favestment Appraisal Decision making Short term Long term (Singleperiodetfect) (Having multi period effects) Investment Appraisal: - A detailed evaluation of projects/invest ments 10 assess the viabilly, is elfecis on shareholders’ wealth is called investment appraisal, : What is Appraisal: - Any expenditure in the expectation of fulure benefits, There are two types of invesiment. GRRE Capital expenditure is anexpenditure which resultsin theacquisition ofnon-currentassets oranimprovementin their cerning capacity. Ibis not charged as an expensein the income statement: this expenditure appears asa non- current asset inthe balance sheet. Rs Charged to the income statement and is expenditure which is incurred, (i) Forthe purpose of he tade of the business thisincludes expenditure classified as selling andidistibution, administration expenses and finance charges. (ij Tomaintain the existing earning capacity of non-current asset 2 The capital budgeting process: ‘The process of identifying, analyzing and salecting investments projects whose returns are expected fo extend beyond one year. ‘These steps are being followed in capital budgeting process 4. Creation of eapitalbudgets This steps involves assessing the time required by projects, when they are anticipated to start, how they willbe financed, how they would effect the current production budget, expected levels of production and long term developmentof organization 2. Investment Decision making process Itinvolves the following steps Origination of Proposals —_ Project screening Analysis Monitoring and Acceptance and Reviewi} (ii) uy Study Notes Finoncial Management -FW: ‘A good understanding of market demand, market conditions and customer perceptions are always needed in order to avail the opportunities. ‘There should be a proper mechanism which identifies the potential opportunities avaiiable in the markatfor investment, and iftechnology is obsoleting, organization should know beforehanc that new investment Is required. Project Screening: - . Each proposal should be screened before doing financial analysis on it. This screening would involve the following questions: © Whatis the purpose of the project? + Does it align with organizations long term objectives? There should not be 2 single confiict between the organization objectives and projecis objectives. + Are sufficient resources available? + Necessary management skills are present? + What kind of risks involved in the project? Analysis and acceptance: - It involves the following steps + Standard formatof financial information as @ formal investment proposal should be submitted, + Project should be classified e.g, what kind of financial appraisal is required, what % of return shouldbe achieved . + Financial analysis should be done. i + Outcome of financialanalysis should be compared with predatermined criteria * Consider the projectin the ight of capita! budaet for the currentand future operating periods + Make the decision (acceptorreject). + Monitorthe progressofthe project. a) Financial Analysis: This stap would involve the application of organization's preferred investment appraisal techniques 2.9. IRR, NPV ete, ‘Some projects e.g. marketing investment decisions have intangible returns in this case more weight may be given to the consideration and qualitative issues. b) Qualitative Issues: - Qualitative Issues are those issues which are difficult or impossible to quantify but decisions should be made after considering these issues e.g, () ——_Howthe project willaifectthe company's image? (i) Would the project help the organization in satistying the customerneeds? ©) Accept orReject: Acceptance depends on three factors 4) Type of investmentFincncialManagemeni-Fia 2) Risk of theinvestment 3) Amount of expenditure required (iv) Monitoring the progress: = A project progress should be monitored regularly, to ensure that capital spending Is not exceeding from the bucget, implementation isnot delayed and the anticipated benefits are eventually obtained, Financial Evaluation Methods Basic Methods (Non-discounted CF) Advanced Methods (Discounted CFI * Accounting Rateof Return (ARR) + NetPresentValueNPY Payback Period % IntermalRateofReturn (IRR) % Discounted PaybackPeriod Inthe above methods, ARR method is based on profits whereas all othermolhode are besedon cash lows, The ‘Advanced Methods Includes Time Value of money Basic Methods 1. Accounting Rate of Return (ARR) Definition: - The earings ofa project expressedas ¢ percentage ofthe capital outlay or average investment Or ‘Average return as a percentage of average investment Formul ARR Average Annual profitx 100 Initial investment Alternative Version of ARR is: ARR = Average Annualprofitx 100 . i. Averagelnvestment Where “Average Investment" is = Initial Investment + Scrap value 2 Decision Rule: - Feasibility Decisio IFARRoftheproject > TargetARR, Acceptthe project IFARRoftheproject liCash flows arise curing the peried, then itis essumedas itarises at the end of that period > Heash lowarisesatthe star‘ of the period, ihenitis assumed as fit arises at the end of he preceding period > Period "is nota period, instead it represents start of period “1” Example: Proposal Co is considering investing in a new project. The following details have been obtained The project requires 1,200 kg of raw material. Proposal Co has 2,000 kg in inventory, bought two years ago for $1.50 per kg, bul ro longer used for any of the fitms' products. The current market price for the material is $2.00 per kg, but Proposal Co could only sell it for $0.80 per kg, 100 hours of labour will be used on this project. There are 300 hours' worth of spare labour capacity. There is a union agreement that steff cannot be laic-off. The workers are paid $8.50 per hour. ‘The variable overheads wil total $34,584 and the fixed overhead rent $42,500. {he project will require a machine which was bought four years ago for $20,000. This machine could be scrapped now for $12,000. iF iis kept it will generate $15,000. An identical machine can currently be purchased for $14,000. What are the relevant costs of this project? SOLUTIONFinancial Management-FM Materials: | The relevant cost is $0.80 = 1,200kg = $960, which is the benefit forgone from the next best allernetive use of the materiel Labour: The relevant cost & nil as there is no incremental cost. Overneads: | The relevant cost is $34,504. The fixed overhead will nat change and so is | not incremental Machine: The original purchase price of $20,000 is not relevant es this is a sunk cost. Ignoring the new opportunity, Proposal Co would keep the machine es it will earn more money (318,000) than its scrap value ($12,000). If the machine is used on the new project. the final question to ask is, will Propogal Co replace it? The answer is yes as the replacement cost ($14,000) is less than the money it will earn ($15,000). So the relevant cost is $14,000 2. PAYBACK PERIOD METHOD: Definition: = “The time period inwhich intial investment gets recovered, known es payback period. ‘The number of years for the cash outlay tobe matched by cash inflows, Formula: - a. For constant(Even) cashflows Payback period= Initial investment Annual inflows b. For Uneven cash flows: Draw a cumulative ceah flow column, then calculate projact payback pevied. Answer should be compared with the tage” Daybackperodortnebusiness, OSE COMMA C&Lbn yah?” Decision rule If payback period is less than target payback period, then ACCEPT the project I payback period is more then target payback period, then REJECT the project. (ii) Comparison Decision: Project with minimum payback period should be preferred, ntages of payback period itis simple to calculate and easy io understand, as itdoes nat involve complex caiculations. * Payback periodmethod can alsobe used as abasic screening device atine first stage forshortlistedpiojects, + Iconsiderscash lows rather than accounting profits, that's why chances of manipulation are vary low. «Payback pericd mathod indirectly avoids risk as it Gives-favor to those investments which have short payback periods. This metiiod helps the company to grow, minimize risk and maximize liquidity. «Inthe situation of capitalrationing, itcanbe usedtoidentify he projects whichgenerateaddttional cash forre- investment quickly.Siudy Notes Financiaitanagement-FM Disadvantages of payback period: - ‘+ It.does not consider the time value of money, + Itdoesnctconsiderthe whole fe ofproject.Itmight