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FINANCIAL MANAGEMENT
Professional Stage Application Level
Study Manual
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©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
chapter 2
Investment Appraisal
Contents
Introduction
Examination context
Topic List
1 Ranking of investment appraisaltechniques
2 Relevant cashflows
3 Taxation
4 Inflation
5 Replacementanalysis
6 Capitalrationing
7 Investment appraisal in a strategiccontext
8 Investing overseas
Summary and Self-test
Answers toSelf-test
Answers to Interactive questions
20 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Introduction
Practical significance
Investmentdecisionssuchasdevelopinganewproductormovingintoanewmarketarerequiredbyany
businessovertimeiftheyaretogeneratenewgrowth.Suchdecisionswilldependuponananalysisofthe
costsandbenefitsoftheoptionsunderreview,inparticularthefinancialpayoffs.Thetechniquesrequired
forthisarecoveredinthischapter.
Working context
Accountantsinvolvedindiscountingfuturecashflowswillfindthetechniquesinthischapteruseful.This
includesthoseworkinginauditing,treasuryandcorporatefinance.
Syllabus links
ThischapterdevelopsthebasicinvestmentappraisaldecisionsintroducedatknowledgelevelManagement
Information.ThestrategiccontextofthesedecisionsistakenfurtherinBusinessStrategy.Theunderlying
techniqueswillbeappliedinexploringvaluationmethodsintheAdvancedlevelpaperBusinessAnalysis .
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
1 Ranking of investment appraisaltechniques
Section overview
Financialmanagementprogressestheskillsfromknowledgelevelintoapplicationlevelintheareaof
investmentappraisal.
Relativemeritsanddemeritsmeanthatdiscountedcashflow(DCF)techniquessuchasNPVandIRR
aresuperior.
Summary of techniques
Payback Thetimetakenforcashinflowsfromaprojecttoequalthecash outflows.
Accountingrateofreturn Averageannualprofitfrominvestment
ARR= ×100
Initialinvestment
Averageannualprofitfrominvestment
or ×100
Averageinvestment
Initialoutlay Scrapvalue 2
whereaverageinvestment=
Note: profit is after depreciation
Netpresentvalue Themaximumaninvestorwouldpayforagivensetofcashflows(at
his/hercostofcapital)comparedtotheactualamounthe/sheisbeing asked
topay.
Thedifference,theNPV,representsthechangeinwealthoftheinvestor as a result of
investing in the project.
Internal rateofreturn AcostofcapitalatwhichtheNPVofaprojectwouldbeCU0.
IRR is usually found via interpolation using two discount rates.
NPVa
IRR = a + (b-a)
NPVa – NPVb
Where a is the first discount rate giving NPVa
b is the second discount rate giving NPVb
22 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Interactivequestion1:Revisionofbasictechniques [Difficulty level:Easy]
Acompanyisconsideringexpandingitsbusiness.TheexpansionwillcostCU350,000initiallyforthe
premisesandafurtherCU150,000torefurbishthepremiseswithnewequipment.Cashflowprojections
fromtheprojectshowthefollowingcashflowsoverthenextsixyears.
Year Net cash flows
CU
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
Theequipmentwillbedepreciatedtoazeroresalevalueoverthesameperiodand,afterthesixthyear,it
isexpectedthatthenewbusinesscouldbesoldforCU350,000.
Requirements
Calculate
(a) The payback period for theproject
(b) TheARR(usingtheaverageinvestmentmethod)
(c) TheNPVoftheproject.Assumetherelevantcostofcapitalis12%
(d) The IRR of theproject
Therearefourbasicinvestmentappraisaltechniquesthatareusedinpracticebycompanies.Thereason
whysomeareusedmorethanothersisbecauseoftheirrelativemeritsanddemerits.
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
24 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Interactivequestion2:Rankingoftechniques [Difficulty level:Easy]
Whataretherelativemeritsanddemeritsofthefollowinginvestmentappraisaltechniquesandwhat
conclusionwouldyouthereforedrawabouttheirrelativeattractiveness?
Accounting rate of
return
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Merits Demerits Rank
Internal rate of return
Net present value Takes into account The need to Technically superior
the time value of estimate a cost of technique
money capital
Gives an absolute Difficulty in obtaining
measure, allowing all relevant
for comparison of costs/benefits
projects
Assumes cash flows
Considers all cash occur at annual
flows of projects intervals
Internal rate of return Takes into account May conflict with Easier to use and
the time value of NPV decision communicate
money practically
Assumes cash
Represents a reinvested at IRR
breakeven point so
does not need an
exact cost of capital
Considers all cash
flows of projects
Theaboveexampleemphasisestheideaofprogression–thetechniquesintroducedatknowledgelevelwill
26 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
beappliedheretosolverealworldproblems.
2 Relevant cashflows
Section overview
Cashflowsshouldbeusedininvestmentappraisalratherthanprofitsasthismorecloselyreflectsthe
impact on shareholders'wealth.
