Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
Подождите немного. Документ загружается.
.
Chapter 6 Project appraisal – applications 155
6.5 TAXATION IS A CASH FLOW
In Chapter 2, we introduced the subject of taxation and its broad implications for finan-
cial management. In this section, we examine in greater depth the taxation considera-
tions for capital investment projects.
Recall that in the UK, Corporation Tax is assessed by the Inland Revenue on the prof-
its of the company after certain adjustments. While it is not calculated on a project basis
by the Inland Revenue, the actual tax bill will increase with every new project offering
additional profits and reduce with every project offering losses. Corporation Tax is
charged on the profits, gains and income of an accounting period, usually the period
for which accounts are made up annually. In arriving at taxable profits, a deduction is
made for capital allowances on certain types of capital investment. Following the prin-
ciple outlined earlier of identifying the incremental cash flow, we need to ask: by how
much will the Corporation Tax bill for the company change each year as a result of the
decision? To answer this, we must consider the tax charged on project operating prof-
its and the tax relief obtained on the capital investment outlay.
■ Taxation implications of Tiger 2000 for Woosnam plc
Woosnam plc invests in a new piece of equipment, the Tiger 2000, costing £40,000 on
1 January 2000. It intends to operate the equipment for four years when the scrap value
will be zero. Expected net cash flows from the project are £10,000 in the first year and
£20,000 for each of the next three years. The discount rate is 15 per cent and the rate of
Corporation Tax is 30 per cent.
No tax position
If we ignore taxation (perhaps Woosnam is making losses and is unlikely to pay tax for
some time), the net present value of the project’s pre-tax cash flows is £8,390, as shown in
Table 6.5. The positive NPV suggests that, on economic grounds, it should be accepted.
With Corporation Tax but no capital allowances
Most companies have to pay Corporation Tax, and a large company, like Woosnam plc,
will pay at the rate of 30 per cent of taxable profits. A recent change is that this tax is
now paid in the same year as the related profits, usually by quarterly instalments.
Hitherto, companies enjoyed a tax delay of at least a year, which meant that the tax pay-
ment would typically lag a full year behind the investment cash flows to which they
relate. Most investments attract a capital allowance (equivalent to a depreciation
charge) which reduces the tax bill. At this stage, we assume that the Tiger 2000 does not
attract any capital allowances.
Table 6.5
Project Tiger 2000
(assuming no capital
allowances)
(1) (2) (3) (4) (1 4) (3 4)
Pre-tax Tax @ After-tax Discount PV PV
cash flows 30% cash flows factor pre-tax post-tax
Year £ £ @ 15% £ £
0 (40,000) – (40,000) 1.0 (40,000) (40,000)
1 10,000 (3,000) 7,000 0.869 8,690 6,083
2 20,000 (6,000) 14,000 0.756 15,120 10,584
3 20,000 (6,000) 14,000 0.657 13,140 9,198
4 20,000 (6,000) 14,000 0.572 1
1,440 8,008
NPV 8,390 (6,127)
CFAI_C06.QXD 10/26/05 11:27 AM Page 155
.
156 Part II Investment decisions and strategies
Table 6.6
Woosnam plc – Tiger
2000 tax reliefs
Tax written-down Writing-down 30%
End of value allowance tax relief
accounting year £ £ £
1– Initial outlay 40,000
WDA at 25% 10,000 10,000 3,000
30,000
2– WDA at 25% 7,500 7,500 2,250
22,500
3– WDA at 25% 5,625 5,625 1,688
16,875
4– Sale proceeds –
Balancing allowance 16,875 16,875 5,062
40,000 12,000
Table 6.5 shows that after deducting tax to be paid, the NPV for the project falls
sharply to –£6,127. It is no longer economically viable.
With corporation tax and capital allowances
For many types of capital investment, tax relief is granted on capital expenditure
incurred. In the United Kingdom, this is in the form of a first-year allowance and subse-
quent annual writing-down allowances (WDAs). The first-year allowance is a govern-
ment incentive to encourage firms to invest and has in the past been as high as 100 per
cent. Currently, for large companies, it is as follows:
Plant and machinery 25 per cent on the reducing balance
Industrial buildings 4 per cent on the initial cost
So for expenditure on machinery of £1,000, the allowance would be as follows:
Written-down value
Year Tax allowance (£) at year-end (£)
1 750
2 562
3 etc. 422, etc.
