Chapter 4:

Investment Appraisal-
Further Aspects of
Discounted Cash Flows

Presented by:
Margarita Kouloumbri

1
Chapter Map
1
The impact of
7 inflation on interest 2
rates The impact of
Dealing with
inflation on cash
questions with tax
flows
and inflation

3
Specific and
general inflation
Contents
rates

6
Laying out long
NPV questions 4
5 Dealing with tax in
Incorporating NPV
Working Capital

Investment Appraisal- further aspects 2

of discounted cash flows
1. The impact of inflation on interest
rates
What is inflation?
IT IS A GENERAL INCREASE IN PRICES LEADING TO
A DECLINE IN THE REAL VALUE OF MONEY

Illustration:
Theodore wants to invest $100 for one year. He requires a real
return of 10% (i.e a return that he would achieve if there was
no inflation in the economy). In addition he requires a
compensation as a result of the loss in the purchasing power of
5%.
What is Theodore’s money rate of return?( total return)
Investment Appraisal- further aspects 3
of discounted cash flows
1. The impact of inflation on interest
rates

So….
1. To compensate for inflation
he requires an increase of 5% 100*5%= $105

2. He requires a real return

10% i.e 105*1.10%= $115.50

3. Overall increase money return

115.50/100=15.5%

Investment Appraisal- further aspects 4

of discounted cash flows
1. The impact of inflation on interest
rates

FORMULA It is in my
formula
sheet!!!

Investment Appraisal- further aspects 5

of discounted cash flows
1. The impact of inflation on interest
rates
Example 1:
$1,000 is invested in an account that pays 10%interest pa.
Inflation is currently 7% What is the real return?
Solution to Example 1:

Example 2:
Assuming that the real rate is 8% and the rate of inflation is
5%. What should be the money rate?
Solution to Example 2

Investment Appraisal- further aspects 6

of discounted cash flows
2 The impact of inflation on cash
flows
 Current/Real Cash flows: The cash flows which
have not increased for inflation
 Money/Nominal Cash flows: The cash flows which
have been increased for inflation.
Sales are $100 in
current Sales will be $100 in
terms The first year, and inflate
but are expected to by 10
increase by 10% % for the next 2 years
for the next 3 years i.e i.e
Year 0: $100 Year 1: $100
Year 1: $110 Year 2: $110
Year 2: $121 Year 3: $121
Year 3: &133.10

Investment Appraisal- further aspects 7

of discounted cash flows
2 The impact of inflation on cash
flows

Investment Appraisal- further aspects 8

of discounted cash flows
2 The impact of inflation on cash
flows
Example 3:
A project has the following cash flows before inflation.
Time Cash flow $
0 (750)
1 330
2 242
3 532
The company’s money rate is 15.5%, the inflation rate is
5% and expected to remain at this level.

Evaluate the project in terms of real cash flows and

real rate, and money cash flows and money rates.
Investment Appraisal- further aspects 9
of discounted cash flows
2 The impact of inflation on cash
flows

Solution to Example 3:

Investment Appraisal- further aspects 10

of discounted cash flows
2 The impact of inflation on cash
flows

Solution to Example 3:

Investment Appraisal- further aspects 11

of discounted cash flows
3 Specific and general inflation rates

Investment Appraisal- further aspects 12

of discounted cash flows
3 Specific and general inflation rates
Example 4:
Marlon Brando Ltd is considering a project which involves the
purchase of a machine costing $7,000, U.E.L of 5 years and no
scrap value and will result in annual savings on wage costs of
$1,000 and on material costs of $400.
Forecasts of inflation for the next 5 years:
Wage Costs 10%
Material Costs 5%
General Prices 6%
The cost of capital in real terms is 8.5%. Evaluate the project.

Investment Appraisal- further aspects 13

of discounted cash flows
3 Specific and general inflation
rates
Solution to Example 4:

Investment Appraisal- further aspects 14

of discounted cash flows
3 Specific and general inflation
rates
Solution to Example 4:

Investment Appraisal- further aspects 15

of discounted cash flows
4 Dealing with Tax in NPV

Investment Appraisal- further aspects 16

of discounted cash flows
4 Dealing with Tax in NPV

IMPORTANT NOTES!!!!!

 Operating Cash inflows will be taxed the

corporate tax rate
 Operating Cash Outflows will attract tax relief
on the corporate tax rate
 Tax is paid one year after the related CF

 Investment will attract Capital allowances (see

below)

Investment Appraisal- further aspects 17

of discounted cash flows
4 Dealing with Tax in NPV
What are Capital Allowances or Written down
Allowances (WDA)?
DEPRECIATION IS NOT
ACCEPTED FOR TAX PURPOSES,
INSTEAD CAPITAL ALLOWANCES
CAN BE CLAIMED
Rules:
 WDA are calculated on a reducing balance basis- usually at 25%
 WDA are claimed for every year except the year of disposal
 WDA are claimed as early as possible
 In the year of scrap a Balancing Allowance (BA) or a Balancing
Charge (BC) arises
Investment Appraisal- further aspects 18
of discounted cash flows
4 Dealing with Tax in NPV

How do we calculate the BC

or BA of the final year?

