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ACCA Paper F9 – Financial Management

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+AddVance ACCA Paper F9


Financial Management

Data Map +AddVance Study Text

Contents
ISBM and Copyright statement
For the ladies only
+AddVance Study text
Our aim
There are 15 tutorials
Reference icons and colour codes
The syllabus outline and our pathway along it ….
Contents of an+AddVance tutorial
A lighthearted but not lightweight approach to studying
Why study from a computer screen?
Electronic links within the database
Print outs

Syllabus
The structure of the syllabus
Intellectual levels
Learning hours
Guide to exam structure
Guide to examination assessment
Aim
Main capabilities
Relational diagram of main capabilities
Rational
Detailed syllabus
Approach to examining the syllabus

Study guide
A. Financial management function
B. Financial management environment
C. Working capital management
D. Investment appraisal
E. Business finance
F. Cost of capital
G. Business valuations
H. Risk management

PV table
Annuity table
Formulae sheet
Symbols and notations

Route maps
Tutorial pathway

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ability in a number of ways …..

+A How to focus quickly on the facts and figures that matter most in a given situation (either in the exam
hall or in professional practice).

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+A How to present exam answers (and reports) for greater impact and acceptance by your examiners
(and by implication acceptance at all levels of management).

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working with financial facts and fingers within a financial team).

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planning and other decision making).

There are 15 tutorials


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 practical examples - to reinforce important concepts
 tutorial comments - as additional explanation to clarify uncertainties
 tables and charts - for summaries and overviews
 a fast and flexible search facility

Compatible with Tony Surridge's own teaching approach, our +AddVance materials lets you study at your own
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Reference icons and colour codes


Look for the following ICONS and COLOUR CODES in the different screens.

Tutorial objectives
You will find this icon at the front of each Tutorial. It signals objectives and a
synopsis of the topics that are covered in the tutorial you are about to start.

Activity
This is a short problem that exercises your understanding of the topic
concerned.

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A step by step answer that allows you to assess how well you have
addressed the problem. The answer is positioned immediately after the
activity.

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Definitions are important building blocks. Take care not to learn them ‘word-
by-word in parrot fashion’. Examiners are not impressed with candidates who
simply produce ‘paper replicas’ by using rote learning methods.

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develops a complicated concept.

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The summary screen itemises the topics covered in the tutorial you have just
studied.

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The syllabus outline and our


pathway along it ….
‘Click and flick’ from this screen to your
+AddVance tutorials.

TUTORIAL 2
TUTORIAL 1
STAKEHOLDERS TUTORIAL 3 TUTORIAL 5 TUTORIAL 6
THE TUTORIAL 4
AND THEIR OBJECTIVES IN THE ECONOMIC WORKING
FINANCIAL FINANCIAL
IMPACT ON NOT-FOR-PROFIT ENVIRONMENT CAPITAL
MANAGEMENT ANALYSIS
CORPORATE ORGANISATIONS FOR BUSINESS MANAGEMENT
FUNCTION
OBJECTIVES

SAMPLE
CHAPTER

TUTORIAL 7
WORKING TUTORIAL 8 TUTORIAL 10 TUTORIAL 11
CAPITAL THE NATURE CAPITAL CAPITAL TUTORIAL 12
TUTORIAL 9
NEEDS, CASH AND ROLE OF INVESTMENT INVESTMENT BUSINESS
BUSINESS
MANAGEMENT FINANCIAL APPRAISAL: APPRAISAL: VALUATIONS
FINANCE
AND FUNDING MARKETS AND NATURE AND APPLICATIONS
STRATEGIES INSTITUTIONS TECHNIQUES

TUTORIAL 14
GEARING
TUTORIAL 13 TUTORIAL 15
AND CAPITAL
COST OF RISK
STRUCTURE
CAPITAL MANAGEMENT
CONSIDERA-
TIONS

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The syllabus outline and our pathway along it ….


Tutorial Link
TUTORIAL 1 28
The financial management function
TUTORIAL 2 54
Stakeholders and their impact on corporate objectives
TUTORIAL 3 80
Objectives in not-for-profit organisations
TUTORIAL 4 91
Financial analysis
TUTORIAL 5 124
The economic environment for business
TUTORIAL 6 158
Working capital management
TUTORIAL 7 209
Working capital needs, cash management and funding strategies
TUTORIAL 8 256
The nature and role of financial markets and institutions
TUTORIAL 9 299
Business finance
TUTORIAL 10 339
Capital investment appraisal: Nature and techniques
TUTORIAL 11 382
Capital investment appraisal: Applications
TUTORIAL 12 440
Business valuations
TUTORIAL 13 483
Costs of capital
TUTORIAL 14 532
Gearing and capital structure considerations
TUTORIAL 15 586
Risk management

The beginning is the most important part of any


work.

Plato
370 B.C.

