PEARSON EDEXCEL INTERNATIONAL AS/A LEVEL ......PEARSON EDEXCEL INTERNATIONAL AS/A LEVEL Student Book...

PEARSON EDEXCEL INTERNATIONAL AS/A LEVEL

Student Book 2ACCOUNTING

SAMPLE

PROJECT APPRAISALThis section looks at the methods used by businesses to decide on whether future capital investments are viable and should proceed. You will learn a variety of methods used to determine whether the capital expenditure should be approved by the directors and owners of the business. As this type of expenditure often involves large sums of money, you will learn how to evaluate (appraise) whether a project should proceed and possibly make recommendations. These methods will include discounted and non-discounted methods of project appraisal. Having made the calculations relating to project appraisal, you will learn how to apply both quantitative and qualitative factors to the decision on whether the project should be given the go-ahead by the owners and managers of the business.

Unc

orre

cted

pro

of, a

ll co

nten

t sub

ject

to c

hang

e at

pub

lishe

r dis

cret

ion.

Not

for r

esal

e, c

ircu

latio

n or

dis

trib

utio

n in

who

le o

r in

part

. ©Pe

arso

n 20

20

GETTING STARTEDWhen you are thinking about buying a product which costs a considerable amount of money, what factors do you consider before you purchase? Do you think about the initial cost? Do you think about how long your purchase will last? How do you think companies might decide which capital investments to make? Do you think they will consider future cash inflows or future profits or both?

INTRODUCTIONCompanies need to grow to satisfy increasing demand for their products. This means that they need new property, new machinery and other non-current assets. Non-current assets will lose their effectiveness for a number of reasons, and when this happens, they will need to be replaced.

One of the most important aspects of the initial assessment is to decide what, and when, to buy. For any new idea, we need to:●● fund the original capital costs ●● ensure a positive contribution towards any additional

fixed costs ●● be certain that any interest due on borrowed money

can be met●● determine the profit remaining.

Although there are many methods that can be used in assessing a new investment, managers are not

UNIT 2

LEARNING OBJECTIVESAfter you have studied this chapter, you should be able to:

◾◾ understand the application of non-discounted methods of project appraisal

◾◾ understand the application of discounted methods of investment appraisal.

8 PROJECT APPRAISALin agreement as to which method is best. This is mainly because of the many unknown factors that can occur when we try to look several years ahead. Some managers prefer to use a simple method, or a combination of methods, to predict results, while others use more complicated, but more logical, procedures.

PROJECT APPRAISALProject appraisal describes how decisions are made regarding when and how to spend money on capital projects. More importantly, it asks whether or not a project should be taken on. The benefits are compared with the costs. If the return is not reasonable then investors will stay away from that company in the future.

Whichever appraisal method is used, the yearly cash flows must be estimated for the project being considered. There is usually an initial cash outflow which could be for the purchase of a capital asset such as property, plant or equipment. Further cash outflows may occur, such as extra parts for the new equipment or modifications to the property.

Cash flows into the business from sales, while the outflows consist of the expenses incurred in generating those sales. The income is not reduced by depreciation as we charge the total cost as a cash outflow and depreciation is not a cash item.

METHODS OF CALCULATIONThere are two main groups of method. They are:●● non-discounted methods●● discounted methods.

The most important distinction between the various methods is whether they take account of the fact that money now is worth more than money received in the future. Discounted methods take this fact into account, whereas non-discounted methods do not. Although non-discounted cash flow methods are easier to calculate manually, even the most complicated discounted cash flow calculations can be performed relatively easily on a computer spreadsheet.

2.6.1–2.6.2

1458 PROJECT APPRAISALSPECIFICATION 2.6.1–2.6.2U

ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

NON-DISCOUNTED METHODSThere are two non-discounted methods of investment appraisal:●● payback period●● average rate of return

Payback period methodThe payback period is the length of time taken for the project to recover the initial cost of the investment.

In this method, the positive cash flows are deducted from the initial cost of the project. We are then able to calculate, from the net cash inflow, how long it takes to pay back the full cost of the project. By using this method, which emphasises liquidity, calculations are both quick and easy.

We are told that the initial cost of two possible projects are £730 000 and £985 000 respectively. The net cash flows for these projects are as follows.

Project 1 Project 2

£ £

Year 1 200 000 225 000

Year 2 210 000 225 000

Year 3 220 000 290 000

Year 4 240 000 360 000

From this information, we can construct a net cash flow for the project.SolutionThe initial cost represents a cash outflow, so is negative. Years 1–4 represent cash inflows so are positive.

Project 1 Project 2

Annual cash flow

Cumulative cash flow

Annual cash flow

Cumulative cash flow

£ £ £ £

Initial cost (730 000) (730 000) (985 000) (985 000)

Year 1 200 000 (530 000) 225 000 (760 000)

Year 2 210 000 (320 000) 225 000 (535 000)

Year 3 220 000 (100 000) 290 000 (245 000)

Year 4 240 000 140 000 360 000 115 000

From the cash flow table, we can see that Project 1 has a negative balance at the end of Year 3, so it has not paid back the initial investment but by the end of Year 4, it has a positive balance which indicates it has paid back during the year. We now know that the project pays back in three years plus part of a year.

It is normal to calculate the payback period in years and months, so we now need to calculate when in Year 4 the balance was zero. To do this we can divide the amount required (£100 000) by the cash inflow for the year (£240 000) and then multiply by 12.

