Revision 2 Investment Appraisal

Topics List
1. Investment Appraisal Methods a. Payback period Computation & comment Advantages and disadvantages Discounted payback period b. Accounting rate o return !A""# Computation & comment Exam Question Reference

Jun 09 Jun 11 Pi$ot Jun 09 Dec 12

Q2b Q1c Q%b Q2b Q1b

Advantages and disadvantages c. &et present va$ue !&P'# Computation & comment Advantages and disadvantages d. )nterna$ rate o return !)""# Computation & comment

Jun 09 Dec 10

Q2b Q1a(b

2. %. ).

Advantages and disadvantages

Dec 0* Jun 0+ Jun 09 Dec 11 Pi$ot Jun 10 Jun 09

Q2b Q%b Q2b Q1b Q%c Q,c Q2a

ta!es in "apital Investment #ro$ects &etermination of relevant and non'relevant cash flo(s Allo(in! for Tax* Inflation and +or,in! "apital a. )n $ation -peci ic in $ation and genera$ in $ation

Pi$ot Jun 0+ Jun 09 Dec 10 Jun 11 Jun 12

Q%a Q%a Q2b Q1a Q1a Q1a

1,

"ea$ and money interest rate . /is0er1s e2uation

b. 3a4ation

c. 5orking capita$

Dec 12 Jun 1, Pi$ot Jun 10 Jun 1, Pi$ot Dec 0* Jun 0+ Dec 0+ Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 1, Jun 0+ Dec 0+ Jun 11 Dec 11 Jun 1, Dec 0* Jun 11 Dec 0* Jun 11 Jun 12 Dec 0* Jun 11 Dec 11 Jun 12 Jun 10 Jun 11

Q1a Q1a Q%a Q,b Q1b Q%a Q2a Q%a Q,b Q,b Q1a Q1a Q1a Q1a Q1a Q1a Q%a Q,b Q1a Q1a Q1a Q2c Q1c Q2c Q1c Q1c Q2c Q1c Q1c Q1c Q,c!iii# Q1c

-.

#ro$ect Appraisal and Ris, a. "isk and uncertainty b. Probabi$ity ana$ysis

c. -ensitivity ana$ysis

d. -imu$ation e. "isk6ad7usted discount rate .. Asset Investment &ecisions a. 8ease or buy &umerica$ ana$ysis

Dec 09

Q1a(b

1%

/inance $ease meaning 9perating $ease meaning Attractions o inance $ease Attractions o operating $ease b. Asset ac2uisition by &P'

c. "ep$acement cyc$es

Pi$ot Dec 0* Jun 0+ Dec 0+ Dec 09 Jun 10 Jun 12 Dec 11 Dec 09 Dec 11

Q%a Q2a Q%a Q,b Q1b Q,c Q1b Q1d Q1d Q1d

d. Capita$ rationing :ard !e4terna$# and so t !interna$# capita$ rationing -ing$e period capita$ rationing
#art I/ Investment Appraisal Jun61, Topics I. 0ature of Investment &ecisions and Appraisal #rocess 1. Distinguis0 bet<een capita$ & revenue e4penditure( bet<een non6current assets and <orking capita$ management 2. =4p$ain t0e ro$e o investment appraisa$ in t0e capita$ budgeting process ,. Discuss t0e stages o t0e capita$ budgeting process II. %. >. ?. 0on'discounted "ash 1lo( Techni2ues )denti y and ca$cu$ate re$evant cas0 $o<s Ca$cu$ate payback period and its use u$ness Ca$cu$ate A"" and its use u$ness Dec612 Jun612 Dec611 Jun611 Dec610 Jun610 Dec609

;u$ti6period capita$ rationing

Jun609

Dec60+

Jun60+

Dec60*

Pi$ot

2a

1a

1a 1b

1a

1a

1a

1a

,b

1a(b

2b 2b!iii#(c

,b

%a

2a

%a %b

III. &iscounted "ash 1lo( 3&"14 Techni2ues *. =4p$ain and app$y concepts re$ating to interest and discounting( inc$uding@ a. "e$ations0ip bet<een interest rates and in $ation( rea$ and nomina$ interest rates 1b b. Ca$cu$ation o uture va$ues and app$ication o t0e annuity c. Ca$cu$ation o present va$ues o annuity and perpetuity d. 3ime va$ue o money +. Ca$cu$ate &P' and discuss its use u$ness 1a 9. Ca$cu$ate )"" and discuss its use u$ness 10. Discuss t0e superiority o DC/ met0ods over non6DC/ met0ods 11. Discuss t0e re$ative merits o &P' and )"" I/. Allo(in! for Inflation and Taxation in &"1 12. App$y and discuss t0e rea$6terms and nomina$6terms to DC/ 1,. Ca$cu$ate t0e ta4ation e ects o re$evant cas0 $o<s( inc$uding ta4 bene its o capita$ a$$o<ances and ta4 $iabi$ities 1%. Ca$cu$ate and app$y be ore6 and a ter6ta4 discount rates /. Ad$ustin! for Ris, and 5ncertaint6 in Investment Appraisal 1>. Di erence bet<een risk and uncertainty 1?. App$y sensitivity ana$ysis and discuss t0e use u$ness 1*. App$y probabi$ity ana$ysis and discuss t0e use u$ness 1+. App$y and discuss ot0er tec0ni2ues o ad7usting or risk and uncertainty a. -imu$ation b. Ad7usted payback c. "isk6ad7usted discount rates /I. pecific Investment &ecisions 19. =va$uate $easing and borro<ing to buy using t0e be ore6 and a ter6ta4 cost o debt 20. =va$uate asset rep$acement decisions using e2uiva$ent annua$ cost 21. =va$uate investment decisions under sing$e6period capita$ rationing a. Ca$cu$ation o pro itabi$ity inde4es or divisib$e pro7ects b. Ca$cu$ation o &P' o combinations o non6divisib$e pro7ects c. Discuss t0e reasons or capita$ rationing

1b 1a 1a 1a 1b 1a 1a(b ,a(b 1a(b 2b!i#(c 2b!ii#(c ,b %a %b %c 2a 2b 2b %a %c %c

,c!ii#

1a

1a

1a

1a

1a

1a

,b

1a

,b

%a

2a

%a

1c 1c 1c

,c!iii# 1c 1c 1c

2c 2c 2c

1c 1c

2b!iv#(c

1b

,c!i#

1a 1c

1d

1d

1>

1?

1.
1.1 1.1.1 1.1.2

Investment Appraisal Methods

#a67ac, period

Time it ta,es the pro$ect to pa67ac, its initia$ investment. 50en is use u$A seeking to cla( 7ac, cash rom investments as 2uic,l6 as possi7le common$y used or initial screenin! o investment a$ternatives 1.1., A lon! pa67ac, period is considered ris,6 because it re$ies on cas0 $o<s t0at are in t0e distant uture. 1.1.% Decision ru$e@ on$y se$ect pro7ects <0ic0 pa67ac, (ithin the specified time period choose 7et(een options on t0e basis o t0e fastest pa67ac, provides a measure of li2uidit6 1.1.> Benera$ approac0@ 8ear 0 1 2 , % > "ash flo(s 394 !100(000# 20(000 ,0(000 %0(000 ,0(000 %0(000 "umulative cash flo(s 394 !100(000# !+0(000# !>0(000# !10(000# 20(000

Payback period C , years D 10(000E,0(000 C ,.,, years or , years % mont0s 1.1.? Discounted payback period@ 8ear "ash flo( 39:::4 !2(000# ?00 >00 ?00 ?00 ,00 200 &iscounted "ash flo( ;1:< 39:::4 !2(000# >%> %1, %>1 %10 1+? 11, "umulative cash flo( 39:::4 !2(000# !1(%>># !1(0%2# !>91# !1+1# > 11+

0 1 2 , % > ?