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List of important Symbols

d0 Current dividend
d1 Next dividend
dn Dividend in year n
g Expected annual percentage growth in dividends
i Annual interest payment
P0 Current market value of a security
Ve Market value of equity
Vd The market value of debt
Vb The market value of a bond
Va Total market value of a firm
T Rate of corporation (or corporate) tax
ke Cost of equity
kp Cost of preference shares
kd Cost of debt
WACC Weighted average cost of capital
re Expected return of equity
rp Expected return of preference shares
rd Expected return of debt
rf Risk-free interest rate
rm Expected return on the market portfolio
ß Beta factor
ßa Asset beta
ße Equity beta
ßd Debt beta
PV Present value
NPV Net present vale
IRR Internal rate of return
EPS Earnings per share
ROE Return on equity
PBIT Profit before interest and tax
R Real rate of return
M Nominal (or money) rate of return
P Inflation rate that affects purchasing power
Ch Cost of holding inventory
C0 Cost of a purchase receipt
D Annual demand for material
JIT Just in time
EOQ Economic order quantity
F0 Expected spot rate
S0 Current spot rate
ic Interest rate of country C
ib Interest rate of country B
hc Interest rate of country C
hb Interest rate of country B

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Economic order quantity


2C0 D
=
CH

Miller-Orr Model
1 
Return point = Lower limit +  x spread 
 3 
1
 3 3
 x transaction cost x variance of cash flows 
Spread = 3 4 
 interest rate 
 
 

The capital Asset Pricing Model

( ) (
E r i = R f + βi E(rm ) - R f )
The asset beta formula
 Ve   V + (1 - T) 
βa = 


( βe  +  d
Ve + Vd (1 - T ) 

)
 Ve + V (1 - T )
 d
βd 


( )
The Growth Model
D0 (1 + g )
P0 =
(re - g )

Gordon’s growth approximation


g = bre

The weighted average cost of capital

   Vd 
Ve
(1 - T )
WACC = 

(
 Ve + V
d )k
 e

+ 
(
 Ve + V
 d )
k
 d

The Fisher formula


(1 + i) = (1 + r )(1 + h )
Purchasing power parity and interest rate parity
(1 + h c ) (1 + ic )
s1 = s 0 x
1 + hb ( ) f1 = s 0 x
(
1 + ib )

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Present Value Table

Present value of 1 i.e. (1 + r)- n

here r = discount rate


n = number of periods until payment

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Annuity Table

Present value of an annuity of 1 i.e.


(
1 - 1 + r)- n )
r
Where r = discount rate
n = number of periods

“It has always been an axiom of mine that the little


things are infinitely the most important.”

Sherlock Holmes
Arthur Conan Doyle, 1859 - 1930

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Tutorial 10
Investment appraisal –
Nature and techniques

ACCA Paper F9
Financial Management

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In this tutorial:

 The capital budgeting cycle.


 Types of capital expenditure.
 Working capital.
 Capital expenditure forecast.
 Capital Expenditure Committee.
 Capital expenditure decision.
 Authorisation of capital projects.
 Capital expenditure control.
 Evaluation of alternative investments.
 Determination of business strategy.
 Establishing investment funding implications.
 Undertake initiate initial investment feasibility study.
 Detailed business case.
 Project authorisation.
 Control of authorised projects.
 Post-implementation review.
 Introduction to capital investment appraisal
 Cashflows and their timing.
 Opportunity costs and cashflow.
 Main evaluative criteria.
 Three project scenarios.
 The payback method.
 Calculation of the payback period.
 The effect of tax on the payback period.;
 Limitations and strengths.
 The ARR method.
 Calculation of ARR.
 Limitations and strengths.
 Compound interest.
 Discounting.
 Annuities.
 Perpetuities.
 Different approaches.
 Risk adjustment.
 IRR method.
 Use of linear Interpolation.
 Projects with constant cash flows.
 Cash flows which are perpetuities.
 Multiple internal rates of return
 Implications of the IRR.
 Conflict between NPV and IRR.
 Advantages of DCF and advantages/limitations of IRR and NPV.

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The capital budgeting process

1. The capital budgeting cycle

An ongoing feature of business activity is the need to commit funds by purchasing land, buildings,
machinery, etc., in anticipation of being able to earn, in the future, an income greater than the funds
committed. This indicates the need for an assessment of:

(a) the size of the outflows and inflows of funds,


(b) the life or the investment,
(c) the degree of risk attached (greater risk being justified perhaps by greater returns), and
(d) the cost of obtaining funds.

Particularly in recent years many chief executives and boards of directors have made, or are still
contemplating, major investments in advanced manufacturing technology as part of a world-class
manufacturing strategy to strengthen or sustain their competitive position. Such decisions are
particularly difficult in periods of cash shortage, but equally important if companies are going to hold or
build their market share.

2. Types of capital expenditure

Reasons for capital expenditure vary widely. Projects may be classified into the following categories:
(a) Maintenance - replacement of worn out or obsolete assets, safety and security, etc.
(b) Profitability - increasing profit by cost savings, quality improvement, productivity, relocation, etc.
(c) Expansion - new products, new outlets, research and development, etc.
(d) Indirect - office building, welfare facilities, etc.

