Year Capital cost and maintenance
Contribution Net cash flow
Discount factors
Present value
$ $ $
0 275,000 (275,000) 1.000 (275,000)
1 40,000 130,000 90,000 0.893 80,370
2 40,000 × 1.105 = 44,200 145,000 100,800 0.797 80,338 3 40,000 × 1.1052 = 48,841 155,000 106,159 0.712 75,585 4 40,000 × 1.1053 = 53,969 160,000 106,031 0.636 67,436 5 40,000 × 1.1054 = 59,636 160,000 100,364 0.567 56,906
–––––––
Net present value 85,635
(b) Discounted payback
Replace the machine Overhaul the machine
Year Net
discounted cash flow
Cumulative present value
Net discounted
cash flow
Cumulative present value
$ $ $ $
0 (450,000) (450,000) (275,000) (275,000) 1 111,625 (338,375) 80,370 (194,630) 2 114,071 (224,304) 80,338 (114,292)
3 114,710 (109,594) 75,585 (38,707)
4 113,808 4,214 67,436 28,729
5 105,810 110,024 56,906 85,635
Tutor’s top tips:
The above shows a really efficient layout for your Workings since it minimises the number of times you need to copy down information.
Option 1 – Replace the machine:
Discounted payback period = 3 years +
113,808 109,594
× 12 months = 3 years 11.6 month Option 2 – Overhaul existing machine:
Discounted payback period = 3 years + 67,436 38,707
× 12 months = 3 years 6.9 months (c)
Tutor’s top tips:
This part of the question is just about clearly stating what all of your calculations mean and why.
Both methods of investment appraisal use relevant cash flows to appraise the alternative investments and take account of the time value of money.
The discounted payback period calculates the time taken to pay back the initial investment. Using this criterion, overhauling the machine is the better option, with the slightly shorter payback period.
The net present value is the profit in present value terms. If the cost of capital is 12%, the machine should be replaced, since this option has the higher NPV.
Overall, to maximise shareholder wealth, the project with the highest NPV should be chosen which means that, provided the outcomes are not risky and 12% is the appropriate cost of capital, the machine should be replaced.
26 INVESTMENT APPRAISAL
Key answer tips
Part (a) should present an opportunity to gain some easy marks by outlining some basic areas of the syllabus. The calculations in part (b) were relatively straightforward. Make sure you don’t neglect the final part of the requirement – to identify other factors that the company should take into account when deciding of the optimal cycle. The highlighted words are key phrases that markers are looking for.
(a) Accounting rate of return (ARR) is a measure of the return on an investment where the annual profit before interest and tax is expressed as a percentage of the capital sum invested. There are a number of alternative formulae which can be used to calculate ARR, which differ in the way in which they define capital cost. The more common alternative measures available are:
average annual profit to initial capital invested, and
average annual profit to average capital invested.
The method selected will affect the resulting ARR figure, and for this reason it is important to recognise that the measure might be subject to manipulation by managers seeking approval for their investment proposals. The value for average annual profit is calculated after allowances for depreciation, as shown in the example below:
Suppose ARR is defined as:
invested
capital Initial
on) depreciati
(after profit Average
× 100%
A project costing $5 million, and yielding average profits of $1,250,000 per year after depreciation charges of $500,000 per year, would give an ARR of:
1,250,000/5,000,000 × 100% = 25%
If the depreciation charged were to be increased to $750,000 per year, for example as a result of technological changes reducing the expected life of an asset, the ARR becomes:
1,000,000/5,000,000 × 100% = 20%
The attraction of using ARR as a method of investment appraisal lies in its simplicity and the ease with which it can be used to specify the impact of a project on a company’s statement of profit or loss. The measure is easily understood and can be directly linked to the use of ROCE as a performance measure. Nonetheless, ARR has been criticised for a number of major drawbacks, perhaps the most important of which is that it uses accounting profits after depreciation rather than cash flows in order to measure return. This means that the capital cost is over‐stated in the calculation, via both the numerator and the denominator. In the numerator, the capital cost is taken into account via the depreciation charges used to derive accounting profit, but capital cost is also the denominator. The practical effect of this is to reduce the ARR and thus make projects appear less profitable. This might in turn result in some worthwhile projects being rejected. Note, however, that this problem does not arise where ARR is calculated as average annual profit as a percentage of average capital invested.