WORKED EXAMPLE

Months =Negative balance required

Net cash flow in payback year × 12

=100 000

240 000 × 12

= 5 monthsFor Project 1 the payback period is 3 years 5 months.

For Project 2 the payback also falls in the fourth year. For the number of months:

Months = 245 000

360 000 × 12

= 8.2 monthsPayback occurs quicker with Project 1. If payback time is important, then Project 1 must be selected as it is shorter than with Project 2.

146 8 PROJECT APPRAISAL SPECIFICATION 2.6.1–2.6.2U

ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

Average rate of return % = average annual profit

average investment × 100

Where:

Average annual profit =total profit

number of years

Average investment =

opening value of investment + closing value of investment

2

An alternative method of calculating the ARR is to use the value of the initial investment rather than the average investment when there is insufficient information given to calculate the average investment. Therefore:

Average rate of return % = average annual profit

initial investment × 100

Advantages of the pay back method●● Simple calculation and easy to understand, so highly

favoured by managers and non-accountants.●● Considers the cash inflows and outflows and so

reflects liquidity.●● Recognises that cash received earlier in the project is

probably preferable to cash received later.●● Indicates the project that is at risk for the shortest

amount of time.

Disadvantages of the payback method●● Does not measure total profitability over the life of

the investment but merely tells how long it will take to recover the initial investment.

●● Does not consider the time value of money – see discounted methods.

●● Does not recognise the net cash inflows after the payback period.

●● Life of the non-current asset not considered in the calculation.

Average rate of return methodThe average rate of return (ARR) is the profit as a percentage of the cost of the investment over the life of the investment.

The ARR method takes the average profit that the investment will generate and expresses it as a percentage of the average investment in the project. For a positive decision to invest, a firm must achieve a pre-determined minimum ARR. When a choice of projects is being considered then the project with the higher ARR would be chosen.

Always read the requirement of the question when calculating payback period. You need to check the units carefully – they could be years, months, days or even a fraction of a year!

EXAM HINT

You will probably have to calculate the net cash flows in the examination. The formula is net cash flow = cash inflow – cash outflow. In addition, you may need to calculate the cash inflows and outflows. An example of this is given later in the chapter.

EXAM HINT

The average rate of return is often called the accounting rate of return.

EXAM HINT

This method gives us the profitability of the investment by dividing the average annual profit by the average investment or the initial investment. To find these figures, we take the total profits earned over the life of the investment and divide it by the life expectancy of the project.

For example, say we have profit figures of £1 000 in Year 1, £1 500 in Year 2 and £5 000 in Year 3, the total profit for the three years is £7 500. Therefore, the average profit over the three years is £2 500. If the cost of the investment is £15 000 over three years, then the average cost is £5 000.

ARR =average annual profitaverage investment

× 100

=2 5005 000

× 100

= 50%


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

Here are the net cash flow figures given for Projects 1 and 2 in the previous worked example:

Project 1 Project 2

£ £

Year 1 200 000 225 000

Year 2 210 000 225 000

Year 3 220 000 290 000

Year 4 240 000 360 000

We now wish to use the average rate of return method to appraise the project.

Solution

For this method, we need to know the annual profit figures rather than the cash flow figures.

Let us assume that there are no relevant accruals or prepayments, that there is no estimated scrap value for either project, and that depreciation is calculated using the straight-line method for both projects.

We also need to know what percentage rate of return would be considered acceptable by the firm.

Annual depreciation charge:

Project 1: initial cost £730 000 ÷ 4 years = £182 500

Project 2: initial cost £985 000 ÷ 4 years = £246 250

By deducting the depreciation from the cash flows calculated above, we arrive at the following annual profits:

Project 1 Project 2

£ £

Year 1 17 500 –21 250

Year 2 27 500 –21 250

Year 3 37 500 43 750

Year 4 57 500 113 750

140 000 115 000

Average annual profit =total profit

number of years

Project 1: £140 000 ÷ 4 = £35 000

Project 2: £115 000 ÷ 4 = £28 750

We also need to calculate the average sum invested. To do this we take the investment at the start and the investment at the end (0) and divide by 2:

Average investment =

opening value of investment + closing value of investment

2Project 1: (£730 000 – 0) ÷ 2 = £365 000

Project 2: (£985 000) – 0) ÷ 2 = £492 500


× 100

Project 1:£35 000£365 000

× 100 = 9.59%

Project 2:£28 750£492 500

× 100 = 5.84%

Project 1 has a higher average rate of return and would be chosen ahead of Project 2. This should be compared with the company’s required return on investment or its cost of capital.

WORKED EXAMPLE

One important thing to note is that profit, rather than cash flow, is used in these calculations.

Advantages of the average rate of return method●● Simple calculation and easy to understand, so highly

favoured by managers and non-accountants.●● Focus on profit, often a company’s primary objective.●● Accounts for all revenues and costs of a capital

project.

Disadvantages of the average rate of return method●● Does not consider the time value of money.●● Does not consider the timing of the cash flows,

which might be important if the company has liquidity problems.

●● Does not show how long the project takes to recover the initial outlay.

●● Does not consider the duration of the project.●● Profit figures are only estimates.


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

ACTIVITY 1 SKILLS

Why plc contemplates the purchase of a new machine to produce additional units of its product. It has a choice of three different machines, each of which have similar technical specifications, but have different costs.The company prepares a forecast of its cash flows covering each of the three machines.