A particular investment project, of course, could combine any number or all of the above classifications.
Note that not all expenditure will be termed capital according to accepted accountancy definitions.
For example, it may be decided to write off expenditure in the year in which it is incurred, rather than
capitalising it and then writing it off over a period of years, In this context, most organisations have a
de minimus rule, under which any asset costing under a given sum is not capitalised but is written off
in the year of purchase, despite the fact that it may be used for several years to come; relevant
accounting standards will of course need to be observed. However, the important consideration is
that cash is being spent now in the expectation of future cash profits. For example, whether the
decision is to spend on a new machine or to relocate an existing machine, identical considerations will
apply: size of cash outflows and inflows, timing of cash flows, life of project, etc.

Even projects unlikely to earn profits must be subjected to investment appraisal, in order to choose the
best way of achieving the project's objectives. For example, investment appraisal can be used to find the
cheapest method for constructing a staff canteen, although such a project is unlikely to earn profits.

3. Working capital

In most industrial projects, investment is required in working capital as well as fixed asset capital,
although the risk attached to working capital is less than that for fixed asset capital. Working capital
normally does not depreciate. Values of land and buildings may appreciate and so present less risk, but
money invested in machinery is a sunk cost, which is unlikely to be recovered, save for perhaps
minimal scrap values.

4. Capital expenditure forecast

(a) Allocation of funds


In preparing capital budgets, it is necessary to consider how much money can or must be
allocated to capital expenditure. Capital development schemes may be started because a
surplus of cash resources is revealed by the long-term plan, but usually management decide on
a capital development scheme and seek the means to finance it.
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(b) Reasons why funds are required


Initially, the budget will be an expression of management's intention to allocate funds for certain
broad purposes. In the budget period, money will be required for

(i) existing projects previously authorised; and


(ii) new projects, full details of which may not yet be available.

The forecasts will indicate whether sufficient funds are available, and perhaps when additional
funds will need to be obtained. It is advisable, therefore, for managers to submit long-term
capital expenditure forecasts, say for two to five years ahead; consequently, the possibility of
obsolescence (and the direction of the future development of the firm) must be borne in mind.

(c) A dual process


The capital budget is the outcome of a dual process:

(i) higher management allocating funds to various areas in relation to the corporate plan, i.e.
according to the long-term strategic objectives of the company; and

(ii) individual managers seeking to utilise the funds for specific projects.

(d) Capital budgeting is important


The importance of this aspect of planning cannot be over-emphasised, because present capital
investment will determine the structure and profitability of the company in the near future. Errors
made in forecasting and planning will, therefore, have serious results, and may prove difficult to
rectify.

(e) The capital budget 'rolls‘


The capital budget usually 'rolls' on an annual basis. As an extra year of
budget is added the first year (past year) is removed. Figure 10.1
illustrates the rolling nature of the budget. The Capital Budget
normally ‘rolls’
period by period.

The ‘rolling’ capital budget system


The Capital Budgeting model shown below assumes a FIVE year budget period.
CAPITAL EXPENDITURE ITEMS AND PROJECTS

2010 2011 2012 2013 2014

1st year 2nd year 3rd year 4th year of 5th year of
of budget of budget of budget budget budget

The Capital Budget “rolls”, perhaps on an annual basis.

2011 2012 2013 2014 2015

Ist year of 2nd year 3rd year 4th year of 5th year of
budget of budget of budget budget budget

The first year is “removed” from the budget and the remaining four years are updated in light
of new (“ex post”) information. A “new” fifth year is added to the budget period.

Figure 10.1: The ‘rolling’ capital budget system


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5. Capital expenditure committee

(a) The committee


Assuming a large company, a capital expenditure committee may be formed, either as a sub-
committee of the budget committee or as a separate meeting of the entire budget committee. In
a small/medium sized company it is usually the board of directors.

(b) The functions of the committee


The functions of such a committee are to:

(i) Co-ordinate capital expenditure policy.


(ii) Appraise and authorise capital expenditure on specific projects.
(iii) Review actual expenditure on capital projects against the budget.

(c) Project teams


Often, multi-disciplinary teams, or working parties, are set up to investigate individual proposals
and report back to top management on their findings. Such a team might comprise:

(i) project engineer,


(ii)production engineer,
(iii)
accountant,
(iv)relevant specialist, e.g.:
- human resources officer, say for a project involving sports facilities or canteen facilities;
and/or
- safety officers, etc.,
(v) economist.

Figure 10.2 shows the stages involved in the capital budgeting cycle, the position of the
expenditure committee and the support expected from accountants at the different stages of the
cycle.

6. Capital expenditure decision

(a) The capital investment decision is critical


The crucial importance of all decisions relating to capital expenditure must be stressed.
Decisions made at this time will affect the direction and pace of the company's future growth or,
indeed, its very survival. If a wrong decision is made, it will be difficult to correct, particularly
where special-purpose plant is involved.