The most important criticism of ARR is that it takes no account of the time value of money. A second limitation of ARR, already suggested, is that its value is dependent on accounting policies and this can make comparison of ARR figures across different investments very difficult. A further difficulty with the use of ARR is that it does not give a clear decision rule. The ARR on any particular investment needs to be compared with the current returns being earned within a business, and so unlike NPV for example, it is impossible to say ‘all investments with an ARR of x or below will always be rejected.
The payback method of investment appraisal is used widely in industry – generally in addition to other measures. Like ARR, it is easily calculated and understood. The payback approach simply measures the time required for cumulative cash flows from an investment to sum to the original capital invested.
Example
Original investment $100,000
Cash flow profile: Years 1 – 3 $25,000 p.a.
Year’s 4 – 5 $50,000 p.a.
Year 6 $5,000
The cumulative cash flows are therefore:
End Year 1 $25,000 End Year 2 $50,000 End Year 3 $75,000 End Year 4 $125,000 End Year 5 $175,000 End Year 6 $180,000
The original sum invested is returned via cash flows some time during the course of Year 4. If cash flows are assumed to be even throughout the year, the cumulative cash flow of $100,000 will have been earned halfway through year 4. The payback period for the investment is thus 3 years and 6 months.
The payback approach to investment appraisal is useful for companies which are seeking to claw back cash from investments as quickly as possible. At the same time, the concept is intuitively appealing as many businessmen will be concerned about how long they may have to wait to get their money back, because they believe that rapid repayment reduces risks. This means that the payback approach is commonly used for initial screening of investment alternatives.
The disadvantages of the payback approach are as follows:
(i) Payback ignores the overall profitability of a project by ignoring cash flows after payback is reached. In the example above, the cash flows between 3 – 4 years and the end of the project total $80,000. To ignore such substantial cash flows would be nạve. As a consequence, the payback method is biased in favour of fast‐return investments. This can result in rejecting investments that generate cash flows more slowly in the early years, but which are overall more profitable.
(ii) As with ARR, the payback method ignores the time value of money.
(iii) The payback method, in the same way as ARR, offers no objective measure of what is the desirable return, as measured by the length of the payback period.
(b) If the laptops are replaced every year:
NPV of one year replacement cycle
Year Cash flow DF at 14% PV
$ $
0 (2,400) 1.000 (2,400.0)
1 1,200 0.877 1,052.4
–––––––
(1,347.6)
–––––––
Equivalent annual cost = PV of cost of one replacement cycle/Cumulative discount factor
= $1,347.6/0.877 = $1,536.6
NPV of two‐year replacement cycle
Year Cash flow DF at 14% PV
$ $
0 (2,400) 1.000 (2,400.0)
1 (75) 0.877 (65.8)
2 800 0.769 615.2
––––––––
(1,850.6)
––––––––
EAC = $1,850.6/1.647 = $1,123.6 NPV of three‐year replacement cycle
Year Cash flow DF at 14% PV
$ $
0 (2,400) 1.000 (2,400.0)
1 (75) 0.877 (65.8)
2 (150) 0.769 (115.4)
3 300 0.675 202.5
––––––––
(2,378.7)
––––––––
EAC = $2,378.7/2.322 = $1,024.4 Conclusion
The optimal cycle for replacement is every three years, because this has the lowest equivalent annual cost. Other factors which need to be taken into account are the non‐financial aspects of the alternative cycle choices. For example, computer technology and the associated software is changing very rapidly and this could mean that failure to replace annually would leave the salesmen unable to utilise the most up to date systems for recording, monitoring and implementing their sales. This could have an impact on the company’s competitive position. The company needs to consider also the compatibility of the software used by the laptops with that used by the in‐house computers and mainframe. If system upgrades are made within the main business that render the two computers incompatible, then rapid replacement of the laptops to regain compatibility is essential.
27 DARN CO
Key answer tips
Part (a) presents a fairly straight forward test of investment appraisal with inflation and tax.
There should be no surprises here. The examiner repeatedly comments that the material tested in part (b) is coped with less‐well than he would hope for. Knowledge of this syllabus area should not be overlooked as it can provide some relatively quick and easy marks.
(a) Calculating the net present value of the investment project using a nominal terms approach requires the discounting of nominal (money terms) cash flows using a nominal discount rate, which is given as 12%.
