Revision 2 – Investment Appraisal

Topics List1. Investment Appraisal Methods Exam Question

Referencea. Payback period

Computation & comment Advantages and disadvantages Discounted payback period Jun 09

Jun 11Q2bQ1c

b. Accounting rate of return (ARR) Computation & comment Pilot

Jun 09Dec 12

Q4bQ2bQ1b

Advantages and disadvantagesc. Net present value (NPV)

Computation & comment Jun 09Dec 10

Q2bQ1a,b

Advantages and disadvantagesd. Internal rate of return (IRR)

Computation & comment Dec 07Jun 08Jun 09

Q2bQ4bQ2b

Dec 11 Q1b Advantages and disadvantages Pilot

Jun 10Q4cQ3c

2. Stages in Capital Investment Projects Jun 09 Q2a

3. Determination of relevant and non-relevant cash flows

4. Allowing for Tax, Inflation and Working Capitala. Inflation

Specific inflation and general inflation PilotJun 08Jun 09Dec 10Jun 11Jun 12

Q4aQ4aQ2bQ1aQ1aQ1a

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Dec 12Jun 13Dec 13

Q1aQ1aQ1a

Real and money interest rate – Fisher’s equation PilotJun 10Jun 13Dec 13

Q4aQ3bQ1bQ1b

b. Taxation PilotDec 07Jun 08Dec 08Jun 10Dec 10Jun 11

Q4aQ2aQ4aQ3bQ3bQ1aQ1a

Dec 11Jun 12Dec 12Jun 13Dec 13

Q1aQ1aQ1aQ1aQ1a,b

c. Working capital Jun 08Dec 08Jun 11

Q4aQ3bQ1a

Dec 11Jun 13Dec 13

Q1aQ1aQ1a,b

5. Project Appraisal and Riska. Risk and uncertainty Dec 07

Jun 11Q2cQ1c

b. Probability analysis Dec 07Jun 11Jun 12

Q2cQ1cQ1c

c. Sensitivity analysis Dec 07Jun 11

Q2cQ1c

Dec 11Jun 12

Q1cQ1c

d. Simulatione. Risk-adjusted discount rate Jun 10 Q3c(iii)

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Jun 11 Q1c6. Asset Investment Decisions

a. Lease or buy Numerical analysis Dec 09

Dec 13Q1a,bQ4a

Finance lease meaning Operating lease meaning Attractions of finance lease Dec 13 Q4b Attractions of operating lease Dec 13 Q4b

b. Asset acquisition by NPV PilotDec 07Jun 08Dec 08

Q4aQ2aQ4aQ3b

c. Replacement cycles Dec 09Jun 10Jun 12

Q1bQ3cQ1b

d. Capital rationing Hard (external) and soft (internal) capital rationing Dec 11 Q1d Single period capital rationing Dec 09 Q1d

Dec 11 Q1d Multi-period capital rationing

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1. Investment Appraisal Methods

1.1 Payback period

1.1.1 Time it takes the project to payback its initial investment.1.1.2 When is useful?

seeking to claw back cash from investments as quickly as possible commonly used for initial screening of investment alternatives

1.1.3 A long payback period is considered risky because it relies on cash flows that are in the distant future.

1.1.4 Decision rule: only select projects which payback within the specified time period choose between options on the basis of the fastest payback provides a measure of liquidity

1.1.5 General approach:Year Cash flows ($) Cumulative cash flows ($)

0 (100,000) (100,000)1 20,000 (80,000)2 30,000 (50,000)3 40,000 (10,000)4 30,000 20,0005 40,000

Payback period = 3 years + 10,000/30,000= 3.33 years or 3 years 4 months

1.1.6 Discounted payback period:Year Cash flow

($000)Discounted

Cash flow @10%($000)

Cumulative cash flow

($000)0 (2,000) (2,000) (2,000)1 600 545 (1,455)2 500 413 (1,042)3 600 451 (591)4 600 410 (181)5 300 186 56 200 113 118

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The payback period is about 5 years.1.1.7 Advantages and disadvantages of payback period

Advantages Disadvantages It is simple It is useful in certain situations:

Rapidly changing technology Improving investment

conditions It favours quick return:

Helps company growth Minimizes risk Maximizes liquidity

It uses cash flows, not accounting profit.

It ignores overall profitability after the payback period

It ignores time value of money It is subjective – no definitive

investment signal

1.2 Accounting Rate of Return (ARR) (Pilot, Jun 09, Dec 12)

1.2.1 Also known as ROCE or ROI.1.2.2 Decision rule:

ARR > target return or hurdle rate, accept the project Take the project with the highest ARR

1.2.3 Calculation of ARR – three version Annual basis –

ARR =Profit for the year

× 100%Asset book value at start of year

Then, take average of each year’s ARR to find the average ARR.

Total investment basis –

ARR =Average annual profit

× 100%Initial capital invested

Average investment basis –

ARR =Average annual profit

× 100%Average capital invested

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Average capital invested =Initial investment + Scrap value

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1.2.4 Advantages and disadvantages of ARR

Advantages Disadvantages It is a quick and simple

calculation It involves the familiar concept of

a percentage return It looks at the entire project life

It is based on accounting profit and not cash flows.

It depends on accounting policies and this can make comparison of ARR being difficult.

It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment

Like the payback method, it ignores the time value of money.

1.3 Net Present Value (NPV)

1.3.1 PV of cash inflows compare with the PV of cash outflows to obtain a NPV.1.3.2 The discount rate equals its cost of capital or WACC.1.3.3 Decision rule:

NPV > 0, the project is financially viable, i.e. accepted. NPV = 0, the project breaks even. NPV < 0, the project is not financially viable, i.e. rejected.

1.3.4 If the company has two or more mutually exclusive projects under consideration it should choose the one with the highest NPV.