Machine A Machine B Machine C

£ £ £

Purchase price 150 000 180 000 165 000

Net cash flows:

Year 1 45 000 36 000 30 000

Year 2 45 000 42 000 39 000

Year 3 45 000 90 000 39 000

Year 4 30 000 60 000 75 000

Year 5 24 000 45 000 75 000

The management of Why Ltd use the payback method to assist them in deciding which machine it should choose.1 Showing your workings, state clearly the

recommendation you would make to the company.

CASE STUDY: WHY PLC

INTERPRETING, REASONING

ACTIVITY 2 SKILLS

Cam Water Coolers are considering the purchase of a new plant in which to produce their latest water coolers. They have a decision to make between two projects:

Option 1: the initial cost of the plant will be £3 200 000Option 2: the initial cost will be £4 000 000The estimated profits for the two options are:

Option 1Estimated profits

Option 2Estimated profits

£ £

Year 1 500 000 600 000

Year 2 500 000 650 000

Year 3 600 000 750 000

Year 4 800 000 400 000

Year 5 600 000 500 000

It is calculated that the residual value of the plant for Option 1 will be £1 200 000 and for Option 2 it will be £800 000.

1 Calculate the average rate of return for Options 1 and 2, stating which option Cam Water Coolers plc should proceed with.

CASE STUDY: CAM WATER COOLERS PLC

PROBLEM SOLVING, REASONING


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

DISCOUNTED METHODSThere are two discounted methods of investment appraisal:●● net present value●● internal rate of return

Net present valueNet present value (NPV) is found by calculating the discounted value of an investment’s cash inflows less the discounted cash outflows of the investment.The following information is needed to calculate NPV:●● initial cost●● cost of capital●● annual cash flows●● expected life of the project and amount of any

residual valueThe NPV method applies the time value of money to cash flows. It recognises that the value of £1 received in the future will be less than the value of £1 now. The value of money tends to fall over time with the effects of inflation. The spending power of £1 now is greater than the spending power of £1 a company might receive in five years. Investment projects are the exchange of money at today’s values in exchange for future cash inflows.

For example, £100 invested now at a rate of interest of 5 per cent would be worth £105 in one year. Looking at this from a point in the future, in this case one year, £105 received in one year has a present value of £100. In terms of real value or spending power there is no difference between £100 now or £105 received in one year. From here we can deduce that the present value

Applying discount factors to future receipts of money is a way of comparing the value of £1 spent today with the value of £1 received in the future. As such, it gives greater importance to the early receipt of cash. For this reason, it is generally agreed that the NPV method is better than either the ARR or payback methods. It also allows an assessment of the profitability of the project. If the present value is positive, the project is viable.

The most appropriate discount factor to use is determined by a business’s cost of capital.

You will be provided with the figures in the examination, you will not be expected to calculate the discount factors.

EXAM HINT

of £105 received after one year, at 5 per cent interest, is £100 and that the present value of £100, at 5 per cent, would be £95.24, a discount factor of 0.952.

With each year that passes, the spending power of today’s £100 decreases by a further 5 per cent. A discount table to show the reduction is given below.

Year 5% Discount factor1 0.952

2 0.907

3 0.864

4 0.823

5 0.784

◾▲ Table 8.1 Present values at 5 per cent

WORKED EXAMPLETaking the cash flows for Projects 1 and 2 from the previous worked example, and assuming that the cost of capital is 8 per cent, calculate the NPV of each project.

Project 1 Project 2

Year 1 200 000 225 000

Year 2 210 000 225 000

Year 3 220 000 290 000

Year 4 240 000 360 000

Year 8% discount factor

1 0.926

2 0.857

3 0.794

4 0.735

SolutionWe know that we would rather have £500 now, instead of waiting until next year. If we could invest the £500 and earn 8 per cent interest, we would gain an additional £40 interest after one year. This shows that the later we receive the £500, the more interest we lose.

By not receiving the £500 until the end of the year, we have lost interest, so to find the present value, we use the discount factor of 0.926 (8 per cent for one year). The net present value is simply the sum of the discounted values of the net cash flows for each year, minus the initial sum invested.

Turning to the cash flows for Projects 1 and 2, then, the assumption is that the cash outflow for financing the projects occurs at the beginning of Year 1 – in other words Year 0 – but that the net cash inflows do not occur until the end of each year.


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

Year Discount factor Project 1 Project 2

Net cash flow

Discounted cash flow

Net cash flow

Discounted cash flow

£ £ £ £

Year 0 1.000 (730 000) (730 000) (985 000) (985 000)

Year 1 0.926 200 000 185 200 225 000 208 350

Year 2 0.857 210 000 179 970 225 000 192 825

Year 3 0.794 220 000 174 680 290 000 230 260

Year 4 0.735 240 000 176 400 360 000 264 600

NPV (13 750) (88 965)

The yearly discounted cash flow figure is calculated by multiplying the net cash flow by the discount factor. So, for:

Year 1 = (£730 000) × 1 = (£730 000)

Year 2 = 200 000 × 0.926 = 185 200

This is repeated for all years of the project, and then the yearly discounted cash flows are added together to arrive at the net present value for the project.

The results tell us that neither project has a positive net present value using the given rate of 8 per cent, but Project 1 is better (or less bad) than Project 2.