Clearly, the tax allowances diminish over time. Companies are allowed to write
assets down for tax purposes to their disposal value. Any discrepancy between written-
down value (WDV) and disposal value may trigger a tax liability (balancing charge)
or qualify for tax relief (balancing allowance). In the above example, disposal of the
asset for £500 after three years would mean that the capital allowances have been over-
generous to the extent of £78 (i.e. disposal value of £500 – WDV of £422). This balanc-
ing charge of £78 would then be subject to Corporation Tax. Disposal for, say, £300
would qualify the company for a balancing allowance of £122 (i.e. £422 – £300), a loss
that would be set against the taxable profits.
Let us return to the Woosnam plc example, this time assuming that the Tiger 2000
attracts a 25 per cent writing-down allowance. Table 6.6 calculates the WDAs. Tax is
payable in the same year as the investment cash flows to which they relate.
The difference between what the investment finally sold for (in this case zero) and
the balance at the start of the year is a balancing allowance, which is treated in the
25% 562
ˇˇˇ 141,
25% 750
ˇˇˇ 188
25% 1,000 250
annual writing-down
allowances (WDAs)
Allowances for depreciation on
capital expenditure allowed for
tax purposes
CFAI_C06.QXD 10/26/05 11:27 AM Page 156
.
Chapter 6 Project appraisal – applications 157
Table 6.7
Woosnam plc – Tiger
2000 with tax relief
Pre-tax Tax relief Net cash
cash flows Tax at on WDA flows Discount PV
Year £ 30% £ £ factor 15% £
0 (40,000) – (40,000) 1.000 (40,000)
1 10,000 (3,000) 3,000 10,000 0.869 8,690
2 20,000 (6,000) 2,250 16,250 0.756 12,285
3 20,000 (6,000) 1,688 15,688 0.657 10,307
4 20,000 (6,000) 5,062 19,062 0.572 10,903
2,185
same way as the writing-down allowance. (We will not introduce further complica-
tions such as the election to pool plant and machinery in this book.) A useful check is
to see that the total WDA (column 3) equals the initial investment, and the tax benefit
(column 4) on this total corresponds, in this case £40,000 at 30% =£12,000.
These cash flows can then be added to the earlier example, as in Table 6.7, showing
that the investment offers a positive NPV of £2,185 after tax.
How would the after-tax NPV differ were Woosnam plc a small or medium-size
company? Such firms currently have a further tax incentive to invest by attracting a
40 per cent initial allowance, rather than 25 per cent. The effect is to reduce the tax bill
in the early years, deferring it to later years. Because later cash flows are less valuable,
this means that the NPV will increase.
Taxation therefore affects cash flows from investments. It is payable on taxable prof-
its arising from the investment decision after deduction of capital allowances.
Self-assessment activity 6.5
Your boss says: ‘We only assess capital projects before tax. Every firm has to pay tax, so we
can ignore it’. Do you agree?
(Answer in Appendix A at the back of the book)
6.6 USE OF DCF TECHNIQUES
It is a common misconception that the discounted cash flow approach is a relatively
recent phenomenon. Historical records reveal an understanding of compound interest
(upon which discounted cash flow techniques are based) as far back as the Old
Babylonian period (c. 1800–1600
BC) in Mesopotamia. The earliest manuscripts setting
out compound interest tables date back to the 14th century, while the first recorded ref-
erence to the net present value rule is found in a book by Stevin published in 1582.
In these early days, the application of discounted cash flow methods was restricted
to financial investments such as loans and life assurance, where either the cash flows
were known or their probabilities could be determined based on actuarial evidence.
Only in the 19th century, with the Industrial Revolution well established, did the scale
of capital investments lead some engineering economists to begin to apply discounted
cash flow concepts to capital assets. However, in practice, these concepts were largely
ignored until the early 1950s in the USA and the early 1960s in the UK.
Surveys between 1975 and 1997 provide a clearer picture of the changing trends in
the practices of larger firms in the UK. Table 6.8 shows that, while all firms surveyed
CFAI_C06.QXD 10/26/05 11:27 AM Page 157
.
158 Part II Investment decisions and strategies
Table 6.8
Capital investment
evaluation methods in
100 large UK firms
1975 1981 1986 1992 1997
Firms using: (%) (%) (%) (%) (%)
Payback 73 81 92 94 66
Average accounting rate of return 51 49 56 50 55
DCF methods (IRR or NPV) 58 68 84 88 100
Internal rate of return 44 57 75 81 84
Net present value 32 39 68 74 97
Sources: Pike (1988, 1996), Arnold and Hatzopoulos (2000)
conduct financial appraisals on capital projects, the choice of method varies consider-
ably, and most firms employ a combination of appraisal techniques.