1.3.5 The NPV gives the impact of the project on shareholder wealth. (Jun 08) All acceptable investment project should have positive NPV The market value of the company, theoretically at least, increases by the

amount of the NPV The share price of the company should theoretically increase as well Objective of maximizing the wealth of shareholders is usually substituted

by the objective of maximizing the share price of a company

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1.3.6 Advantages and disadvantages of NPV

Advantages Disadvantages Considers the time value of money Is an absolute measure of return,

i.e. absolute increase in corporate value

Is based on cash flows not profits Considers the whole life of the

project Should lead to maximization of

shareholder wealth Can accommodate changes in

discount rate Has a sensible re-investment

assumption Can accommodate non-

conventional cash flows

It is difficult to explain to managers and relatively complex

It requires knowledge of the cost of capital

1.3.7 Why NPV is superior to other methods? NPV considers cash flows NPV considers the whole life of an investment project NPV considers the time value of money NPV is an absolute measure of return NPV directly links to the objective of maximizing shareholders’ wealth NPV offers the correct investment advice NPV can accommodate changes in the discount rate NPV has a sensible re-investment assumption NPV can accommodate non-conventional cash flows

1.4 Internal Rate of Return (IRR) (Dec 07, Jun 08, Jun 09, Dec 11)

1.4.1 IRR is defined as the discount rate at which the NPV equals zero. In other words, the IRR represents the breakeven discount rate for the investment.

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1.4.2 Decision rule: IRR > cost of capital, project accepts The higher IRR is the better

1.4.3 Steps in calculating the IRR using linear interpolation:1. Calculate two NPV at two different discount rates. One must be positive and

another one must be negative.2. Using the following formula to find the IRR

IRR = L +

where:L = Lower rate of interestH = Higher rate of interestNL = NPV at lower rate of interestNH = NPV at higher rate of interest

1.4.4 Advantages and disadvantages of IRR (Pilot, Jun 10)

Advantages Disadvantages Considers the time value of money Is a percentage and therefore

easily understood Uses cash flows not profits Considers the whole life of the

project Means a firm selecting projects

where the IRR exceeds the cost of capital should increase shareholders’ wealth.

It is not a measure of absolute increase in company value.

Interpolation only provides an estimate and an accurate estimate requires the use of a spreadsheet program

It is fairly complicated to calculate

Non-conventional cash flows may give rise to multiple IRRs

Can offer conflicting advice between IRR and NPV in the evaluation of mutually exclusive projects

Assume cash inflows being reinvested at the IRR rate, this is

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unrealistic when IRR is high.

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2. Stages in the Capital Investment Projects (Jun 09)

2.1 Stages can be summarized as follows:

Stages ExplanationIdentify investment opportunities

Arise from analysis of strategic choice, business environment, R&D or legal environment, etc.

Key requirement is to achieve the organizational objectives.

Screen investment proposals

Select those proposals with best strategic fit and the most appropriate use of economic resources.

Analyse and evaluate investment proposals

Analyse and evaluate which proposal(s) offer the most attractive opportunities to achieve company objectives, e.g. increase shareholder wealth.

Investment appraisal plays a key role here, e.g. choose highest NPV among different proposals.

Approve investment proposals

Pass to relevant level of authority for approval. Large proposals approve by board of directors,

smaller proposals approve by divisional level.Implementation Responsibility for the project is assigned to a project

manager or other responsible person. Resources will be available and specific target should

be set.Monitoring Progress must be monitored to check whether there

are any big variances and unforeseen events.Post-completion audit To facilitate organizational learning and to improve

future investment decisions.

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3. Determination of the Cash Flows

3.1 Relevant cash flows

3.1.1 The following principles should be applied when identifying costs that are relevant to a period.

Relevant costs ExplanationFuture costs Future cost arises as a direct consequence of a

decision. Sunk costs should not be included because it is past

and so irrelevant to any decision.Cash flows Future costs which are in the form of cash should be

included. So depreciation should be ignored because it is not

cash spending.Incremental costs Increase in costs results from making a particular

decision.Opportunity costs It is the value of a benefit foregone as a result of

choosing a particular course of action.

3.2 Non-relevant costs

3.2.1 Other non-relevant costs: Committed costs – they are future cash flow but will be incurred anyway,

regardless of what decision will be taken. Interest costs – they have already been included in the discount rate, if

counted, it will be double counted.

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4. Allowing for Tax, Inflation and Working Capital

4.1 Inflation(Pilot, Jun 08, Jun 09, Dec 10, Jun 11, Jun 12, Dec 12, Jun 13, Dec 13)

4.1.1 Inflation has two impacts on NPV: Specific inflation – cash flow rises by the rate of inflation General inflation – cost of capital (or discount rate) rises by the rate of

inflation.

4.1.2 Real and money (nominal) interest rate It has the following relationship between real interest rate and nominal interest

rate under Fisher’s equation. (Pilot, Jun 10, Jun 13, Dec 13)

(1 + i) = (1 + r) (1 + h)

Where h = inflation rater = real interest ratei = nominal interest rate

4.1.3 Nominal approach in calculating NPV (Jun 13, Dec 13) This approach discounts nominal cash flows with a nominal cost of capital. Nominal cash flows are found by inflating forecast values from current price

estimates, e.g. using specific inflation.4.1.4 Real terms approach in calculating NPV (Jun 13, Dec 13)

This approach discounts real cash flows with a real cost of capital. Real cash flows are found by deflating nominal cash flows by the general rate

of inflation. The real cost of capital is found by deflating the nominal cost of capital by the

general rate of inflation, using the Fisher equation.

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4.2 Taxation(Pilot, Jun 07, Dec 07, Jun 08, Dec 08, Jun 10, Dec 10, Jun 11, Dec 11, Jun 12,Dec 12, Jun 13, Dec 13)

4.2.1 Taxation has the following two effects on cash flow:

Effects ExplanationTax on profits Calculate the taxable profits (before capital

allowances) and calculate tax at the rate given. The effect of taxation will not necessarily occur in

the same year, often one year in arrears in the examination.