The initial expenditure of the project in Year 0 is discounted by a factor of 1. That is the discounted value is the actual value. This value is a negative number as it represents a net cash outflow.

EXAM HINT

WORKED EXAMPLEThe directors of Modern Printing are unsure of whether to purchase a new computerised printing system to improve the quality of the product. They have asked you to carry out an investment appraisal. The following information is available.The initial cost of the system will be £800 000.The additional inflows and outflows are estimated as follows:

Year Cash inflow £

Cash outflow £

1 500 000 300 000

2 600 000 350 000

3 550 000 300 000

4 550 000 250 000

5 400 000 250 000

The cost of capital of Modern Printing is 5 per cent. The discount factors are shown below.


1 0.952

2 0.907

3 0.864

4 0.823

5 0.784

1 Calculate the net present value of the project.2 Calculate the payback period of the project.Solution

Step 1 – Calculate the net cash flows for each year of the project using the formula:Net cash flow = cash inflows – cash outflows.Step 2 – Calculate the cumulative cash flows, i.e. the running balance. These figures are used to find the payback period.Step 3 – Calculate the present value (PV) for each year by applying the following formula:PV = net cash flow × discount factor


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

Year Cash inflow Cash outflow Net cash flow Cumulative PV

£ £ £ £ £

0 800 000 (800 000) (800 000) (800 000)

1 500 000 300 000 200 000 (600 000) 190 400

2 600 000 350 000 250 000 (350 000) 242 500

3 550.000 300 000 250 000 (100 000) 216 000

4 500 000 260 000 240 000 140 000 188 160

1 NPV = total of the PV column = £37 060 As this is a positive number, the project should be

recommended.2 To calculate the payback period, find the year the

cumulative cash flow becomes positive – Year 4. To find the number of months of Year 4 required

to reach a cumulative cash flow of zero, divide the amount required by the net cash flow in Year 4, then multiply by 12.

£100 000 ÷ £240 000 × 12 = 5 months.The payback period is 3 years and 5 months.

WORKED EXAMPLEIn this worked example, cash inflows and outflows must be calculated as well as the NPV and ARR.

Power From Sun is a new business start-up planning to generate electricity from a solar farm. It has agreed to purchase land and equipment for £3 million and operate the solar farm for five years. At the end of this period it will sell the land and equipment for £2.4 million.

Additional information:●● sales in Year 1 are expected to be £400 000●● sales in Years 2–4 are expected to be £1 million●● sales in Year 5 are expected to fall by 25 per cent

from the previous year

●● running costs, including depreciation, will be: Year 1 £10,000 per week Years 2–4 £11,000 per week Year 5 £12,000 per week●● the solar farm will operate for 52 weeks of the year.●● the cost of capital is 6 per cent. The discount

factors are given below.


1 0.943

2 0.890

3 0.840

4 0.792

5 0.747

1 Calculate the NPV and ARR for this project.

SolutionStep 1 – Calculate the cash inflows and the cash outflows.Cash inflows:Years 1–4 given in the question.For Year 5, two calculations are needed:

(i) Revenue is expected to fall by 25 per cent from Year 4.

£1m × 0.75 = £750 000 (ii) At the end of Year 5 the land and equipment

will be sold for £2 400 000. Therefore the total cash inflow for Year 5 is:

£750 000 + £2 400 000 = £3 150 000


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

These figures can now be entered into the table below into Column 2.Cash outflows:Depreciation is a non-cash transaction, included in the running costs, so remove it from the total outflows.Total depreciation is the difference between the cost of the non-current assets, in this example land and equipment, and the sales proceeds at the end of the project.Initial cost – sales proceeds = £3 000 000 – £2 400 000 = £600 000Annual depreciation charge = £600 000 ÷ 5 years = £120 000Annual cash out flows therefore:Year 1: (£10 000 × 52) – £120 000 = £400 000Years 2–4: (£11 000 × 52) – £120 000 = £452 000Year 5: (£12 000 × 52) – £120 000 = £504 000These figures can now be entered into the table below into Column 3.Net cash flow = cash in – cash outYear 0 represents the initial investment as a cash outflow:

Year Cash inflow Cash outflow Net cash flow

£ £ £

Year 0 Nil 3 000 000 (3 000 000)

Year 1 400 000 400 000 Nil

Year 2 1 000 000 452 000 548 000

Year 3 1 000 000 452 000 548 000

Year 4 1 000 000 452 000 548 000

Year 5 3 150 000 504 000 2 646 000

Step 2 – Calculate the net present value by applying the discount factors to the net cash flow for each year. So, for Year 1 the discounted value would be nil as the net cash flow is nil and for Year 2 it would be £548 000 × 0.890 = £487 720.

Year Discounted value

£

0 (3 000 000)

1 nil

2 487 720

3 460 320

4 434 016

5 1 976 562

NPV 358 618

The net present value is positive and so the project should go ahead.

Step 3 – Calculate the average rate of return.

First calculate the profit earned from the project. As depreciation is an expense this must now be included in the calculations.

Year Revenue Costs Profit

£ £ £

1 400 000 520 000 (120 000)

2 1 000 000 572 000 428 000

3 1 000 000 572 000 428 000

4 1 000 000 572 000 428 000

5 750 000 624 000 126 000

Total profit 1 290 000

Having calculated the total profit, calculate the average annual return:£1 290 000 ÷ 5 years = £258 000The average investment is £3 million + £2.4 million ÷ 2 = £2.7 million


× 100

=£258 000

£2 700 000 × 100

= 9.56%This rate of return is greater than the 6 per cent cost of capital used by Power From Sun and shows the project should be recommended.