1*

1.1.*

30e pa67ac, period is about - 6ears. Advantages and disadvantages o payback period Advanta!es )t is simp$e )t is use u$ in certain situations@ "apid$y c0anging tec0no$ogy )mproving investment conditions )t avours 2uick return@ :e$ps company gro<t0 ;inimiFes risk ;a4imiFes $i2uidity )t uses cas0 $o<s( not accounting pro it. &isadvanta!es )t ignores overa$$ pro itabi$ity a ter t0e payback period )t ignores time va$ue o money )t is sub7ective . no de initive investment signa$

1.2 1.2.1 1.2.2

Accountin! Rate of Return 3ARR4

3#ilot* =un :>* &ec 124

1.2.,

A$so kno<n as "9C= or "9). Decision ru$e@ A"" G target return or 0urd$e rate( accept t0e pro7ect 3ake t0e pro7ect <it0 t0e 0ig0est A"" Ca$cu$ation o A"" . t0ree version Annual 7asis . A"" C Pro it or t0e year H 100I Asset book va$ue at start o year 30en( take average o eac0 year1s A"" to ind t0e average A"". Total investment 7asis . A"" C Average annua$ pro it )nitia$ capita$ invested

H 100I

Avera!e investment 7asis . A"" C Average annua$ pro it Average capita$ invested

H 100I

1+

Average capita$ invested

)nitia$ investment D -crap va$ue 2

1.2.%

Advantages and disadvantages o A"" Advanta!es )t is a 2uic, and simple calculation )t invo$ves t0e familiar concept of a percenta!e return )t $ooks at t0e entire pro$ect life &isadvanta!es )t is 7ased on accountin! profit and not cash flo(s. )t depends on accountin! policies and t0is can ma,e comparison o A"" being difficult. )t is a relative measure rather than an a7solute measure and 0ence ta,es no account of the si?e of the investment 8ike t0e payback met0od( it i!nores the time value of mone6.

1.%

0et #resent /alue 30#/4

1.,.1 P' o cas0 in $o<s compare <it0 t0e P' o cas0 out $o<s to obtain a &P'. 1.,.2 30e discount rate e2ua$s its cost o capita$ or 5ACC. 1.,., Decision ru$e@ &P' G 0( t0e pro7ect is inancia$$y viab$e( i.e. accepted. &P' C 0( t0e pro7ect breaks even. &P' J 0( t0e pro7ect is not inancia$$y viab$e( i.e. re7ected. 1.,.% ) t0e company 0as t(o or more mutuall6 exclusive pro$ects under consideration it s0ou$d choose the one (ith the hi!hest 0#/. 1.,.> 30e &P' gives t0e impact o t0e pro7ect on shareholder (ealth. 3=un :@4 A$$ acceptab$e investment pro7ect s0ou$d 0ave positive &P' 30e mar,et value o t0e company( theoreticall6 at $east( increases 76 the amount of the 0#/ 30e share price o t0e company s0ou$d theoreticall6 increase as <e$$ 9b7ective o maximi?in! the (ealth of shareholders is usua$$y su7stituted 76 the o7$ective of maximi?in! the share price of a compan6

19

1.,.?

Advantages and disadvantages o &P' Advanta!es Considers t0e time va$ue o money )s an abso$ute measure o return( i.e. abso$ute increase in corporate va$ue )s based on cas0 $o<s not pro its Considers t0e <0o$e $i e o t0e pro7ect -0ou$d $ead to ma4imiFation o s0are0o$der <ea$t0 Can accommodate c0anges in discount rate :as a sensib$e re6investment assumption Can accommodate non6 conventiona$ cas0 $o<s &isadvanta!es )t is di icu$t to e4p$ain to managers and re$ative$y comp$e4 )t re2uires kno<$edge o t0e cost o capita$

1.,.* 50y &P' is superior to other methodsA &P' considers cash flo(s &P' considers t0e (hole life o an investment pro7ect &P' considers t0e time value of mone6 &P' is an a7solute measure of return &P' direct$y lin,s to the o7$ective of maximi?in! shareholdersA (ealth &P' o ers t0e correct investment advice &P' can accommodate chan!es in the discount rate &P' 0as a sensi7le re'investment assumption &P' can accommodate non'conventional cash flo(s 1.) 1.%.1 Internal Rate of Return 3IRR4 3&ec :B* =un :@* =un :>* &ec 114

)"" is de ined as t0e discount rate at <0ic0 t0e 0#/ e2uals ?ero. )n ot0er <ords( t0e )"" represents t0e 7rea,even discount rate or t0e investment.

20

1.%.2

Decision ru$e@ IRR C cost of capital( pro7ect accepts 30e hi!her IRR is the 7etter -teps in ca$cu$ating t0e )"" using $inear interpo$ation@ 1. Ca$cu$ate t<o &P' at t<o di erent discount rates. Dne must be positive and anot0er one must be ne!ative. 2. Ksing t0e o$$o<ing ormu$a to ind t0e )""
NL ! H L# NL + NH

1.%.,

)"" C 8 D

<0ere@ 8 C 8o<er rate o interest : C :ig0er rate o interest &8 C &P' at $o<er rate o interest &: C &P' at 0ig0er rate o interest 1.%.% Advantages and disadvantages o )"" Advanta!es Considers t0e time value of mone6 )s a percenta!e and t0ere ore easil6 understood Kses cash flo(s not profits Considers t0e (hole life of the pro$ect ;eans a irm se$ecting pro7ects <0ere t0e )"" e4ceeds t0e cost o capita$ s0ou$d increase s0are0o$ders1 <ea$t0. 3#ilot* =un 1:4 &isadvanta!es )t is not a measure o a7solute increase in compan6 value. )nterpo$ation on$y provides an estimate and an accurate estimate re2uires t0e use o a spreads0eet program )t is fairl6 complicated to ca$cu$ate 0on'conventional cash flo(s may give rise to multiple IRRs Can o er conflictin! advice 7et(een IRR and 0#/ in t0e eva$uation o mutua$$y e4c$usive pro7ects Assume cash inflo(s 7ein! reinvested at the IRR rate( t0is is unrealistic <0en )"" is 0ig0.

21

22

2.
2.1

ta!es in the "apital Investment #ro$ects

3=un :>4 -tages can be summariFed as o$$o<s@ ta!es )denti y investment opportunities -creen proposa$s investment Explanation Arise rom ana$ysis o strategic c0oice( business environment( "&D or $ega$ environment( etc. Ley re2uirement is to ac0ieve t0e organiFationa$ ob7ectives. -e$ect t0ose proposa$s <it0 best strategic it and t0e most appropriate use o economic resources. Ana$yse and eva$uate <0ic0 proposa$!s# o er t0e most attractive opportunities to ac0ieve company ob7ectives( e.g. increase s0are0o$der <ea$t0. )nvestment appraisa$ p$ays a key ro$e 0ere( e.g. c0oose 0ig0est &P' among di erent proposa$s. Pass to re$evant $eve$ o aut0ority or approva$. 8arge proposa$s approve by board o directors( sma$$er proposa$s approve by divisiona$ $eve$. "esponsibi$ity or t0e pro7ect is assigned to a pro7ect manager or ot0er responsib$e person. "esources <i$$ be avai$ab$e and speci ic target s0ou$d be set. Progress must be monitored to c0eck <0et0er t0ere are any big variances and un oreseen events. 3o aci$itate organiFationa$ $earning and to improve uture investment decisions.

Ana$yse and eva$uate investment proposa$s Approve proposa$s investment ;onitoring Post6comp$etion audit

)mp$ementation

2,

%.
%.1 ,.1.1

&etermination of the "ash 1lo(s

Relevant cash flo(s 30e o$$o<ing princip$es s0ou$d be app$ied <0en identi ying costs t0at are re$evant to a period. Relevant costs /uture costs Cas0 $o<s )ncrementa$ costs 9pportunity costs Explanation /uture cost arises as a direct conse2uence of a decision. un, costs should not 7e included because it is past and so irre$evant to any decision. /uture costs <0ic0 are in t0e orm o cash s0ou$d be inc$uded. -o depreciation should 7e i!nored because it is not cas0 spending. )ncrease in costs results from ma,in! a particular decision. )t is t0e va$ue o a 7enefit fore!one as a resu$t o c0oosing a particu$ar course o action.