Tax benefits from WDAs

Normally 25% writing-down allowances on plant and machinery (can be straight-line)

Remember the balancing allowance or balancing charge in the final year.

4.3 Working capital (Jun 08, Dec 08, Jun 11, Dec 11, Jun 13, Dec 13)

4.3.1 New project requires an additional investment in working capital.4.3.2 The treatment of working capital is as follows:

Initial investment is a cost at the start of the project, i.e. cash outflow. If increasing during the project, the increase is a relevant cash outflow. Working capital is released at the end of the project and treated as cash

inflow.

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4.4 General layout of cash flow preparation

4.4.1 The general layout can be shown as follows:

Year 0 1 2 3 4$000 $000 $000 $000 $000

Sales X X X

Costs (X) (X) (X)

Operating cash flows X X X

Taxation (X) (X) (X)

Tax benefit of CAs X X X

Capital expenditure and scrap value (X) X

Working capital changes (X) (X) (X) (X) X

Net cash flows (X) X X X X

Discount factor X X X X X

Present value (X) X X X X

Question 10The following draft appraisal of a proposed investment project has been prepared for the finance director of OKM Co by a trainee accountant. The project is consistent with the current business operations of OKM Co.Year 1 2 3 4 5Sales (units/yr) 250,000 400,000 500,000 250,000

$000 $000 $000 $000 $000Contribution 1,330 2,128 2,660 1,330Fixed costs (530) (562) (596) (631)Depreciation (438) (438) (437) (437)Interest payments (200) (200) (200) (200)Taxable profit 162 928 1,427 62Taxation (49) (278) (428) (19)Profit after tax 162 879 1,149 (366) (19)Scrap value 250After-tax cash flows 162 879 1,149 (116) (19)Discount at 10% 0.909 0.826 0.751 0.683 0.621Present values 147 726 863 (79) (12)

Net present value = 1,645,000 – 2,000,000 = ($355,000) so reject the project.

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The following information was included with the draft investment appraisal:

1. The initial investment is $2 million2. Selling price: $12/unit (current price terms), selling price inflation is 5% per year3. Variable cost: $7/unit (current price terms), variable cost inflation is 4% per year4. Fixed overhead costs: $500,000/year (current price terms), fixed cost inflation is 6%

per year5. $200,000/year of the fixed costs are development costs that have already been incurred

and are being recovered by an annual charge to the project6. Investment financing is by a $2 million loan at a fixed interest rate of 10% per year7. OKM Co can claim 25% reducing balance capital allowances on this investment and

pays taxation one year in arrears at a rate of 30% per year8. The scrap value of machinery at the end of the four-year project is $250,0009. The real weighted average cost of capital of OKM Co is 7% per year10. The general rate of inflation is expected to be 4.7% per year

Required:

(a) Identify and comment on any errors in the investment appraisal prepared by the trainee accountant. (5 marks)

(b) Prepare a revised calculation of the net present value of the proposed investment project and comment on the project’s acceptability. (12 marks)

(c) Discuss the problems faced when undertaking investment appraisal in the following areas and comment on how these problems can be overcome:(i) assets with replacement cycles of different lengths;(ii) an investment project has several internal rates of return;(iii) the business risk of an investment project is significantly different from the

business risk of current operations. (8 marks)(25 marks)

(ACCA F9 Financial Management June 2010 Q3)

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5. Project Appraisal and Risk

5.1 Risk and uncertainty (Dec 07, Jun 11, Jun 12)

5.1.1 Since future cash flows cannot be predicted with certainty, managers must consider how much confidence can be placed in the results of the investment appraisal process. They must therefore be concerned with the risk and uncertainty of a project.

5.1.2 Risk refers to the situation where probabilities can be assigned to a range of expected outcomes, so it can be quantified.

5.1.3 Uncertainty refers to the situation where probabilities cannot be assigned to expected outcomes, so it is unquantifiable. It can only be described.

5.1.4 If risk and uncertainty were not considered, managers might make mistake of placing too much confidence in the results of investment appraisal, or they may fail to monitor investment projects in order to ensure that expected results are in fact being achieved.

5.1.5 Assessment of project risk can also indicate projects that might be rejected as being too risky compared with existing business operations, or projects that might be worthy of reconsideration if ways of reducing project risk could be found in order to make project outcomes more acceptable.

5.2 Probability analysis (Dec 07, Jun 11, Jun 12)

5.2.1 It refers to the assessment of the separate probabilities of a number of specified outcomes of an investment project.

5.2.2 The NPV from combinations of future economic conditions could be assessed and linked to the joint probabilities of those combinations. The expected NPV could be calculated.

5.2.3 The expected value (EV) is the weighted average of all possible outcomes, with the weightings based on the probability estimates.EV = Where: p = the probability of an outcome

x = the value of an outcome5.2.4 Other useful information that could be provided by the probability analysis includes

the worst outcome, the best outcome and the most likely outcome. Managers could then make a decision on the investment that took account more explicitly of its risk profile.

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5.2.5 Strengths and weaknesses:

Strenghts Weaknesses(a) The technique recognises that there are

several possible outcomes and is, therefore, more sophisticated than single value forecasts.

(b) Enables the probability of the different outcomes to be quantified.

(c) Leads directly to a simple optimising decision rule.

(d) Calculations are relatively simple.

(a) By asking for a series of forecasts the whole forecasting procedure is complicated. Inaccurate forecasting is already a major weakness in project evaluation. The probabilities used are also usually very subjective.

(b) The EV is merely a weighted average of the probability distribution, indicating the average payoff if the project is repeated many times.

(c) The EV gives no indication of the dispersion of possible outcomes about the EV. The more widely spread out the possible results are, the more risky the investment is usually seen to be. The EV ignores this aspect of the probability distribution.