be possible that twilliavorthe projects, giving high cash inflows in the starting years only and giving very lowcash inflows in the remaining years. * There are no specific eriteria or rule which can justiy that company's target payback period is ‘measured accurately that's why its dificult to measure target payback period, + _ Itmay lead to excessive invesiment in short term projects, + Itdoes not consider the risk and uncertaintyin he projects. Uncertainty ofcash inflows candeteriorate the results, + Itdoes not focus on shareholders’ wealth maximization + Life expectancy of a proget is ignored. + Projects with same payback period may have afferent cash flows. Lecture Examples on Payback Period’ Sa {nitalinvestmentin project Ais $80,000. Life ofthe projectis six years and project generating equal cash inflows of ‘$20,000. If target payback period of the company is 8 years whether the project should be feasible or not. Required: Calculate payback period using non discounting payback period method and comment whether to accopt or roject, Solution: 80,000 ‘Annual inflows 20,000 years Pay-back period 4 years < targeted & yoars, so accept the project Semin Initial investmentin projectZ is $5,000. Projectifeis five years. Forthe yearcash flows from project Z are $2,000, $1,500, $1,000, $500 and $250 respectively. ltargetpayback periodo! company is 7 yearswhetherthe projectshould be feasible ornot. Required: Caleulate how much time is required to regain its investment and comment of it acceptability. solution Exi2 we Cash flow Cumulative cash flow To (6,000) (6,000) h 2,000 (3,000) Te 4,500 (1,500) Te 4,000 (500) Te 500 = 1 260 250 Payback period is 4 years, which is less than the targeted 7 years, therefore, accept the project.Study Notes Financial Manogement-FM Exercise 1 Horizon Co is considering a project that will require an investment in machinery of $80,000 and which will generate a net income of $15,000 in the first year, increasing by $6,000 each subsequent year. The project is expecied to last for fve years and the machinery is not expacted to have any residual value, Calculate the payback period of this project ‘SOLUTION Annual cashflow Cumulative cash flow ‘i 8 8 Investment First year Second year | Third year Fourth year Answer = 3.67 years or 3 years 8 months Exercise 2 Delta Corporation is considering two capital expenditure proposels. Both proposals are for similar products and both are expected to operate for four years. Only one proposal can be accepted The following information is avilable: [Profitiloss) lInitial investment ear Year 2 Years Neara - ~ Loss 7,500 Estimated scrap vaiue atthe endof Year4 4,000 | Depreciation is charged on the straight line basis, Required Calculate the following for both proposals: (). The payback period [Answer: Proposal A = 2.6 years, Proposal B = 3.1 years} (i) The accounting rate of return [Answer: Proposal A = 22%, Proposal B = 26%]study Notes Financiol Management-FM, reico 3 Calculate the Average Rate of Return for project’ A’ and’! from the following information: Project A Project B Investments (k) 25,000 37,000 Expected life (in years) 4 5 Net earnings (Atter depreciation): Yeart 2,500 3,750 Year 2 1,875, 3,750 Year 3 175 2,00 ° ‘Year 4 1,250, 1,250 Year 5 . 4.250 If the desired rate of retum is 12%, which project should be selected? [Answer: Project A = 15%, Project B = 13.5 Exercise 4 * Brenda and Eddie are considering expanding their restaurant business through purchase of the Parkway Diner, which Ciuleest K390,000 to take-over the business and a further K150,000 to rofurbish the premises with new equipment Cash flow projections from the project show the following profits over the next six years. Year Net Cash Profits (K) * 70,000 70,000 80,009 100,000 100,000 120,000 [fe equipment will be depreciated to a zero resale value over the same period and, after the sixth year, Brenda and Eddie confidently expect that they could sell the business for K390,000. oorxena Requirod: Calculate the ROCE of this investment (using the average investment method) 65 Answer: = ARR = = 15.3%] e 425 iStudy Notes FinanciaitManagement-Fi Advanced Methods ~ Discounted cash flow methods Time Value of Money ‘Summ of money received today has more worth than same sum of money received in future because of these reascns. : Inflation : ‘Opportunity to reinvest . Risk and uncertainty ‘Simple interest z 1 4000x10%=$100 2 1000x 10%=$100 3 41000%10%=$400 Cash flows are not reinvested each year Compound interest 1 1000x 10%= 1004 1000= 1100 x 1100x 10%=110+1100= 1210 3. 1240x 10%= 121 +1210=1331 Cash fows arereinvestedeach year resulting nhhigher principal thatincreases the interestamount. We can also calculate the future amourts using this formula A FV=PV (tary : 4 a FV= future vakie= 1331 Compurducs PVs Present Value= 1000 1331 = 1000 x (110%) Discounting Where r = cost of capital = WACC = required rate of reluin PV= FV (t41)* Assumption: Allcash flows are reinvested in the same project or any ther at a given rate of retum (cost of capital). Year Cashflows — DI@12% pv 1 4000 0.893 92.9 2 2000 0.797 1594.39 3 3000 0.712 2136Study Notes Consistent Cesh flows FinancialManogement-FM Acash flows arse in a series of equal cash fows, then tis called Consistent cash flows, These are of two Types: Annuity: {Consistent cash flowforacertain Petiod.e.9, YseorYsx Perpetuity: Consistent cash flowfor infinite period e.g. Y1-0r Ys = Present Values of Consistent Cash flows Pina ue] EY : Where PV = present value A Constant return (starting in one year’s time) . or = poriod interest rate expressed as a decimal n= number of periods PV=Ax1 Where: PV = present value A constant retum (starting in one year's time) r eriod interest rate expressed as a decimal nn Perpetul If Cash Flows Start from Period 1. nnual Cash Flow X Annuity Factor Annual GashFiowXPeretuly Factor 9. ¥18 $10,000 at Disc. Rate of 10% 9. ¥1=$10,000 at Disc. Rateof 10% $10,000 X 3.794 (from annuity table) =$37,910 10,000 X (1/10%) = $100,000 liCach Flows Start rom Period 0, NETPRESENT VALUE (NPV); Definition: - The term NPV means absolute savings from @ project today Formula to calculate NPV: NPV= P.\ of cash inflows minus P.V of cash outflows. Decision Rule: - IENPVotthe project, ciscountedatcostof capital ispositive,Acceptthe project IINPV ofthe project, ciscounted atcostofcaptal is negative, Rejact the projct Advantages of Net Present Value: + NetPresent Valuemethodtakesinto accountthe timevalueoimoney and tis is giving ebetierpictureofine Projects viability, + Itconsiders the timing of cash flows, * _ Reonsidersthewholelife of hepojectbecauseall cash lowsrelatingtotheprojctifeareincorporateinits calculations,‘Study Notes Financial Monagement-Fid with the objective of maximization of shareholders’ wealth, Itfocuses oncash flowsratherthan accountingproft,,scittakesintoaccounttherelevancy andirrelevancy of cash flows. NetPresent Valuzis technically astrongmethocias comparedtoothersasitisan absolute measure. Resultantly itcan be used in isolation Change in cast of capital can be incorporated in it Itean also be used for projects with non-conventional cash flows, Itgives a boiter ranking of mutually exclusive projacts. ‘Itassumes that cash flows ere reinvested at the company’s cost of capital. NPVis technically more superior method to IRR because of ts less rigid assumptions. Disadvantages of Net Present Value: Itinvolves complex calculations as compared to other techniques, Resultantly, itis difficult to calculate and difficult (o understand Managers fee! it difficult to explain the calculations of Net Present Value method Itdoes not take into account the risk and uncertainty of estimates and scarcity of resources. Cost of capital used in NPV calculation is difficult to calculate and gets subjective when we incorporate risk and uncertainty within companies cost of capital. Chenging technology may render the product obsolete before the natural end of the project life. It fails to relate the return of the project to the size of the cash outlay. Lecture Examples on Net Present Value: Example.t Mr, Omar have $50,000 in his old age; he wants to invest into ASA. Project life is $ years and Mr. Omar will get the cash benefit in following manner. Year Cash flow ($) 1 16,000 2 14,000 3 12,000 4 10,000 5 8,000 Rate of interest is 10% per annum. Required: Calculate net present value & comment on its acceptability. EH -Solution Year Cesh flow DF. pv To (60,000) 1 (60,000) W 