%.2 ,.2.1

0on'relevant costs 9t0er non'relevant costs@ "ommitted costs . t0ey are future cash flo( 7ut <i$$ be incurred an6(a6( regard$ess o <0at decision <i$$ be taken. Interest costs . t0ey 0ave a$ready been included in the discount rate( i counted( it <i$$ be dou7le counted.

).
).1 %.1.1

Allo(in! for Tax* Inflation and +or,in! "apital

Inflation 3#ilot* =un :@* =un :>* &ec 1:* =un 11* =un 12* &ec 12* =un 1%4

)n $ation 0as t<o impacts on &P'@ pecific inflation . cas0 $o< rises by t0e rate o in $ation Eeneral inflation . cost o capita$ !or discount rate# rises by t0e rate o in $ation.

2%

%.1.2

"ea$ and money !nomina$# interest rate )t 0as t0e o$$o<ing re$ations0ip bet<een rea$ interest rate and nomina$ interest rate under /is0er1s e2uation. 3#ilot* =un 1:* =un 1%4 31 F i4 G 31 F r4 31 F h4 50ere 0 C in $ation rate r C rea$ interest rate i C nomina$ interest rate

).2

%.2.1

Taxation 3#ilot* =un :B* &ec :B* =un :@* &ec :@* =un 1:* &ec 1:* =un 11* &ec 11* =un 12* &ec 12* =un 1%4 3a4ation 0as t0e o$$o<ing t<o e ects on cas0 $o<@ Effects 3a4 on pro its Explanation "alculate the taxa7le profits 37efore capital allo(ances4 and ca$cu$ate ta4 at t0e rate given. 30e e ect o ta4ation <i$$ not necessaril6 occur in the same 6ear( o ten one 6ear in arrears in t0e e4amination. &orma$$y 2>I <riting6do<n a$$o<ances on p$ant and mac0inery !can be straig0t6$ine# "emember t0e 7alancin! allo(ance or 7alancin! char!e in the final 6ear. 3=un :@* &ec :@* =un 11* &ec 11* =un 1%4

3a4 bene its 5DAs

rom

).% %.,.1 %.,.2

+or,in! capital

&e< pro7ect re2uires an additiona$ investment in <orking capita$. 30e treatment o <orking capita$ is as o$$o<s@ Initial investment is a cost at t0e start o t0e pro7ect( i.e. cash outflo(. ) increasin! durin! the pro$ect( t0e increase is a relevant cash outflo(. 5orking capita$ is released at the end o t0e pro7ect and treated as cash inflo(.

2>

).) %.%.1
Mear -a$es Costs

Eeneral la6out of cash flo( preparation 30e genera$ $ayout can be s0o<n as o$$o<s@
: 9::: 1 9::: N !N# N 2 9::: N !N# N !N# N !N# !N# !N# N !N# !N# N N N !N# N N N % 9::: N !N# N !N# N N !N# N N N N N N N !N# N ) 9:::

9perating cas0 $o<s Taxation Tax 7enefit of "As Capita$ e4penditure and scrap va$ue +or,in! capital chan!es &et cas0 $o<s Discount actor Present va$ue

Question 1: 30e o$$o<ing dra t appraisa$ o a proposed investment pro7ect 0as been prepared or t0e inance director o 9L; Co by a trainee accountant. 30e pro7ect is consistent <it0 t0e current business operations o 9L; Co. 8ear 1 2 % ) -a$es !unitsEyr# 2>0(000 %00(000 >00(000 2>0(000 9::: 9::: 9::: 9::: 9::: Contribution 1(,,0 2(12+ 2(??0 1(,,0 /i4ed costs !>,0# !>?2# !>9?# !?,1# Depreciation !%,+# !%,+# !%,*# !%,*# )nterest payments !200# !200# !200# !200# 3a4ab$e pro it 3a4ation Pro it a ter ta4 -crap va$ue A ter6ta4 cas0 $o<s Discount at 10I Present va$ues 1?2 1?2 1?2 0.909 1%* 92+ !%9# +*9 +*9 0.+2? *2? 1(%2* !2*+# 1(1%9 1(1%9 0.*>1 +?, ?2 !%2+# !,??# 2>0 !11?# 0.?+, !*9# !19# !19# !19# 0.?21 !12#

&et present va$ue C 1(?%>(000 . 2(000(000 C !O,>>(000# so re7ect t0e pro7ect.

2?

30e o$$o<ing in ormation <as inc$uded <it0 t0e dra t investment appraisa$@ 1. 2. ,. %. >. ?. *. +. 9. 10. 30e initia$ investment is O2 mi$$ion -e$$ing price@ O12Eunit !current price terms#( se$$ing price in $ation is >I per year 'ariab$e cost@ O*Eunit !current price terms#( variab$e cost in $ation is %I per year /i4ed over0ead costs@ O>00(000Eyear !current price terms#( i4ed cost in $ation is ?I per year O200(000Eyear o t0e i4ed costs are deve$opment costs t0at 0ave a$ready been incurred and are being recovered by an annua$ c0arge to t0e pro7ect )nvestment inancing is by a O2 mi$$ion $oan at a i4ed interest rate o 10I per year 9L; Co can c$aim 2>I reducing ba$ance capita$ a$$o<ances on t0is investment and pays ta4ation one year in arrears at a rate o ,0I per year 30e scrap va$ue o mac0inery at t0e end o t0e our6year pro7ect is O2>0(000 30e rea$ <eig0ted average cost o capita$ o 9L; Co is *I per year 30e genera$ rate o in $ation is e4pected to be %P*I per year

Re2uiredH !a# !b# !c# )denti y and comment on any errors in t0e investment appraisa$ prepared by t0e trainee accountant. !> marks# Prepare a revised ca$cu$ation o t0e net present va$ue o t0e proposed investment pro7ect and comment on t0e pro7ect1s acceptabi$ity. !12 marks# Discuss t0e prob$ems aced <0en undertaking investment appraisa$ in t0e o$$o<ing areas and comment on 0o< t0ese prob$ems can be overcome@ !i# assets <it0 rep$acement cyc$es o di erent $engt0sQ !ii# an investment pro7ect 0as severa$ interna$ rates o returnQ !iii# t0e business risk o an investment pro7ect is signi icant$y di erent rom t0e business risk o current operations. !+ marks# !2> marks# !ACCA /9 /inancia$ ;anagement June 2010 Q,#

2*

-.
-.1 >.1.1

#ro$ect Appraisal and Ris,

Ris, and uncertaint6 3&ec :B* =un 11* =un 124

>.1.2 >.1., >.1.%

>.1.>

-ince future cash flo(s cannot 7e predicted (ith certaint6 ( managers must consider 0o< muc0 con idence can be p$aced in t0e resu$ts o t0e investment appraisa$ process. 30ey must t0ere ore be concerned (ith the ris, and uncertaint6 o a pro7ect. "isk re ers to t0e situation <0ere pro7a7ilities can 7e assi!ned to a ran!e of expected outcomes( so it can be 2uantified. Kncertainty re ers to t0e situation <0ere pro7a7ilities cannot 7e assi!ned to expected outcomes( so it is un2uantifia7le. )t can onl6 7e descri7ed. ) risk and uncertainty <ere not considered( managers mi!ht ma,e mista,e of placin! too much confidence in t0e resu$ts o investment appraisa$( or t0ey may fail to monitor investment pro7ects in order to ensure t0at e4pected resu$ts are in act being ac0ieved. Assessment of pro$ect ris, can a$so indicate pro$ects that mi!ht 7e re$ected as 7ein! too ris,6 compared <it0 e4isting business operations( or pro7ects t0at mig0t be (orth6 of reconsideration if (a6s of reducin! pro$ect ris, could 7e found in order to make pro7ect outcomes more acceptab$e. #ro7a7ilit6 anal6sis 3&ec :B* =un 11* =un 124

-.2 >.2.1 >.2.2

>.2.,

)t re ers to t0e assessment of the separate pro7a7ilities of a num7er of specified outcomes o an investment pro7ect. 30e &P' rom com7inations of future economic conditions could 7e assessed and lin,ed to the $oint pro7a7ilities o t0ose combinations. 30e expected 0#/ cou$d be ca$cu$ated. 30e e4pected va$ue !='# is t0e <eig0ted average o a$$ possib$e outcomes( <it0 t0e <eig0tings based on t0e probabi$ity estimates.
px =' C 50ere@ p C t0e probabi$ity o an outcome 4 C t0e va$ue o an outcome

2+

-.% >.,.1

ensitivit6 anal6sis

3&ec :B* =un 11* &ec 11* =un 124

>.,.2 >.,., >.,.%

-ensitivity ana$ysis assesses ho( the 0#/ of an investment pro$ect is affected 76 chan!es in pro$ect varia7les. 30e purpose is to identif6 the ,e6 or critical varia7les so t0at management can concern more. 30e chan!e in one varia7le re2uired to ma,e the 0#/ to 7e ?ero. 9r a$ternative$y( t0e c0ange in &P' arising rom a i4ed c0ange in t0e given pro7ect variab$e. :o<ever( sensitivity ana$ysis does not assess the pro7a7ilit6 o c0anges in pro7ect variab$es. A simp$e approac0 to deciding <0ic0 variab$es t0e &P' is particu$ar$y sensitive to is to ca$cu$ate t0e sensitivity o eac0 variab$e@ -ensitivity C &P' P' o pro7ect variab$e I

>.,.>

>.,.?