(d) The EV technique also ignores the investor’s attitude to risk. Some investors are more likely to take risks than others.

5.3 Sensitivity analysis (Dec 07, Jun 11, Dec 11, Jun 12)

5.3.1 Sensitivity analysis assesses how the NPV of an investment project is affected by changes in project variables. The purpose is to identify the key or critical variables so that management can concern more.

5.3.2 The change in one variable required to make the NPV to be zero.5.3.3 Or alternatively, the change in NPV arising from a fixed change in the given project

variable.5.3.4 However, sensitivity analysis does not assess the probability of changes in project

variables. Therefore, it cannot be described as a way of incorporating risk into investment appraisal.

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5.3.5 A simple approach to deciding which variables the NPV is particularly sensitive to is to calculate the sensitivity of each variable:

Sensitivity =NPV

%PV of project variable

5.3.6 The lower the percentage, the more sensitive is NPV to that project variable as the variable would need to change by a smaller amount to make the project non-viable.

5.3.7 Strengths and weaknesses

Strengths Weaknesses(a) No complicated theory to understand.(b) Information will be presented to

management in a form which facilitates subjective judgement to decide the likelihood of the various possible outcomes considered.

(c) Identifies areas which are crucial to the success of the project. If the project is chosen, those areas can be carefully monitored.

(d) Indicates just how critical are some of the forecasts which are considered to be uncertain.

(a) It assumes that changes to variables can be made independently. However, management is more interest in the combination of the effects of changes in two or more key variables.

(b) Looking at factors in isolation is unrealistic since they are often interdependent.

(b) It only identifies how far a variable needs to change. It does not look at the probability of such a change.

(c) It is not an optimising technique. It provides information on the basis of which decisions can be made. It does not point directly to the correct decision.

5.4 Adjusted payback (Jun 09, Jun 11)

5.4.1 Payback can be adjusted for risk: Higher risk project should require shortening the payback period. Putting the focus on cash flows that are more certain (less risky) because they

are nearer in time.5.4.2 Discounted payback:

Adjusted for risk by discounting future cash flows with a risk-adjusted

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discount rate. The normal payback period target can be applied to the discounted cash

flows, which will have decreased in value due to discounting. The overall effect is similar to reducing the payback period with

undiscounted cash flows.5.4.3 Strengths and weaknesses

Strengths Weaknesses(a) It takes into account the time value of

money.(b) It produces a longer payback period

than payback approach, and takes into account more of the project’s cash flows.

(c) It has a clear accept-or-reject criterion.

(a) Cash flows which occur after the payback period are ignored.

(b) One way of dealing with risk is shorten the payback period required, it cannot recommended as a method of adjusting risk.

5.5 Simulation

5.5.1 An analysis of how changes in more than one variable (e.g. market share and sales price) may affect the NPV of a project.

5.5.2 Strengths and weaknesses:

Strengths Weaknesses(a) It includes all possible outcomes in

the decision-making process.(b) It is a relatively easily understood

technique.(c) It has a wide variety of applications

(inventory control, component replacement, etc.)

(a) Models can become extremely complex and the time and costs involved in their construction can be more than is gained from the improved decisions.

(b) Probability distributions may be difficult to formulate.

Question 11Umunat plc is considering investing $50,000 in a new machine with an expected life of five years. The machine will have no scrap value at the end of five years. It is expected that 20,000 units will be sold each year at a selling price of $3·00 per unit. Variable production costs are expected to be $1·65 per unit, while incremental fixed costs, mainly the wages of a

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maintenance engineer, are expected to be $10,000 per year. Umunat plc uses a discount rate of 12% for investment appraisal purposes and expects investment projects to recover their initial investment within two years.

Required:

(a) Explain why risk and uncertainty should be considered in the investment appraisal process. (5 marks)

(b) Calculate and comment on the payback period of the project. (4 marks)(c) Evaluate the sensitivity of the project’s net present value to a change in the following

project variables:(i) sales volume;(ii) sales price;(iii) variable cost;and discuss the use of sensitivity analysis as a way of evaluating project risk.

(10 marks)(d) Upon further investigation it is found that there is a significant chance that the

expected sales volume of 20,000 units per year will not be achieved. The sales manager of Umunat plc suggests that sales volumes could depend on expected economic states that could be assigned the following probabilities:

Economic state Poor Normal GoodProbability 0.3 0.6 0.1Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project. (6 marks)(25 marks)

(ACCA 2.4 Financial Management and Control December 2004 Q5)

Question 12 – ENPVCarcross Co engages in off-shore drilling operations for oil deposits. The company has recently spent $5 million in surveying a region in the Gulf of Mexico and has found the existence of significant oil deposits there. The sea bed in the region, however, has a rock formation that may make access to the oil deposits difficult. The total oil deposits in the region have been estimated at 30 million barrels but the amount extracted will vary according to the conditions faced when drilling operations commence. The company’s senior geologist believes that three possible outcomes are likely from drilling operations and

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has made the following estimates concerning the percentage of total oil deposits that will be extracted under each outcome:

Outcome Percentage of total oil deposits extracted

Probability

1 100% 0.12 40% 0.53 25% 0.4

If the company decides to go ahead with the drilling operation, an immediate payment of $40 million for drilling rights, along with annual payments of $5 for each barrel of oil extracted must be made to the Mexican government. Equipment costing $125 million must be acquired immediately but drilling will not commence until the second year of the four-year licence period. It is expected that, whichever of the above outcomes arise, the oil will be extracted evenly over the drilling period. Annual operating costs (excluding any payments to the Mexican government) will be $120 million in the first year and $160 million for each of the remaining three years of the licence. At the end of the licence period, the equipment will be sold at a price that is equal to its original cost less $8 for each barrel of oil that has been extracted.

Oil prices over the period of the drilling licence are estimated to be as follows:

Year Price per barrel1 $702 $853 $754 $100

The company has a cost of capital of 14%.Workings should be in $millions and to one decimal place.