Year 1 2 3 4 5
$000 $000 $000 $000 $000
Sales revenue 1,308.75 2,817.26 7,907.87 5,443.58 Costs (523.50) (1,096.21) (2,869.33) (2,102.93)
––––––– –––––––– –––––––– ––––––––
Net revenue 785.25 1,721.05 5,038.54 3,340.65 Tax payable (235.58) (516.32) (1,511.56) (1,002.20) CA tax benefits 150.00 112.50 84.38 253.13 –––––––– –––––––– –––––––– –––––––– ––––––––
After‐tax cash flow 785.25 1,635.47 4,634.72 1,913.47 (749.07) Working capital (150.86) (509.06) 246.43 544.36 –––––––– –––––––– –––––––– –––––––– ––––––––
Project cash flow 634.39 1,126.41 4,881.15 2,457.83 (749.07) Discount at 12% 0.893 0.797 0.712 0.636 0.567 –––––––– –––––––– –––––––– –––––––– ––––––––
Present values 566.51 897.75 3,475.38 1,563.18 (424.72) –––––––– –––––––– –––––––– –––––––– ––––––––
$000
PV of future cash flows 6,078.10 Initial investment (2,000.00) Working capital (130.88)
––––––––
NPV 3,947.22
––––––––
The net present value is $3,947,220 and so the investment project is financially acceptable.
Workings
Year 1 2 3 4
Sales revenue ($000) 1,250 2,570 6,890 4,530 Inflated sales revenue ($000) 1,308.75 2,817.26 7,907.87 5,443.58
Year 1 2 3 4
Costs ($000) 500 1,000 2,500 1,750
Inflated costs ($000) 523.50 1,096.21 2,869.33 2,102.93
Year 1 2 3 4
Inflated sales revenue ($000) 1,308.75 2,817.26 7,907.87 5,443.58 Working capital ($000) 130.88 281.73 790.79 544.36 Incremental ($000) (130.88) (150.86) (509.06) 246.43
Year 1 2 3 4
Tax‐allowable depreciation ($000) 500.00 375.00 281.25 843.75
Tax benefit ($000) 150.00 112.50 84.38 253.13
(b)
Tutorial note:
There are more points noted below than would be needed to earn full marks, however, they do reflect the full range of reasons that could be discussed.
The directors of Darn Co can be encouraged to achieve the objective of maximising shareholder wealth through managerial reward schemes and through regulatory requirements.
Managerial reward schemes
As agents of the company’s shareholders, the directors of Darn Co may not always act in ways which increase the wealth of shareholders, a phenomenon called the agency problem. They can be encouraged to increase or maximise shareholder wealth by managerial reward schemes such as performance‐related pay and share option schemes. Through these methods, the goals of shareholders and directors may increase in congruence.
Performance‐related pay links part of the remuneration of directors to some aspect of corporate performance, such as levels of profit or earnings per share. One problem here is that it is difficult to choose an aspect of corporate performance which is not influenced by the actions of the directors, leading to the possibility of managers influencing corporate affairs for their own benefit rather than the benefit of shareholders, for example, focusing on short‐term performance while neglecting the longer term.
Share option schemes bring the goals of shareholders and directors closer together to the extent that directors become shareholders themselves. Share options allow directors to purchase shares at a specified price on a specified future date, encouraging them to make decisions which exert an upward pressure on share prices. Unfortunately, a general increase in share prices can lead to directors being rewarded for poor performance, while a general decrease in share prices can lead to managers not being rewarded for good performance. However, share option schemes can lead to a culture of performance improvement and so can bring continuing benefit to stakeholders.
Regulatory requirements
Regulatory requirements can be imposed through corporate governance codes of best practice and stock market listing regulations.
Corporate governance codes of best practice, such as the UK Corporate Governance Code, seek to reduce corporate risk and increase corporate accountability.
Responsibility is placed on directors to identify, assess and manage risk within an organisation. An independent perspective is brought to directors’ decisions by appointing non‐executive directors to create a balanced board of directors, and by appointing non‐executive directors to remuneration committees and audit committees.
Stock exchange listing regulations can place obligations on directors to manage companies in ways which support the achievement of objectives such as the maximisation of shareholder wealth. For example, listing regulations may require companies to publish regular financial reports, to provide detailed information on directorial rewards and to publish detailed reports on corporate governance and corporate social responsibility.