30e lo(er the percenta!e( t0e more sensitive is &P' to t0at pro7ect variab$e as t0e variab$e <ou$d need to c0ange by a sma$$er amount to make t0e pro7ect non6viab$e. Ad$usted pa67ac, 3=un :>* =un 114

-.)

>.%.1 Payback can be ad7usted or risk@ Ii!her ris, pro$ect s0ou$d re2uire s0ortening the pa67ac, period. Putting t0e ocus on cas0 $o<s t0at are more certain !$ess risky# because t0ey are nearer in time. >.%.2 Discounted payback@ Ad7usted or risk by discountin! future cash flo(s <it0 a ris,'ad$usted discount rate. 30e normal pa67ac, period tar!et can 7e applied to t0e discounted cas0 $o<s( <0ic0 <i$$ 0ave decreased in va$ue due to discounting. 30e overall effect is similar to reducin! the pa67ac, period <it0 undiscounted cas0 $o<s.

29

-.>.>.1

imulation An ana$ysis o 0o< chan!es in more than one varia7le !e.g. market s0are and sa$es price# may a ect t0e &P' o a pro7ect.

Question 11 Kmunat p$c is considering investing O>0(000 in a ne< mac0ine <it0 an e4pected $i e o ive years. 30e mac0ine <i$$ 0ave no scrap va$ue at t0e end o ive years. )t is e4pected t0at 20(000 units <i$$ be so$d eac0 year at a se$$ing price o O,P00 per unit. 'ariab$e production costs are e4pected to be O1P?> per unit( <0i$e incrementa$ i4ed costs( main$y t0e <ages o a maintenance engineer( are e4pected to be O10(000 per year. Kmunat p$c uses a discount rate o 12I or investment appraisa$ purposes and e4pects investment pro7ects to recover t0eir initia$ investment <it0in t<o years. Re2uiredH !a# !b# !c# =4p$ain <0y risk and uncertainty s0ou$d be considered in t0e investment appraisa$ process. !> marks# Ca$cu$ate and comment on t0e payback period o t0e pro7ect. !% marks# =va$uate t0e sensitivity o t0e pro7ect1s net present va$ue to a c0ange in t0e o$$o<ing pro7ect variab$es@ !i# sa$es vo$umeQ !ii# sa$es priceQ !iii# variab$e costQ and discuss t0e use o sensitivity ana$ysis as a <ay o eva$uating pro7ect risk. !10 marks# Kpon urt0er investigation it is ound t0at t0ere is a signi icant c0ance t0at t0e e4pected sa$es vo$ume o 20(000 units per year <i$$ not be ac0ieved. 30e sa$es manager o Kmunat p$c suggests t0at sa$es vo$umes cou$d depend on e4pected economic states t0at cou$d be assigned t0e o$$o<ing probabi$ities@ =conomic state Probabi$ity Annua$ sa$es vo$ume !units# Poor 0., 1*(>00 &orma$ 0.? 20(000 Bood 0.1 22(>00 !? marks# !2> marks#

!d#

Ca$cu$ate and comment on t0e e4pected net present va$ue o t0e pro7ect.

,0

!ACCA 2.% /inancia$ ;anagement and Contro$ December 200% Q>#

..
..1 ?.1.1 ?.1.2

Asset Investment &ecisions

Lease or 7u6 3&ec :>4

?.1.,

?.1.%

?.1.>

DC/ tec0ni2ues can a$so be used to assess <0et0er to inance an investment <it0 a $ease or a bank $oan. &umerica$ ana$ysis 30e 7enefits of leasin! vs purchasin! !<it0 a $oan# can be assessed by an &P' approac0@ -tep 1@ t0e cost of leasin! !payments( $ost capita$ a$$o<ances and $ost scrap revenue# -tep 2@ t0e 7enefits of leasin! !savings on $oan repayments C P' o $oan C initia$ out$ay# -tep ,@ discountin! at the after tax cost of de7t -tep %@ calculate the 0#/ . i positive it means t0at t0e $ease is c0eaper t0an t0e a ter ta4 cost o a $oan. Alternative method . to evaluate the 0#/ of the cost of the loan and t0e 0#/ of the cost of the lease separatel6( and to choose the cheapest option. /inance $ease@ 3rans er substantia$$y a$$ o t0e risks and re<ards o o<ners0ip to $essee. 8essee can use t0e asset or a$$ or most o its use u$ economic $i e. )t cannot be cance$$ed or <it0 severe inancia$ pena$ties even <0en cance$$ed. 30ere ore( it is a kind o medium6 to $ong6term source o debt inance. 8eased asset must be capita$iFed toget0er <it0 t0e amount o ob$igations or t0e $ease payments. 9perating $ease@ )t1s rena$ agreement and t0e $ease period is s0orter t0an t0e asset1s use u$ economic $i e. ;aintenance and simi$ar costs are borne by t0e $essor. Cance$$ed <it0out pena$ty at s0ort notice. )t can avoid t0e obso$escence prob$em( so suitab$e or 0ig06tec0 assts. &o need to be capita$iFed and no $iabi$ities need to be recogniFed. Attractions of finance lease or lessee@ &ot enoug0 cas0 and a$so di icu$t to obtain bank $oan.

,1

)nterest may be cheaper than a 7an, loan. :aving tax relief suc0 as t0e interest e4penses and depreciation a$$o<ance !but re er to t0e e4amination 2uestion( it may not 0ave#. ?.1.? Attractions of operatin! lease or lessee@ &o e ect on assets and $iabi$ities( so no increase in its !earin! ratio. Can have the up'to'date assets at a$$ time because t0e $essee can rep$ace <it0 no cost. :ig0er flexi7ilit6 <it0 cancellation at short notice uita7le for small companies <0o may ind it difficult to raise de7t C0eaper t0an borro< to buy 9 6ba$ance s0eet inancing ?.1.* Attractions of operatin! lease or lessor@ 8eased asset can be recovered i t0e $essee de au$t on $ease renta$s 8essor can take advantage o bu$k buying 8essor can 0ave access to $o<er cost inance by virtue o being a muc0 $arger company. =n7oy ta4 bene its suc0 as depreciation a$$o<ance and ot0er a$$o<ab$e e4penses. Question 12 Lease or 7u6 and capital rationin! 8eaminger )nc 0as decided it must rep$ace its ma7or turbine mac0ine on ,1 December 200+. 30e mac0ine is essentia$ to t0e operations o t0e company. 30e company is( 0o<ever( considering <0et0er to purc0ase t0e mac0ine outrig0t or to use $ease inancing. #urchasin! the machine outri!ht 30e mac0ine is e4pected to cost O,?0(000 i it is purc0ased outrig0t( payab$e on ,1 December 200+. A ter our years t0e company e4pects ne< tec0no$ogy to make t0e mac0ine redundant and it <i$$ be so$d on ,1 December 2012 generating proceeds o O20(000. Capita$ a$$o<ances or ta4 purposes are avai$ab$e on t0e cost o t0e mac0ine at t0e rate o 2>I per annum reducing ba$ance. A u$$ year1s a$$o<ance is given in t0e year o ac2uisition but no <riting do<n a$$o<ance is avai$ab$e in t0e year o disposa$. 30e di erence bet<een t0e proceeds and t0e ta4 <ritten do<n va$ue in t0e year o disposa$ is a$$o<ab$e or c0argeab$e or ta4 as appropriate. Leasin! 30e company 0as approac0ed its bank <it0 a vie< to arranging a $ease to inance t0e mac0ine ac2uisition. 30e bank 0as o ered t<o options <it0 respect to $easing <0ic0 are as