Required:

(a) Calculate the expected net present value (ENPV) of the investment proposal.(10 marks)

(b) Calculate the net present value of the worst possible outcome. (5 marks)

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(c) Comment on the results of your calculations in (a) and (b) above. (2 marks)(d) Discuss the weaknesses of the ENPV approach for decision-making purposes.

(3 marks)(20 marks)

6. Asset Investment Decisions

6.1 Lease or buy (Dec 09, Dec 13)

6.1.1 DCF techniques can also be used to assess whether to finance an investment with a lease or a bank loan.

6.1.2 Numerical analysis The benefits of leasing vs purchasing (with a loan) can be assessed by an

NPV approach:Step 1: the cost of leasing (payments, lost capital allowances and lost scrap revenue)Step 2: the benefits of leasing (savings on loan repayments = PV of loan = initial outlay)Step 3: discounting at the after tax cost of debtStep 4: calculate the NPV – if positive it means that the lease is cheaper than the after tax cost of a loan.

Alternative method – to evaluate the NPV of the cost of the loan and the NPV of the cost of the lease separately, and to choose the cheapest option.

6.1.3 Finance lease: Transfer substantially all of the risks and rewards of ownership to lessee. Lessee can use the asset for all or most of its useful economic life. It cannot be cancelled or with severe financial penalties even when

cancelled. Therefore, it is a kind of medium- to long-term source of debt finance.

Leased asset must be capitalized together with the amount of obligations for the lease payments.

6.1.4 Operating lease: It’s renal agreement and the lease period is shorter than the asset’s useful

economic life. Maintenance and similar costs are borne by the lessor. Cancelled without penalty at short notice. It can avoid the obsolescence

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problem, so suitable for high-tech assts. No need to be capitalized and no liabilities need to be recognized.

6.1.5 Attractions of finance lease for lessee: (Dec 13) Not enough cash and also difficult to obtain bank loan. Interest may be cheaper than a bank loan. Having tax relief such as the interest expenses and depreciation

allowance (but refer to the examination question, it may not have).6.1.6 Attractions of operating lease for lessee: (Dec 13)

No effect on assets and liabilities, so no increase in its gearing ratio. Can have the up-to-date assets at all time because the lessee can replace

with no cost. Higher flexibility with cancellation at short notice Suitable for small companies who may find it difficult to raise debt Cheaper than borrow to buy Off-balance sheet financing

6.1.7 Attractions of operating lease for lessor: (Dec 13) Leased asset can be recovered if the lessee default on lease rentals Lessor can take advantage of bulk buying Lessor can have access to lower cost finance by virtue of being a much larger

company. Enjoy tax benefits such as depreciation allowance and other allowable

expenses.

Question 13 – Lease or buy and capital rationingLeaminger Inc has decided it must replace its major turbine machine on 31 December 2008. The machine is essential to the operations of the company. The company is, however, considering whether to purchase the machine outright or to use lease financing.

Purchasing the machine outrightThe machine is expected to cost $360,000 if it is purchased outright, payable on 31 December 2008. After four years the company expects new technology to make the machine redundant and it will be sold on 31 December 2012 generating proceeds of $20,000. Capital allowances for tax purposes are available on the cost of the machine at the rate of 25% per annum reducing balance. A full year’s allowance is given in the year of acquisition but no writing down allowance is available in the year of disposal. The difference between the proceeds and the tax written down value in the year of disposal is allowable or chargeable for tax as appropriate.

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LeasingThe company has approached its bank with a view to arranging a lease to finance the machine acquisition. The bank has offered two options with respect to leasing which are as follows:

Finance lease Operating leaseContract length (years) 4 1Annual rental $135,000 $140,000First rent payable 31 December 2009 31 December 2008

GeneralFor both the purchasing and the finance lease option, maintenance costs of $15,000 per year are payable at the end of each year. All these rentals (for both finance and operating options) can be assumed to be allowable for tax purposes in full in the year of payment. Assume that tax is payable one year after the end of the accounting year in which the transaction occurs. For the operating lease only, contracts are renewable annually at the discretion of either party. Leaminger Inc has adequate taxable profits to relieve all its costs. The rate of corporation tax can be assumed to be 30%. The company’s accounting year-end is 31 December. The company’s annual after tax cost of capital is 10%.

Required:

(a) Calculate the net present value at 31 December 2008, using the after tax cost of capital, for:(i) purchasing the machine outright(ii) using the finance lease to acquire the machine(iii) using the operating lease to acquire the machine.Recommend the optimal method. (12 marks)

(b) Assume now that the company is facing capital rationing up until 30 December 2009 when it expects to make a share issue. During this time the most marginal investment project, which is perfectly divisible, requires an outlay of $500,000 and would generate a net present value of $100,000. Investment in the turbine would reduce funds available for this project. Investments cannot be delayed.

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Calculate the revised net present values of the three options for the turbine given capital rationing. Advise whether your recommendation in (a) would change.

(5 marks)(c) As their business advisor, prepare a report for the directors of Leaminger Inc that

assesses the issues that need to be considered in acquiring the turbine with respect to capital rationing. (8 marks)

(Total 25 marks)(Adapted ACCA Paper 2.4 Financial Management and Control December 2002 Q4)

6.2 Asset replacement

6.2.1 NPV can be applied to situations of assets replacement.6.2.2 Compare the purchase cost with the cost savings or benefits,

Cost savings or benefits > purchase cost, replace the old one.

6.3 Replacement cycles (Dec 09, Jun 10, Jun 12)

6.3.1 How frequently should an asset be replaced? The equivalent annual cost (EAC) or annual equivalent annuity (AEA) can be used for evaluation.

EAC =NPV of costs

Annuity factor for the number of years in the cycle

The best decision is to choose the option with the lowest EAC.

6.3.2 Is it worth paying more for an asset that has a longer expected life? The equivalent annual benefit (EAB) can be applied.