(b) The organisation becomes committed


It has frequently been reported that in both the private and public sectors, investment decisions
are made rather casually and this laxity has been one of the causes of lack of growth in the UK
economy. Of all the decisions taken by management, those concerned with investment are the
most crucial: once made, they may fix the future of the company in terms of its technological
role, cost structure and market effort required, i.e. once the product has been selected and the
plant built, the company is committed to the specific cost structure which accompanies that
particular type of plant and product made.

7. Authorisation of capital projects

(a) Detailed proposals are submitted


The capital budget will be based on a detailed analysis of required projects. It is likely that
managers will be asked to forecast their capital expenditure requirements for inclusion in the
budget and it is necessary for detailed proposals to be submitted to the committee before the
project may be started.

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The Capital budgeting process

Typical strategic objectives:


Business
strategy
 Cost reduction
 Quality improvement
 Market penetration
 Market development
 Product development Implementation
 Product-market diversification of strategy Managers are
 Acquisition calls for aided by
investments financial
specialists

Investments are required for:


Identifying investment
 Replacement of technology need
 Maintenance of asset level
(with growth) - Senior managers
 New technology - Business unit managers
 Acquisition - Other managers
 Market development
(advertising, etc.)
 Staffing costs

Business case includes details of: Business


case
 Initial investment costs Investment
 Useful earning life of investment proposal
 Running costs – year by year
 Benefits of the investment
- detailed Financial
 Consequences of not investing specialists
- detailed control the
 Financial evaluations, including: strategic
- payback period (capital)
- accounting rate of return (ARR) budget

- net present value (NPV)


- accounting rate of return
Expenditure
- sensitivity projections
controlled by
- risk assessment
normal budget
- tax implications
disciplines
Decision unit
say, ‘Expenditure Committee’

Entered as part of
Capital Decision strategic (capital)
expenditure budget
appraisal
techniques
Managers are Investment Investment
aided by Modification
proposal proposal
financial required
rejected approved
specialists

Figure 10.2: The Capital budgeting process

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(b) Independent investment decisions


Many projects will incur fairly small expenditure and, in order not to involve the committee in
unnecessary detail, broad guidelines ought to be laid down regarding the amounts of expenditure
which may be committed by each level of management. Top management must see that the
types of expenditure to be treated as capital are clearly defined, and that every subordinate or
committee knows precisely the limits to which s/he or they can approve capital expenditure.

(c) The detail required


Capital expenditure requiring approval by the committee must be formulated by the
managers. The amount of detail should be stipulated by the committee. Major projects would
probably be subjected to a comprehensive financial evaluation, as part of the committee's
consideration; less important projects could be submitted, accompanied by an economic
justification.

8. Capital expenditure control Remember the


‘application > appraisal > authorisation’
cycle.
(a) Strict control must be maintained
Strict control of large projects must be maintained and the accountant should submit periodic
reports to senior management on progress and cost. A typical report would include such data
as:

(i) Budgeted cost of the project, date started and scheduled completion date.
(ii) Cost and over or under, expenditure to date.
(iii) Estimated cost to completion, and estimated final over or under, expenditure.
(iv) Estimated completion date and details of any penalties, if any.

(b) Overspending needs to be explained


The capital expenditure committee will seek explanations for any overspending that may have
arisen. Where projects are incomplete and actual expenditure exceeds the authorisation,
additional authority needs to be sought to complete the projects. In so doing, the committee
must consider the value of the project as it then stands and the additional value that will be
gained by completing it, compared with the additional expenditure to completion.

A vital consideration is the adequacy of funds available. Where existing projects are
overspending their allocation, other perhaps more desirable projects, may be delayed. When
reviewing progress, therefore, the committee must consider the funds available, in the light of
which it may become necessary to revise the order of priority in which funds are awarded to
projects.

The approach to project appraisal

1. Evaluation of alternative investments

(a) The crucial first stage


The careful evaluation of alternative investments then is a crucial first stage in successfully
employing capital budgeting, and financial managers should make a significant input as part
of a structured team approach. Decisions made will substantially affect the business's
performance when implemented, and if incorrect judgments are made it is unlikely the decision
process could be easily reversed, and therefore a damaging, negative business performance is
likely to be the outcome.

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(b) Eight steps are involved


We now examine eight major steps involved in successfully evaluating and controlling
proposed major capital investments. The financial manager will make effective inputs to the
work of 'expert teams/committees' created to oversee the selection, implementation and
maintenance of the investments. The steps are:

(i) Determination of business strategy.


(ii) Establishing investment funding implications and prioritising investment cases.
(iii) Undertake initial investment feasibility study.
(iv) Prepare detailed business case.
(v) Project authorisation.
(vi) Effective control of authorised projects.
(vii) Undertake post-implementation review.
(viii) Develop action plans for continuous improvement.

We look at each step below.

(i) Determination of business strategy.