Relevantcashflowsarethosewhichareaffectedbythedecision.
Opportunitycostsreflectthecashforgoneasaconsequenceofusingresources.
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Worked example: Working capital
GorgonLtdexpectsthefollowingsalesfromanewprojectoveritsthreeyearlife:
CU
t1 150,000
t2 175,000
t3 200,000
Workingcapitalequalto10%ofannualsalesisrequiredanditneedstobeinplaceatthestartofeachyear. Calculate the
working capitalflows.
Solution
First,calculatetheabsoluteamountsofworkingcapitalneededatthestartofeachyearandthenfindthe cashflows.
t0 t1 t2 t3
CU CU CU CU
Working capital at start 15,000 17,500 20,000 Nil
Cash flow (15,000) (2,500) (2,500) 20,000
Onlytheincrementalflowisrelevant,soforexampleatt 1anadditionalCU2,500isrequiredoverand above the
CU15,000 already inplace.
At the end of the project all working capital is assumed to be recovered, i.e. an inflow of CU20,000 at t 3.
Definition
The relevant cash flows are future, incremental, cash flows arising from the decision being made.
28 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
The relevant cash flow is the difference between:
The cash flow if the course of action is taken,and
The cash flow if it isnot
Theassessmentofrelevantcashflowsneedstobedonefromthepointofviewofthebusinessasawhole and not
individual divisions ordepartments.
Typical items which are excluded from the analysis as irrelevant are discussed below:
Sunkcosts–moneyalreadyspent,e.g.whentryingtodeterminewhetheranexistingmachinewhich
costCU250,000threeyearsagoshouldbeusedonanewproject,theanalysisshouldignorethe
CU250,000asnothingcanbedoneaboutit;instead,themachine'scurrentworth(eitherscrapvalue
orcashbenefitsfromretention)shouldbeincluded
Accountingentries–e.g.depreciation(asdiscussedabove)isnotacashflow
Bookvalues–e.g.FIFO/LIFOinventoryvalues.ThisissimilartosunkcostsaboveastheFIFO/LIFO
conventionsmerelydealwiththetreatmentofmoneyalreadyspent
Unavoidablecosts–moneyalreadycommitted,e.g.anon-cancellableleaseorapportionedfixed
costs.Asfarasfixedcostsareconcerneditisthetotalamountwhichisimportant(notanyattemptto
spreadthefixedcost,i.e.apportionment).Ifthetotalchanges,thenthisisrelevant;ifnot,thefixed
costsareignoredastheyareunaffectedbythedecision.Forexample,ifafirmcanmakeanew
productwithinitsexistingrentedfactory,thenanyshareoftherentapportionedtothenewproduct
shouldbeignoredasthetotalrentbillisunchanged.However,ifanewfactoryneedstoberented,
thentheadditionalrentisrelevantintheappraisalofthenewproduct
Financecosts–e.g.interest(discountingdealswiththisbyfindingthepresentvalueoftheflows
allowingforthetimethefinanceistiedupandtheinterestrate)
Specifically include:
All opportunity costs andrevenues.
Definition
Theopportunitycostofaresourcemaybedefinedasthecashflowforgoneifaunitoftheresourceis
usedontheprojectinsteadofinthebestalternativeway.
Iftherearescarcitiesofresourcestobeusedonprojects(e.g.labour,materials,machines),thenconsideration
mustbegiventorevenueswhichcouldhavebeenearnedfromalternativeusesoftheresources.
Shareholdersareconcernedwiththeflowsgeneratedbythewholeorganisationintermsofassessing their
impact on theirwealth
Thecashflowsofasingledepartmentordivisioncannotthereforebelookedatinisolation.Itis
alwaysthecashflowsofthewholeorganisationwhichmustbeconsidered
Forexample,theskilledlabourwhichisneededonthenewprojectmighthavetobewithdrawn
fromnormalproductioncausingalossincontribution.Thisisobviouslyrelevanttotheproject appraisal
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
With what cost should the new contract be charged for the ZX 81?
Solution
TheuseofthematerialininventoryforthenewcontractmeansthatmoreZX81mustbeboughtfor
normalworkings.Thecosttotheorganisationisthereforethemoneyspentonpurchase,nomatter
whetherexistinginventoryornewinventoryisusedonthecontract.
Assumingthattheadditionalpurchasesaremadeinthenearfuture,therelevantcosttotheorganisationis
currentpurchaseprice,i.e.50tonnes CU210=CU10,500.
9,000
Solution
What is lost if the labour is transferred from normal working?
30 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
CU
Contribution per hour lost fromnormalworking 6
Labourcostperhourwhichisnotsaved 8
Cashlostperhourasaresultofthelabourtransfer 14
Thecontractshouldbechargedwith5,000 CU14 CU70,000
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Answer to Interactive question 7
Costs and revenues of proceeding with the project.
CU
(1) CoststodateofCU150,000aresunkcosts,thereforeignore.
(2) Materials – purchase price of CU60,000 is also sunk.