EAB =NPV of project

Annuity factor for the life of project

The best decision is to choose the option with the highest equivalent annual benefit.

Question 14 – Replacement cycle and limitations of NPVBread Products Ltd is considering the replacement policy for its industrial size ovens which

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are used as part of a production line that bakes bread. Given its heavy usage each oven has to be replaced frequently. The choice is between replacing every two years or every three years. Only one type of oven is used, each of which costs $24,500. Maintenance costs and resale values are as follows:

Year Maintenance per annum Resale value$ $

1 5002 800 15,6003 1,500 11,200

Original cost, maintenance costs and resale values are expressed in current prices. That is, for example, maintenance for a two year old oven would cost $800 for maintenance undertaken now. It is expected that maintenance costs will increase at 10% per annum and oven replacement cost and resale values at 5% per annum. The money discount rate is 15%.

Required:

(a) Calculate the preferred replacement policy for the ovens in a choice between a two year or three year replacement cycle. (12 marks)

(b) Identify the limitations of Net Present Value techniques when applied generally to investment appraisal. (13 marks)

(25 marks)

6.4 Capital rationing (Dec 09, Dec 11)

6.4.1 In a perfect capital market, a company can raise funds as and when it needs them.6.4.2 However, in practice, it is not the case. The capital available is always to be limited or

rationed. There are two types of rationing:6.4.3 External (hard) capital rationing:

Cannot raise external finance due to too risky. Financial risk – the company’s gearing may be seen as too high. Business risk – lenders may be uncertain on the company’s future profits

whether it can meet the interest and principal payments6.4.4 Internal (soft) capital rationing:

Managers impose restrictions on the funds. The reasons are as follows: Managers may not want to raise new external finance, for example

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Not wish to raise new debt to increase future interest payments Not wish to issue new equity to avoid dilution of control.

Managers may prefer slower organic growth in order to remain in control of the growth process and so avoid rapid growth.

Managers may want to make capital investments compete for funds in order to week out weaker or marginal projects.

6.4.5 Single period capital rationing Rationing occurs when limits are placed for only one year or one period. Two types of single-period rationing:

Divisible projects – a proportion rather than the whole investment can be undertaken and use profitability index (PI) to rank the project for priority.

PI =PV of future cash flows

Initial investment

Indivisible projects – use trial and error to find the affordable combination that maximizes NPV

6.4.6 Multi-period capital rationing Limits are placed for more than one period, in this case, linear

programming should be employed. More complex linear programming problems require the use of computers.

6.4.7 Practical steps to deal with capital rationing include: Leasing Entering into a joint venture with a partner Delaying projects to a later period Raising new capital if possible

Question 15 – Capital rationing and relevant cash flowsBasril plc is reviewing investment proposals that have been submitted by divisional managers. The investment funds of the company are limited to $800,000 in the current year. Details of three possible investments, none of which can be delayed, are given below.

Project 1An investment of $300,000 in work station assessments. Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased

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efficiency and from reduced absenteeism due to work-related illness. Savings in labour costs from these assessments in money terms are expected to be as follows:Year 1 2 3 4 5Cash flows ($000) 85 90 95 100 95

Project 2An investment of $450,000 in individual workstations for staff that is expected to reduce administration costs by $140,800 per annum in money terms for the next five years.

Project 3An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per annum are expected in current price terms and these are expected to increase by 3·6% per annum due to inflation during the five-year life of the machines.

Basril plc has a money cost of capital of 12% and taxation should be ignored.

Required:

(a) Determine the best way for Basril plc to invest the available funds and calculate the resultant NPV:(i) on the assumption that each of the three projects is divisible;(ii) on the assumption that none of the projects are divisible. (10 marks)

(b) Explain how the NPV investment appraisal method is applied in situations where capital is rationed. (3 marks)

(c) Discuss the reasons why capital rationing may arise. (7 marks)(d) Discuss the meaning of the term ‘relevant cash flows’ in the context of investment

appraisal, giving examples to illustrate your discussion. (5 marks)(25 marks)

(ACCA 2.4 Financial Management and Control December 2003 Q3)

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Additional Examination Style Questions

Question 16 – WACC, NPV and Project-specific Discount RateRupab Co is a manufacturing company that wishes to evaluate an investment in new production machinery. The machinery would enable the company to satisfy increasing demand for existing products and the investment is not expected to lead to any change in the existing level of business risk of Rupab Co.

The machinery will cost $2·5 million, payable at the start of the first year of operation, and is not expected to have any scrap value. Annual before-tax net cash flows of $680,000 per year would be generated by the investment in each of the five years of its expected operating life. These net cash inflows are before taking account of expected inflation of 3% per year. Initial investment of $240,000 in working capital would also be required, followed by incremental annual investment to maintain the purchasing power of working capital.

Rupab Co has in issue five million shares with a market value of $3·81 per share. The equity beta of the company is 1·2. The yield on short-term government debt is 4·5% per year and the equity risk premium is approximately 5% per year.

The debt finance of Rupab Co consists of bonds with a total book value of $2 million. These bonds pay annual interest before tax of 7%. The par value and market value of each bond is $100.

Rupab Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable depreciation) on machinery are on a straight-line basis over the life of the asset.

Required:

(a) Calculate the after-tax weighted average cost of capital of Rupab Co. (6 marks)(b) Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms,

and calculate and comment on its net present value. (8 marks)(c) Explain how the capital asset pricing model can be used to calculate a project-specific

discount rate and discuss the limitations of using the capital asset pricing model in investment appraisal. (11 marks)

(25 marks)(ACCA F9 Financial Management December 2008 Q3)

Question 17 – NPV and Project-specific Cost of Equity

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CJ Co is a profitable company which is financed by equity with a market value of $180 million and by debt with a market value of $45 million. The company is considering two investment projects, as follows.