The strategic decision to invest in large capital projects should flow from an assessment of
the business strategy; in particular how to create and sustain competitive advantage in
the marketplace. This must be a board-level decision based on hard-nosed strategic
analysis rather than detailed investment appraisal.

The assessment of business strategy should lead to the formulation of inter-linking product-
market, research and design, manufacturing and financial strategies. A full discussion of
strategy formulation is beyond the scope of this syllabus but it will be recognised that
capital investment policy should flow from the assessment of business strategy.

(ii) Establishing investment funding implications and prioritising investment cases


Social and environmental pressure are resulting in an increasing proportion of many
companies' capital investment programmes being in respect of non-profit adding projects,
e.g. improved welfare facilities, safety and environmental expenditure etc. It is important to
establish the likely scale of investments required overall for the company, and whether
adequate funding will be available.

Once the strategic decisions have been taken, funding availability determined and
investment policy formulated, the evaluation of the different business and other investment
proposals prior to final approval is the key stage. In large companies it is preferable to
undertake initial investment feasibility studies on major investments before giving
agreement to move to more detailed evaluation of alternative proposals.

(iii) Undertake initial investment feasibility study

It is probable that not only will limited funds be available for investment, but so also the
resources to evaluate and successfully implement projects. Therefore, it is essential that
only key important investments are worked upon.

It is advisable that prior to any detailed technical and financial work being undertaken, an
outline of the proposed investment should be submitted to the investment committee or
its equivalent.

(iv) Prepare detailed business case

The preparation of a business case for each major investment proposal is the crucial stage
in the successful evaluation of the company's investment policy. Motteram and Sizer
suggest that a detailed financial evaluation will comprise a number of components. These
are summarised in Table 10.1.
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Table 10.1
COMPONENTS OF FINANCIAL EVALUATION OF BUSINESS CASE

1 INVESTMENT COSTS
- including costs of planning, purchasing, installing, commissioning plant and
machinery and related computer hardware and software.

2 RUNNING COSTS

3 BENEFITS OF INVESTMENT
- Cost savings
- Increased flexibility
- Reductions in working capital
- Market factor benefits
- Taxation and investment grants

4 CONSEQUENCES OF NOT INVESTING

5 APPRAISAL
- including sensitivity of cashflows, DCF returns or NPVs and payback periods to
variations in key assumptions.

The important aspects of each element in Table 10.1 are discussed below.

- Investment costs

Investment costs include costs of planning, purchasing, installing and


commissioning plant and machinery, and related computer hardware and software.
Overspends tend to occur because of these expenditures and it is advisable to
test the sensitivity of cashflows and measures of profitability in both initial spend
and time scales.

- Running costs

When building the model of estimated running costs it is necessary to build in


operating cycle times, learning curves, fixed and variable costs, support costs,
costs of maintenance and any other costs which are peculiar to an individual
proposal. The assumptions in the forecast need to be tested for sensitivities.

- Benefits of the investment

When evaluating benefits to be derived from the capital investment proposal it is useful
to differentiate between: cost savings (such as reductions in direct costs, savings in
scrap and space, and increased versatility), reductions in working capital (inventory
and other current assets items), and benefits arising from increased competitive
advantages.

- Consequences of not investing

When evaluating the financial and other implications of a capital investment it is always
useful to consider the zero-change position, and to evaluate its possible effects. It is
possible that the company is facing a reduced competitive strength and thus a loss
of market share, also rising costs, falling real selling prices and squeezed
contributions. It is important not to be over-pessimistic about the consequences of not
investing. Over pessimism is often the political consequence of the eagerness of the
project champion to get the project authorised.
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- Taxation and investment grants


Investment projects should be assessed on post-tax and investment-grant basis. In
international business it is important to consider different tax regimes, rates of
capital allowances and tax and timings of payments. These can vary significantly
between one country state and another. The effects of possible future political changes
within the life-cycle time of the proposal may be built into the evaluation model, but in
practice this is often difficult to accomplish.

- Test sensitivity of cashflows, DCF rates of return, and payback periods


By this stage in the preparation of the business case it is possible to produce
cashflows and financial evaluations in the forms of payback periods, accounting
rate of return (ARR), net present value (NPV) and the internal rate of return
(IRR). It is important that the key assumptions which underpin these financial
evaluations are identified, and the sensitivity of these assumptions are tested, so that
the committee is presented with a complete picture of the range of possible project
outcomes. The expenditure committee should not be presented with a single 'most
likely', or worst, or 'most optimistic' set of cash flow and profitability measures.

(v) Project authorisation


The completed business case should be presented to the investment committee, and
subsequently to the board of directors, for approval.

It must be recognised that the business case evaluation data will be couched in both
financial and non-financial terms and therefore management judgment will be the
predominant arbitration.

(vi) Effective control of authorised projects


To repeat what was discussed previously. Strict control of large projects must be
maintained and the accountant should submit periodic reports to senior management on
progress and cost.