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

Advantages of net present value●● Considers the time value of money, recognising that

£1 received in the future has less value than £1 at the present time.

●● All cash flows used in the calculation of NPV.●● Considers the timings of the cash inflows and

outflows with greater importance being placed on early net cash flows.

Disadvantages of net present value●● Cost of capital used to determine the NPV values

may be difficult to set.●● Estimates of cash flow may be wrong – this applies

to all methods, especially in later years.●● Cost of capital may change over the life of the project.

An alternative method of calculating the months is to calculate the monthly net cash flow and then use this figure to divide the amount required. In the example above, the calculation would be £240 000/12 = £20 000 per month. Number of months required to cover (£100 000) is £100 000/£20 000 = 5 months. This answer is in months and is not a decimal of the year.

EXAM HINT

Depreciation is a non-cash transaction and must not be included in cash flows. However it is an expense and should be included in the profit calculation for ARR.

EXAM HINT

If you are provided with costs or expenses, then you may need to subtract the depreciation from the cash outflows as this is a non-cash transaction.

EXAM HINT

ACTIVITY 3

Aziz Aggregates are expanding their operations and have decided to develop a new quarry. They must choose between two locations, A and B.

The net cash flows are given below:

YearInflow both

locationsOutflow

Location A Outflow

Location B 6% discount

factor

£m £m £m

1 11.1 4.0 5.6 0.943

2 11.1 4.0 5.6 0.890

3 11.1 4.0 5.6 0.840

4 11.0 3.9 5.0 0.792

5 11.0 3.9 5.0 0.747

The cost of capital for the factory will be 6 per cent. The discount factors are given in the table.

The cost of Location A is £24 million and the cost of Location B is £18 000.

1 Calculate the net present value of each location and state which location should be chosen.

CASE STUDY: AZIZ AGGREGATES

SKILLS PROBLEM SOLVING, REASONING


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

Internal rate of return (IRR)The internal rate of return shows the true return on the investment expressed as a percentage and is the cost of capital when the net present value is equal to zero.

While the NPV method of investment appraisal considers the discounted future cash flows, it does not give directors of companies the expected rate of return on an investment. The investment must cover the cost of the capital employed by a business – if it does not then the project will not return a profit for the company.

The aim of this method is to determine the rate of interest that will give a net present value of zero for a project.

The method for calculating the IRR is:1 Calculate two discount rates – one that provides

a positive net present value and one that gives a negative net present value.

2 Apply the results of the calculations to the following formula:

IRR = lower discount rate +

(difference between the rates × NPV of lower rate)

difference between the NPVs

Advantages of internal rate of return●● Considers the time value of money.●● Provides the business with the exact discounted cash

flow rate of return the project is expected to make, allowing comparisons.

Disadvantages of internal rate of return●● Complicated to use and will not be easily understood

by non-accountants.●● Time-consuming, as choosing the discount rates for

the cost of capital are a matter of guesswork.

WORKED EXAMPLEA company is appraising an investment project and has already calculated the net present values for the project using two discount rates.

Discount rate Net present value12% £22 500

16% (£34 440)

Using the formula above, you are asked to calculate the internal rate of return.

SolutionIRR = lower discount rate

+



= 12% +(4 × £22 500)

£56 940= 12% + (4 × 0.3952)= 12% + 1.58= 13.58%

When calculating the difference between two numbers, where one is a negative number, the difference is the sum of the two numbers, as in the example above.

EXAM HINT

WORKED EXAMPLEIn the worked example on page 150–1, Project 2 had a negative NPV of £88 965. You have been asked to establish the interest rate at which Project 2 becomes feasible.SolutionStep 1 – Find one NPV that is a low positive, and another NPV that is a low negative.Using the information previously calculated for the NPV, apply different interest rates to Project 2.

Project 2 at 5 per cent:

Year Discount factor

Cash flow Discounted cash flow

£ £

Year 0 1.000 (985 000) (985 000)

Year 1 0.952 225 000 214 200

Year 2 0.907 225 000 204 075

Year 3 0.864 290 000 250 560

Year 4 0.823 360 000 296 280

NPV (19 885)


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

ANALYSIS OF DISCOUNTED METHODSSo far this chapter has discussed four methods. To illustrate further, this section will now look at three different projects and apply each method to each project.

Year Project A Project B Project C

£ £ £

0 (200 000) (200 000) (200 000)

1 20 000 80 000 60 000

2 40 000 60 000 60 000

3 50 000 60 000 60 000

4 60 000 40 000 60 000

5 60 000 40 000

6 68 000 20 000

Total profit 108 000 40 000 100 000

Payback period4 years

6 months

3 years3 years

4 months

ARR 18% 10% 16.7%

NPV at 12% (£884) (£12 580) £15 100

IRR 12% 8.5% 15%

The payback method selects project B but does not consider the short life remaining after payback. Using IRR, it highlights the short life of project B and shows it as the least profitable of all three projects. ARR selects project A, but when timing of profits are taken into account by using IRR, project A only shows a return of approximately 12 per cent. When compared to project C, the extra profit of £8 000 achieved by project A does not compensate for the slow build-up of the project. Even though project C earns less profit than project A, it is more profitable when the time value of money is taken into account, as shown by IRR.