Project AThis project is an expansion of existing business costing $3·5 million, payable at the start of the project, which will increase annual sales by 750,000 units. Information on unit selling price and costs is as follows:

Selling price: $2.00 per unit (current price terms)Selling costs: $0.04 per unit (current price terms)Variable costs: $0.80 per unit (current price terms)

Selling price inflation and selling cost inflation are expected to be 5% per year and variable cost inflation is expected to be 4% per year. Additional initial investment in working capital of $250,000 will also be needed and this is expected to increase in line with general inflation.

Project BThis project is a diversification into a new business area that will cost $4 million. A company that already operates in the new business area, GZ Co, has an equity beta of 1·5. GZ Co is financed 75% by equity with a market value of $90 million and 25% by debt with a market value of $30 million.

Other informationCJ Co has a nominal weighted average after-tax cost of capital of 10% and pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances (tax-allowable depreciation) on a 25% reducing balance basis on the initial investment in both projects.

Risk-free rate of return: 4%Equity risk premium: 6%General rate of inflation: 4·5% per year

Directors’ views on investment appraisalThe directors of CJ Co require that all investment projects should be evaluated using either payback period or return on capital employed (accounting rate of return). The target payback period of the company is two years and the target return on capital employed is 20%, which is the current return on capital employed of CJ Co. A project is accepted if it satisfies either of

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these investment criteria.

The directors also require all investment projects to be evaluated over a four-year planning period, ignoring any scrap value or working capital recovery, with a balancing allowance (if any) being claimed at the end of the fourth year of operation.

Required:

(a) Calculate the net present value of Project A and advise on its acceptability if the project were to be appraised using this method. (12 marks)

(b) Critically discuss the directors’ views on investment appraisal. (7 marks)(c) Calculate a project-specific cost of equity for Project B and explain the stages of your

calculation. (6 marks)(25 marks)

(ACCA F9 Financial Management December 2010 Q1)

Question 18 – NPV, IRR and Maximization of Shareholders’ WealthSC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle due to rapidly changing technology. The machine is expected to cost $1 million. Production and sales of product P are forecast to be as follows:

Year 1 2 3 4Production and sales (units/year) 35,000 53,000 75,000 36,000

The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product (in current price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co has spare capacity in both space and labour terms.

Producing and selling product P will call for increased investment in working capital. Analysis of historical levels of working capital within SC Co indicates that at the start of each year, investment in working capital for product P will need to be 7% of sales revenue for that year.

SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capital allowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basis over the four-year life of the proposed investment. The new

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machine is expected to have no scrap value at the end of the four-year period.

SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.

Required:

(a) Calculate the net present value of the proposed investment in product P.(12 marks)

(b) Calculate the internal rate of return of the proposed investment in product P.(3 marks)

(c) Advise on the acceptability of the proposed investment in product P and discuss the limitations of the evaluations you have carried out. (5 marks)

(d) Discuss how the net present value method of investment appraisal contributes towards the objective of maximising the wealth of shareholders. (5 marks)

(Total 25 marks)(ACCA F9 Financial Management June 2008 Q4)

Question 19 – NPV, IRR and Comparison of Investment Appraisal MethodsCharm plc, a software company, has developed a new game, ‘Fingo’, which it plans to launch in the near future. Sales of the new game are expected to be very strong, following a favourable review by a popular PC magazine. Charm plc has been informed that the review will give the game a ‘Best Buy’ recommendation. Sales volumes, production volumes and selling prices for ‘Fingo’ over its four-year life are expected to be as follows.

Year 1 2 3 4Sales and production (units) 150,000 70,000 60,000 60,000Selling price (£ per game) £25 £24 £23 £22

Financial information on ‘Fingo’ for the first year of production is as follows:

Direct material cost £5.40 per gameOther variable production cost £6.00 per gameFixed costs £4.00 per game

Advertising costs to stimulate demand are expected to be £650,000 in the first year of production and £100,000 in the second year of production. No advertising costs are expected in the third and fourth years of production. Fixed costs represent incremental cash fixed

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production overheads. ‘Fingo’ will be produced on a new production machine costing £800,000. Although this production machine is expected to have a useful life of up to ten years, government legislation allows Charm plc to claim the capital cost of the machine against the manufacture of a single product. Capital allowances will therefore be claimed on a straight-line basis over four years.

Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they arise. Charm plc uses an after-tax discount rate of 10% when appraising new capital investments. Ignore inflation.

Required:

(a) Calculate the net present value of the proposed investment and comment on your findings. (11 marks)

(b) Calculate the internal rate of return of the proposed investment and comment on your findings. (5 marks)

(c) Discuss the reasons why the net present value investment appraisal method is preferred to other investment appraisal methods such as payback, return on capital employed and internal rate of return. (9 marks)

(Total 25 marks)(ACCA Paper 2.4 Financial Management and Control June 2006 Q5)

Question 20 – NPV and Discussion with Risk IncorporationBRT Co has developed a new confectionery line that can be sold for $5·00 per box and that is expected to have continuing popularity for many years. The Finance Director has proposed that investment in the new product should be evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) will depend on sales volume, as follows.

Sales volume (boxes) less than 1 million 1 – 1.9 million 2 – 2.9 million 3 – 3.9 million

Variable costs ($ per box) 2.8 3.00 3.00 3.05

Total fixed costs ($) 1 million 1.8 million 2.8 million 3.8 million

Forecast sales volumes are as follows.

Year 1 2 3 4

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Demand (boxes) 0.7 million 1.6 million 2.1 million 3.0 million

The production equipment for the new confectionery line would cost $2 million and an additional initial investment of $750,000 would be needed for working capital. Capital allowances (tax-allowable depreciation) on a 25% reducing balance basis could be claimed on the cost of equipment. Profit tax of 30% per year will be payable one year in arrears. A balancing allowance would be claimed in the fourth year of operation.