The use of DCF methods in larger firms increased greatly from 58 per cent in 1975
to 100 per cent by 1997. Hitherto, the IRR method enjoyed much greater popularity
than the theoretically preferred NPV approach. However, in recent years, there has
been a marked acceleration in adoption of the NPV method, with virtually all large
firms now employing it.
The payback method has declined in popularity in recent years, but remains more
popular with smaller firms. It is clear that firms do not normally rely on any single
appraisal measure, but prefer to employ a combination of simple and more sophisti-
cated techniques. DCF methods therefore complement, rather than substitute for,
traditional approaches.
■ Dangers with DCF
While we have argued that DCF analysis offers a conceptually sound approach for
appraising capital projects, a word of caution is appropriate.
From the emphasis devoted by most textbooks to advanced capital budgeting meth-
ods, one might be forgiven for assuming that successful investment is exclusively
attributable to the correct evaluation method. However, DCF methods often create an
illusion of exactness that the underlying assumptions do not warrant. As top manage-
ment places more weight on the quantifiable element, there is a danger that the
unquantifiable aspects of the decision, which frequently have a critical bearing on a
project’s success or failure, will be devalued. The human element is particularly
important with regard to the project sponsor. The margin between a project’s success
or failure often hinges on the enthusiasm and commitment of the person sponsoring
and implementing it.
Managers cannot afford to treat investment decisions in a vacuum, ignoring the
complexities of the business environment. Any attempt to incorporate such complex-
ities, however, will at best consist of abstractions from reality relying on generalised
and simplified assumptions concerning business relationships and environments. A
fundamental assumption underlying DCF methods is that decision-makers pursue
the primary goal of maximising shareholders’ wealth. For many firms, this may not
be the case.
Critical errors may often be seen in the way DCF theory is applied by managers.
Usually, these errors are biased against investment. For example, many firms do not
adjust their operating cash flows for inflation, but discount them at the money cost of
capital, rather than the real rate of return before inflation. The effect is that cash flows
in later years (typically the strong positive cash flows) are unduly deflated by the high
discount factor, giving a lower net present value than should be the case.
Perhaps even more important, DCF methods ignore the value of investment options.
This key topic is the subject of Chapter 12.
CFAI_C06.QXD 10/26/05 11:27 AM Page 158
.
Chapter 6 Project appraisal – applications 159
Common errors in applying DCF
■ Discount rates are calculated on a pre-tax basis, while operating cash flows are calcu-
lated after tax.
■ Discount rates are increased to compensate for non-economic statutory and welfare
investments.
■ Including interest charges in cash flows.
■ Cash flows are specified in today’s money (excluding inflation), while hurdle rates are
based on the money cost of capital (including inflation).
■ Managerial aversion to uncertainty frequently results in conservative project life and
terminal value assumptions.
■ Use of a single cut-off rate instead of a rate reflecting project risk. This often leads to
rejection of low-risk/low-return replacement projects.
■ Failure to include scrap values.
■ Neglect of working capital movements.
6.7 TRADITIONAL APPRAISAL METHODS
Managers have developed and come to rely upon simple rule-of-thumb approaches to
analysing investment worth. Two of the most popular traditional methods are the pay-
back period and the accounting rate of return, both of which were described in earlier
chapters. Our present concern is to ask whether they have a valuable role to play in the
modern capital budgeting process. Do they offer anything to the decision-maker that
cannot be found in the DCF approaches?
■ Accounting rate of return (ARR)
We discussed the basic application of the ARR approach in Chapter 5. Table 6.8 reports
that a little over half the companies surveyed employ the accounting rate of return
approach in assessing investment decisions. This is not altogether surprising, given that
the rate of return on capital is a very important financial goal in practice.
The ARR can be criticised on at least two counts: it uses accounting profits rather
than cash flows, and it ignores the time-value of money. Nevertheless there has been
a certain amount of support for the ARR in the literature. The absence of ARR leads to
an inconsistency between the methods commonly used to report a firm’s results and
the techniques most frequently employed to appraise investment decisions. This is
most acutely experienced where the divisional manager of an investment centre is
expected to use a DCF approach in reaching investment decisions, while his or her
short-term performance is being judged on a return on investment basis. Little won-
der, then, that the divisional manager generally shows a marked reluctance to enter
into any profitable long-term investment decisions that produce low returns in the
early years.