Thereisanopportunitybenefitofthedisposalcostssaved. 5,000
(3) Labourcost–thedirectcostofCU40,000willbeincurredregardlessof
whethertheprojectisundertakenornot–andsoisnotrelevant.
Opportunitycostoflostcontribution=150,000–(100,000–40,000) (90,000)
Theabsorptionofoverheadsisirrelevant–itismerely
anapportionmentofexistingcostswhichdonotchange.
(4) Research staffcosts
Wagesfortheyear (60,000)
Increase in redundancy pay (35,000 – 15,000) (20,000)
(5) Equipment
Deprival value if used in the project = disposal value (8,000)
Disposal proceeds in one year 6,000
(All book values and depreciation figures are irrelevant)
(6) General building services
Apportioned costs – irrelevant
Opportunitycostsofrentalforgone (7,000)
(174,000)
Sales value of project 300,000
Increased contribution from project 126,000
Advice. Proceed with the project.
2.5 Deprivalvalue
When an asset which is currently owned by the business is required for another specific
contract/project,theexistingactivityistobedeprivedofthatasset.Thevaluetobeusedinthe investment
appraisal is, therefore, the asset's deprivalvalue.
Solution
(a) Theexistingcustomerscreatemorevaluethansellingthemachine,sothemachinewouldnotbesold.
32 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
HencetheopportunitycostisthevalueinuseofCU1,500
Note:ifthevalueinuseeverdroppedbelowthenetrealisablevalue(NRV),thentheassetwouldnot be worth keeping.
(b) (i) Ifthenewcontractwillmakeuseofacurrentlyownedmachinetheninprinciplethecostof
usingitwillbethereplacementcost.IfthevalueinuseisCU1,500,andthereplacementcostis
CU800,thenthemachinewillbereplaced.Theequipmentcostofthenewcontractwould therefore
beCU800.
(ii) Ifhowever,thereplacementcostisCU1,800thenitisnotworthreplacing.Thustherelevantcost
ofequipmentforthenewcontractwillbetheopportunitycostorbenefitforgone–i.e.the CU1,500.
Ineachcasethereforetherelevantcostisthecashfloweffectofthedecisiontousetheexisting resource–
eitherthereplacementcostorthebenefitinthenextbestcase,i.e.thedeprivalvalue.
Deprival value
= lower of
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Iftheassethasanetrealisablevalueinexcessofitseconomicvalueitshouldbesold,i.e.itisbetterto
discontinueusingit.Iftheeconomicvalueishigherthanthenetrealisablevalueitisworthkeepingand
using.Atthispoint,therefore,werethefirmtobedeprivedoftheasset,thebestalternativeforgone
isthehigherofthenetrealisablevalueoreconomicvalue(the'recoverableamount')
However,iftherecoverableamountislessthanthereplacementcost,thentherecoverableamountis
thedeprivalvalue,i.e.theassetwouldnotbereplacedwerethefirmtobedeprivedofitsuse.Ifthe
recoverableamountexceedsthereplacementcost,theassetshouldbereplacedasthelatter represents its
deprivalvalue
3 Taxation
Section overview
Taxableprofitandaccountingprofitmaynotbethesame.
Tax is charged on net cashflow.
Tax depreciation reduce the taxpayable.
3.1 Basics
Income statement
Imagineanincomestatementdrawnupattheendofthefirstyearofaproject'slifeusingnormalfinancial
accountingprinciples:
34 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Solution
Corporationtaxforyear1oftheprojectisnotsimplyCU2,500timesthetaxrate.Someadjustmentsneed
tobemadetotheprofitcalculationbeforecomputingthetaxcharge:
Onlyincrementalrelevantcashflowsneedbeconsidered(ascoveredinsection2above)andthe
incrementaltaxcharge.Thussomeoftheabovecosts–e.g.fixedcosts,maynotberelevantand
thereforethetaxeffectoftheseisnotrelevant
Depreciationshouldbeignored(itisnotallowedasadeductionfromprofitswhencalculatingthetax
– see below)
Interestshouldbeignored.Thetaxeffectofinterestisincorporatedintothecostofcapital
3.2 Effects
Taxation has two effects in investment appraisal, both giving rise to relevant cash flows.
OUTFLOW INFLOW
3.4 Otherassumptions
Although large companies make tax payments in four equal instalments during the income year, for
examinationpurposesthewholetaxpaymentisassumedtobemadeattheendoftheyeartowhichitrelates
Forexaminationpurposescorporationtaxisassumedtobepaidat30%(althoughotherratesare possible in
the realworld)
Thetaxratecanbeassumedtobeconstantoverthelifeoftheproject(unlikelyinpractice)
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 35
Itshouldbeassumedthatworkingcapitalflowshavenotaxeffects
36 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Worked example: Tax Depreciation
HappyLtdboughtamachineforCU10,000on31December20X1,itsaccountingyearend.Theasset generated cash
flows of CU7,000 pa. It sold the asset on 31 December 20X3 for CU2,000.