(vii) Undertake post-implementation review


After implementation of the project, audit(s) should be undertaken to examine its profitability
and compare it with the plan. Also a post-completion audit should be undertaken which
will take the character of a post-mortem. There are three main reasons for undertaking
these audits:

- To discourage managers from spending money on doubtful projects, because


they know they may be called to account at a later date.
- It may be possible over a period of years to discern a trend of reliability in the
estimates of various managers.
- A similar project may be undertaken in the future, and then the recently completed
project will provide a useful basis for estimation.

8 steps for developing an investment strategy

1 Business strategy
2 Prioritising investment need
3 Feasibility study
4 Detailed business case
5 Project authorisation
6 Control
7 Post-implementation review
8 Planning for continuous improvement

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Capital investment appraisal techniques

1. Introduction

We have seen as part of the capital budgeting process that there are various techniques available to
determine if new investments or projects should be undertaken. The techniques can be applied to any
type of investment (made by individuals or corporations) where the financial implications can be
identified. We shall, however, examine them exclusively in relation to corporate investments made
with the objective of maximising the benefit to ordinary shareholders, i.e. maximising shareholders'
wealth. We are not concerned here with different types of investment, examining how cashflows can
be identified or whether cashflows are relevant or not for a particular investment; we will consider
these in a later study. An investment will simply mean something which involves an initial capital
outlay and which produces future cash inflows. We shall also assume, at this stage, that there are no
constraints on the investments which can be undertaken; for example, there will be no limitation on the
amount of capital available.

2. Cashflows and their timing

The following "sign" conventions will apply to all investments:

(a) Cash outflows or expenditure are represented by negative figures.


(b) Cash inflows or income are represented by positive figures.

The timing of cashflows is very important in an investment appraisal; for convenience an annual time
scale is used where:

0 represents the date of making an investment (i.e. 'present' time)


1 represents the date one year after the initial investment. It is the last day of the first year in
the life of the investment and also is the beginning of the second year.
2 represents the last day of the second year and beginning of the third year of an investment, and
so on.

It is important to remember that 0, 1, 2 etc., represent points in time. Many cashflows will, however,
cover periods of time, e.g. wages, overheads and sales. It is usual to aggregate these and treat them
as arising at the end ( last day) of the year in which they occur.

3. Opportunity costs and cash flow

(a) Incremental cost


An incremental cost is the additional cost incurred as a result of the investment. It is
therefore important to identify cash flows (both sales and cash costs) which occur
specifically because of the investment or project.

(b) Opportunity cost


An opportunity cost (or ‘relevant cost’ ) is the amount of income foregone or the amount of
cost savings foregone if one alternative were chosen instead of another. In other words, it is
the economic benefit (income or cost savings) that was foregone by choosing one alternative
over another. There is no actual payment for an opportunity cost nor is it usually recorded in
accounting records. However, an opportunity cost is relevant to certain capital investment
decisions because it meets the following relevant cash flow conditions:

(i) it is an expected future payment caused by the investment, or


(ii) it is a sales receipt foregone because of the investment,

both of which will reduce the firm's future cash flow.

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An example for demonstrating an opportunity cost is factory capacity. There is either an alternative
use for the factory capacity or there is no alternative use. An opportunity cost exists if there is an
alternative use for the factory capacity that can generate income or cost savings.

The following two lists provide a quick revision of your previous studies in the topic of opportunity
costing:

(i) Costs not affecting future cash flow:


- sunk cost
- committed cost
- allocated or absorbed fixed overhead

(ii) Costs that would affect future cash flow:


- payment made as a result of the project
- cash receipt foregone because of the investment
- incremental cost
- avoidable cost
- differential cost
- opportunity cost.

Definitions

Relevant cost
Relevant cost analysis involves the identification and comparison of the relevant costs
and revenues for each alternative being considered in the decision process. The
costs and revenues that affect a decision are relevant. The costs and revenues that
do not affect a decision are irrelevant.

Sunk cost
A cost which has already been incurred (or committed) is considered sunk and is
not relevant in the decision process. A sunk cost is always irrelevant because it is
not a future expected cost and will not affect a firm's future cash flow.

Incremental cost
An incremental cost is the extra cost incurred as a result of the decision.

Avoidable cost
An avoidable cost is the specific cost of an activity which could be avoided if the
activity did not exist.

Differential cost
A differential cost arises from the comparison of the relevant costs of two options and
the identification of the difference.

End of definitions

Activity 10.1

Buckland Company is a manufacturer of medical equipment and is proposing to start


project BK, a new product line. This project would be for the four years from the
1 January 2010 to the 31 December 2013. There would be no production of the new
product after 2013.

You have recently joined the company's accounting and finance team and have
been provided with the following information relating to the project.
Continued on the
next screen

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Activity 10.1 (continued)

Capital expenditure
A feasibility study costing $45,000 was completed and paid for last year. This study
recommended that the company buy new plant and machinery costing $1,640,000 to be
paid for at the start of the project. The machinery and plant would be depreciated at
20% of cost per annum and sold during the year 2014 for $242,000 receivable at the
end of 2014.