A common assumption among managers is that the accounting rate of return and
the internal rate of return produce much the same solutions. But while there is a rela-
tionship between a project’s discounted return and the ARR, the relationship is not
simple. Consider an investment costing £10,000 and generating an annual stream of
net cash flows of £3,000. Assuming straight-line depreciation, the relationship between
the internal rate of return and the accounting rate of return calculated on both the total
investment and the average investment is as shown in Table 6.9.
From this example we can see that the accounting rate of return on total investment
consistently understates, and the accounting rate of return on average investment over-
states, the internal rate of return. The case for retaining the accounting rate of return is,
CFAI_C06.QXD 10/26/05 11:27 AM Page 159
.
160 Part II Investment decisions and strategies
Table 6.9
Relationship between
ARR and IRR
Project duration (years) 5 10 20 25
IRR (%) 15.2 27.3 29.8 30
ARR on total investment (%) 10 20 25 27.5
Deviation from IRR
ARR on average investment (%) 20 40 50 55
Deviation from IRR
2520.212.74.8
2.54.87.35.2
£m PV @ 10% (£m)
Yr 1 profit 10
Investment outlay: £60 m
10% capital charge on investment (6
)
Residual income 4
Yr 2 profit 10
Book value of assets: £40 m
10% capital charge (4
)
6
Yr 3 profit 10
Book value of assets: £20 m
10% capital charge (2
)
8
Net present value 14.600
0.751 6.008
0.826 4.956
0.909 3.636
therefore, valid only when applied as a secondary criterion to highlight the likely
impact on the organisation’s profitability upon which the divisional manager is
judged.
Residual income approach: Pluto Electronics
While the average accounting return can be a misleading decision indicator for capital
projects, it is possible to employ a profit-based approach that is in line with net present
value. This involves calculating the Residual Income (RI), the profit less a cost of capital
charge based on the book value of the assets employed.
Pluto Electronics has acquired the rights to manufacture a product for three years
and has set up a new division to do so. The investment outlay is £60 million and annu-
al cash flows are forecast to be £30 million. The company operates a straight-line
depreciation policy and has a cost of capital of 10 per cent.
We can calculate the NPV (£m) as:
The same answer is given by calculating the residual income for each year and dis-
counting at the cost of capital, as shown below. The annual profit is £10 million (i.e. £30
million cash flow less £20 million depreciation).
NPV 60 30
#
PVIFA
10,3
60 130 2.48682 £14.6 m
Residual Income
Operating profit less the charge
for capital
■ Payback period
Most finance texts have condemned the use of the payback period as potentially mis-
leading in reaching investment decisions. However, Table 6.8 shows that it continues to
flourish, being employed by most firms surveyed. Typically, the payback period
required by firms is within 2–4 years (Arnold & Hatzopoulos 2000). Why is payback
so popular? Does it possess certain qualities not so apparent in more sophisticated
approaches?
CFAI_C06.QXD 10/26/05 11:27 AM Page 160
.
Chapter 6 Project appraisal – applications 161
The two main objections to payback (PB)
1 It ignores all cash flows beyond the payback period.
2 It does not consider the profile of the project’s cash flows within the payback period.
Although such theoretical shortcomings could fundamentally alter a project’s ranking and
selection, the payback criterion possesses a number of merits.
1 PB estimates DCF return
The payback period provides a crude measure of investment profitability. When the
annual cash receipts from a project are uniform, the payback reciprocal is the internal
rate of return for a project of infinite life, or a good approximation to this rate for long-
lived projects.
In the case of very long-lived projects where the cash inflows are, on average, spread
evenly over the life of the project, the payback reciprocal is a reasonable proxy for the
internal rate of return. For example, a project offering permanent cash savings and giv-
ing a four-year payback period with relatively stable annual cash returns will have
approximately a 25 per cent internal rate of return (i.e. the reciprocal of payback peri-
od). However, if the project life is only ten years, the IRR would fall to 21 per cent –
some four percentage points below the payback reciprocal. In fact, the payback recip-
rocal consistently overstates the true rate of return for finite project lives.
2 PB considers uncertainty
Whereas more sophisticated techniques attempt to model the uncertainty surrounding
project returns, payback assumes that risk is time-related; the longer the period, the
greater the chance of failure. General economic uncertainty makes the task of forecast-
ing cash flows extremely difficult; but for the most part, cash flows are correlated over
time. If the operating returns are below the expected level in the early years, they will
probably also be below plan in the later years.