20X1 20X2 20X3
Acquired Disposed
Thecompanypaystaxat30%.TaxDepreciationisavailableat25%onareducingbalancebasis.
ShowtheTDAsandanybalancingchargeorallowance.
Solution
Year ended 31 Dec Tax WDV (WDV = written down value)
CU
20X1 10,000
TDA@25% (2,500)
Asset owned at end of each of
20X2 7,500 20X1and20X2. 25%TDA
TDA @ 25% (1,875) calculated
20X3 5,625 In 20X3 asset sold. As proceeds
Proceeds (2,000) (inthiscase)arelessthanWDVa
Balancing allowance 3,625 balancing allowance is given.
Totalreliefs=CU(2,500+1,875+3,625)=CU8,000(=cost–scrap).Taxpayments,cashflowsetccan then be
shown asfollows:
Tax computation
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
Net inflows 7,000 7,000
TDA/Balancingallowance (2,500) (1,875) (3,625)
Taxable (2,500) 5,125 3,375
Tax @ 30% 750* (1,537.50) (1,012.50)
*Taxsaved,assumingsufficientprofitsexistelsewhereinthebusinesstoobtainrelieffromTDAassoonas possible
(section 3.3above).
Normally the tax effect is shown as two separate elements:
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
Net inflows 7,000 7,000
(1) Tax paid @ 30% (2,100) (2,100)
TDAs/Balancingallowance (2,500) (1,875) (3,625)
(2) Tax saved @ 30%* 750 562.50 1,087.50
Total tax (above) (1) + (2) 750 (1,537.50) (1,012.50)
* i.e. being able to deduct the TDA from profit saves tax @ 30%.
The NPV calculation would show (rounding to the nearest CU):
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
Net inflows 7,000 7,000
Tax (2,100) (2,100)
Asset purchase (10,000)
Scrap 2,000
Tax saved on TDAs 750 562 1,088
Net CF for discounting (9,250) 5,462 7,988
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 37
Interactive question 9:TaxDepreciation [Difficulty level:Intermediate]
1 AcompanybuysanassetforCU10,000attheendofitsaccountingperiod,31December20X0,to undertake a two
yearproject.
2 Nettradinginflowsatt1andt2areCU5,000.
3 TheassethasaCU6,000scrapvaluewhenitisdisposedofattheendofyear2.
4 Taxischargedat30%.TDAsareavailableat15%pa
Requirement
Calculatethenetcashflowsfortheproject.
38 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Working
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 39
WORKING
Tax computation
t0 PROFITS t1 t2
IN
YEAR 1
4 Inflation
Section overview
Inflationratecanbeincorporatedintobothcashflowanddiscountrate('money@money').
Inflationcanbeignoredinbothcashflowsanddiscountrate('real@real').
InflationinBangladeshhasvariedbetween1%and25%pasince1972.Asinflationwillcontinuetoexistin
thefuture,accountneedstobetakenofitseffects,i.e.increasesinprices,whenappraisingprojects.It
createstwoproblemsininvestmentappraisal:
Estimating future cash flows – the rate of inflation must be taken intoaccount
Therateofreturnrequiredbyshareholdersandlenderswillincreaseasinflationrises–thediscount rate is
thereforeaffected
40 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
4.1 Real and money (or nominal)rates
The rates of interest that would be required in the absence of inflation in the economy are referred to as the real
rates ofinterest
Whenrealratesofinterestareadjustedfortheeffectofgeneralinflation,measuredbytheconsumer
pricesindex(CP1),theresultsarereferredtoasmoney(ornominal)ratesofinterest
Requirement
What return in money terms does Kuman require?
Solution
ThetotalreturnmustcompensateKumanforhisconsumptionpreferencei.e.thefactthathewouldprefer
toconsumenow.Hemustthereforeearn10%toreflecthistimevalueofmoney.Inaddition,theratemust
compensateKumanforthefactthatpricesarerisingby5%pa.
This can be illustrated as follows.
Now 1 yearlater
t0 Underlying
t1'Real'return
required
ConsumeCU100 CU110 is theamount
r=10%
requiredtosati
sfytheconsumption
preference i.e. Kuman needs to
be able to purchase
10% more goodsInflation
i = 5%
CU15.50
Overallmoneyreturn(m)required= =15.5%
CU100
Moneyrates,realratesandgeneralinflation(CPI)arelinkedbythefollowing:
(1+m)=(1+r)(1+i)
where m = money rate
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 41
r = real rate
i = general inflation
42 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Thus in the example above
(1+m) = (1.10) (1.05) =1.155
m =15.5%
4.4 Discounting
Moneymethod('money@money')
ItisessentialtomatchlikewithlikewhenperformingNPVcalculations.Intherealworldmoneyflowsare
theeasiesttodealwithastheyaretheeverydayflowspeopleareusedto.Sotousethemoneymethod:
Adjusttheindividualcashflows,e.g.sales/revenue,materials,labourusingtheirspecificinflationrates to convert to
money cash flows, i.e. the flows which will actuallyoccur
Discountthesemoneyflowsusingthemoneyrate,i.e.therateofinterestwhichwillactuallyoccur.