This shows that payback should not be used by itself. Using a discounting method is far more accurate.

Project 2 at 4 per cent:

Year Discount factor

Cash flow Discounted cash flow

£ £

Year 0 1.000 (985 000) (985 000)

Year 1 0.962 225 000 216 450

Year 2 0.925 225 000 208 125

Year 3 0.889 290 000 257 810

Year 4 0.855 360 000 307 800

NPV 5 185

The two tables show that the NPV of Project 2 is still negative at a cost of capital of 5 per cent but is positive at a cost of capital of 4 per cent.IRR = lower discount rate

+



= 4% +(1 × £5 185)

£25 070= 4% + 1 × 0.207= 4.207%

ACTIVITY 4

Clean Clothes Laundrette wishes to buy a new set of washing machines and dryers for £150 000. Profit before depreciation is estimated at £60 000 for the first four years, reducing to £20 000 for Years 5 and 6.

At the end of Year 6, the machines will be thrown away, as they would no longer be economic. The company requires a minimum return on all projects of 20 per cent per year. The relevant discount factors are given below.

CASE STUDY: CLEAN CLOTHES LAUNDRETTE

SKILLS INTERPRETING, REASONING


30% discount factor

0 1.000 1.000

1 0.833 0.759

2 0.694 0.592

3 0.579 0.455

4 0.482 0.350

5 0.402 0.259

6 0.335 0.207

1 Advise the directors of the viability of the project.


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

WEIGHTED AVERAGE COST OF CAPITALWhen a company raises finance for expansion or for a capital project, there are costs associated with these funds. The project or projects under consideration must be able to make a return that is at least equal to this cost, otherwise there will be no return for the shareholders. As such, it represents the minimum return that is acceptable.

The weighted average cost of capital is based on the capital structure of the company. It includes the equity finance (ordinary share capital and preference shares) and the debt finance (debentures and bank loans).

The formula for the weighted average cost of capital (WACC) is:

WACC = cost of interest and returns

total cost of project × 100

ACTIVITY 5

1 Using the data given for Why plc in Activity 1, calculate the net present values of each of the possible machine investments, assuming a cost of capital of 12 per cent.

2 Compare the results to those from Activity 1. Using these results, which machine, if any, would you recommend that Why plc purchase?

CASE STUDY: WHY PLC

SKILLS PROBLEM SOLVING, INTERPRETING, REASONING

WORKED EXAMPLE

Global Digital Construction plc has been offered a large contract to develop telecommunications infrastructure for a government. The contract is worth £950 million.

The proposed funding for the project is:

Source of funds

Amount £m

Interest rate/expected return

Ordinary shares 300 5%

Preference shares 90 3.5%

Debenture 410 8%

Bank loan 150 4.75%

You have been asked to calculate the weighted average cost of capital.SolutionTo do this, we need to calculate the annual cost to the company for each source of finance that the project uses.

Source of funds

Amount £m

Interest rate/expected

return

Interest/return

£m

Ordinary shares 300 5% 15.000

Preference shares 90 3.5% 3.150

Debenture 410 8% 32.800

Bank loan 150 4.75% 7.125

Total 950 58.075

WACC =cost of interest and returns

total cost of project × 100

=58.075

950.000 × 100

= 6.11%

This cost of capital is sometimes referred to as the ‘hurdle rate’. It is the minimum rate of return that must be achieved from an investment for it to be profitable.

Sometimes a company will put forward different options for the finance of a project. Following the calculation of the different weighted average costs of capital, the business should choose the option that has the lowest.


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

ACTIVITY 6

Following further research into possible funding combinations, the directors of Global Digital Construction plc have requested that the weighted average cost of capital be calculated for the following finance package, which is now available for the telecommunications infrastructure project.

Source of funds 2nd option £m

Interest rate/expected return

Ordinary shares 250 6%

Preference shares 190 3%

Debenture 340 8%

Bank loan 170 5%

1 Calculate the weighted average cost of capital.2 Select the most appropriate funding option for the

directors of Global Digital Construction plc, giving one reason for your funding choice.

CASE STUDY: GLOBAL DIGITAL CONSTRUCTION PLC


PROFITABILITY INDEXThe profitability index is a measure of the acceptability of a capital project. It compares the initial investment of a project with the present value of the future cash flows (NPV). The formula for calculating this is:

Profitability index % (PI%) =net present value

initial investment× 100

If the profitability index (PI) is greater than zero, i.e. positive, then the project is worth investing in.

Where two or more projects are being compared, the project with the highest profitability index should be chosen.

WORKED EXAMPLEA company has a choice of two projects and has undertaken an investment appraisal for them with the following results.

Project 1 Project 2

£ £

Initial investment 23 000 000 16 500 000

Net present value 7 250 000 6 750 000

The directors are unsure about which project to proceed with. They recognise that Project 1 has the greater NPV, but see that Project 2 has a much lower initial investment.

You have been asked to calculate the profitability index.

Solution

For Project 1:

PI% =net present value


=7 250 000

23 000 000 × 100

= 31.52%

For Project 2:

PI% =net present value


=6 750 000

16 500 000 × 100

= 40.91%The PI index suggests that the better project to invest in is Project 2, as it has a higher profitability index.

In the examination, you may be asked to calculate the NPV for two alternative projects, and then to evaluate and recommend which of the two the company should go ahead with. In this case, it is good exam technique to calculate the PI for both. Do not wait for the examiner to ask you to calculate it!