As a result of the proposed project it was also recommended that an old machine be
sold for cash at the start of the project for its book value of $16,000. This machine had
been scheduled to be sold for cash at the end of 2011 for its book value of $12,000.

Other data relating to the new product line:

2010 2011 2012 2013


$'000 $'000 $'000 $'000
Sales 1,000 1,300 1,500 1,800
Accounts receivable (at the year end) 84 115 140 160
Lost contribution on
existing products 30 40 40 36
Purchases 400 500 580 620
Accounts payable (at the year end) 80 100 110 120
Payments to sub-contractors, 60 90 80 80
including prepayments of 5 10 8 8
Net tax payable
associated with this project 96 142 174 275
Fixed overheads and advertising:
With new line 1,330 1,100 990 900
Without new line 1,200 1,000 900 800

Notes

- The year-end accounts receivable and accounts payable are received and paid in
the following year.

- The net tax payable has taken into account the effect of any capital allowances.
There is a one year time-lag in the payment of tax.

- The company's cost of capital is a constant 10% per annum.

- It can be assumed that operating cash flows occur at the year end.

- Apart from the data and information supplied there are no other financial
implications after 2013.

Labour costs

From the start of the project, three employees currently working in another department
and earning $24,000 each would be transferred to work on the new product line, and an
employee currently earning $20,000 would be promoted to work on the new line at a
salary of $30,000 per annum. The effect of the transfer of employees from the other
department to the project is included in the lost contribution figures given above.

Continued on the
next screen

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Activity 10.1 (continued)

As a direct result of introducing the new product line, four employees in another
department currently earning $20,000 each would have to be made redundant at the
end of 2010 and paid redundancy pay of $31,000 each at the end of 2011.

Agreement had been reached with the trade unions for wages and salaries to be
increased by 5% each year from the start of 2011.

Material costs

Material UCK which is already in stock, and for which the company has no other
use, cost the company $6,400 last year, and can be used in the manufacture of
the new product. If it is not used the company would have to dispose of it at a
cost to the company of $2,000 in 2010.

Material LAN is also in stock and will be used on the new line. It cost the company
$11,500 some years ago. The company has no other use for it, but could sell it on
the open market for $3,000 in 2010.

Required

(a) Prepare and present an opportunity cash flow budget for project BK, for the
period 2010 to 2014.

(b) Write a short report for the board of directors which explains why certain figures
which were provided in (a) were excluded from your cash flow budget.
End of Activity 10.1

Tutorial comment

The Examiner at the time stated that the objectives of this question were to
prepare and discuss the concept of incremental/relevant cash flows (parts (a)
and (b) and that there was some confusion on the part of some candidates between
whether to attempt to do a cash budget or an incremental cash flow budget.
Candidates do need to appreciate that for investment appraisal, it should be the
incremental/relevant cash flows that are used. The candidates who performed
well in this area were those who demonstrated a good understanding of the subject
in the report which was called for in part (b). However, although many candidates
were able to explain why sunk costs, depreciation and the feasibility study were
not relevant costs they were unable to apply the same kind of logic to some of the
other costs. In the computation section (part (a)) some candidates did not attempt to
calculate the amount of cash from sales or paid out for purchases.

A step by step answer plan would be useful here.

Step 1 Read the question carefully and make sure that you understand
precisely what is required. This case study involves a manufacturing
company which is evaluating a new investment project.

Step 2 To determine the relevant cash flows for inclusion in the cash budget for
subsequent capital investment appraisal, you need to work carefully
through the data to identify the avoidable, incremental and future cash
receipts and payments. So, for example, sales need to be converted to
cash receipts using opening and closing accounts receivable; tax paid
is one year later than payable; only the extra fixed costs should be
included, and feasibility study costs are excluded. Whilst doing this, note
the figures that you decide to exclude, for your answer to part (b).
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Tutorial comment (continued)

Step 3 As well as the contents specified, your report must include a proper
heading and introduction. A conclusion is not required in this case.
Start the main explanation by summarising the criteria for inclusion of a
figure in the cash flow budget. Then go through the specific items in the
question where a figure has been excluded, to show the reasons why they
have been excluded.