This is the simplest technique. Use wherever possible unless a question directs otherwise.
Real method ('real @ real')
AnalternativewayofreachingthesameNPVandagainmatchinglikewithlike,istousetherealmethod.
Theproblemwiththismethodisthatrealcashflowsandinterestratesarenotdirectlyidentifiableinthe
waythatmoneyflowsandratesare.Forexample,banksregularlypublishmoneyinterestratesonsavings
accounts,overdrafts,etc.Theunpublishedrealrateneedstobederivedbystrippingoutthegeneral
inflationusedtodeterminethemoneyrate(asinsection4.1above).Sotousetherealmethod:
Remove the effects of general inflation from money cash flows to generate real cashflows
Discount using realrate.
AlthoughthisachievesthesameNPVasthemoneymethod,itisoftenverylongwindedandwouldonlybe
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 43
usefulinaquestionwheretherealflowsandinterestratewerealreadygiven.
44 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Interactive question 11: Money@money [Difficulty level:Intermediate]
Project InvestCU10,000att0innewplantandequipment
ReturnsCU5,000paincurrenttermsforthreeyears,inflatingat7%pa Money
rate of interest is10%
Requirement
Calculatetheproject'sNPVusingthemoneymethod.
NPV = CU4,192
Effective method
Thismethodcansometimesbeashortcutforthemoneymethod,e.g.forlongprojectswithannuity or perpetuity
cashflows
Tousetheeffectivemethodleavecashflowsincurrent(t 0)termsandadjustthediscountrateas
shownbelowtoincorporatebothinflatinganddiscounting
Discount current terms cash flows using effective rate(e):
1 m
1+e=
1 is
where is = inflation specific to given cash flow
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 45
1.1 = (1 + e) (1.08)
e = 1.9%
𝐶𝑈10,000
= CU526,316
0.019
Practicalconsiderations
Generalinflationmaynotbeconstant,thusthemoneydiscountratemayvaryyearonyear.Inorder
todiscountcashflowswithadifferentmoneyinterestrateineachyear,themoney@money approach
discussed above should beused
Theimpactofinflationismoresignificantforlongerperiodsastheincreaseinpricesiscompounded
yearonyear.However,asnotedearlier,thefurtherintothefuturethemoredifficultitistoestimate
specificinflationrates,soerrorsinestimateswillbecompounded
46 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
4.5 NPVProforma
ThefollowingproformasummarisesthetopicsdealtwithsofarandprovidesalayoutforNPVcalculations useful in 95%+
ofsituations:
t0 t1 t2 t3
CU CU CU CU
Operating cash flows
Adjust for inflation Sales/revenue X X X
Include only relevant cash flows Net Costs (X) (X) (X)
Tax X X X
Asset (X) (X) (X)
Purchase
Scrap (X)
Tax on TDAs X
X X X X
Working capital Net (X) (X) (X) X
flows (X) X X X
* Discount factor 1 X X X
PVofcashflows (X) X X X
PV = NPV
* Usediscountfactorsfortheafter-taxcostofcapital
5 Replacementanalysis
Section overview
Theoptimalreplacementcycleistheonewiththelowestequivalentannualcost.
Theanalysisassumesthereplacementdecisionwillapplyindefinitely.
Sofarithasbeenassumedthatinvestmentinanassetisaone-offdecision.However,aprojectislikely
toinvolvecommitmenttolong-termproduction,andmachinerywillthereforeneedtobereplaced
Abusinessneedstoknowhowoftentoreplacesuchassets.Replacingafteralongtimemeansnot
replacingasoften,sodelayingthecostofanewreplacementmachine.Howeverthisinvariablymeans
keepinganassetwhosevalueisdecliningandwhichcostsmoretomaintain.Thesecostsandbenefits need to
bebalanced
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 47
Solution
NPVs
9,000
1yearcycle NPV = (12,000)+ = CU(4,174)
1.15
(2,000) 7,500
2yearcycle NPV=(12,000)+ + = CU(8,068)
1.15 1.152
(2,000) (3,000) 7,000
3yearcycle NPV = (12,000)+ + + = CU(11,405)
1.15 1.152 1.153
Thesecostsarenotcomparable,becausetheyrefertodifferenttimeperiods.Thereasontheoneyearcycleappearsch
eaperisbecauseitonlyreflectsthecostofhavingamachineforoneyear,whereasthe
CU11,405forthe3yearcycleisthecosttothebusinessofkeepingtheresourceforthreeyears.Thereare
twopossibleapproachestomakingthecostscomparable.
48 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
2 yearcycle (8,068) = X AF 2 years @15%
(8,068)=X 1.626 X
=CU(4,962)
3 yearcycle (11,405) = X AF 3 years @15%
(11,405)=X 2.283
X=CU(4,996)
Thusitischeapesttoreplacethevanseveryyear,becausethiscyclehasthelowestcostinNPVterms.
