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CIMA C1Fundamentals of Management AccountingInvestment Appraisal Techniques

CIMA C1Fundamentals of Management AccountingClass Slides Ian Wilson

Explain the process of long term investmentsCalculate the Net Present Value (NPV), Internal Rate of Return(IRR) & Payback for an InvestmentLearning Aims: (CIMA)In the course to date, we have focused on COSTS & CASH FLOWS that relate to normal & typical BUSINESS COSTS & EXPENSES.This is called REVENUE ExpenditureTypically, Materials, Labour, Rent, Rates, Insurance etc fall into this category.A business will also need to purchase & fund ASSETS TANGIBLE ASSETS, typically items such as:Computers, Machinery, Premises & Vehicles

Capital Expenditure

This is called:CAPITAL EXPENDITUREA business will have to decide IF it can afford to purchase ASSETS & what benefit & Financial Return those Assets will createAs such, Managers have to:PLAN buy the assetMAKE a DECISION is it the right assetCONTROL against that Decision will it give an actual return as we expect?Capital Expenditure (Capex)This process is called:PROJECT APPRAISALManagement accountants are involved heavily in this process, guiding managers to the right outcome:Techniques used could be:Net Present Value (NPV)Internal rate of Return (IRR)Payback

Capital Expenditure

Cash Flow ForecastingBefore a Company can look at a specific asset, it has to consider the relevant costs associated with the project.To do this, it must understand the FUTURE CASH FLOWS associated with the life time of the asset:The purchase cost today year 0The following years income generated by the Asset:Year 1, Year 2 etc & at the end of the term and disposal proceedsWe can now see an important aspect of this process developing:Cash Flows take place over a longer time period, often 3 years, 5 years or even longerPremises may be used for 20+ years, a vehicle for 10 years and so onOver time money changes in valueYou will have to consider the Time Value of MoneyCash Flow ForecastingWhat is this?Based on the concept that money received now is worth more than the same sum received in one years time or at another time in the future.When capital expenditure projects are evaluated, it is appropriate to decide whether the investment will make enough profit to allow for the time value of money as capital is tied up over time.Time Value of Money

$1000 received NOW is worth MORE than $1000 received in say, 2 years time.Why?InflationUncertainty & RiskOpportunities to Invest

You need to learn some key terms also:

Time Value of MoneySimple Interest:Simple interest involves adding interest to an invested capital sum of money, whereby the interest that is added each period is added to the capital sum only and not to the interest earned in previous periods.Simple interest formula :FV = PV (1 + rn)You need to understand the Key:See the next slide:Basic Ideas:Simple interest formula FV = PV (1 + rn)Where: FV = Future Value after n periodsPV = Present or Initial Valuer = Rate of Interest per periodn = Number of periods

Basic Ideas:

$1,000 is invested at the start of year 1 and simple interest is added each year at 10% per annum.How much income will the investment generate by the end of Year 2?Answer:Initial investment $1,000Interest year 1 $1,000 x 10% $100Interest year 2 $1,000 x 10% $100Value at end of year 2 $1,200A Simple, Simple Interest QuestionCompound interest is a system that adds interest each year to both the original capital PLUS any interest added to date.Compound interest formula :FV = PV (1 + r)nWhere:FV = Future Value after n periodsPV = Present or Initial Valuer = Rate of Interest per periodn = Number of periods

Compound Interest$1,000 is invested at the start of year 1 and compound interest is added each year at 10% per annum.Calculate the value of the investment at the end of Year 3.Answer on next Slide:Compound Interest QuestionInitial investment $1,000Interest year 1 $1,000 x 10% $100Value end of year 1 $1,100Interest year 2 $1,100 x 10% $110Value end of year 2 $1,210Interest year 3 $1,210 x 10% $121Value end of year 3 $1,331Compound Interest AnswerYes! Apply the formula:Remember:FV = PV (1 + r)nFV = $1000 x (1+0.10)3FV = $1331Compound Interest: Can we make it Simpler?Present Values (PVs):This calculates the present value (at year 0) of all cash flows, & sums them to give the NPV. If this value is positive, the investment goes ahead.