16,000 0.909 14,545 T2 14,000 0.826 11,564 13 12,000 o7s1 9,012 Ts 10,000 0683 6.830 15 8,000 eat 4,988 NPV = - 3,082‘Wheel Ltd. has the opportunity to invest A B 3 5 (90,000)| (20,000) 40,000, 10,000] 2 30,000 _-€,000) 3 20,000) 6,000] 4 20.000, 4,009 5 20,000/ 4,000 FinencialMonagement-FM, Reject the Project in investment with the following initial cost & returns (cash profit) Residual value in case of A $4,000 end in cese of 8 $2,000. Cost of Capital in both situations are 10%. Required: Calculate NPV of A & B, Ex#2 Solution Project A Yr To un 2 3 4 15 Project B To 1 T2 13 Ta 15 Cash flow (90,000) 40,000 30;000 20,000 20,000 24,000 Cash flow (20,000) 40,000 8,000 6,000 4,000 6,000 DF. 0.909 0.626 0.781 0.683, 0.621 DF. a.909 0.826 0751 0.683 0621 Pv (90,000) 36,360 24,780 15020 13.6860 14,904 = NPV = 14,724 PV (20,000) 9,090 6,608 4,508 2,132 25 $8,662Siudy Notes Financio! Manegement-FM 4. Internal Rate of Return (IRR): Definition: IRR is the total rate of return offered by an investment over its life, The Internal Rate of Retum (IRR) is the discount factor which gives @ zero NPV. As the discount factor increases, the NPY reduces. As can be seen on the following diagram, this forms a curved relationship: nev Due to this curved relationship, finding the precise IRR would be very time consuming, so instead we find en approximate IRR by using the interpolation method, as shown below: Formula to calculate IRI =a% + [ (b% - aY IRR=a% + [TE (b% a%)] Where a: 0% owerdiscountrate * igher discountrate PVatlowerdiscountrate and B=NPVathigherdiscountrate Decision Rule: - a. Feasibility Decision: Y-_IfIRR of the project > Cost of Capital, Accept the project because the project is adding value to the owner's wealth resuling in positive NPV. Y IfIRRofthe project < Cost of Capital, Reject the project because the projectis destroying value in shape of negative NPV. b. Comparison Decision: Project with higher IRR shall be preferred. Lecture Example of IRR Suppose @ company has project Y with the following cash flows to evaiuate Year cash flows, K 80,000 20,000 20,000 20,000 20.000 20,000Financial Management-Fi jig feeale value of project at the end of year 5 fs K10,000_ If is the campany's policy to undertake projects only if they are expected to yield a (discounted cash flow) return of 10% or more, ascertain whether this project be undertaken (calculate the IRR). SOLUTION STEPL Calculate the frst NPV, using the company's cost of capital of 10% Year cash flow PV factor 10% PV of cash flows K:000 000 ° (@0,000) 4.000 (20,000) +5 20,000 3.791 75,820 5” 10,090 0.621 ° 6.210 NPV= -2,030 This is positive, which means that the IRR is more than 10% ‘STEP 2 calculate the second NPV, using a rate that is greater than the first rate, es tho first rate gave a positive answer Suppose we try 12% Year cash flow PV factor 12% PV of cash flow « 000 K'000 o (80,000) 4,000 (80,000) 15 20,000 3.605 72,400 5 10,000 0.567 5.670 NPV= 3 (2,230) : STEP 3Using the interpolation method, the estimated IRR is 10.95%, say 11% Advantages of IRR: + _IRRtakes intoaccountthe time value of money andthus giving abetter picture of the projects viability. ‘+ Itconsiders the timing and life of the project + Itoan be calculated by assuming any discount rate inits calculation, + IRRiseasier to understand as compared to NPV. + Riskcan be incorporated inte decision making by adjusting the company’s target discount rate Dis: idvantages of IRR + tignores thesizeofinvesimentandiengthotthe project + Itgivesno absolute measureto reach atsomeconclusion + itis fairly complicated to calculate. + Itcan be confused with accounting ROCE. + Interpolation technique used in IRR calculation does not give exact answer. It only provides an estimate and if the margin between required rate ofreturn andIRR is fairly smal, this lack ofaccuracy could resultinwrong decision being taken, + Incaseofnon-conventionalcash flows, there may beseveral IRRs which can mislead thedecision makers. IRR does not give indication about the increase ordecrease in the wealth of shareholders.Study Notes: Financial Management-FMt # Itconsicers the long term viabilty of the project; losses may be madein the short term. * Ittequires assumption ofreinvestment 2t IRR which may not be fulfiled incase of higheriRR, Discounted Payback period metho: Definition: The time period in which initial investment is recovered in terms of present value, known as payback period or ~The number of years for the present value of the cash out fay to be matched by present velue of casi inflows, lkissimlarto simple payback period. Theonly ifferenceisthat he discounted cash flows ereused instead of simple cash flows forcalculation. Decision Rule Y Feasibility Decision: lfdiscounted payback periodis less than target discounted paybackperiod, then ACCEPT the project. Idiscounted payback pericdis merethan target discounted payback period, then REJECT theproject. ¥ Comparison Decision: - Project with minimum ciscounted payback period should be preferred. Advantages of Discounted payback period: - "+ Itfakes into account the time value of money and tmings of cash flows + Payback period metnodcanalso be usedas ébasicscreeningdevice a the fiststage (or shortlisted projects: + Itconsiders cash flows rather thanaccounting profits that'swhy chances of manipulation are very low. + Risk and uncertainty can be incorporated with the help ofrisk adjusted cost of capital + Inthe situation ofcapital rationing, it can be used to identity the projects which generate adaitionalcesh for reinvestment quickly ‘+ Short payback period sesult in increased liquidity and enable business to grow more quickly, so used in rapidly changing technologies andindustries Disadvantages of Discounted payback period: ~ + Iedoes not consider the whole life of project + Calculation of discounted target payback period is dificult to measure. + Disadvantages of Discounted payback period does not ive incication abut the increase or decreasein the wealth of shareholders + Itmay lead to excessive investmentin short teim project, + Itrequires knowledge of cost of capital whichis diffcultto calculate. * Life expectancy of a projectis ignored + Iitakes into account the Risk of ming ofcash flows but not the variability of those cashflows.Financial Management-FiM Lecture Examples on Discounted Payback period Example.t Initial investment in a project A is $60,000, Net cash inflows during project life of 7 years are $26,000, $20,000, $18,000, $16,000, $15,000, $13,000 & $10,000. Required: ) Calculate payback period ii) Calculate ciscounted payback period, (Ifcost of capltalls 10% p.a.) Solutions Ex #4 (a) 2 in Yr Cash flow Cumulative cash flow To (60,000) (60,000) a 25,000 (35,000) Te 20,000 (15,000) bh 18,000 3,000 tw 18,000 19,000 T 45,000 34,000 ke 43,000 47000 7 10,000. 57.000 Payback period = 2 years + aoe years = 2.83 years (b) t 5 Yr Cash flow DF. PY Cum PV Te (60,000) 4.900 (00,000) (60,000) th 25,000 0.909 22,726 (37,278) Te 20,000 0826 16,820 (20,758) Ts 18,000 0.751 13,618 (7,237) T+ 16,000 0.683, 10,928 3.691 Ts 18.000 0.821 9u18t 86,089 Discounted Payback period = 3 years + ae years = 3.66 years The relative merits of NPV over IRR are: > Itprovides a clear decision i.e. accept if positive, reject f negative > Italways gives the correct decision (when evaluating single projects, or mutually exclusive projects) > Italways gives a single answer (some projects have more than one IRR) > Itmaximizes the shareholders’ wealth The rolative morit of IRR over NPV is: > Itis much easier for non-accountants to accept > Itdoes not require the exact cost of funds to be knownStudy Notes ‘financial Management FM, Effect of Taxation in investment appraisal "Taxation ls a major practical consideration for business. It's vital to take into account in making dedsions. 