Sothemethodcanbesummarisedas:
1 CalculatetheNPVofeachreplacementstrategy
2 CalculatetheannualequivalentcostoftheNPVforeachstrategy
3 Choosethestrategywiththelowestannualequivalentcost.
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 49
INVESTMENT APPRAISAL 2
CU18,350 CU18,350
Annual equivalent = = = CU10,570
AF2 years @10% 1.736
50 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
6 Capitalrationing
Section overview
Scarcecapitalmeansthatprojectshavetoberankedaccordingtohowefficientlytheyusethelimiting
factor.
DivisibleprojectsarerankedusingNPVperCUofscarcecapital.
Indivisibleprojectsarerankedusingtrialanderrorbyfindingthecombinationofprojectsthat
maximisesNPV.
Definition
CapitalrationingisthesituationwhereinsufficientfundsexisttoundertakeallpositiveNPVprojects,so
achoicemustbemadebetweenprojects.
40 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Answer to Interactive question 14
ThesolutionassumesitispossibletoaccepthalfofprojectA,i.e.projectsareperfectlydivisiblesothathalf
theoutlaygiveshalftheNPV,etc.
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 41
6.3 Indivisibleprojects
ThesolutiontoInteractivequestion14assumesitispossibletoaccepthalfofprojectA,i.e.thatprojects
areperfectlydivisiblesohalftheoutlaygiveshalftheNPV,etc.
Inrealityprojectsmaybeindivisible,i.e.allornothing,inwhichcasetrialanderrorisnecessarytofindthe
optimalcombination.
In Interactive question 14 above, possible combinations are:
NPV Funds
CU CU
A 100,000 50,000
C and D 129,000 25,000
ThereforechooseCandD.
P, R, S, T Q,R,S,T
andseewhichproducesthehigheroverallNPV.
6.5 Projectsynergy
Sofarprojectshavebeenconsideredindependently.Itmaybethecasethatbyundertakingcertain
combinationsofprojects,somesynergy(extraNPV)iscreated,e.g.fromcostsavings.
42 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Y 11,000 ÷ 50,000 = 0.22 2
Z 8,000 ÷ 40,000 = 0.20 3
ProjectXusingallCU100,000available,NPVCU25,000.
Considering X and Y +Z
Project NPV÷outlay Rank
X 25,000 ÷ 100,000=0.25 2
Y+Z (11,000+8,000+4,400)÷(50,000+40,000)=0.26 1
Plan:
NPV Funds
CU CU
Accept Y+Z 23,400 90,000
AcceptonetenthofX 2,500 10,000
25,900 100,000
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7 Investment appraisal in a strategiccontext
Section overview
Investmentappraisalneedstobeconsideredinastrategiccontext
Shareholdervalueanalysis(SVA)focusesondecisionswhichmaximiseshareholderwealth
Investmentmaygiverisetonewopportunities,knownasrealoptions.
Analysethecurrentpositionofthebusinessbyexaminingthe
external(egcompetitors)andinternal(eghumanresources)
environment.NormallysummarisedbySWOTanalysis
(strengths,weaknesses,opportunities,threats)
Determinemissionandobjectives(here
assumedtobewealthmaximisation)
Identifyandselectstrategies(egn
ewproducts,newmarkets,etc)
Definition
Shareholdervalueanalysis(SVA)istheprocessofanalysingtheactivitiesofabusinesstoidentifyhow
theywillresultinincreasingshareholderwealth.
Managers may sometimes be influenced to act in a manner which is inconsistent with maximising
shareholderwealth.TheclaimedadvantageofSVA,asaphilosophyofbusinessdecision-making,isthatthe actions of
managers can be directly linked to value generation and the outcomes of decisions can be assessed in
thatcontext.
44 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Interactive question16:SVA [Difficulty level:Easy]
Explainwhatpossibleproblemsarecreatedwhenusingthefollowingmeasurestoassessmanagement
effectiveness.
Return on capital employed
Earnings per share
Traditional accounting-based measures of management effectiveness, like the return on capital employed ratio (ROCE)
and the earnings per share value (EPS), have been criticised for not focusing sufficiently on what businesses ultimately
seek to do, namely to generate wealth for their shareholders.
The problems with the accounting measures is that they tend to focus on sales and profit increases, not on value
generation.
For example, it is always open to a business to increase its ROCE and EPS, at least in the short term, by taking on more
risky activities. Such activities may well have the effect of reducing value.
The increasing emphasis on the wealth of the shareholders as a corporate goal, has led to the emergence of ideas like
shareholder value analysis (SVA). SVA is based on the totally logical principle that the value of the business overall is equal
to the sum of the present values (PVs) of all of its activities. The shareholders' financial stake in the business is the value of
the business, less the value of its outstanding debt. Thus if the value of the PVs of the various activities of the business can
be increased, this should mean greater value for shareholders, either to be paid out as dividends or reinvested in other
projects that will, in turn, result in still more shareholder value.
