.

Average investment = $(120,000 + 20,000)/2 + $15,000

= $85,000.

ARR = ($13,750/$85,000) × 100% = 16.2%.

The project offers an accounting return higher than the minimum required

accounting return of 15%. Therefore using ARR as the investment appraisal method,

the project should be undertaken.

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2.3 Advantages and disadvantages of using the ARR method

The main advantages of the ARR are that:

 It is fairly easy to understand. It uses concepts that are familiar to business

managers, such as profits and capital employed.

 It is easy to calculate.

However, there are significant disadvantages with the ARR method.

 It is based on accounting profits, and not cash flows. However investments are

about investing cash to obtain cash returns. Investment decisions should

therefore be based on cash flows, and not accounting profits.

 Accounting profits are an unreliable measure. For example, the annual profit

and the average annual investment can both be changed simply by altering the

rate of depreciation and the estimated residual value.

 The ARR method ignores the timing of the accounting profits. Using the ARR

method, a profit of $10,000 in Year 1 and $90,000 in Year 2 is just as valuable as a

profit of $90,000 in Year 1 and $10,000 in Year 2. However, the timing of profits

is significant, because the sooner the cash returns are received, the sooner they

can be reinvested to increase returns even more.

 The ARR is a percentage return, relating the average profit to the size of the

investment. It does not give us an absolute return. However the absolute return

can be significant. For example if the ARR on an investment of $1,000 is 50%, the

average profit is $500; whereas if the ARR on an investment of $1 million is 20%,

the average annual profit will be $200,000. An accounting return of $200,000 on

an investment of $1 million might be preferred to an accounting return of 50%

on an investment of $1,000.

 When using the ARR method for investment appraisal, a decision has to be

made about what the minimum target ARR should be. There is no rational

economic basis for setting a minimum target for ARR. Any such minimum target

accounting return is a subjective target, with no economic or investment

significance.

Exercise 1

A capital project would involve the purchase of an item of equipment costing

£240,000. The equipment will have a useful life of six years and would generate cash

flows of £66,000 each year for the first three years and £42,000 each year for the final

three years.

The scrap value of the equipment is expected to be £24,000 after six years. An

additional investment of £40,000 in working capital would be required.

The business currently achieves a return on capital employed, as measured from the

data in its financial statements, of 10%.

Chapter 7: Introduction to investment appraisal and capital investment decisions

Required

(a) Calculate the ARR of the project, using the initial cost of the equipment to

calculate capital employed.

(b) Calculate the ARR of the project, using the average cost of the equipment to

calculate capital employed.

expected ARR.

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The payback method of capital investment appraisal

 Definition of payback

 Decision rule for the payback method

 Advantages and disadvantages of the payback method

3 The payback method of capital investment appraisal

3.1 Definition of payback

Payback is measured by cash flows, not profits.

It is the length of time before the cash invested in a project will be recovered (paid

back) from the net cash returns from the investment project.

For example, suppose that a project will involve capital expenditure of $80,000 and

the annual net cash returns from the project will be $30,000 each year for five years.

The expected payback period is:

$80,000

$30,000

= 2.67 years.

3.2 Decision rule for the payback method

Using the payback method, a maximum acceptable payback period is decided, as a

matter of policy. The expected payback period for the project is calculated.

 If the expected payback is within the maximum acceptable time limit, the project

is acceptable.

 If the expected payback does not happen until after the maximum acceptable

time limit, the project is not acceptable.

The

time value of money is ignored, and the total return on investment is not

considered.

Example

A company requires all investment projects to pay back their initial investment

within three years. It is considering a new project requiring a capital outlay of

$140,000 on plant and equipment and an investment if $20,000 in working capital.

The project is expected to earn the following net cash receipts:

Year

1 $40,000

2 $50,000

3 $90,000

4 $25,000

Chapter 7: Introduction to investment appraisal and capital investment decisions

Should the investment be undertaken?

Answer

Note that for the purpose of investment appraisal, ‘now’ is usually referred to as

‘Year 0’.

The investment in working capital should be included as an outflow of cash at the

beginning of the project. This is because when there is an increase in working

capital, cash flows are lower than cash profits by the amount of the increase.