,2

o$$o<s@

Contract $engt0 !years# Annua$ renta$ /irst rent payab$e

/inance $ease % O1,>(000 ,1 December 2009

9perating $ease 1 O1%0(000 ,1 December 200+

Eeneral /or bot0 t0e purc0asing and t0e inance $ease option( maintenance costs o O1>(000 per year are payab$e at t0e end o eac0 year. A$$ t0ese renta$s ! or bot0 inance and operating options# can be assumed to be a$$o<ab$e or ta4 purposes in u$$ in t0e year o payment. Assume t0at ta4 is payab$e one year a ter t0e end o t0e accounting year in <0ic0 t0e transaction occurs. /or t0e operating $ease on$y( contracts are rene<ab$e annua$$y at t0e discretion o eit0er party. 8eaminger )nc 0as ade2uate ta4ab$e pro its to re$ieve a$$ its costs. 30e rate o corporation ta4 can be assumed to be ,0I. 30e company1s accounting year6end is ,1 December. 30e company1s annua$ a ter ta4 cost o capita$ is 10I. Re2uiredH !a# Ca$cu$ate t0e net present va$ue at ,1 December 200+( using t0e a ter ta4 cost o capita$( or@ !i# purc0asing t0e mac0ine outrig0t !ii# using t0e inance $ease to ac2uire t0e mac0ine !iii# using t0e operating $ease to ac2uire t0e mac0ine. "ecommend t0e optima$ met0od. !12 marks# Assume no< t0at t0e company is acing capita$ rationing up unti$ ,0 December 2009 <0en it e4pects to make a s0are issue. During t0is time t0e most margina$ investment pro7ect( <0ic0 is per ect$y divisib$e( re2uires an out$ay o O>00(000 and <ou$d generate a net present va$ue o O100(000. )nvestment in t0e turbine <ou$d reduce unds avai$ab$e or t0is pro7ect. )nvestments cannot be de$ayed. Ca$cu$ate t0e revised net present va$ues o t0e t0ree options or t0e turbine given capita$ rationing. Advise <0et0er your recommendation in !a# <ou$d c0ange. !> marks# As t0eir business advisor( prepare a report or t0e directors o 8eaminger )nc t0at

!b#

!c#

,,

assesses t0e issues t0at need to be considered in ac2uiring t0e turbine <it0 respect to capita$ rationing. !+ marks# !3ota$ 2> marks# !Adapted ACCA Paper 2.% /inancia$ ;anagement and Contro$ December 2002 Q%# ..2 ?.2.1 ?.2.2 Asset replacement &P' can be app$ied to situations o assets rep$acement. Compare t0e purc0ase cost <it0 t0e cost savings or bene its( Cost savings or bene its G purc0ase cost( rep$ace t0e o$d one. Replacement c6cles 3&ec :>* =un 1:* =un 124

..% ?.,.1

:o< re2uent$y s0ou$d an asset be rep$acedA 30e e2uivalent annual cost 3EA"4 or annual e2uivalent annuit6 3AEA4 can be used or eva$uation. =AC C &P' o costs Annuity actor or t0e number o years in t0e cyc$e 30e best decision is to choose the option (ith the lo(est EA".

?.,.2

)s it <ort0 paying more or an asset t0at 0as a $onger e4pected $i eA 30e e2uivalent annual 7enefit 3EAJ4 can be app$ied. =AR C &P' o pro7ect Annuity actor or t0e $i e o pro7ect 30e best decision is to choose the option (ith the hi!hest e2uivalent annual 7enefit.

Question 1% Replacement c6cle and limitations of 0#/ Rread Products 8td is considering t0e rep$acement po$icy or its industria$ siFe ovens <0ic0 are used as part o a production $ine t0at bakes bread. Biven its 0eavy usage eac0 oven 0as to be rep$aced re2uent$y. 30e c0oice is bet<een rep$acing every t<o years or every t0ree years. 9n$y one type o oven is used( eac0 o <0ic0 costs O2%(>00. ;aintenance costs and resa$e va$ues are as o$$o<s@

,%

Mear 1 2 ,

;aintenance per annum O >00 +00 1(>00

"esa$e va$ue O 1>(?00 11(200

9rigina$ cost( maintenance costs and resa$e va$ues are e4pressed in current prices. 30at is( or e4amp$e( maintenance or a t<o year o$d oven <ou$d cost O+00 or maintenance undertaken no<. )t is e4pected t0at maintenance costs <i$$ increase at 10I per annum and oven rep$acement cost and resa$e va$ues at >I per annum. 30e money discount rate is 1>I. Re2uiredH !a# !b# Ca$cu$ate t0e pre erred rep$acement po$icy or t0e ovens in a c0oice bet<een a t<o year or t0ree year rep$acement cyc$e. !12 marks# )denti y t0e $imitations o &et Present 'a$ue tec0ni2ues <0en app$ied genera$$y to investment appraisa$. !1, marks# !2> marks# "apital rationin! 3&ec :>* &ec 114

..) ?.%.1 ?.%.2 ?.%.,

?.%.%

)n a perfect capital mar,et( a company can raise funds as and (hen it needs t0em. :o<ever( in practice( it is not t0e case. 30e capita$ avai$ab$e is a$<ays to be limited or rationed. 30ere are t<o types o rationing@ External 3hard4 capita$ rationing@ "annot raise external finance due to too ris,6. 1inancial ris, . t0e company1s !earin! may be seen as too hi!h. Jusiness ris, . lenders may be uncertain on t0e company1s future profits <0et0er it can meet t0e interest and principa$ payments Internal 3soft4 capita$ rationing@ Mana!ers impose restrictions on t0e unds. 30e reasons are as o$$o<s@ ;anagers may not (ant to raise ne( external finance( or e4amp$e &ot <is0 to raise ne< debt to increase uture interest payments &ot <is0 to issue ne< e2uity to avoid di$ution o contro$. ;anagers may prefer slo(er or!anic !ro(th in order to remain in contro$ o t0e gro<t0 process and so avoid rapid !ro(th. ;anagers may <ant to make capita$ investments compete for funds in order

,>

?.%.>

to (ee, out (ea,er or mar!inal pro$ects. in!le period capita$ rationing "ationing occurs <0en limits are placed for onl6 one 6ear or one period. T(o t6pes o sing$e6period rationing@ &ivisi7le pro7ects . a proportion rat0er t0an t0e <0o$e investment can 7e underta,en and use profita7ilit6 index 3#I4 to ran, t0e pro7ect or priority. P) C P' o uture cas0 $o<s )nitia$ investment Indivisi7le pro7ects . use trial and error to ind t0e a ordab$e combination t0at ma4imiFes &P' Multi'period capita$ rationing 8imits are p$aced or more than one period( in t0is case( linear pro!rammin! s0ou$d be emplo6ed. ;ore comp$e4 $inear programming prob$ems re2uire t0e use o computers. #ractical steps to deal (ith capita$ rationing inc$ude@ Leasin! =ntering into a $oint venture <it0 a partner &ela6in! pro$ects to a $ater period Raisin! ne( capital i possib$e

?.%.?