Investment Operating
in working
Shareholder profit
capital wealth margin
Investment
in non- Corporation
current tax rate
assets
Sales growth
rate
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Ifagreaterlevelofsalescanbegeneratedinthefuturethanwasexpected,thisshould
createmorecashflowsand,therefore,value.Thegreaterlevelofsalescouldcome
Operating fromanewproductand,providedthatthisdidnothaveanadverseeffectononeof
profit margin theothervaluedrivers,greatervaluewouldnecessarilybecreated.Similarly,arresting
anexpecteddeclineinsaleslevelsforsomeexistingproducthasthepotentialto
generatevalue.
Corporation Theoperatingprofitmarginistheratioofnetprofit,beforefinancingchargesandtax,
tax rate tosales.Thehigherthisratiothemorecashflowsthereareforeachsale.Thusif
costscanbecontrolledmoreeffectively,morecashwilltendtoflowfromeachsale and value
will beenhanced.
Thisclearlyaffectscashflowsandvaluebecause,broadly,taxislevieddirectlyon
operatingcashflows.Management'sabilitytoaffectthetaxrateandtheamountoftax
paidbythebusinesstends,atbest,tobemarginal.
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Investment in Normallycashhastobespentonadditionalnon-currentassetsinordertoenhance
non-current shareholdervalue.Wherevermanagerscanfindwaysofreducingtheoutlayonplant etc
assets without limiting the effectiveness of the business, this will tend to enhance
shareholdervalue.
Investment in Nearly all business activities give rise to a need for working capital: inventories,
working capital receivables, payables and cash. Amounts tied up in working capital can be
considerable.Stepsthatcanbetaken,forexample,toencouragetradereceivablesto
paymorequicklythanexpected,willbringcashflowsforwardandtendtogenerate
value,aslongasthebenefitsofquickerpaymentoutweighthecostofdeliveringit.
Cost of capital
Thecostoffundsusedtofinancetheactivitiesofthebusinesswilltypicallybeamajor
determinantofshareholdervalue.Soifthebusinesscanfindalternative,cheaper,
Life of
sourcesoflong-termfinance,valuewouldtendtobeenhanced.
projected cash
flows Clearly,thelongerthatthelifeofanycashgeneratingactivitycancontinue,thelonger its potential to
generatevalue.
7.5 Realoptions
One problem of NPV analysis is that it only considers cash flows related directly to the project. It is
possiblethataprojectwithanegativeNPVisacceptedfor'strategic'reasons.Thisisbecausemanagement
acceptthatthereareoptionsassociatedwithaparticularprojectwhichoutweightheconventionally
calculatednegativeNPV.
The revised decision model becomes
Projectworth=TraditionalNPV+valueofanyoptions
Situation Realoption
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Situation Realoption
Abandonment options Both projects offer the right to abandon the
projectifthingsgowrong,bysellingtheassets.
Afirmisconsideringinvestingintwoprojects,
Thevalueofthesecondoptionismuchgreater
bothhavingthesameexpectedNPV.Thefirstuses
andcouldwellbepreferredbymanagement.
ahighlyspecialisedmachinewithlittleresalevalue or
alternative use. The second involves The right to sell is known as a put option.
expendituremainlyonhighlymarketablelandand
Some projects such as those in the natural
buildings.
resourceindustry(timber,miningetc)haveinbuilt
optionstoreducecapacityorsuspendoperations
temporarily.
Timing options Projectswherecommencementcanbedelayedare
oftenattractive.Inavolatilemarketaprojectthat
Afirmhasthedevelopmentrightsoverapieceof
canbedelayedislikeacalloptionwithalong period of
land.Therightscanbeexercisedanytimeoverthe next
expiry. If the company can delay
fiveyears.
investmentitcanwaitandseewhathappenstothe
market before investing or not (exercising the
optionornot).Thelongerthedelay,themore valuable
theoption.
Theoptiontodelayisonlyvaluableifitoffsetsany loss
from delaying e.g. delaying results in a
competitorestablishingaloyalcustomerbasethat
makesitdifficultforthecompanytoenterlater.
Patentsandotherbarrierstoentrycanoffersome
protection againstthis.
Growth options Choices might include
Newtechnology,deregulationetcpresent Full investment and hope it pays off (high risk)
uncertaingrowthopportunitiesforfirms– Wait and see but competitors might take a lead
investing could produce substantiallosses. Acquire 'growth option' Growth
options include
Start with small capacity, expanding later if
market conditions are good
Jointventuresandstrategicalliancesasentry
strategiesintoemergingmarkets,e.g.China
R&D avoiding 'wait and see' risk and, if prospects
look poor, no full investment, e.g. pharmaceutical
companies
Follow on options noted above
Theabovereferstooptionsassociatedwithinvestments–socalled'real'options.Chapters9and10will
introducehowoptionstobuyandsellcurrency,shares,bonds,etccanbeusedtomanageriskssuchas interest rates and
exchangerates.