Similarly when working capital is reduced to $0 at the end of the project, the

reduction is added to cash flows because when there is a reduction in working

capital, cash flows are higher than cash profits by the amount of the reduction.

Year

Cash flow

Cumulative cash position

at the end of the year

$ $

0 (160,000) (160,000) (= $140,000 + $20,000)

1 40,000 (120,000)

2 50,000 (70,000)

3 90,000 20,000

4 465,000 65,000 cash flow = $25,000 + $20,000

(a) If we assume that all cash flows occur at the end of each year, the payback

period is three years.

(b) If we assume that cash flows arise evenly over the course of each year, then

the payback period is:

2 years + (70,000/90,000) year

= 2.78 years = 2 years 9 months.

Note: The payback period of 2 years 9 months is calculated as follow.

(1) Payback occurs during the third year. At the beginning of year 3 the cumulative

cash flow is $(70,000). During the year there are net cash flows of $90,000. The

cumulative cash flow therefore starts to become positive, assuming even cash flows

through the year, after 70,000/90,000 of the year = 0.78 year.

(2) A decimal value for a year can be converted into months by multiplying by 12, or

into days by multiplying by 365. So 0.78 years = 9 months (= 0.78

× 12) or 285 days

(= 0.78

× 365).

3.3 Advantages and disadvantages of the payback method

The advantages of the payback method for investment appraisal are as follows:

 Simplicity – The payback is easy to calculate and understand.

 The method analyses cash flows, not accounting profits. Investments are about

investing cash to earn cash returns. In this respect, the payback method is better

than the ARR method.

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 Payback is often used together with a DCF method, particularly by companies

that have liquidity problems and do not want to tie up cash for long periods.

Payback can be used to eliminate projects that will take too long to pay back.

Investments that pass the payback test can then be evaluated using one of the

DCF methods.

The

disadvantages of the payback method are as follows:

 It ignores all cash flows after the payback period, and so ignores the total cash

returns from the project. This is a significant weakness with the payback

method.

 It ignores the timing of the cash flows during the payback period. For example,

for an investment of $100,000, cash flows of $10,000 in Year 1 and $90,000 in Year

2 are no different from cash flows of $90,000 in Year 1 and $10,000 in Year 2,

because both pay back after two years. However it is clearly better to receive

$90,000 in Year 1 and $10,000 in Year 2 than to receive $10,000 in Year 1 and

$90,000 in Year 2.

Exercise 2

A company must choose between two investments, Project A and Project B. It

cannot undertake both investments. The expected cash flows for each project are:

Year Project A Project B

$ $

0 (80,000) (80,000)

1 20,000 60,000

2 36,000 24,000

3 36,000 2,000

4 17,000 -

The company has a policy that:

 The maximum permissible payback period for an investment is three years.

 If a choice has to be made between two projects, the project with the earlier

payback will be chosen.

Required

Calculate the payback period for each project:

(a) assuming that cash flows occur at that year end

(b) assuming that cash flows after Year 0 occur at a constant rate throughout each

year

Are the projects acceptable, according to the company’s payback rule?

Which project should be selected?

Do you agree that this is the most appropriate investment decision?

Chapter 7: Introduction to investment appraisal and capital investment decisions

Relevant costs in investment decisions

 Relevant costs and decision-making

 Relevant cost of materials

 Relevant cost of existing equipment

 Relevant cost of investment in working capital

 Opportunity costs

4 Relevant costs in investment decisions

4.1 Relevant costs and decision-making

You should already be familiar with the concept that when any decision is

evaluated in accounting, relevant costs should be used for the evaluation. Since the

ARR method uses accounting profits and not cash flows, it is a poor investment

appraisal method that should not be used for making investment decisions.

Relevant costs are used for payback method analysis and for DCF analysis. DCF

analysis is described in the next chapter.

Definition of relevant costs and benefits

Relevant costs and benefits are future cash flows arising as a direct consequence of

the decision under consideration.