Investment Appraisal- further aspects 19

of discounted cash flows
4 Dealing with Tax in NPV
Example 5:
Greta Carbo Ltd purchased an asset for
$100,000. At the time of its disposal the
cumulative capital allowances claimed over the
life of the asset were $68,000.
Calculate the balancing allowance or balancing
charge if the asset is disposed of for:
1. $20,000

2. $40,000

Investment Appraisal- further aspects 20

of discounted cash flows
4 Dealing with Tax in NPV
Solution to example 5:

Investment Appraisal- further aspects 21

of discounted cash flows
4 Dealing with Tax in NPV
THE ISSUE: FOR TAX PURPOSES ASSETS
ARE ASSUMED TO BE BOUGHT AT T0.
e.g. An asset can be bought at the very end of the
accounting period 31/12/X1 or at the very start
1/1/X2
Is there any
difference for
accounting
purposes? YES
Is there any
difference for tax
purposes?? NO!!!!

Investment Appraisal- further aspects 22

of discounted cash flows
4 Dealing with Tax in NPV

Investment Appraisal- further aspects 23

of discounted cash flows
4 Dealing with Tax in NPV

Investment Appraisal- further aspects 24

of discounted cash flows
4 Dealing with Tax in NPV
Example 6:
Edith Piaf company buys an asset on the last day of the
accounting period for $26,000. It will be used on a project
for 3 years after which it will be disposed of on the last day
of year 3.
Tax is payable at 30% one year in arrears and capital
allowances at 25% reducing balance.

1. Calculate the WDA for each year, if the proceeds on disposal

of the asset are $12,500
2. If the operating cash flow of the project is $16,000 and the
cost of capital is 8%, calculate the NPV of the project
3. What if the asset was bought on the first day of the
accounting period?

Investment Appraisal- further aspects 25

of discounted cash flows
4 Dealing with Tax in NPV
Solution to example 6:

Investment Appraisal- further aspects 26

of discounted cash flows
4 Dealing with Tax in NPV
Solution to example 6:

Investment Appraisal- further aspects 27

of discounted cash flows
4 Dealing with Tax in NPV
Solution to example 6:

Investment Appraisal- further aspects 28

of discounted cash flows
4 Dealing with Tax in NPV
Solution to example 6:

Investment Appraisal- further aspects 29

of discounted cash flows
5 Incorporating Working Capital

WORKING CAPITAL IS
THE DIFFERENCE
BETWEEN CURRENT
ASSET AND
CURRENT
LIABILITIES

Steps:
• Initial investment is a cost at the start project of the project
•If the investment is increased the increase is a relevant cash flow
•At the end of the project all the WC is released and treated as a cash
inflow

Investment Appraisal- further aspects 30

of discounted cash flows
5 Incorporating Working Capital
Example 7:
Madonna Ltd expects sales for a new CD to be
$225,000 in the first year growing at 5% pa. The CD
is expected to be realizing cash flows for the next 4
years. Working capital equal to 10% of annual sales
is required and needs to be in place at the start of
each year.
Calculate the working capital flows for incorporation
into the NPV calculation.

Investment Appraisal- further aspects 31

of discounted cash flows
5 Incorporating Working Capital
Solution to example 7:

Investment Appraisal- further aspects 32

of discounted cash flows
6 Laying out long NPV questions

PROFORMA

Investment Appraisal- further aspects 33

of discounted cash flows
7 Dealing with questions with both tax
and inflation

STEP 1: Inflate costs

and revenues

STEP 2: Ensure that the cost and

disposal value of the NCA
have also been inflated

STEP 3: Calculate Working

Capital

STEP 4: Use after tax discount

rate

Investment Appraisal- further aspects 34

of discounted cash flows
7 Dealing with questions with both tax
and inflation
Example 8:
Audrey Hepburn Ltd is considering a potential project with the following
forecasts:
T0 T1 T2 T3 $
 Initial Investment (1,000)
 Disposal Proceeds 200
 Demand (million of unit) 5 10 6
 The initial investment will be made on the first day of the new accounting
period
 Selling price - $100 per unit, Variable Cost= $30 per unit. These figures are
in today’s terms
 Tax at 30%, WDA at 25% reducing balance
 Real rate of return=6.8%
 General inflation= 3% p.a, Selling price=4% p.a, Variable Costs=5% p.a.
Determine the NPV of the project.

Investment Appraisal- further aspects 35

of discounted cash flows
7 Dealing with questions with both tax
and inflation

Solution to example 8:

Investment Appraisal- further aspects 36

of discounted cash flows
7 Dealing with questions with both tax
and inflation

Solution to example 8:

Investment Appraisal- further aspects 37

of discounted cash flows
How is this Chapter Tested?
 LEARN THE PROFORMA!!!
 Could test the calculations on:
 NPV using real and nominal terms IRR
 WDA’s and Working capital
 Timing of acquisition of the NCA
 Inflation
 June 2008 Q4, Dec 2009 Q1, Dec 2010 Q1 (a),
Dec 2011 Q1

Investment Appraisal- further aspects 38

of discounted cash flows
Thank you !

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