?.%.*

Question 1) "apital rationin! and relevant cash flo(s Rasri$ p$c is revie<ing investment proposa$s t0at 0ave been submitted by divisiona$ managers. 30e investment unds o t0e company are $imited to O+00(000 in t0e current year. Detai$s o t0ree possib$e investments( none o <0ic0 can be de$ayed( are given be$o<. #ro$ect 1 An investment o O,00(000 in <ork station assessments. =ac0 assessment <ou$d be on an individua$ emp$oyee basis and <ou$d $ead to savings in $abour costs rom increased e iciency and rom reduced absenteeism due to <ork6re$ated i$$ness. -avings in $abour costs rom t0ese assessments in money terms are e4pected to be as o$$o<s@ Mear 1 2 , % > Cas0 $o<s !O000# +> 90 9> 100 9> #ro$ect 2

,?

An investment o O%>0(000 in individua$ <orkstations or sta t0at is e4pected to reduce administration costs by O1%0(+00 per annum in money terms or t0e ne4t ive years. #ro$ect % An investment o O%00(000 in ne< ticket mac0ines. &et cas0 savings o O120(000 per annum are e4pected in current price terms and t0ese are e4pected to increase by ,P?I per annum due to in $ation during t0e ive6year $i e o t0e mac0ines. Rasri$ p$c 0as a money cost o capita$ o 12I and ta4ation s0ou$d be ignored. Re2uiredH !a# Determine t0e best <ay or Rasri$ p$c to invest t0e avai$ab$e unds and ca$cu$ate t0e resu$tant &P'@ !i# on t0e assumption t0at eac0 o t0e t0ree pro7ects is divisib$eQ !ii# on t0e assumption t0at none o t0e pro7ects are divisib$e. !10 marks# =4p$ain 0o< t0e &P' investment appraisa$ met0od is app$ied in situations <0ere capita$ is rationed. !, marks# Discuss t0e reasons <0y capita$ rationing may arise. !* marks# Discuss t0e meaning o t0e term Sre$evant cas0 $o<s1 in t0e conte4t o investment appraisa$( giving e4amp$es to i$$ustrate your discussion. !> marks# !2> marks# !ACCA 2.% /inancia$ ;anagement and Contro$ December 200, Q,#

!b# !c# !d#

,*

Additional Examination t6le Questions

Question 1- +A""* 0#/ and #ro$ect'specific &iscount Rate "upab Co is a manu acturing company t0at <is0es to eva$uate an investment in ne< production mac0inery. 30e mac0inery <ou$d enab$e t0e company to satis y increasing demand or e4isting products and t0e investment is not e4pected to $ead to any c0ange in t0e e4isting $eve$ o business risk o "upab Co. 30e mac0inery <i$$ cost O2P> mi$$ion( payab$e at t0e start o t0e irst year o operation( and is not e4pected to 0ave any scrap va$ue. Annua$ be ore6ta4 net cas0 $o<s o O?+0(000 per year <ou$d be generated by t0e investment in eac0 o t0e ive years o its e4pected operating $i e. 30ese net cas0 in $o<s are be ore taking account o e4pected in $ation o ,I per year. )nitia$ investment o O2%0(000 in <orking capita$ <ou$d a$so be re2uired( o$$o<ed by incrementa$ annua$ investment to maintain t0e purc0asing po<er o <orking capita$. "upab Co 0as in issue ive mi$$ion s0ares <it0 a market va$ue o O,P+1 per s0are. 30e e2uity beta o t0e company is 1P2. 30e yie$d on s0ort6term government debt is %P>I per year and t0e e2uity risk premium is appro4imate$y >I per year. 30e debt inance o "upab Co consists o bonds <it0 a tota$ book va$ue o O2 mi$$ion. 30ese bonds pay annua$ interest be ore ta4 o *I. 30e par va$ue and market va$ue o eac0 bond is O100. "upab Co pays ta4ation one year in arrears at an annua$ rate o 2>I. Capita$ a$$o<ances !ta46 a$$o<ab$e depreciation# on mac0inery are on a straig0t6$ine basis over t0e $i e o t0e asset. Re2uiredH !a# !b# !c# Ca$cu$ate t0e a ter6ta4 <eig0ted average cost o capita$ o "upab Co. !? marks# Prepare a orecast o t0e annua$ a ter6ta4 cas0 $o<s o t0e investment in nomina$ terms( and ca$cu$ate and comment on its net present va$ue. !+ marks# =4p$ain 0o< t0e capita$ asset pricing mode$ can be used to ca$cu$ate a pro7ect6speci ic discount rate and discuss t0e $imitations o using t0e capita$ asset pricing mode$ in investment appraisa$. !11 marks# !2> marks# !ACCA /9 /inancia$ ;anagement December 200+ Q,#

Question 1. 0#/ and #ro$ect'specific "ost of E2uit6

,+

CJ Co is a pro itab$e company <0ic0 is inanced by e2uity <it0 a market va$ue o O1+0 mi$$ion and by debt <it0 a market va$ue o O%> mi$$ion. 30e company is considering t<o investment pro7ects( as o$$o<s. #ro$ect A 30is pro7ect is an e4pansion o e4isting business costing O,P> mi$$ion( payab$e at t0e start o t0e pro7ect( <0ic0 <i$$ increase annua$ sa$es by *>0(000 units. )n ormation on unit se$$ing price and costs is as o$$o<s@ -e$$ing price@ -e$$ing costs@ 'ariab$e costs@ O2.00 per unit !current price terms# O0.0% per unit !current price terms# O0.+0 per unit !current price terms#

-e$$ing price in $ation and se$$ing cost in $ation are e4pected to be >I per year and variab$e cost in $ation is e4pected to be %I per year. Additiona$ initia$ investment in <orking capita$ o O2>0(000 <i$$ a$so be needed and t0is is e4pected to increase in $ine <it0 genera$ in $ation. #ro$ect J 30is pro7ect is a diversi ication into a ne< business area t0at <i$$ cost O% mi$$ion. A company t0at a$ready operates in t0e ne< business area( BT Co( 0as an e2uity beta o 1P>. BT Co is inanced *>I by e2uity <it0 a market va$ue o O90 mi$$ion and 2>I by debt <it0 a market va$ue o O,0 mi$$ion. Dther information CJ Co 0as a nomina$ <eig0ted average a ter6ta4 cost o capita$ o 10I and pays pro it ta4 one year in arrears at an annua$ rate o ,0I. 30e company can c$aim capita$ a$$o<ances !ta46 a$$o<ab$e depreciation# on a 2>I reducing ba$ance basis on t0e initia$ investment in bot0 pro7ects. "isk6 ree rate o return@ %I =2uity risk premium@ ?I Benera$ rate o in $ation@ %P>I per year &irectorsA vie(s on investment appraisal 30e directors o CJ Co re2uire t0at a$$ investment pro7ects s0ou$d be eva$uated using eit0er payback period or return on capita$ emp$oyed !accounting rate o return#. 30e target payback period o t0e company is t<o years and t0e target return on capita$ emp$oyed is 20I( <0ic0 is t0e current return on capita$ emp$oyed o CJ Co. A pro7ect is accepted i it satis ies eit0er o
,9

t0ese investment criteria. 30e directors a$so re2uire a$$ investment pro7ects to be eva$uated over a our6year p$anning period( ignoring any scrap va$ue or <orking capita$ recovery( <it0 a ba$ancing a$$o<ance !i any# being c$aimed at t0e end o t0e ourt0 year o operation. Re2uiredH !a# !b# !c# Ca$cu$ate t0e net present va$ue o Pro7ect A and advise on its acceptabi$ity i t0e pro7ect <ere to be appraised using t0is met0od. !12 marks# Critica$$y discuss t0e directors1 vie<s on investment appraisa$. !* marks# Ca$cu$ate a pro7ect6speci ic cost o e2uity or Pro7ect R and e4p$ain t0e stages o your ca$cu$ation. !? marks# !2> marks# !ACCA /9 /inancia$ ;anagement December 2010 Q1#

Question 1B 0#/* IRR and Maximi?ation of hareholdersA +ealth -C Co is eva$uating t0e purc0ase o a ne< mac0ine to produce product P( <0ic0 0as a s0ort product $i e6cyc$e due to rapid$y c0anging tec0no$ogy. 30e mac0ine is e4pected to cost O1 mi$$ion. Production and sa$es o product P are orecast to be as o$$o<s@ Mear Production and sa$es !unitsEyear# 1 ,>(000 2 >,(000 , *>(000 % ,?(000