EXAM HINT


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

ACTIVITY 7

Fast Printing Solutions is a printing company. It was forced to reject a printing order because of insufficient machine capacity. As a result, the company investigated the purchase of a new printer. This would cost £400 000, but its capacity allows for additional work of £500 000. The annual cost of running this printer would be:

●● two operators at £25 000 each●● materials at £100 000.

1 Calculate the payback period.2 Calculate the net present value, assuming that the

company discounts four years of cash flow at 20 per cent per year.

3 Calculate the accounting rate of return, assuming the printer is depreciated over four years.

In addition to the facts above, Fast Printing Solutions currently has its thicker cards cut out of sheets by an outside contractor. On investigation, Fast Printing Solutions found that it could purchase a cutting machine for £300 000, which would then allow it to do this without outside help. The annual cost of the new cutting machine would be £100 000, but there would be a saving of £325 000, which is the amount that Fast Printing Solutions currently pays the outside contractor.4 For the cutting machine calculate:

(a) the payback period(b) the net book value based on a 20 per cent

discount rate(c) the ARR.

5 As Fast Printing Solutions does not have sufficient funds for both the new printer and the card cutting machine, advise the company on which machine to purchase.

CASE STUDY: FAST PRINTING SOLUTIONS

SKILLS PROBLEM SOLVING, INTERPRETING, REASONING ACTIVITY 8

Art Ltd wants to introduce a new product. To do this, the company needs to buy a new machine costing £100 000. The life of the new product is anticipated as four years. At that time Art Ltd will sell the machine as scrap (equipment that is no longer useful or current) and should receive £10 000. To finance the cost of the machine, the company will borrow money at 10 per cent per year.You are given the following net cash flows:

Year £

1 (10 000)

2 60 000

3 95 000

4 75 000

You are also told that the discount factors, using 10 per cent per year, are as follows:

Year 10% discount factor1 0.909

2 0.826

3 0.751

4 0.683

1 Calculate the NPV to determine whether the investment is worthwhile.

You are also given the following discount factors for interest rates of 20 per cent, 25 per cent and 30 per cent:


25% discount factor

30% discount factor

1 0.833 0.800 0.769

2 0.694 0.640 0.592

3 0.579 0.512 0.455

4 0.482 0.410 0.350

2 Using this information, calculate the IRR.

CASE STUDY: ART LTD

SKILLS PROBLEM SOLVING, INTERPRETING


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

Finance is available to the company at 10 per cent per year. The following table gives the present values for £1 at 10 per cent:


2 0.826

3 0.751

1 Calculate the net cash flows for the years 2020, 2021 and 2022.

2 Calculate the net present value for the purchase of the machine.

3 Describe each of the following investment appraisal methods:(a) payback period(b) accounting rate of return

4 Evaluate whether Stylish Wear Ltd should purchase the machine.

5 State how the net present value could be used to find the internal rate of return of purchasing the cutting machine.

6 Why would the internal rate of return be more valuable to Stylish Wear Ltd than the net present value?

ACTIVITY 9

Stylish Wear Ltd manufacturers sports jackets. The company has shown declining profits over the past two years, and the directors have decided that major capital investment is needed in the business if it is to succeed in the future.

A modern finishing machine, which will improve the cut and finish of the jackets, can be bought at a total cost, including installation charges, of £400 000. As this is a highly specialised machine, the full amount would be due and payable on 1 January 2020.

At present the company produces and sells 20 000 jackets per year. Research into the new machine has convinced the directors that a higher production than their present one is possible. The production manager has produced the following data showing the additional output of jackets resulting from the new machine:

Year Units

2020 2 500

2021 3 400

2022 3 900

The cash flow is to be based on the information given by the production manager and also to take into account the fact that all production can be sold without any difficulty.

You are given the following additional information:

2020 2021 2022

£ £ £

Cost of sale 80 87 96

Selling price 146 164 180

CASE STUDY: STYLISH WEAR LTD

SKILLS PROBLEM SOLVING, INTERPRETING, DECISION MAKING

ACTIVITY 10

Helico Ltd received a contract for providing helicopter emergency services for the next six years in London. They undertook an evaluation of the project, before deciding whether to accept the contract. The following information is available:●● The initial cost of purchasing a helicopter will be

£950 000. Depreciation, using the straight-line method, is calculated over the contract period on the basis that at the end of the period the scrap value of the helicopter will be £50 000.

CASE STUDY: HELICO LTD



ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

●● Monthly expenses, including depreciation, for the first two years are anticipated to be £315 000. This will increase in Year 3 by £40 000 per year and in Year 6 by an additional £26 000 per year.

●● The emergency services are expected to operate for 300 days per year. Each emergency will be paid £690. As the service becomes better known, more people will be making use of the service. It is expected that, by Year 3, the service will be operating for 320 days a year and also be used twice per day.

●● In Year 4, the amount payable for the service will be increased by 20 per cent. This price will remain fixed until the end of the contract.

●● Helico Ltd considers that the project would only be worthwhile if it could have a payback period of four years on the project.

●● Funding for the project would be by way of a loan bearing interest at 15 per cent per year.

●● The following is an extract of the present value table for £1 at 15 per cent:


2 0.756

3 0.658

4 0.572

5 0.497

6 0.432

1 Calculate, in years and months, the payback period, the net present value and the average rate of return.

2 Give your recommendations to the company using the information you have calculated. (Assume that it is company policy only to invest in projects achieving an average return of 10 per cent per year.)