ACCA marking scheme
Marks
(a) Inflated sales revenue 1
Inflated costs 1
Tax liability 1
Tax‐allowable deprecation, years 1 to 3 1
Balancing allowance, year 4 1
Tax‐allowable depreciation tax benefits 1
Timing of tax liabilities and benefits 1
Incremental working capital investment 1
Recovery of working capital 1
Market research omitted as sunk cost 1
Calculation of nominal terms NPV 1
Comment on financial acceptability 1
––––
Maximum 12
––––
(b) Managerial reward schemes 1–2
Regulatory requirements 1–2
Other relevant discussion 1–2
––––
Maximum 3
––––
Total 15
––––
28 CHARM CO
Key answer tips
In part (a) the NPV calculation is reasonably straightforward provided you read the information carefully.
In part (b) ensure you compare with NPV with other appraisal methods rather than just stating the benefits of NPV. The highlighted words are key phrases that markers are looking for.
(a) Calculation of NPV of ‘Fingo’ investment project
Year 1 2 3 4
$000 $000 $000 $000
Sales revenue 3,750 1,680 1,380 1,320
Direct materials (810) (378) (324) (324)
Variable production (900) (420) (360) (360)
Advertising (650) (100)
–––––– –––––– –––––– ––––––
Taxable cash flow 1,390 782 696 636
Taxation (417) (235) (209) (191)
–––––– –––––– –––––– ––––––
Net cash flow 973 547 487 445
Discount at 10% 0.909 0.826 0.751 0.683
–––––– –––––– –––––– ––––––
Present values 885 452 366 304
$000
Present value of future benefits
2,007
Initial investment 800.0
–––––
Net present value 1,207
–––––
Comment
The net present value of $1,207k is positive and the investment can therefore be recommended on financial grounds.
(b)
Tutorial note:
There are more points noted below than would be needed to earn full marks, however, they do reflect the full range of reasons that could be discussed.
There are many reasons that could be discussed in support of the view that net present value (NPV) is superior to other investment appraisal methods.
NPV considers cash flows
This is the reason why NPV is preferred to return on capital employed (ROCE), since ROCE compares average annual accounting profit with initial or average capital invested. Financial management always prefers cash flows to accounting profit, since profit is seen as being open to manipulation. Furthermore, only cash flows are capable of adding to the wealth of shareholders in the form of increased dividends.
Both internal rate of return (IRR) and Payback also consider cash flows.
NPV considers the whole of an investment project
In this respect NPV is superior to Payback, which measures the time it takes for an investment project to repay the initial capital invested. Payback therefore considers cash flows within the payback period and ignores cash flows outside of the payback period. If Payback is used as an investment appraisal method, projects yielding high returns outside of the payback period will be wrongly rejected. In practice, however, it is unlikely that Payback will be used alone as an investment appraisal method.
NPV considers the time value of money
NPV and IRR are both discounted cash flow (DCF) models which consider the time value of money, whereas ROCE and Payback do not. Although Discounted Payback can be used to appraise investment projects, this method still suffers from the criticism that it ignores cash flows outside of the payback period. Considering the time value of money is essential, since otherwise cash flows occurring at different times cannot be distinguished from each other in terms of value from the perspective of the present time.
NPV is an absolute measure of return
NPV is seen as being superior to investment appraisal methods that offer a relative measure of return, such as IRR and ROCE, and which therefore fail to reflect the amount of the initial investment or the absolute increase in corporate value.
Defenders of IRR and ROCE respond that these methods offer a measure of return that is understandable by managers and which can be intuitively compared with economic variables such as interest rates and inflation rates.
NPV links directly to the objective of maximising shareholders’ wealth
The NPV of an investment project represents the change in total market value that will occur if the investment project is accepted. The increase in wealth of each shareholder can therefore be measured by the increase in the value of their shareholding as a percentage of the overall issued share capital of the company.
Other investment appraisal methods do not have this direct link with the primary financial management objective of the company.
NPV always offers the correct investment advice
With respect to mutually exclusive projects, NPV always indicates which project should be selected in order to achieve the maximum increase on corporate value.
This is not true of IRR, which offers incorrect advice at discount rates which are less than the internal rate of return of the incremental cash flows. This problem can be overcome by using the incremental yield approach.
NPV can accommodate changes in the discount rate
While NPV can easily accommodate changes in the discount rate, IRR simply ignores them, since the calculated internal rate of return is independent of the cost of capital in all time periods.