The average general level of inflation is expected to be 3% per year and selling price, variable costs, fixed costs and working capital would all experience inflation of this level. BRT Co uses a nominal after-tax cost of capital of 12% to appraise new investment projects.

Required:

(a) Assuming that production only lasts for four years, calculate the net present value of investing in the new product using a nominal terms approach and advise on its financial acceptability (work to the nearest $1,000). (13 marks)

(b) Comment briefly on the proposal to use a four-year time horizon, and calculate and discuss a value that could be placed on after-tax cash flows arising after the fourth year of operation, using a perpetuity approach. Assume, for this part of the question only, that before-tax cash flows and profit tax are constant from year five onwards, and that capital allowances and working capital can be ignored. (5 marks)

(c) Discuss THREE ways of incorporating risk into the investment appraisal process.(7 marks)

(25 marks)(ACCA F9 Financial Management June 2011 Q1)

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Question 21 – NPV, IRR, Sensitivity Analysis and Capital RationingWarden Co plans to buy a new machine. The cost of the machine, payable immediately, is $800,000 and the machine has an expected life of five years. Additional investment in working capital of $90,000 will be required at the start of the first year of operation. At the end of five years, the machine will be sold for scrap, with the scrap value expected to be 5% of the initial purchase cost of the machine. The machine will not be replaced.

Production and sales from the new machine are expected to be 100,000 units per year. Each unit can be sold for $16 per unit and will incur variable costs of $11 per unit. Incremental fixed costs arising from the operation of the machine will be $160,000 per year.

Warden Co has an after-tax cost of capital of 11% which it uses as a discount rate in investment appraisal. The company pays profit tax one year in arrears at an annual rate of 30% per year. Capital allowances and inflation should be ignored.

Required:

(a) Calculate the net present value of investing in the new machine and advise whether the investment is financially acceptable. (7 marks)

(b) Calculate the internal rate of return of investing in the new machine and advise whether the investment is financially acceptable. (4 marks)

(c) (i) Explain briefly the meaning of the term ‘sensitivity analysis’ in the context of investment appraisal; (1 mark)

(ii) Calculate the sensitivity of the investment in the new machine to a change in selling price and to a change in discount rate, and comment on your findings. (6 marks)

(d) Discuss the nature and causes of the problem of capital rationing in the context of investment appraisal, and explain how this problem can be overcome in reaching the optimal investment decision for a company. (7 marks)

(25 marks)(ACCA F9 Financial Management December 2011 Q1)

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Question 22 – NPV, Equivalent Annual Cost, Sensitivity and Profitability AnalysisRidag Co is evaluating two investment projects, as follows.

Project 1This is an investment in new machinery to produce a recently-developed product. The cost of the machinery, which is payable immediately, is $1·5 million, and the scrap value of the machinery at the end of four years is expected to be $100,000. Capital allowances (tax-allowable depreciation) can be claimed on this investment on a 25% reducing balance basis. Information on future returns from the investment has been forecast to be as follows:

Year 1 2 3 4Sales volume (units/year) 50,000 95,000 140,000 75,000Selling price ($/unit) 25.00 24.00 23.00 23.00Variable cost ($/unit) 10.00 11.00 12.00 12.50Fixed costs ($/year) 105,000 115,000 125,000 125,000

This information must be adjusted to allow for selling price inflation of 4% per year and variable cost inflation of 2·5% per year. Fixed costs, which are wholly attributable to the project, have already been adjusted for inflation. Ridag Co pays profit tax of 30% per year one year in arrears.

Project 2Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows:

Year 1 2 3 4Machine 1 ($/year) 25,000 29,000 32,000 35,000Machine 2 ($/year) 15,000 20,000 25,000

Where relevant, all information relating to Project 2 has already been adjusted to include expected future inflation. Taxation and capital allowances must be ignored in relation to Machine 1 and Machine 2.

Other informationRidag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted average cost of capital of 7%.

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Required:

(a) Calculate the net present value of Project 1 and comment on whether this project is financially acceptable to Ridag Co. (12 marks)

(b) Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss which machine should be purchased. (6 marks)

(c) Critically discuss the use of sensitivity analysis and probability analysis as ways of including risk in the investment appraisal process, referring in your answer to the relative effectiveness of each method. (7 marks)

(25 marks)(ACCA F9 Financial Management June 2012 Q1)

Question 23 – NPV, ARR, interest rate and capital investment decisionBQK Co, a house-building company, plans to build 100 houses on a development site over the next four years. The purchase cost of the development site is $4,000,000, payable at the start of the first year of construction. Two types of house will be built, with annual sales of each house expected to be as follows:

Year 1 2 3 4Number of small houses sold: 15 20 15 5Number of large houses sold: 7 8 15 15

Houses are built in the year of sale. Each customer finances the purchase of a home by taking out a long-term personal loan from their bank. Financial information relating to each type of house is as follows:

Small house Large houseSelling price: $200,000 $350,000Variable cost of construction: $100,000 $200,000

Selling prices and variable cost of construction are in current price terms, before allowing for selling price inflation of 3% per year and variable cost of construction inflation of 4·5% per year.

Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred. These would not relate to any specific house, but would be for the provision of new roads, gardens, drainage and utilities. Infrastructure cost inflation is expected to be 2% per year.

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BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances on the purchase cost of the development site on a straight-line basis over the four years of construction.

BQK Co has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of 12% per year. New investments are required by the company to have a before-tax return on capital employed (accounting rate of return) on an average investment basis of 20% per year.

Required:

(a) Calculate the net present value of the proposed investment and comment on its financial acceptability. Work to the nearest $1,000. (13 marks)

(b) Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investment on an average investment basis and discuss briefly its financial acceptability. (5 marks)

(c) Discuss the effect of a substantial rise in interest rates on the financing cost of BQK Co and its customers, and on the capital investment appraisal decision-making process of BQK Co. (7 marks)

(25 marks)(ACCA F9 Financial Management December 2012 Q1)

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