1) Basic Assumption Taxation has two effects in investment appraisal i Negative effect: - Tax charged on net revenue cash flows I.” Positiveetfect -Taxrelief onassets purchased via wring down allowances (capitalatowances) 2) Comoration tax anprofits Calculate the taxable profs (betore capital ellowances) and calculate tax at the rate given i) Taxon Oporating cash flows: Operational cash flows X Rate of Tax ii) Tax Savings on Capital Allowances: Calculate the capital Allowances! Balancing Alowances anc then multiply with Tax Rate. + Theeffect of taxation willnot necessarily ocour in the same year es the relevant cash flow that comes in. Follow the instructions given in exam question BERTSEEE. Initial Investment = 2,000 : Capital Allowances = 25% reducing balance Usefullife = 4 years, Tax rate = 30% payable in arrears, Screp Value = 500 Years Written Capital Tax * Tiening Down Value Allowances @ 25% Savings @ 30% 1 2000 500 150 2 2 1500 376 413 3 a 1125 281 a4 4 4 844 344 103 5 Examplo Penalty Co is considering a project that will require an investment in machinery of $40,000 and which will generate revenue of $27,000 in the frst year, $37,000 in the second year and $49,000 in the third and final year. The direct costs, will equal 35% of the revanue and relevant overheads wil be $8,000 each year. Itis thought that the machinery vill be sold for $19,000 at the end of the project. Penalty Co pays 30% corporation taxon is net operating cash flows and can claim capital allowances on the machinery at 25% on a reducing belance basis, with a balancing allowance or charge in the final yeer. All tax is pald or saved at the end of year in which the cash flows arise. The cost of funds is 9% Calculate the NPV for Penalty Co.Study Notes Finoncio! Management-FIM SOLUTION Time 0 1 2 3 8 3 $ 8 Revenue 27,000 37,000 449,000 Direct costs @ 35% (8.450) (12,950) (17,150) Overheads (8,000) (9,000) (,000)_ Not operating cash flows 550 78,060 22,850 Tax@ 20% (2,538) 518) (6,055) Machinery (40,000) 19,000 Capital allowance savings (W1) 3.000 2,250 050 Net cash flow (40,000) 6,985 12,785 36,045 Diecount Factor @ 9% 3.000 0917 0.842 0772 Present Value (0,000) 27,827 Workings: Capital Allowances (Wt) Time 4 2 a ‘Opening value of equipment 40,000 30,000 22,500 Closing value of equipment 30,000 22,500 19,000 Capital Allowances 25% reducing balance 70000 - 7,600 3,500 Tax Saving at 30% 3,000 2,250 1,050 Effect of Inflation in Investment Appraisal: Inflation Cin Inflation may be defined 2s a general increase in prices, leading to general dectine in the real value of money, (Decrease in purchasing power) Inflation Real rate of General Money rate Return Inflation rate of return i, Real rate of return/cost of cepital Real rate of interest reflects the rate of return that would be required in the absence of inflation. fi, Money rate of returrycost of capital Money or nominal rate of return is rate that will be required in presence of inflation.Study Notes Financial Monegement-FM Relationship between real and nominal rates of interest (Fisher formula) (rey (1th) ate ofinflation/ P| r=realrateofinterest \ominal (money rate of interest) Types of Cash Flows ji) Money cash flows are those cash flows in which the effect of specific inflation has been adjusted. lll Real cash flows are those cash flows which have not bgen acjusted fer inflation Where Nominal Cash flow = Real cash flows (1+ i)" ‘Sometimes Exeminers gives the value in year 1 terms instead of current prices terms then Nominal Cash flow = Real cash flows (1+ i)" Wy Infiation is a problem Tishard to estimate, especially when rates are nigh thas economicimpacts which cause governmenisio take into accauntits impacts on business Differentinfation rates willoccur, cifferent costs and revenues Wullintlate at different rates, Italters the cost of capital Itmakes historic costs itelevant and therefore causes ROCE to be overstated Itcreatesuncertainty encourages business io be short term in looking Inflation may not be constant 7 The longer a project, the more significant the impact of inflation vvvyy yvvy Effect of inflation on the discount rate: “The discount rate used ininvestment appraisal rellecte the nance providers required rate of return (e.g, therate of interest on @ loan raised, or shareholders required return if financed by equity, In times of inflation, the fund providers will require a retum made up of two elements. i) Areturn to compensate for inflation (fo maintain purchasing power} ii) Areal return on top of this for the use of their funds, The required return that incorporates both of these elements is known as a money return. Methods to be used in Investment Appraisal 4. Money method ‘+ Adjust individual eash flows for specific inflation to convert to money cash flows. ‘+ Discount using moneyrate 2. Real method * Noneed toadjust any individuatcasn flows fornfiation to convert io money cash flows + Discount using Realrate + Thisis the simplesttechniqueStudy Notes HinoncialMonagement-FM. + Remove the effects of ceneral inflaton from money cash flows to generate real cash flows, + Achieves the same result as money method Iz > Incase of generalinflation, either of the two methods can be used, > Incase of speciticinflation, only appicable method is Money method Example 4: Rise Co is considering a project that will require an investment in machinery of $50,000 and which will generate net Income of $18,000 in the first year, $24,000 in the second year and $33,000 in the third and finel year. The cost of funds is 12%. None of these figures include inflation. Caleulate the NPV for Rise Co. SOLUTION Timing Cash flow Discount Factor Present Value $ 12% $ ° (60,000) 1.000 (60,000) 1 48,000 0.893 16,074 2 24,000 0.797 19,128 3 33,000 0.712 23.498 NPV= ‘$8,698 Example 2: Infation is currently 7% and is expected to remain at this level for at least the next three years in the country where Rise Co. operates. Calculate the NPV for Rise Co including inflation. SOLUTION To include inflation in the cost of funds we use the formula: (1+) x(1+h) (14 =(1+ 0.12) (1 +007) (141) = 1.1984 1984 or 19.84% Real cash Nominal Discount Present Timing flow Inflation cash flow Factor @ Value 3 1% 5 19.84% s 0 (50,000) 1.00 (50,900) 4.000 (60,000) 1 18,000 1.07 19,260 0.834 16,063 2 24,000 1.072 27.478 0.696 19.125 3 33,000 1073 40,428 0.581 23,488 NPV= $8,676 Note. The small differences are duc to rounding of discount factors to 3 d.p.Study Notes Financial Mangement FM Working Capital Change Every business requires working capital for its operations. Calculate working capital change in two steps: 41. Calculate working capital requirenentone yearinadvance e g. working capitalis 10% of salesatthe stert of eachyear 2. Calculate incremental working capital by taking change of each year working capital 3. Inlastyear. therewilllbe an assumption thatallworking capitalwillerecovered Only forprojectendnot for ongoing business) Bene ‘A.company is considering to inve of each year is 2s follows: a project with its life of 4 years, Total working capital required at the beginning Year Cash flows $000 1 500 2 700 3 1,000 4 ‘600 Required: Calculate the working capital cash flows of each year to be included in NPV calculation Solution ‘Total Working Capital $1000 S yo 500 yt 00 yo 1060 v3 600 v4 ° The Finance Cost The Finance Costwillearelevantcash flow however it will NOT become the part ofcash flows. This isbecause itis part of cost of capital. Performa for Net Present Value Years 0 4 2 $ 4 Sales XK x x Variable Cost ~” ~ ~ “) Incremental Fixed Cost @ sey mw wo ‘Operating cash flows x x x KStudy Notes Financial Monagement-Fut Tax Expense « ~ ) «) Tax Savings on Capital Allowances x x x x Change in Working Capital ~ ” wo 1 @ x Initial Investment *) a Scrap Value - i is Net Gash flows : rR) x x x X Discount Factor x x | x x Present Values std] x x | x x Not Present Value X . Example 1: Quitongo plc is considering a major investment programme which will involve the creation of a chain of retail outlets throughout Zambia The following schedule of expected cash flows has been prepared for analysis. Time ° 1 2 3 4 000 000 000 K'000-—«K'000 Land and Buildings 3,260 Fittings and Equipment 750 Gross Revenue 1,000 1,750 2500 3.200 Drect Costs 800 1,100 1,500 4,600, Marketing 170 250 200 200 Office Overheads 400 100 100 4100 Quitongo pic nas an accounting year end of 31 December. Additional information: (2) 40% of office overhead is an allocation of head office operating costs. (b) The cost of iand and buildings includes K120,000 which has areagy been spent on surveyors’ and olher advisers’ feos. {C) Quitongo ple expects to be able to sell the chain a the end of year fer Ké,600,000. (d) Cost of capital ie 7% Guitongo ple is paying tax at 30% and ts expected to do $0 for:the foreseeable future. Tax is payable one year after profits are earned. {he company will claim capital allowances on ftings end equipment at 25% ‘on a reducing balance basis. Capital allowances are not available on land and buildings Expenditure on the investment programme will take place in January. Eslimated resale proceeds of K200,000 for the fitings and equipment have been included in the total figure of £4,500,000 given above, Required: Calculate the cash flows needed for the NPV of the project AND caiculgte the NPV of the projectFinancial Manogement=FM, Study Notes SOLUTION: 000 Timo o 1 2 3 4 5 Turnover 1000 1,750 «2800 3.200 DirectCosis (800) (1,100) (1,500) (1,600) Marketing (170) 50) OD). vernsads (60%) 160) so _@ Operating Profit (30) 340 740 1,340, Taxaton @ 30% 9 (0) a2) . Fittings & Equipment (750) 200 Sale of business 7 4,300 Land tbuilaings (3,120) aoe of Capital Alowances 56 42 32 6 ViokingCaptalwia) 50) 5) s) NetCash flow (4,130) (80) 330 665 6,060 (367) 7% Discount Factors. 