Discounted cash flow, as practised in most firms, ignores this increase in uncertain-
ty over time. Early cash flows, therefore, have an important information content on the
degree of accuracy of subsequent cash flows. By concentrating on the early cash flows,
the payback approach analyses the data where managers have greater confidence. If
such evaluation provides a different signal from DCF methods, it highlights the need
for a more careful consideration of the project’s risk characteristics.
3 PB as a screening device
Payback provides a relatively efficient method for ranking projects when constraints
prevail. The most obvious constraint is the time that managers can devote to initial
product screening. Only a handful of the investment ideas may stand up to serious and
thorough financial investigation. Payback period serves as a simple, first-level screen-
ing device which, in the case of marginal projects, tends to operate in their favour and
permits them to go forward for more thorough investigation.
Many firms also resort to payback period when experiencing liquidity con-
straints. Such a policy may make sense when funds are constrained and better
investment ideas are in the pipeline. The attractiveness of investment proposals
considered during the interim period will be a function more of their ability to pay
back rapidly than of their overall profitability. This does not necessarily lead to
optimal solutions.
IRR
1
payback period
CFAI_C06.QXD 10/26/05 11:27 AM Page 161
.
162 Part II Investment decisions and strategies
Self-assessment activity 6.6
The following reasons for using payback were made by finance executives from three dif-
ferent companies:
‘We use payback in support of other methods. It is not a sufficiently reliable tool to be
used in isolation.’
‘When liquidity is under pressure, payback is particularly relevant.’
‘Payback helps to give some idea of the riskiness of the project – a long time to get
one’s money back is obviously more risky than a short time.’
To what extent do you agree with these views?
4 PB assists communication
Managers feel more comfortable with payback period than with DCF. In the first place,
it is simple to calculate and understand. The non-quantitative manager is reluctant to
rely on the recommendations of ‘sophisticated’ models when he or she lacks both the
time and expertise to verify such outcomes. Confidence in and commitment to a pro-
posal depend to some degree on how thoroughly the evaluation model is compre-
hended. The payback method offers a convenient shorthand for the desirability of each
investment that is understandable at all levels of the organisation: namely, how quick-
ly will the project recover its initial outlay? Some firms use a project classification sys-
tem in which the payback period indicates how rapidly proposals should be processed
and put into operation.
Ultimately, it is the manager – not the method – who makes investment decisions
and is appraised on their outcome. Payback period is particularly attractive to man-
agers not only because it is convenient to calculate and communicate, but also because
it signals good investment decisions at the earliest opportunity.
While the payback concept may lack the refinements of its more sophisticated eval-
uation counterparts, it possesses many endearing qualities that make it irresistible to
most managers; hence its resilience.
■ The appropriate discount rate
So far the examples used have simply stated the project discount rate based on the cost
of capital, the rate of return required by investors. We discuss in some depth the appro-
priate discount rate in later chapters. Here, we outline one approach, the Weighted
Average Cost of Capital (WACC).
This measures the rate of return that the firm must achieve in order to satisfy all of
the people who invest in it. All of these investors incur an opportunity cost when plac-
ing their money in the hands of the firm’s managers. This is the rate of return they
could have achieved on the next best alternative investment.
Example
Wacky Ideas PLC Ltd produces novelty toys. It currently finances its business one-third
through loans and two-thirds through equity and reserves. Looking ahead it does not
expect to change this funding mix. The accountant estimates that the cost of equity is
12 per cent while the after-tax cost of borrowing is lower at 9 per cent. Given this infor-
mation we can calculate the average cost of capital for the company, duly weighted
according to the proportion of capital represented by equity and borrowings respec-
tively. For Wacky this is:
CFAI_C06.QXD 10/26/05 11:27 AM Page 162
.
Chapter 6 Project appraisal – applications 163
Source of capital Proportion Cost of capital Weighted Cost
Equity 8%
Loans 3
%
WACC 11%
9%
33%
12%
67%
The Weighted Average Cost of Capital (WACC) approach multiplies the cost of each
source of capital by the proportion of the total capital it represents. The results are
summed to provide a WACC estimate of 11 per cent in Wacky’s case. If we assume that
each new investment project receives a slice of the total capital in the same 2:1 equi-
ty:borrowing proportion, and that the project has the same level of risk as the typical
investments in the firm, we can apply a discount rate of 11 per cent in calculating the
project’s net present value. We leave the issue of determining the cost of capital for
each source of finance to a later chapter.