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8 Investingoverseas
Section overview
Overseasinvestmentcarriesadditionalrisks,includingpoliticalandcultural.
Themethodsoffinancingoverseassubsidiarieswilldependonthelengthofinvestmentperiod
envisaged,alsothelocalfinancecosts,taxationsystemsandrestrictionsondividendremittances.
Whendecidingwhattypesofcountryitshouldenter(intermsofenvironmentalfactors,economic
development,languageused,culturalsimilaritiesandsoon),themajorcriteriaforthisdecisionshouldbeas follows.
(a) Marketattractiveness.ThisconcernssuchindicatorsasGNP/headandforecastdemand.
(b) Competitiveadvantage.Thisisprincipallydependentonpriorexperienceinsimilarmarketsandhaving a
culturalunderstanding.
(c) Risk.Thisinvolvesananalysisofpoliticalstability,thepossibilityofgovernmentinterventionand similar
externalinfluences.
8.1 Politicalrisks
Definition
Political Risk is the risk that political action will affect the position and value of a company.
Whenamultinationalcompanyinvestsinanothercountry,e.g.bysettingupasubsidiary,itmayfacea
politicalriskofactionbythatcountry'sgovernmentwhichrestrictsthemultinational'sfreedom.
Ifagovernmenttriestopreventtheexploitationofitscountrybymultinationals,itmaytakevarious measures,
including thefollowing:
Quotas Importquotascouldbeusedtolimitthequantitiesofgoodsthatasubsidiarycanbuy
fromitsparentcompanyandimportforresaleinitsdomesticmarkets.
Tariffs Importtariffscouldmakeimports(suchasfromparentcompanies)moreexpensive
anddomesticallyproducedgoodsthereforemorecompetitive.
Non-tariff Legal standards of safety or quality (non-tariff barriers) could be imposed on
barriers importedgoodstopreventmultinationalsfromsellinggoodsthroughasubsidiary
whichhavebeenbannedasdangerousinothercountries.
Restrictions Agovernmentcouldrestricttheabilityofforeigncompaniestobuydomestic
companies,especiallythosethatoperateinpoliticallysensitiveindustriessuchas
defencecontracting,communications,energysupplyandsoon.
Nationalisation Agovernmentcouldnationaliseforeign-ownedcompaniesandtheirassets(withor
withoutcompensationtotheparentcompany).
Minimum Agovernmentcouldinsistonaminimumshareholdingincompaniesbyresidents.
shareholding Thiswouldforceamultinationaltooffersomeoftheequityinasubsidiaryto
investorsinthecountrywherethesubsidiaryoperates.
46 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
8.1.1 Assessment of politicalrisk
Therearealargenumberoffactorsthatcanbetakenintoaccountwhenassessingpoliticalrisk,for example:
Governmentstability
Political and businessethics
Economicstability/inflation
Degree of internationalindebtedness
Financialinfrastructure
Level of importrestrictions
Remittance restrictions
Evidence ofexpropriation
Existenceofspecialtaxesandregulationsonoverseasinvestors,orinvestmentincentives
Inadditionmicrofactors,factorsonlyaffectingthecompanyortheindustryinwhichitinvests,maybe
moresignificantthanmacrofactors,particularlyincompaniessuchashi-techorganisations.
8.2 Culturalrisk
The following areas may be particularly important depending upon the location of the overseas investment:
(a) Theculturesandpracticesofcustomersandconsumersinindividualmarkets
(b) Themediaanddistributionsystemsinoverseasmarkets
(c) Thedifferentwaysofdoingbusinessinoverseasmarkets
(d) Thedegreetowhichnationalculturaldifferencesmatterfortheproductconcerned(agreatdealfor some
consumer products, e.g. washing machines where some countries prefer front-loading machines
andothersprefertop-loadingmachines,butlesssoforproductssuchasgasturbines)
(e) Thedegreetowhichafirmcanuseitsown'nationalculture'asasellingpoint
8.3 Factorsinfluencingthechoiceoffinanceforanoverseassubsidiary
Indetermininghowanoverseasinvestmentshouldbefinanced,thefollowingconsiderationsneedtobe made:
(a) Thelocalfinancecosts,andanysubsidieswhichmaybeavailable
(b) Taxationsystemsofthecountriesinwhichthesubsidiaryisoperating.Differenttaxratescanfavourborrowingin
hightaxregimes,andnoborrowingelsewhere.Tax-savingopportunitiesmaybe
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maximisedbystructuringthegroupanditssubsidiariesinsuchawayastotakethebestadvantageof the different
local taxsystems
(c) Any restrictions on dividendremittances
(d) Thepossibilityofflexibilityinrepaymentswhichmayarisefromtheparent/subsidiaryrelationship
(e) Accesstocapital.Obtainingcapitalfromforeignmarketsmayincreaseliquidity,lowercostsandmake it easier to
maintain optimumgearing
48 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Summary and Self-test
Summary
Taxation
- Taxchargedonnetca
flow
- tax depreciationgives
taxbenefit
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