4 0.936 0.873, 0816 0.763 O73 PresentValue (4,130) (75) 288 4 4616 (262) NPV = + K971,000 (11) Calculation of corporation tax on e profits: Time i 2 3 4 Operating profit(£000s) (30) 0 740, 1340 Time ie 3 4 5 Tax 8 (102) (22) (402) (W2) Calculation of tax benefit on capital allowances: Time 1 WDA (KO00s) 188 Time 2 ‘Vax 86 2 141 3 a2 3 4105, 4 32 4 118" 5 35 * outlay — scrap proceeds ~ claims to date = 750-200-188-141.105 = 116 (Wa) Calculation of working capital flows: Time 0 W.Cap 250 £0008 (260) “normal assumption 1 300 (50) 2 3 4 375 400 o (75) (25) 400Study Notes Financial Manogement-FM Example 2: Funtime Co, atey compary, has developed 2 new game, ‘Zoom, whichit plans to launch in time for ie school summer acigays Sales of the now geme are expected lobe very stiong, folowing a favorabie review by a national newspaper, Seles and production volumes and selling prices for ‘Zoom’ over its four-year lfe are expected to be ax folowe Year 1 2 2 4 Sales and production (no. of gemes) 150,000 70,000 60,000 60,000 Selling price (per game) k25 ka k23 Ka Financial information on ‘Zoom’ in current prices Is as follows: Direct material cost K5.40 per game Other variable production cost K8.00 per game Apportioned fixed costs + K4.00 per game : Advantica costs to stimulate demand are expected to be K650,000 inthe first year of production and 100,000 in the cecord Year of production, No advertising costs are expecied in the third and fourth years of production, ‘Zoom’ will be prosiced on a new production machine costing KB00,000. Capital allowances can be claimed at 20% on a straight {ie basis, with @ balancing allowance or balancing cherge in the final year. Its expected thal the machine val reo for K150,000 at the end of the project Frnretme,C9 Pays tax on cash flows at the rate of 30% rer year and tx ibiltoe aro soled at the end ofthe year in which they arise. Inflation at 3% pa is ‘expected to apply to the production costs for the duration of the Project. t,he new game is launched, then sales of another game ‘Skip’ would be reduced due to lack of resources to devote icig tet geome. This reduction in sales, would amount to 10,000 units per year. ‘Skip’ currently eamsa eontribetica of K15 per game anc this would be expected to remain constant over the next four years. Horna captal equal {0 10% of the annual sales revenue is noeded ot the start of each year. All working capital will be released at the end of the project. Required: Calculate the net present value of the proposed investment using an after tax nominal diseount rate of 15%. ‘SOLUTION: ‘The net present value of the proposed investment Time 0 1 2 3 4 Koo K000 © KO00-—«K000~—«KOCO Sales (no. of games x selling price) 3,750 1,660 1,380 1,320 Direct materials (K6.40 * no of games * (1+ h)") (834) (401) (354) (385) Variable production costs (927) (446) (393) (408) (K6.00 x no of games » (1+ h)") Advertising (650) (100) - - Lost contribution on existing game (10,000 « K15) (150) (150) _(160)_(150) Net operating cash flow 1189 583 433. 400 Tax @ 30% 857) (175) (148) (120) New machine (800) 150 Tax saved on Capital Allowances (W1) 48 48 48 51 Working capital (w2) (375) _207 30 6 432 Net cash flow 178) “4.087 488. 302 913 Discount Factor @ 15% 1.000 _ 0870 0658 _ 0.572 Presont Value T1758) — 946 268 35T Net Present Value.Study Notes _ Financial Management-Fit ‘As the net present value is posttive, the proposed invesiment should be accepted as it will increase the shareholders’ wealth by K747k (W1) Tax saved on Capital Allowances Time Tax ‘Tax Saved Gash Flow $000 000 0 Purchase 800 1 CA@ 20% (160) 48 640 vy CA@ 20% 7 (ey 48 RS 480 3 cA@ 2% (160) 46 «t 320 4 Sale Proceeds (150) 170 Balancing Allowance (170) @30% 51 Nil 195 (W2) Working capital Time. 0 1 2 3 4 a sooo $000 $000.» $000 $000 Sales (no. of games x selling price) 3,750 1,680 1,380 1,920 Working capital needed (10% x sales) 375168 138 132 0 Working capital cash flows, 875) 207 30 6 432 Investment appraical in Capital Rationing situation : [Capital rationing} ‘Where the finance available for capital expenditure is limited to an amount which prevents acceptance of all new projects with a positive NPV, the companys said to experience ‘capital rationing’ There are two types of capital rationing. A. GEREERIEIEIEI This applies when a company is restricted from undertaking all worthwhile investment opportunities due to external factors over which ithies no control. These factors may include goveriment monetay restrictions and the general economic and financial climate (2.9. a depressed stock market, which prectudes arightsissue of ordinary sheres), 8. SERENE This applies when a company decides to limit the amount of capital expenditure which it is prepared to authorize. Segments of divisionalsad companies often have their capital budgets imposed by the main beard of drectors. Acompany may purposely curl its capital exnenditure for a number of reasons e.g, tay consider that it has insufficient depth of management expertise to explcit all available opportunities without jeopardizing the success of both new and ongeing operations. Capital retioning may exist in a: & riod capital rationi Available finance is only in short supply during the current period, butwill become freely available in subsequentStudy Notes Financiol Management 5M Projects may be: 1. Divisible—An entire project or any fraction of that project maybe undertaken. in his avant projects maybe ranked by means ofa profitability index, which can be calculated by dividing the present value (or NPY) ofeach Projectby the capital outlay required during the period of restriction. Projecis displaying the highest profitability indiceswill bepreferred. Use of the proftabilty index assurres that project retums increase in dlrect proportion to the amount invested in each project. ‘i Indivisible—An entire project mustbe undertaken, sinceitisimpossibletcacceptpartofaprojectonly.Inthis event thie NPV ofall available projects must be calculated. These projects must then be combinedon e tiial and errorbesis in order to select that combination which provides the highest total NPV'within the consiraintsof thecapital available. This approach will sometimes resultin some funds being unused. Sinale petiod capital rationing describes the situation where an organization does not heve sufficient funds to undertake all positive NPV projects at one particular point in time. * The calculation of profitability Indexes for divisible investment projects If the investment projects are divisible, this means that part of @ project could be undertaken and a comparable art of the positive NPV generated. “In such situations we need to rank the projects by identifying the net present value generated from the current investment or in other words, how much NPV do we generate from each $1 of investment. This measure is known as the Profitability index (Pl) Net Present Value (NPV) Profitabiity Index (Pl) Initial Investment Example: 3 Short Cois trying to choose betiveen four projects, all of which have positive NPV's, to invest, Delails of the four projects are as follows: however Short only has $1,000,000 Project: A B ¢ D a s $ 3 in Initial investment (800,000) (370,000) (143,000) (1,000,000) PV of future cash flows 445,000___ 500.000 _200,000_ _1,340,000 NPV 445,000 000 87,000 340,000 All four of the projects are divisible. What is the optimum investment policy for Short Co? SOLUTION Project: A B c D s $ $ $ NPV 145000 _ 130,000 _§7,000__340,000 Initial investment 300000 © "370,000 ~443,000 7,000,000 Profiteblty Index 048 0.35 0.40 0.34 Ranking 4st ad and ahStady Notes FinonclolManagement-Fi_ Project Proportion NPV Funds available/required % s 1,000,000 & 400 145,000 (300,000) a 700,006 & 100 57,000 (143,000) 557,000 8 100 130,000 (370,000) é s 187,000 D 187 63,580 (187,000 $305,680 Nil So Short Co should do all of projects A, C, and B and 18.7% of D. ions of non-divisible investment projects The calculation of the NPV of combin if the investment projects are non-divisiole, this means that either the whole project is undertaken or none of it is undertaken. In such situations we need to identify all possible combinations of whole projects that can be undertaken and then select the combination with the greatest total NPV. Example: ‘Short Co now realizes that the four projects are non-divisibie. What is the optimum investment policy for Short Co? SOLUTION : " Possible combinations Required investment Total NPV s § ABEC 813,000 332,000 D 4,000,000 340,000 So Short Co should undertake project D A discussion of the reasons for capital rationing Capital ratoning can be caused by two different reasons: 4 The organisation would like to raige moro funds, but no stakeholder is prepared to invest. This is known as hard capital rationing and may result from the potential returns not being high enough to compensate for the perceived risks involved, The organisation could raise more funds, but has internally decided not to. This is known as soft capitat rationing and may result from a concern that the available finance is t90 expensive or may resul in a loss of controlStody Notes -Financiel Monagement-FM. LEASE VS BUY DECISIONS A specific decision that compares two specific financing options, the use of a finance lease or buying outright financing via a bank loan. Key information > Discount rate = posttax cost of borrowing. ‘The rateis given by the rate on the bank loan in the question. iftis pre-taxthen therate mustbe adjusted fortax Ifthe loanratewas 10% pre-taxand corporation taxis 20% thenthe post-taxratewouldbe 7%. (10% x(1-0.3). > Cash flows: Bankloan Finance Lease p 4. Costofthe investment 4.Lease rental ~in advance 2. WDAtaxroliofoninvestment annuity 3. Residualvalue 2Tax relief onrental Other considerations: ¥ Whoreceives the residual value in the lease agreement? It is possible thet the residual value may be received wholly by the lesser or almost completely by the lessee. There may be restrictions associated with the taking on of leased equipment. The agreements tend to be much more restrictive than bank loans. : Are there any adgitional benefits associated with lease agreement? Many lease agreements include within the Payments, some measure of maintenance or other support service. ‘The benefits of any type of lease to the lessee can be * Availability;a frm ihatcanno:getabenkloan to fundthe purchase of en asset (capital rationing-see next section for urther discussion), the samebank that refused the loan will often be happy to offeralease * Avoiding tax exhaustion; ifa frm cannotuse all oftheir capital allowances (the lesser can use the capital llowances and then set a lease that transfers some of the benefit to the lessee) Avoiding covenants; restricting future borrowing capability. Benefits to the lesser: Banks offer leases to exploit their ability to raise low cost capital Companies (e.g. IBM) offer leases to attract customers, + Profitable companies set upleasingsubsidiaries io sholter their own profits rom tax(egM&S, Tesco) Ater deciding on the viability of an investment using NPV enalysis, a separate decision may be needed to determine Whether a lease would be better than an outright purchase. [ Key terms Definition Lessor Receives lease payments Lesses Makes lease payments Types of leases: There are two main types of leases, finance leases and operating leases.Study Notes Financial Monagement-FM Operating lease (2) Short term rental x (b)__ No iniial capital outlay {e) No risk of obsolescence (@___ Often maintained & insured by the lessor (©)___ Off balance shest finance (Expensive : Finance lease (@)__Long term rental (b) Lessee responsible for upkeap, servicing and maintenance of the asset (b)__No need for initial capital outlay (©) Simply an alternative source of finance | (@)__ May be cheaper (see below) “ Once an organization has decided to acauire en asset it then needs to decide how it Is going to finance ths acquisition, The two alternatives we are going to compare here are leasing the asset or borrowing the required funds and buying the asset. The most significant difference between these two altematives is that with a lease, the organisation (lessee) is not the legal owner; whereas if the asset is purchased then the organisation is the legal owner. Legal ownership is particularly important when considering taxation. Only the legal owner can claim capital allowances, however the lease payments are assumed to be Tully tax allowable. Any disposal proceeds are also only received by the legal owner and so are also a relevant cash flow. To evaluate these two alternatives, we discount the relevant cash flows and see which option 's cheapest. We can discount the.cash flows using ary discount factor, however itis recommended to use the cost of borrowing. The reason for this is that we can then avoid calculating and including the loan repayments and interest and insted just put in the amount borrowed eg. If you borrow K1,000 for one year at 10% interest, in one year you will have to repay K1,100. If you discount this at 10%, the present value is K1,000 i.e. the amount borrowed. The benefits of any type of lease to the lessee can be: {a) Availability; @ firm that cannot get 2 bank can to fund the purchase of an asset; the same bank that refused the loan will often be happy to offer a lease. {b) Avoiding tax exhaustion, if a firm cannot use all of their capital allowances (the lessor cen use the capital allowances and then set a lease that transfer some of the benefit to the lessee). (c) Avoiding covenants; restricting future borrowing capability. Leases in the real world Operating leases: (2) Projects (plant hire) where an expensive assatiis only needed fora specific job (2) High tech equipment (computer leasing} where leases often offer protection against technological risk and break down, Finance leases: (2) Used in vehicle rental (planes, trains, cars) where the lessor has the opportunity to obtain bulk purchase discoun's that are not availaole 10 the lessee or where the lessor can borrow at a lower rate of interest. Numerical analysis The benefits of leasing vs purchasing (with a loan) can be assessed by an NPV approach: Step 1 the costs of leasing (payments, lost capital allowances and lost screp revenue) Step 2 the benefits of leasing (savings cn loan repayments = PV of loan = intict outizy) Step 3 discounting at the post tax cost of debtSuey Notes Finoncioi Management-FM. Step4 calculaic the NPV ~ if positve it means that the lease is cheaper than the post-tax cost of a loan An alternative method is to evaluate the NPV of the cost of the loan and the NPV of the cost of the leaso separately, and to choose the cheapest option. Note that the costof the loan should not include the interest repayments on the loan eg. the NPV of the repayments on a loan for K10,000 repayable in 1 year at 10% interest is K10,000 when discounted at 10% - so the cost of a loan Is just its initial time 0 value, here £10,000. In numerical questions you can assume that the lessee is not able to claim capital allowances unless told otherwise. Before and after-tax discount rates {tin casn flows, we allow for the impact of tax: to be consistent we should also allow for the impact of tax on the discount rate. Let us compare two companies both earning the sare amount, however one has borrowed K1,000 and pays 10% interest and the other has not: jo Interest Co [interest Co K K Eamings 00 800 . inferes Wil ‘loa, 00 700 ffax@30% (240 (210) [After tax earnings 550 420 ‘So despite paying K100 of interest, Interest Co after tax earnings ere only K70 lower than No Interest Co. Hence the aiter-tax cost is: 10% (1-0.30) = % Or in more general terme: Befors-lax rate (1 ~tax rate) = Atter-tax rate > If we are discounting post-tax cash flows, then we need to use a post-tax discount rate. > Therefore, if tax is included in the cash flows in a lease vs buy calculation the cash flows should be discounted alan after-tax cost of borrawing, > The examiner may provide you with a discount rate which is already post tax — hence it's very important to read the question Example 1 Penalty Co has decided that it would like a machine costing K40,000. It can either borrow the money from its bank at an