Key Definitions:In other words:The value at time 0 of a future cash flow, having taken account of the time value of money. In investment appraisal, it represents the maximum an investor would be willing to invest for a future cash inflow given a specified required return

Key DefinitionsDiscounted Cash Flow(DCF):DCF is a technique that takes into account the timing of cash flows & allows comparison between cash flows arising at different points in time.

Key Definitions:Compounding Re-cap:Compounding calculates the future value of a given sum of money FV = PV (1 + r)nwhere FV = Future Value after n periods PV = Present or Initial Value r = Rate of Interest per period n = Number of periods

Key DefinitionsFinal re-cap:Compounding: we move from a present value to a future value by adding compound interest each year

Key DefinitionsDiscounting:Discounting is the reverse of compounding we start at the future value and work back to the present value.PV = FV (1 + r)nWhere:PV = present valueFV = future valuer = rate of interestn = number of periods

Key DefinitionsKey DefinitionsCompounding:Discounting:YEAR 0YEAR 1What do they contain?Periods n for 15 years, by single yearDiscount rate r, r = a %, 1 to 20%Read off the years/periods & discount rate & you get a factor, something to multiply your cash flow by to get the:PRESENT VALUE, ie the value in todays terms for a cash flow in the futurePresent Value TablesPresent Value Tables

You can calculate your own factors with a formula: 1 1+r^nSay r = 10%, substitute 0.10 into the formula in your calculator: 1 1+ 0.1^n = 0.909 = the same answer as your tables Without TablesHow do we deal with timescales of many years, ie n=2, or n=3 etc?.You have to use to the power of for each year.2 years = power of 2, n=23 years = power of 3, n=3Your calculator has a ^ key for you to do this10% on 2 years would be: 1 1 + 0.1 power 2 = 0.826 Multiple yearsSee page 132: find the present value of $80,000 at the end of year 5 Remember your formula for FV = PV (1 + r)nSubstitute into the formula:FV = $80,000, r = 10%FV = 80000 (1+.10)5= $49674 invested today to get $80000 in 5 years timeExercise 1The answer again:PV = FV/(1 + r)nPV = 80,000 / (1 + 0.1)5PV = 80,000 / 1.61051 = $49,674Exercise 1NPV looks at the comparison of how much cash will an investor get back from an investment compared to how much cash they have had to pay for the investment.Everything is compared in present value terms.The techniques is used to evaluate whether or not a project should be accepted.There are Three steps to follow:Net Present ValueStep 1: sort out the numbering of the years between the investment & each future valueStep 2: decide what Cost of capital to use & find discount factorsStep 3: multiply each future value by the relevant discount factor to give the present valuesNet Present ValueDecision Criteria:If the investment has a positive NPV then the project should be accepted (negative -rejected). A positive NPV means that the project will increase the wealth of the company by the amount of the NPV at the current cost of capital

Net Present ValueNet Present Value

A company is evaluating a project that has the following cash flows:Machine to be purchased on January 1 2011: for $50,000You are given Net Cash Flows for 2011 to 2014.The Company can borrow money at 10%Is the project worthwhile?Use the template on page 133Exercise 2YearCash FlowDiscount Factor@ 10%Present Value0($50,000)1.000($50,000)1$20,0000.909$18,1802$10,0000.826$8,2603$20,0000.751$15,0204$15,0000.683$10,2455Exercise 2: AnswerNet Present Value: $1,705The rate of interest (discount) at which the NPV = 0

The Internal Rate of Return

If the IRR is greater than the cost of capital the project should be accepted, because this suggests that the NPV is positive at the cost of capitalLook at Exercise 3You will need the linear interpolation formula:The Internal Rate of ReturnThe Internal Rate of Return

Lets look at this example:

Exercise 4What is it?The length of time it takes for cash inflows from trading to pay back the initial Investment in Year 0Is your payback period right or wrong?The answer is you dont know unless you have a Target.What is the Target?, measure against that.It depends!

Payback

How do we calculate it?This is the length of time it takes for cash inflows from trading to pay back theinitial investment.Payback period = Initial investment / Annual inflowPaybackA company invests in a project with an initial cash outflow of $100,000. Cash inflows resulting from the project are $40,000 per annum.Calculate the payback period.Payback QuestionPayback period = $100,000 / $40,000 = 2.5 yearsPayback: AnswerPayback

Page 135Exercise 5