Capital investment projects often require large amounts of finance and will have a significant effect on the future financial performance of a company. For this reason, the decision on which project to go ahead with or whether to invest at all, is very important. A company will use both quantitative and qualitative information to arrive at a decision. Some qualitative factors could include:●● whether the project fits with the aims and

objectives of the business●● the environmental impact of the project●● what impact the project will have on employees,

including possible redundancies●● the impact the project might have on suppliers.

The different project appraisal techniques will often show different outcomes. Project appraisal will require careful analysis and evaluation from managers before a decision can be made. Careful consideration of conflicting information is needed before recommending a project.

EVALUATE

When considering non-financial factors it is often useful to use the stakeholder approach – consider the impact of the project on the different stakeholders.

EXAM HINT

WORKED EXAMPLE

Fast Fitness plc has been awarded a contract to run leisure facilities for local government after they were threatened with closure. The company is unsure about whether to accept the contract. It has


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

conducted a project appraisal and the following information is available.●● The initial investment will be £750 000.●● The cost of capital is 9 per cent.●● The contract will operate for 4 years.●● The payback period has been calculated as

2 years and 8 months.●● The NPV is £140 000.●● The IRR is 19 per cent.

You have been requested to make an evaluation of the investment opportunity and make a recommendation to the directors.Solution

For the investment Against the investmentNPV is positive. No calculation of ARR.

The payback period is relatively short and should be acceptable as the contract is for 4 years.

The contract is only for 4 years which is not a long time – what happens after that could be an issue.

The IRR is 19 per cent which is above the cost of capital.

How accurate are the forecasts behind the numbers provided?

Providing this type of service would meet corporate social responsibilities.

Overall, the project appears to be viable. Therefore, it should be accepted, as the quantitative factors are positive.

In this example, the information is given in a table. In an exam, you should write in continuous prose.

EXAM HINT

1 State two non-discounted methods of project appraisal.

2 The payback period method uses profit. True or false?

3 State the formula used to calculate net cash flow.

4 A long payback period is better than a short payback period. True or false?

5 State the formula used to calculate ARR.

6 State the formula for average investment.

7 Depreciation is a cash outflow. True or false?

8 ARR uses profit in its calculation. True or false?

9 Explain what is meant by the term ‘time value of money’.

10 State two methods of discounted project appraisal.

11 A high NPV indicates that the project should not proceed. True or false?

12 State the formula used to calculate the internal rate of return.

13 Explain why a bank overdraft would not be used in the calculation of the weighted average cost of capital.

14 Explain how the profitability index would be used by a company.

CHECKPOINT

average rate of return (Accounting rate of return, ARR) the percentage return expected from a capital investment project compared to the initial investmentcost of capital the return from a capital project required to make a project worthwhileinternal rate of return (IRR) the discount rate that results in a net present value of zeronet cash flow the difference between the cash inflows and the cash outflowsnet present value (NPV) a method of capital investment appraisal that considers the time value of moneypayback period the length of time a capital project takes to return the initial cost of the investmentprofitability index a measure of the acceptability of a capital project. It compares the initial investment of a project with the present value of the future cash flows (NPV)project appraisal the evaluation of investment projectstime value of money the concept that money received in the future does not have the same value as the same amount paid todayweighted average cost of capital (WACC) the average amount a company pays for its capital, from all funding sources

SUBJECT VOCABULARY


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

●● The depot will operate for 52 weeks of the year.●● Dunburr Transport plc has a cost of capital of

6 per cent.


1 0.943

2 0.890

3 0.840

4 0.792

5 0.747

1 Explain the following accounting terms: (a) accounting rate of return (b) weighted average cost of capital (4 marks)2 Calculate the net present value. (20 marks)3 Calculate the payback period. (2 marks)4 Evaluate the use of the payback period as

a method of appraising an investment (6 marks)

CRITICAL THINKING, PROBLEM SOLVING, DECISION MAKINGSKILLS

EXAM PRACTICE

Dunburr Transport has bought a depot where it plans to operate a fl eet (group) of delivery vehicles for a large supermarket chain. It has obtained a six-year contract to deliver to their stores. The following information is available:●● The initial cost of the depot is £1.6 million and it will

be sold at the end of the contract for £1.5 million.●● The revenues are expected to be:

Year 1 £6 000 per weekYear 2 £6 500 per weekYears 3 and 4 £8 000 per weekYear 5 £7 500 per week

●● The running costs, including depreciation are expected to be:

Year 1 £2 000 per weekYears 2 and 3 £2 100 per weekYear 4 £2 000 per weekYear 5 £1 800 per week


ncor

rect

ed p

roof

, all

cont

ent s

ubje

ct to

cha

nge

at p

ublis

her d

iscr

etio

n. N

ot fo

r res

ale,

cir

cula

tion

or d

istr

ibut

ion

in w

hole

or i

n pa

rt. ©

Pear

son

2020

PEARSON EDEXCEL INTERNATIONAL AS/A LEVEL ......PEARSON EDEXCEL INTERNATIONAL AS/A LEVEL Student Book...

Documents

Transcript of PEARSON EDEXCEL INTERNATIONAL AS/A LEVEL ......PEARSON EDEXCEL INTERNATIONAL AS/A LEVEL Student Book...