End of Tutorial comment


Activity 10.1: Answer
Project BK

(a) Budgeted Incremental Cash Flows

Inflows: 2010 2011 2012 2013 2014


$'000 $'000 $'000 $'000 $'000
Sales (Note 1) 916 1,269 1,475 1,780 160
Savings, employees
made redundant 84 88.2 92.6
Residual value
new machine 242
Material UCK, saving
on cost of disposal 2

918 1,353 1,519.1 1,826.3 402

Outflows:
Purchases (Note 2) 320 480 570 610 120
Sale of old machine
not received 12
Labour:
Employee promoted 10 10.5 11.03 11.58
Redundancy pay 124
Materials:
Material LAN, lost
residual value 3
Sub-contractors 60 90 80 80
Lost contribution from
existing product 30 40 40 36
Overheads and
advertising 130 100 90 100
Taxation 96 142 174 275

553 852.5 933.03 1,011.58 395

Incremental Cash flow 365 500.5 586.07 814.72 7

Workings
Note 1: Cash from sales
2010 2011 2012 2013 2014
$'000 $'000 $'000 $'000 $'000
Opening
accounts receivable - 84 115 140 160
Add sales 1,000 1,300 1,500 1,800 -

1,000 1,384 1,615 1,940 160


Less closing
accounts receivable 84 115 140 160 -

Cash from sales 916 1,269 1,475 1,780 160


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Activity 10.1: Answer (continued)

Note 2: Purchase payments


2010 2011 2012 2013 2014
$'000 $'000 $'000 $'000 $'000
Opening
accounts payable - 80 100 110 120
Add purchases 400 500 580 620 -

400 580 680 730 120

Less closing
accounts payable 80 100 110 120 -

Cash from purchases 320 480 570 610 120

(b) To : The Board of Directors of Buckland Company


From : Project accountant
Date :

Feasibility Report Re-The New Product Line

We have now prepared the cash flow budget enclosed herewith, and
computed the net present value of the project.

The cash flows

The principal reason why certain figures were not included in the cash flows
is that we have shown the incremental cash flows and therefore have only
included the income and expenditure which will arise if the project goes
ahead. The other figures are not relevant to the investment decision.

The following figures were not included in the incremental cash flow:

- the feasibility study which cost $45,000 had to be paid out whether or not
the project went ahead.

- the depreciation is a non-cash movement item. The cash expended on


the asset moves when it is paid over to the vendor.

- the three employees paid $24,000 each would continue to receive the
amount whether or not the project goes ahead.

- the cost of materials UCK and LAN were paid for some time ago and is not
therefore a relevant cash flow.

- the prepayments were already included in the amounts paid to the sub-
contractors and did not require any adjustment to the cash flows. The
relevant figures are the actual cash to be paid to them each year, e.g. 2010
$60,000, and so on.

End of Answer for Activity 10.1

4. Main evaluative criteria

Figure 10.3 provides an overview of the main criteria used for appraising investment projects. The
criteria comprises two main categories:

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Capital investment appraisal techniques


DEPARTMENTAL/
CORPORATE
FUNCTIONAL
MANAGERS EARNINGS- BASED
MANAGERS
MEASURES

STRATEGY INVESTMENT
Accounting Rate of Return
PROPOSALS PROPOSALS
(ARR)

Often large sums Often relatively Net Present Value (NPV)


of money are small sums of
involved money are involved
Internal Rate of Return
(IRR)

Evaluative Evaluative
criteria criteria
RISK- BASED
MEASURES

Sources of capital CAPITAL


INVESTMENT Payback period
APPRAISAL

Gearing
Earnings per share

Breakeven
(Not examined in this
Gearing ratio syllabus)
EVALUATION
CRITERIA
Sensitivity of estimates
Effect on share
price

The very large investments


involved in these types of strategic
decisions are not
evaluated by using traditional Taxation
capital investment appraisal Some investment appraisal
techniques covered in this tutorial. techniques require the use of the
Inflation cost of capital. How the cost of
capital is decided is dealt with later
in our
e-publication
Capital rationing

Figure 10.3: Capital investment appraisal techniques

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(i) Earnings potential


- Accounting rate of return (ARR)
- Net present value (NPV)
- Internal rate of return (IRR).

(ii) Risk
- Payback period (cash flow and discounted cash flow)
- Gearing (financial and operating). We cover gearing in Tutorial 14.
- Sensitivity analysis.

5. Three project scenarios

Table 10.2 provides three project scenarios which we will use to examine the main appraisal
techniques.

Table 10.2 Scenario for the different assignments

The following information relates to three capital expenditure projects under review.
Because of capital rationing only one project can be accepted.

The data provided here will illustrate the calculations used for:

- payback period
- accounting rate of return (ARR)
- net present value (NPV)
- internal rate of return (IRR)
Project
X Y Z

Initial cost $400,000 $460,000 $360,000


Expected life 5 years 5 years 4 years
Scrap value expected $ 20,000 $ 30,000 $ 16,000

Expected net cash inflows (inflows - outflows)

$ $ $
End year
1 160,000 200,000 110,000
2 140,000 140,000 130,000
3 130,000 100,000 190,000
4 120,000 100,000 200,000
5 110,000 100,000 -

The company estimates its cost of capital is 18%

Payback method

1. The payback method of investment appraisal

The payback method of project appraisal involves calculating the period of time that it is likely to
take to recoup the initial outlay on a project, and then comparing this with what the company defines
as an acceptable period. Often, the shorter the payback period the more valuable is the
investment. If the payback period is less than that defined as acceptable, and provided that there
are no other constraints, for example capital rationing, the project will be accepted.

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