One of the most difficult aspects of capital budgeting is identifying and gathering the
relevant information for analysis. This chapter has examined the incremental cash
flow approach to project analysis. Specific attention has been paid to the replacement
decision and to the impact of inflation and taxation on investment decisions.
Key points
■ Include only future, incremental cash flows relating to the investment decision and
its consequences. This implies the following:
1 Only additional fixed overheads are included.
2 Depreciation (a non-cash item) is excluded.
3 Sunk (or past) costs are not relevant.
4 Interest charges are financing (not investment) cash flows and are therefore
excluded from the cash flow profile.
5 Opportunity costs (e.g. the opportunity to rent or sell premises if the proposal is
not acceptable) are included.
■ Replacement decision analysis examines the change in cash flows resulting from the
decision to replace an existing asset with a new asset.
■ Inflation can have important effects on project analysis. Two approaches are possi-
ble: (1) specify all cash flows at ‘money-of-the-day’ (i.e. including inflation) prices
and discount at the money cost of capital, or (2) specify cash flows at today’s prices
and discount at the real (i.e. net of inflation) cost of capital. We recommend the for-
mer in most cases.
■ Taxation is for most organisations a cash flow. Tax is calculated by deducting any
cash benefits from tax relief on the initial capital expenditure from tax payable on
additional cash flows. Care should be taken in estimating the timing of tax cash
flows.
■ In practice, most firms, particularly larger companies, employ a combination of
DCF and traditional appraisal methods.
■ One way of estimating the discount rate to be used is to calculate the firm’s
Weighted Average Cost of Capital.
SUMMARY
CFAI_C06.QXD 10/26/05 11:27 AM Page 163
.
164 Part II Investment decisions and strategies
Table 6.10
Allis plc cash flows for
two projects
Year Forklift trucks Conveyor system
0 (30,000) (66,000)
1 10,000 12,000
2 15,000 20,000
3 18,000 20,000
4 18,000
5 15,000
6 15,000
NPV at 10% 5,010 6,538
Further reading
Most finance texts are not particularly strong on the applied aspects of capital budgeting.
Pohlman et al. (1988) describe cash flow estimation practices in large firms. Levy and Sarnat
(1994) has useful chapters, but the US tax system is employed. For a discussion on the invest-
ment appraisal criteria under low inflation, see the Bank of England (1994). Pointon (1980)
examines the effect of capital allowances on investment, while Hodgkinson (1989) surveys tax
treatment in corporate investment appraisal.
Studies on the investment practices of UK firms are well worth reading. See, for example, Pike
(1982, 1988, 1996), McIntyre and Coulthurst (1985), Mills (1988), Pike and Wolfe (1988) and
Arnold and Hatzopoulos (2000). Useful references on the capital budgeting process are Cooper
(1975), Pinches (1982) and Neale and Holmes (1991). Tomkins (1991) and Butler et al. (1993)
explore the strategic and organisational aspects in greater depth.
replacement chain
approach
The process of comparing like-
for-like replacement decisions
for mutually exclusive projects
with different lives over a com-
mon time period
APPENDIX
THE PROBLEM OF UNEQUAL LIVES: ALLIS PLC
Comparing mutually exclusive projects – such as retaining the old asset or replacing it
with a new one – frequently involves the problem of assessing projects with different
economic lives.
Allis plc is seeking to modernise and speed up its production process. Two propos-
als have been suggested to achieve this: the purchase of a number of forklift trucks and
the acquisition of a conveyor system. The accountant has produced cost savings fig-
ures for the two proposals using a 10 per cent discount rate, shown in Table 6.10.
At first sight, the more expensive conveyor system appears more wealth-creating.
But it is not appropriate to compare projects with different lives without making some
adjustment. Two approaches can be employed for this: the replacement chain approach
and the equivalent annual annuity approach.
The replacement chain approach recognises that while, for convenience, we usually
consider only the time-horizon of the proposal, most investments form part of a
replacement chain over a much longer time-period. We therefore need to compare
mutually exclusive projects over a common period. In the example, this period is six
years, two forklift truck proposals (one following the other) being equivalent to one
conveyor system proposal. Assuming the cash flows for the original forklift trucks
also apply to their replacements in Year 4 (a pretty big assumption, given inflation,
CFAI_C06.QXD 10/26/05 11:27 AM Page 164