30e se$$ing price o product P !in current price terms# <i$$ be O20 per unit( <0i$e t0e variab$e cost o t0e product !in current price terms# <i$$ be O12 per unit. -e$$ing price in $ation is e4pected to be %I per year and variab$e cost in $ation is e4pected to be >I per year. &o increase in e4isting i4ed costs is e4pected since -C Co 0as spare capacity in bot0 space and $abour terms. Producing and se$$ing product P <i$$ ca$$ or increased investment in <orking capita$. Ana$ysis o 0istorica$ $eve$s o <orking capita$ <it0in -C Co indicates t0at at t0e start o eac0 year( investment in <orking capita$ or product P <i$$ need to be *I o sa$es revenue or t0at year. -C Co pays ta4 o ,0I per year in t0e year in <0ic0 t0e ta4ab$e pro it occurs. 8iabi$ity to ta4 is reduced by capita$ a$$o<ances on mac0inery !ta46a$$o<ab$e depreciation#( <0ic0 -C Co can c$aim on a straig0t6$ine basis over t0e our6year $i e o t0e proposed investment. 30e ne<
%0

mac0ine is e4pected to 0ave no scrap va$ue at t0e end o t0e our6year period. -C Co uses a nomina$ !money terms# a ter6ta4 cost o capita$ o 12I or investment appraisa$ purposes. Re2uiredH !a# !b# !c# !d# Ca$cu$ate t0e net present va$ue o t0e proposed investment in product P. !12 marks# Ca$cu$ate t0e interna$ rate o return o t0e proposed investment in product P. !, marks# Advise on t0e acceptabi$ity o t0e proposed investment in product P and discuss t0e $imitations o t0e eva$uations you 0ave carried out. !> marks# Discuss 0o< t0e net present va$ue met0od o investment appraisa$ contributes to<ards t0e ob7ective o ma4imising t0e <ea$t0 o s0are0o$ders. !> marks# !3ota$ 2> marks# !ACCA /9 /inancia$ ;anagement June 200+ Q%#

Question 1@ 0#/* IRR and "omparison of Investment Appraisal Methods C0arm p$c( a so t<are company( 0as deve$oped a ne< game( S/ingo1( <0ic0 it p$ans to $aunc0 in t0e near uture. -a$es o t0e ne< game are e4pected to be very strong( o$$o<ing a avourab$e revie< by a popu$ar PC magaFine. C0arm p$c 0as been in ormed t0at t0e revie< <i$$ give t0e game a SRest Ruy1 recommendation. -a$es vo$umes( production vo$umes and se$$ing prices or S/ingo1 over its our6year $i e are e4pected to be as o$$o<s. Mear -a$es and production !units# -e$$ing price !U per game# 1 1>0(000 U2> 2 *0(000 U2% , ?0(000 U2, % ?0(000 U22

/inancia$ in ormation on S/ingo1 or t0e irst year o production is as o$$o<s@ Direct materia$ cost 9t0er variab$e production cost /i4ed costs U>.%0 per game U?.00 per game U%.00 per game

Advertising costs to stimu$ate demand are e4pected to be U?>0(000 in t0e irst year o production and U100(000 in t0e second year o production. &o advertising costs are e4pected in t0e t0ird and ourt0 years o production. /i4ed costs represent incrementa$ cas0 i4ed
%1

production over0eads. S/ingo1 <i$$ be produced on a ne< production mac0ine costing U+00(000. A$t0oug0 t0is production mac0ine is e4pected to 0ave a use u$ $i e o up to ten years( government $egis$ation a$$o<s C0arm p$c to c$aim t0e capita$ cost o t0e mac0ine against t0e manu acture o a sing$e product. Capita$ a$$o<ances <i$$ t0ere ore be c$aimed on a straig0t6$ine basis over our years. C0arm p$c pays ta4 on pro it at a rate o ,0I per year and ta4 $iabi$ities are sett$ed in t0e year in <0ic0 t0ey arise. C0arm p$c uses an a ter6ta4 discount rate o 10I <0en appraising ne< capita$ investments. )gnore in $ation. Re2uiredH !a# !b# !c# Ca$cu$ate t0e net present va$ue o t0e proposed investment and comment on your indings. !11 marks# Ca$cu$ate t0e interna$ rate o return o t0e proposed investment and comment on your indings. !> marks# Discuss t0e reasons <0y t0e net present va$ue investment appraisa$ met0od is pre erred to ot0er investment appraisa$ met0ods suc0 as payback( return on capita$ emp$oyed and interna$ rate o return. !9 marks# !3ota$ 2> marks# !ACCA Paper 2.% /inancia$ ;anagement and Contro$ June 200? Q>#

Question 1> 0#/ and &iscussion (ith Ris, Incorporation R"3 Co 0as deve$oped a ne< con ectionery $ine t0at can be so$d or O>P00 per bo4 and t0at is e4pected to 0ave continuing popu$arity or many years. 30e /inance Director 0as proposed t0at investment in t0e ne< product s0ou$d be eva$uated over a our6year time60oriFon( even t0oug0 sa$es <ou$d continue a ter t0e ourt0 year( on t0e grounds t0at cas0 $o<s a ter our years are too uncertain to be inc$uded in t0e eva$uation. 30e variab$e and i4ed costs !bot0 in current price terms# <i$$ depend on sa$es vo$ume( as o$$o<s.
-a$es vo$ume !bo4es# 'ariab$e costs !O per bo4# 3ota$ i4ed costs !O# $ess t0an 1 mi$$ion 2.+ 1 mi$$ion 1 . 1.9 mi$$ion ,.00 1.+ mi$$ion 2 . 2.9 mi$$ion ,.00 2.+ mi$$ion , . ,.9 mi$$ion ,.0> ,.+ mi$$ion

/orecast sa$es vo$umes are as o$$o<s.

Mear

1
%2

Demand !bo4es#

0.* mi$$ion

1.? mi$$ion

2.1 mi$$ion

,.0 mi$$ion

30e production e2uipment or t0e ne< con ectionery $ine <ou$d cost O2 mi$$ion and an additiona$ initia$ investment o O*>0(000 <ou$d be needed or <orking capita$. Capita$ a$$o<ances !ta46a$$o<ab$e depreciation# on a 2>I reducing ba$ance basis cou$d be c$aimed on t0e cost o e2uipment. Pro it ta4 o ,0I per year <i$$ be payab$e one year in arrears. A ba$ancing a$$o<ance <ou$d be c$aimed in t0e ourt0 year o operation. 30e average genera$ $eve$ o in $ation is e4pected to be ,I per year and se$$ing price( variab$e costs( i4ed costs and <orking capita$ <ou$d a$$ e4perience in $ation o t0is $eve$. R"3 Co uses a nomina$ a ter6ta4 cost o capita$ o 12I to appraise ne< investment pro7ects. Re2uiredH !a# Assuming t0at production on$y $asts or our years( ca$cu$ate t0e net present va$ue o investing in t0e ne< product using a nomina$ terms approac0 and advise on its inancia$ acceptabi$ity !<ork to t0e nearest O1(000#. !1, marks# Comment brie $y on t0e proposa$ to use a our6year time 0oriFon( and ca$cu$ate and discuss a va$ue t0at cou$d be p$aced on a ter6ta4 cas0 $o<s arising a ter t0e ourt0 year o operation( using a perpetuity approac0. Assume( or t0is part o t0e 2uestion on$y( t0at be ore6ta4 cas0 $o<s and pro it ta4 are constant rom year ive on<ards( and t0at capita$ a$$o<ances and <orking capita$ can be ignored. !> marks# Discuss 3:"== <ays o incorporating risk into t0e investment appraisa$ process. !* marks# !2> marks# !ACCA /9 /inancia$ ;anagement June 2011 Q1#