 Relevant costs are cash flows. Any items of cost that are not cash flows must be

ignored for the purpose of decision. For example, depreciation expenses are not

cash flows and must always be ignored.

 Relevant costs are future cash flows. Costs that have already been incurred are

not relevant to a decision that is being made now. The cost has already been

incurred, whatever decision is made, and it should therefore not influence the

decision. For example, a company might incur initial investigation costs of

$20,000 when looking into the possibility of making a capital investment. When

deciding later whether to undertake the project, the investigation costs are

irrelevant, because they have already been spent.

 Relevant costs are also costs that will arise as a direct consequence of the

decision

, even if they are future cash flows. If the costs will be incurred

whatever decision is taken, they are not relevant to the decision.

Some examples of relevant costs are given below, but you should already be

familiar with the concept of relevant costs from your previous studies.

Paper F9: Financial management

4.2 Relevant costs of materials

When materials will have to be purchased for a project, because there are no

existing inventories of the materials, their relevant cost is their future purchase cost.

However if the materials required for a project are already held in inventory, their

relevant cost depends on circumstances.

 If the materials are in regular use, and quantities consumed for the investment

project would be replaced in the normal course of trading operations, the

relevant cost of the materials is their current replacement cost.

 If the materials will not be replaced if they are used for the investment project,

their relevant cost is the higher of:

− their net disposal value and

− the net contribution that could be earned using the materials for another

available use.

4.3 Relevant cost of existing equipment

When new capital equipment will have to be purchased for a project, the purchase

cost of the equipment will be a part of the initial capital expenditure, and so a

relevant cost.

However, if an investment project will also make use of equipment that the business

already owns, the relevant cost of the equipment will be the higher of:

 the current disposal value of the equipment, and

 the present value of the cash flows that could be earned by having an alternative

use for the equipment.

4.4 Relevant cost of investment in working capital

It is important that you should understand the relevance of investment in working

capital for cash flows. This point has been explained previously.

Strictly speaking, an investment in working capital is not a cash flow. However, it

should be treated as a cash flow, because:

 when capital investment projects are evaluated, it is usual to estimate the cash

profits for each year of the project

 however, actual cash flows will differ from cash profits by the amount of the

increase or decrease in working capital.

You should be familiar with this concept from cash flow statements.

 If there is an increase in working capital, cash flows from operations will be

lower than the amount of cash profits. The increase in working capital can

therefore be treated as a cash outflow, to adjust the cash profits to the expected

cash flow for the year.

 If there is a reduction in working capital, cash flows from operations will be

higher than the amount of cash profits. The reduction in working capital can

Chapter 7: Introduction to investment appraisal and capital investment decisions

therefore be treated as a cash inflow, to adjust the cash profits to the expected

cash flow for the year.

Example

A company is considering whether to invest in the production of a new product.

The project would have a six-year life. Investment in working capital would be

$30,000 at the beginning of Year 1 and a further $20,000 at the beginning of Year 2.

For the purpose of investment appraisal, it is usually assumed that a cash flow,

early during a year, should be treated as a cash flow as at the end of the previous

year.

The relevant cash flows for the working capital investment would therefore be as

follows:

Year $

1 (cash outflow) (30,000)

2 (cash outflow) (20,000)

6 (cash inflow) 50,000

4.5 Opportunity costs

Opportunity costs are the benefits forgone by using assets or resources for one

purpose, instead of using them in the most profitable alternative way. Opportunity

costs are commonly measured as contribution forgone, but might also be measured

as a present value (in DCF analysis).

When resources have more than one alternative use, and are in limited supply, their

opportunity cost is the contribution forgone by using them for one purpose and so

being unable to use them for another purpose.

Example

A company is considering an investment in a major new information system. The

investment will require the use of six of the company’s IT specialists for the first one

year of the project. These IT specialists are each paid $100,000 each per year. IT

specialists are difficult to recruit. If the six specialists are not used on this project,

they will be employed on other projects that would earn a total contribution of

$500,000.

The relevant cost of the IT specialist in Year 1 of the project would be:

Basic salaries 600,000

Contribution forgone 500,000

Total relevant cost 1,100,000

Paper F9: Financial management

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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