interest rate of 13% or @ leasing company has offered to lease the machine to Penalty Co for throe years at an annual cost of K11,200. Itis thought that the machine can be sold in three years' time for 1,000. Penalty Go pays 30% corporation tax on its net operating cash flows and can claim capital allowances on the machinery at 25% on a reducing balance basis, with a balancing allowance or charge in the final year. All ax is paid or saved at the end of year in which the cash flows arise. Would it be beiter for Penalty to lease or borrow and buy this machine? SOLUTIONStudy Notes FinorciolMenegement-Fat Lease: Timing Cash tlow Discount Factor Present Value K 13% kK 1-3 (11,300) 2.961 (26,679) Borrowing and buy: Timing * Cash flow Discount Factor Present Value K 19% K 0 (40,000) 4.000 (40,000) 3 49,000 0.693 19,107 K(26.833) The two alternatives are very close, but the lease is marginally cheaper, In the previous example we ignored tax. As we earlier, tax reduces the cost of debt and brings in tax on the operating cash flows and capital allowances. Example 2 Would it be better for Penalty to lease or borrow and buy this machine efter allowing for tax? SOLUTION The after tax cost of borrowing = 13% (1 ~ 0.30) = 9% Lease: Time Payments Not operating cash flows Tax saved @ 30% Net cash flow Discount Factor @ 9% Present Value 0 1 2 s k K K K (11,300) _(17,300)__ (14,300) (14,300) (14,800) (17,300) 3,390 3,390 3,380 (7,910) (7,910) (7,910) 0.917 0.842 0.772 ¢ (6650) (G107) ——_.—_ Gorrew and buy: Time eerrow tachinery 2pital allowance savings (W1) et cash flow Scount Factor @ 0% esent Value NPV = $(20,020) 0 1 2 3 3 s $ $ (40,000) 19,000 ——3.000 ——2,250 ——+,050 ~~ (40,000) 3000 «2250S, 050 4,000 0.917 0.842 772 (40,000) 2754 1804 16,479Finoncial Monagement-Fa Ne el NPV = (19,876) Study Notes The two elternatives are stil very clase, but now borrow and buy is marginally cheaper. Workings: Capital Allowances (W1) ime 1 2 3 Opening value of equipment 40,000 20,000 22,600 Closing value of equipment 30,000 22,500 19,000 Capital Allowances 25% reducing balance 19,000 7,500 «3800. ‘Tax Saving at 30% 3000 2,260 4,050 Exercise 1: Spicer plc is considering how to finance a new project that has been accepted by its investment appraisal process. For the four -year life of the project the company can either arrange a bank joan at an interest rate of 15% before corporation {fax relief. The loan is for $100,000 and would be taken out immediately prior to the year end. The residual value of the equipment is $10,000 at the ond of the fourth yeer. An alternative would be to lease the asset over four years at a rental of $30,000 per annum payable in advance, Tax is payable at 33% one year in arrears. Capital allowances are available at 25% on the written down value of the assat Required: Should the company lease or buy the equipment? ASSET REPLACEMENT DECISIONS USING EQUIVALENT ANNUAL COST Once the decision has been made to replace the asset, tho asset wil be replaced but we aim to adopt the most cost effective replacement strategy. The key in allquestons ofthis type isthe lifecycle of tne assetin years Asset Replacement issues: 1, How frequently an asset be replaced? 2. Is itworth paying mote for an assot that has a longer expected life? ¥ |nbotho! these-scenarios, the deal approach istokeep the costs per annum (in NPVterrrs)toa minimum. This 'S calculated as an equivalent annual cost (EAC). v EAC= NPV Annuity factor for the project life ¥ The best decision is to choose the option with the lowest EAC. Key ideas/assumptions: Y Cashinflows fromtrading (revenues) are notnormally considered i this type of question. The assurnption being that they willbe similar regardless of the replacement decision The operating efficiency of machines will be similar with differing machines or with machines of differing eges. Y _ The assetswill be replaced in perpetuity Sometimes an investment decision will involve choosing between two alternatives where the benefits are unequal e.g. ‘comparing renting one property for five years and an alternative for seven years.Study Hotes Financial Management=FM, In such situations comparing the NPV's would not necessarily give the correct decision and so instead we calculate the equivalent annual cost (EAC): EAG = NPV Annuity factor for the project lite 4 The EAC represents a constant annual cash flow that has the same present value as the actual cash flows arising under each proposal. The proposal with the lowest EAC should be chosen. 4 We are assuming that the replacement will keep happening forever. EXAMPLE y * Mobile Co is trying to decide whether to repiace its grinding machines every one, two or three years. Each machine costs K7,000. Mobile Ltd has 2 cost of capital of 12%. Costs and scrap value data is as follows: Year 1 2 3 K K K Maintenance costs 500 4,000 4,500 Running costs 2,500 3,000 3.250 Year-end scrap value 5,000 3,500 2,500 What is the optimum replacement cycle for the machines? Replace every year: Tim Cash 12% Pv Annuity EAC ° flow OF factor 0 (7,000) 4,000 1 (3,000) 0.893 1 5,000 0.893 a 0.893 (839) Replace every 2 years: Time Cash 12% Pv Annuity EAC flow OF factor 0 (7,000) 1.000 1 (3,000) 0.803 2 (4,000) 0.797 2 3,500 0.797 7 4.690 (6962) Replace every 3 years: Time Cash 12% Pv Annuity EAC flow. DF factor e (7,000) 1.000 4 (3,000) 0.893 2 (4,000) 0.797 3 (4,750) orte 3 2,600 or (4,469) 2.402 (6024) ‘So Mobile Co should replace their grinding machines every year.Study Notes FinanciaiManagement-FMt Lecture exercise 1 ‘Acompany operatesamachinewhichhasthe followingcostsandresalevalues overitsfour yearlfe. purchase cost 25,000. Yeart Year2 Years -Yeard kK K k kK Running costs (cash expenses) 7.500 11,000 12.500 15,000 Resale value (end of year) 15,000 10,000 7,500 2,500 The organizations cost of capital is 10%, s Required: Youarerequirod to aesesshow frequently the asset shouldbe replaced. Lecture exorcise Northern Co. regularly buysnew delivery vans. Each van costs K30,000, hes running costsof K9,000anda sc-apvalueof 10,000 inits 1st yea, In iis 2ndyear the vanhashigher runningcosts (k4,000) & alowerscrap valtie(K7.000). Vehicles are not kept for > 2 years for reliability reasons. Required:Using - Northern Co.’scostof capitalof 15%, identifyhowoftenthevanshould bereplaced. ignoretax Lecture example ‘Acompariy operates amachine which has the cllowing costs and resale values overits three-year fe. Purchase cost: K30,000, Year! Year2 Year3 Ko. ok K ‘ Running costs (cash expenses) 7,000 12,900 13,000 Resale value (end of year) 12,000 9,260 8200 ‘Theorgenization'scostofcapital - is25%. Specific - inflation inrunningcostandresidual valieis6%& 7.5% respectively. Required: You are required to assess how frequently the asset should be replaced,Study Hotes Financiol Menegement -FMFinanciaiMenogement-FM Study Nes Risk & Uncertainty If the probability of projects outcome are: Predictable Not predictable Risk Uncertain Before deciding to spend money on a project, managers will want to be able to make a judgment on the risk/uncertainty of its return ‘Acontitioninwhich severalpossible outcomes exist, the probabilities of whichcan be quantified from historical data, Uncertainty: “The inabiity to predict possible outcomes due to a back of historical data being available for quantification. If project cashflowsare: ._ | adil Risky (Techniques) > Expectedvalues (Techniques shouldbe) > Risk agjusteddiscount factor ‘Adjusted payback period Sensitivity Analysis Certainty equivalents Simulationmodets Expected values: The quantitaive resut of weighting uncertain events by the probability of theiroccurrence. Or Using probabilties to create an assessment of the average expected net present value from an investment The simple expected value decision rule is appropriate, f three conditions are met or nearly met. O Thereisareasonable basis for making the forecast and estimating the probability of different outcomes. D_Thedecision is relatively small in relation to the business. Risk is then small in magnitude 1 Thedecisionis for a category of decisions that arectten made. A technique, which maximizes averagepay of, is then valid, Advantages of expected value method 5 Recognizes that there are several possible outcomes and is therefore, more sophisticated then single value forecasts. J Enable the probability of the different outcomes to be quantifiedStudy Notes Financial Monagement FW. Leads directly to a simple optimizing decision rule. 1 , Caloulations are relativelysimple Disadvantages of expected value method: 0 Forecastingprocedure is complicated. Inaccurate evaluations already amajor weakness in projectevalation The probabilities used arealso usually very subjective. Theexpected value is merely a weighted average ofthe probability distribution, indicating the average pay off ifthe project is repeated many times. The ¢xpected value gives no indication of the disporsion of possible outcomes 0 Aboutthe expected value. The more widely spread cutof the possible resultsare, the more risky theinvestment is usually see to be.; The expected value technique also ignores the investors attitude to risk. Some investors are more likely to take risks than others Risk adjusted discount rate: - Risk adjusied discount rate technique shall be covered in cost of capital area because this technique involves the calculation ofrisk premium which requires the knowledge of Capital asset pricing model (CAPM), Lecture Examples on Expected value method: Example.t Mr. Sajid wants to open a campus in Sargodha, Initial investment is $100,000. Project life is 4 years. Sales Revenue ing cost Probability {s) ($) = * g0,000 0s 20,000 0.60 50,000 03 20,000 0.35 20,000 02 '50,0c0 0.05 Residual value of project, 40,000 0.50 5,000 0.50 Cost of capital of Mr. Sajid is 10% p.a. Required: Calculate the expected net present value of project. Exanipio.2 Initial investment in a project is $300,000. Project lifes 2 years. Net cash inflows from the project are Yoar 1: Cashflows(s). Probability 400,000 025 200,000 aso 300,000 025FinuucivlManagement-FM Study Notes Year 2: Heash inflowin yeart Cashflowsinyear2 Probability is (Sy @) i) 100,000 100,000 0.50 200,000 025 Ni 025 i) 200,000 400,000 025 200,000 050 300,000 025 ii) 300,000 200,000 025 300,000 0.50 350,000 025 Cost of capital is 10% pa. Required: Calculato the expectednet present value of project. Uncortainty: Uncertainty cannot be quantified, but can be desorbed usin Period, sensitivity analysis and simulation. Simple payback period and adjusted payback pari in earlier studies (basic techniques of investment appraisal). We have cover ‘The quicker the payback the less relevant a project Sensitivity Analysis: Definitions: (on the later, more uncertain cash flows. Sensitiviy analysis assess howresponsive thepprojecis' NPVis to changes inthe variables usedtocalculate thatnet present valve, In general, risky projects are those whose future cash flows, and hence the projectretums, are likely tobe variable, The greater the variability is, the greater therisk. The problem ofrisk is more accurate with capital investment decisions than other decisions for the following reasons, 5. Estimates ot capital expendituremight be forseveral Actual costs may escalate well above budget as the work progresses. 9 Estimates for benefits willbe forseveral years ahead, sometimes 11 long-term estimates can be at besi by approximations. Practical factors may be those over which managers have no control. years ahead, such a¢ for major consumption projecis. 0, 18 or 20 years ahead or even longer, and 9 different techniques e.g. payback period. Adjusted paybackStudy Notes Financial Management -F¥v. Formulatocalculate sensitivity ofa particularcashfiow: Sensetivity (%) = pee IE PV of area of senstivity Formulatocalculate sensitivity of cost ofcapitals- Sensetivity(96)~ The best approach of sensitivity analysis isto calculate the projects net present value under altemative assumptions to determine how sensitive itis to changing conditions. This indicates which variables may impact mostupon the net present value (critical vanables) and the extent to which those variables may change before the invesiment results ina negative NPV. Advantages of sensitivity analy: | This is not a complicated theory to understand Information will be presentedto management ina form, which facilitates subjective judgmenttodecide the likeihood of the various possible outcomes considered C1 Identifies areas, which are crucial to the saucersof the project, iftis proceed with, those areas can be carefully monitored Indicates just how entical are some of the forecast which are considered to be uncertain Disadvantages of sensitivity analysis: 1D Itassumes that changes to variables can be made independently e.g. in isolatich, material prices will change independenty of others variables. Thisis unlikely. If material prices wert up, the firm would probably increase selling price at the same time and there would be itt effect onnet present value 1D Itonlyidentifies how faravariableneedstochange: itdoes notlook at theprobabilityofsuch achange. In the above analysis, sales volume appears to be the mosiciucial variable, but ifthe fimwere facing volatile raw materialmarkets 265% change in raw material prices would be far more likely than @ 29% change in sales volume. 0. Itienotan optimizingtechnique. Itprovides informationon the basis ofwhich decision canbe made. Itdo2s ot point to the correct decision directly. Lecture example: Initial investment in a projectis$ 1,000,000. Project lfeis4 years Sales limits per year are 20,000. Siunit Selling price 100 Meterial cost 50 Labour cost 20 Variable overheads 50 Increment fixed cost is $100,000 per annum cost of cagital is 10% p.aRequired; a) b) Solutions Sensivty Analysis vr Cash flow To Initial inv. (1000) T1-Te Sales 2000 Th-Te Mat - (1000), Th-Ts Leb (400) ThH-Ts v.FOH (100) Th-Ts Inc. F.C (150) Te RV 50 % age sensitivity = MY ty = Seep InitialNPV= im * 100 = 14.33% sig = Sales = Gag * 100 => 2.2606 e Mat 193. 109-3 4.526% Lab 103 x 100=> 11.3% vFoH nro =a tayso.10% RV EE o> a1961% Certainty equivaton Calculate net present value of the project. Calculate sensitivity of each vanable at the project. Definition:- One particuler approach to sensitivity analysis, the certainty equivalent approach, invelves the conversion of the Expected cash flows of the project to risk less equivalant amounts. The greater the risk of an expected cash flow, the smaller the certainty equivalent value (for receipts) or the larger the certainty equivalent value (for payments). The disadvantage of the certainty equivalent approach is that tho amount of the adjustment to each cash flow is decided subjectively by management. As the casi flow are reduced to supposedly certain amounts they should then be discounted at a risk free rate. DF. 3.169 3.169 3.169 3.169 3.169 0.883 Finenciol Moaagement-FMs Pv (1000) 6338 + (169) (267) 18.9) (475.35) 34.150 + 143.37Study Notes, = ‘nancial onagement-F Lecture example: intial investment in a project is $20,000. $/Annum Sales Revenue 40,000 Material cost 16,000 Labour cost 5,000 Cost of capital 10% Project life is 4 years, Fotlowing are the ratio of certainty equivalent for cash inflows and cash outfiow. Yoar Cash inflow Cash outflow 1 0.95 1.08 2 0.90 4.40 3 0.85 1.15 4 0.80 448 Required: Calculate the NPV of project using certainty equivalent approach. Solutions Exat " te th hota Te , (000) $(000) $(000) $(000) —_$(000) Sales 8 %6 34 32 Less MC (169) (16.5) (17.25) (177) Loss Ve 3) 5) (575) (69) Initial (20) Go ws 7 1 aa DF 10.909 0.826 0.751 0.683 G0) 15.271 11564 8261 5737 NPV = 420.839 Simuiation: use of simulation Simulation is a technique, which allows more than one variable to change at the same time. One example of simulationisamathematical model, which could be approached using the "Mente Carlo" methodStily Notes Finacial Management-FM 1 Specify the majorvariables Specify the relationship between the variables Attach probability distibution to each variable and assign random memberste reflect the distribution Stimulate the environment by generating random numbers. Reward the outcomes of each simulation 11 Repeat simulation many times to obiain a probability distribution of ikely outcomes. oa Advantages of simulation D_Itgives more information about the possible outcomes and their relative probability, 0 Itis useful for problems, which cannotbe solved analytically. 1 Itisnota technique formakinga decision only for obtaining more information aboutths possiblo . outcomes, 0 Itcanbe very time-consuming without a computer _Itcould prove expensive in cesigning end running the simulation ona computer Simulationsare only as good as the probabilities assumptions and estimates made, Variables The net present value could depend on a number of certain independent variables. O Selling price Sales volume 1D. Cost of capital Initial cost 3 Operating costs 0 Benefit