!b#

!c#

%,

Question 2: 0#/* IRR* ensitivit6 Anal6sis and "apital Rationin! 5arden Co p$ans to buy a ne< mac0ine. 30e cost o t0e mac0ine( payab$e immediate$y( is O+00(000 and t0e mac0ine 0as an e4pected $i e o ive years. Additiona$ investment in <orking capita$ o O90(000 <i$$ be re2uired at t0e start o t0e irst year o operation. At t0e end o ive years( t0e mac0ine <i$$ be so$d or scrap( <it0 t0e scrap va$ue e4pected to be >I o t0e initia$ purc0ase cost o t0e mac0ine. 30e mac0ine <i$$ not be rep$aced. Production and sa$es rom t0e ne< mac0ine are e4pected to be 100(000 units per year. =ac0 unit can be so$d or O1? per unit and <i$$ incur variab$e costs o O11 per unit. )ncrementa$ i4ed costs arising rom t0e operation o t0e mac0ine <i$$ be O1?0(000 per year. 5arden Co 0as an a ter6ta4 cost o capita$ o 11I <0ic0 it uses as a discount rate in investment appraisa$. 30e company pays pro it ta4 one year in arrears at an annua$ rate o ,0I per year. Capita$ a$$o<ances and in $ation s0ou$d be ignored. Re2uiredH !a# !b# !c# Ca$cu$ate t0e net present va$ue o investing in t0e ne< mac0ine and advise <0et0er t0e investment is inancia$$y acceptab$e. !* marks# Ca$cu$ate t0e interna$ rate o return o investing in t0e ne< mac0ine and advise <0et0er t0e investment is inancia$$y acceptab$e. !% marks# !i# =4p$ain brie $y t0e meaning o t0e term Ssensitivity ana$ysis1 in t0e conte4t o investment appraisa$Q !1 mark# !ii# Ca$cu$ate t0e sensitivity o t0e investment in t0e ne< mac0ine to a c0ange in se$$ing price and to a c0ange in discount rate( and comment on your indings. !? marks# Discuss t0e nature and causes o t0e prob$em o capita$ rationing in t0e conte4t o investment appraisa$( and e4p$ain 0o< t0is prob$em can be overcome in reac0ing t0e optima$ investment decision or a company. !* marks# !2> marks# !ACCA /9 /inancia$ ;anagement December 2011 Q1#

!d#

%%

Question 21 0#/* E2uivalent Annual "ost* ensitivit6 and #rofita7ilit6 Anal6sis "idag Co is eva$uating t<o investment pro7ects( as o$$o<s. #ro$ect 1 30is is an investment in ne< mac0inery to produce a recent$y6deve$oped product. 30e cost o t0e mac0inery( <0ic0 is payab$e immediate$y( is O1P> mi$$ion( and t0e scrap va$ue o t0e mac0inery at t0e end o our years is e4pected to be O100(000. Capita$ a$$o<ances !ta46 a$$o<ab$e depreciation# can be c$aimed on t0is investment on a 2>I reducing ba$ance basis. )n ormation on uture returns rom t0e investment 0as been orecast to be as o$$o<s@ 8ear -a$es vo$ume !unitsEyear# -e$$ing price !OEunit# 'ariab$e cost !OEunit# /i4ed costs !OEyear# 1 >0(000 2>.00 10.00 10>(000 2 9>(000 2%.00 11.00 11>(000 % 1%0(000 2,.00 12.00 12>(000 ) *>(000 2,.00 12.>0 12>(000

30is in ormation must be ad7usted to a$$o< or se$$ing price in $ation o %I per year and variab$e cost in $ation o 2P>I per year. /i4ed costs( <0ic0 are <0o$$y attributab$e to t0e pro7ect( 0ave a$ready been ad7usted or in $ation. "idag Co pays pro it ta4 o ,0I per year one year in arrears. #ro$ect 2 "idag Co p$ans to rep$ace an e4isting mac0ine and must c0oose bet<een t<o mac0ines. ;ac0ine 1 0as an initia$ cost o O200(000 and <i$$ 0ave a scrap va$ue o O2>(000 a ter our years. ;ac0ine 2 0as an initia$ cost o O22>(000 and <i$$ 0ave a scrap va$ue o O>0(000 a ter t0ree years. Annua$ maintenance costs o t0e t<o mac0ines are as o$$o<s@ 8ear ;ac0ine 1 !OEyear# ;ac0ine 2 !OEyear# 1 2>(000 1>(000 2 29(000 20(000 % ,2(000 2>(000 ) ,>(000

50ere re$evant( a$$ in ormation re$ating to Pro7ect 2 0as a$ready been ad7usted to inc$ude e4pected uture in $ation. 3a4ation and capita$ a$$o<ances must be ignored in re$ation to ;ac0ine 1 and ;ac0ine 2. Dther information "idag Co 0as a nomina$ be ore6ta4 <eig0ted average cost o capita$ o 12I and a nomina$ a ter6ta4 <eig0ted average cost o capita$ o *I.
%>

Re2uiredH !a# !b# !c# Ca$cu$ate t0e net present va$ue o Pro7ect 1 and comment on <0et0er t0is pro7ect is inancia$$y acceptab$e to "idag Co. !12 marks# Ca$cu$ate t0e e2uiva$ent annua$ costs o ;ac0ine 1 and ;ac0ine 2( and discuss <0ic0 mac0ine s0ou$d be purc0ased. !? marks# Critica$$y discuss t0e use o sensitivity ana$ysis and probabi$ity ana$ysis as <ays o inc$uding risk in t0e investment appraisa$ process( re erring in your ans<er to t0e re$ative e ectiveness o eac0 met0od. !* marks# !2> marks# !ACCA /9 /inancia$ ;anagement June 2012 Q1#

Question 22 0#/* ARR* interest rate and capital investment decision RQL Co( a 0ouse6bui$ding company( p$ans to bui$d 100 0ouses on a deve$opment site over t0e ne4t our years. 30e purc0ase cost o t0e deve$opment site is O%(000(000( payab$e at t0e start o t0e irst year o construction. 3<o types o 0ouse <i$$ be bui$t( <it0 annua$ sa$es o eac0 0ouse e4pected to be as o$$o<s@ 8ear &umber o sma$$ 0ouses so$d@ &umber o $arge 0ouses so$d@ 1 1> * 2 20 + % 1> 1> ) > 1>

:ouses are bui$t in t0e year o sa$e. =ac0 customer inances t0e purc0ase o a 0ome by taking out a $ong6term persona$ $oan rom t0eir bank. /inancia$ in ormation re$ating to eac0 type o 0ouse is as o$$o<s@ mall house O200(000 O100(000 Lar!e house O,>0(000 O200(000

-e$$ing price@ 'ariab$e cost o construction@

-e$$ing prices and variab$e cost o construction are in current price terms( be ore a$$o<ing or se$$ing price in $ation o ,I per year and variab$e cost o construction in $ation o %P>I per year. /i4ed in rastructure costs o O1(>00(000 per year in current price terms <ou$d be incurred. 30ese <ou$d not re$ate to any speci ic 0ouse( but <ou$d be or t0e provision o ne< roads( gardens( drainage and uti$ities. )n rastructure cost in $ation is e4pected to be 2I per year.

%?

RQL Co pays pro it ta4 one year in arrears at an annua$ rate o ,0I. 30e company can c$aim capita$ a$$o<ances on t0e purc0ase cost o t0e deve$opment site on a straig0t6$ine basis over t0e our years o construction. RQL Co 0as a rea$ a ter6ta4 cost o capita$ o 9I per year and a nomina$ a ter6ta4 cost o capita$ o 12I per year. &e< investments are re2uired by t0e company to 0ave a be ore6ta4 return on capita$ emp$oyed !accounting rate o return# on an average investment basis o 20I per year. Re2uiredH !a# !b# Ca$cu$ate t0e net present va$ue o t0e proposed investment and comment on its inancia$ acceptabi$ity. 5ork to t0e nearest O1(000. !1, marks# Ca$cu$ate t0e be ore6ta4 return on capita$ emp$oyed !accounting rate o return# o t0e proposed investment on an average investment basis and discuss brie $y its inancia$ acceptabi$ity. !> marks# Discuss t0e e ect o a substantia$ rise in interest rates on t0e inancing cost o RQL Co and its customers( and on t0e capita$ investment appraisa$ decision6making process o RQL Co. !* marks# !2> marks# !ACCA /9 /inancia$ ;anagement December 2012 Q1#

!c#

%*