NPV has a sensible re‐investment assumption
NPV assumes that intermediate cash flows are re‐invested at the company’s cost of capital, which is a reasonable assumption as the company’s cost of capital represents the average opportunity cost of the company’s providers of finance, i.e. it represents a rate of return which exists in the real world. By contrast, IRR assumes that intermediate cash flows are reinvested at the internal rate of return, which is not an investment rate available in practice,
NPV can accommodate non‐conventional cash flows
Non‐conventional cash flows exist when negative cash flows arise during the life of the project. For each change in sign there is potentially one additional internal rate of return. With non‐conventional cash flows, therefore, IRR can suffer from the technical problem of giving multiple internal rates of return.
29 PLAY CO
Key answer tips
This is a fairly typical NPV with tax and inflation question. The key to picking up the easy marks in the calculative part (a) is to take a methodical approach that you show clearly in a series of Workings.
Part (b) is discursive and requires you to demonstrate your knowledge in the context of this scenario. Try to think broadly and ensure you go into sufficient depth in your answer to score highly.
The highlighted words in the written sections are key phrases that markers are looking for.
(a)
Year 1 2 3 4 5
$000 $000 $000 $000 $000
Costs saved (W1) 350 385 455 560 Variable costs (W2) (82) (94) (113) (144) Maintenance costs (42) (44) (46) (49)
–––––– –––––– –––––– ––––––
Taxable cash flow 226 247 296 367
Taxation (68) (74) (89) (110)
CA tax benefits (W3) 30 23 17 36
Scrap value 50
–––––– –––––– –––––– –––––– ––––––
After‐tax cash flows 226 209 245 345 (74) Discount at 15% 0.870 0.756 0.658 0.572 0.497
–––––– –––––– –––––– –––––– ––––––
Present values 197 158 161 197 (37)
–––––– –––––– –––––– –––––– ––––––
$000
Present value of benefits 676
Initial investment (400)
Early termination fine (150)
––––
Net present value 126
––––
The net present value is positive and so the investment is financially acceptable.
Workings
(W1) Costs saved
Year 1 2 3 4
Demand (tonnes/yr) 100,000 110,000 130,000 160,000
Cost ($/tonne) 3.50 3.50 3.50 3.50
––––––– ––––––– ––––––– –––––––
Contribution ($/yr) 350,000 385,000 455,000 560,000
––––––– ––––––– ––––––– –––––––
(W2) Variable costs incurred
Year 1 2 3 4
Demand (tonnes/yr) 100,000 110,000 130,000 160,000 Cost ($/tonne) –
3% inflation
0.82 0.85 0.87 0.90
––––––– ––––––– ––––––– –––––––
Contribution ($/yr) 82,000 93,500 113,100 144,000 ––––––– ––––––– ––––––– –––––––
(W3) Tax‐allowable depreciation tax benefits Year Tax‐allowable
depreciation ($)
Tax benefit ($)
1 100,000 (400,000 × 0.25) 30,000 (0.3 × 100,000) 2 75,000 (300,000 × 0.25) 22,500 (0.3 × 75,000) 3 56,250 (225,000 × 0.25) 16,875 (0.3 × 56,250)
–––––––
231,250
50,000 (scrap value)
–––––––
281,250
4 118,750 (by difference) 35,625 (0.3 × 118,750)
–––––––
400,000
–––––––
(b)
Tutor’s top tips:
Start by identifying the range of stakeholders affected before considering the impact this proposal will have on them. Make sure you include the details given in the scenario to ensure you give a tailored answer.
The project should affect the different stakeholders of Play Co as follows:
Stakeholder Impact
Shareholders Wealth would increase by the positive NPV of the project – i.e. $126,000
Society More tyres will be recycled, protecting the environment Customers Customers may perceive the quality of the product to
increase because it is more environmentally friendly
Suppliers Existing suppliers of particles will lose business (although they will receive the $150,000 early termination fine) Potential
investors
Play Co will become more attractive to “green chip”
investors, possibly making future financing easier.
30 DUO CO Walk in the footsteps of a top tutor
Key answer tips
Given the generic nature of part (b), it would be sensible to tackle this part of the requirement first. You can then follow on with the calculations in part (a).
The key learning point from this question is the importance of being efficient when reading the scenario to cut down on the amount of time wasted trying to locate information. By forming an expectation of what you’ll be given and considering the significance of information that you read, you can easily complete the question in the time allocated. The highlighted words are key phrases that markers are looking for.