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ACCA - F9 - Study Text - 2014/2015, Kaplan
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ACCA
PaperF9
FinancialManagement
EssentialText
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British library cataloguinginpublication data
AcataloguerecordforthisbookisavailablefromtheBritishLibrary.
Publishedby:KaplanPublishingUKUnit2TheBusinessCentreMollyMillarsLaneWokinghamBerkshireRG412QZ
KaplanFinancialLimited,2014
ThetextinthismaterialandanyothersmadeavailablebyanyKaplanGroupcompanydoesnotamounttoadviceonaparticularmatterandshouldnotbetakenassuch.Norelianceshouldbeplacedonthecontentasthebasisforanyinvestmentorotherdecisionorinconnectionwithanyadvicegiventothirdparties.Pleaseconsultyourappropriateprofessionaladviserasnecessary.KaplanPublishingLimitedandallotherKaplangroupcompanies expresslydisclaimallliabilitytoanypersoninrespectofanylossesorotherclaims,whetherdirect,indirect,incidental,consequentialorotherwisearisingin relationtotheuseofsuchmaterials.
PrintedandboundinGreatBritain.
Acknowledgements
WearegratefultotheAssociationofCharteredCertifiedAccountantsandtheCharteredInstituteofManagementAccountantsforpermissiontoreproducepastexaminationquestions. TheanswershavebeenpreparedbyKaplanPublishing.
Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmitted,inanyformorbyanymeans,electronic,mechanical,photocopying,recordingorotherwise,withoutthepriorwrittenpermissionofKaplanPublishing.
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Contents
Page
Chapter 1 Thefinancialmanagementfunction 1
Chapter 2 Basicinvestmentappraisaltechniques 19
Chapter 3 Investmentappraisaldiscountedcashflowtechniques
37
Chapter 4 Investmentappraisalfurtheraspectsofdiscountedcashflows
69
Chapter 5 Assetinvestmentdecisionsandcapitalrationing 99
Chapter 6 Investmentappraisalunderuncertainty 123
Chapter 7 Workingcapitalmanagement 147
Chapter 8 Workingcapitalmanagementinventorycontrol 177
Chapter 9 Workingcapitalmanagementaccountsreceivableandpayable
199
Chapter 10 Workingcapitalmanagementcashandfundingstrategies
219
Chapter 11 Theeconomicenvironmentforbusiness 239
Chapter 12 Financialmarketsandthetreasuryfunction 251
Chapter 13 Foreignexchangerisk 269
Chapter 14 Interestraterisk 301
Chapter 15 Sourcesoffinance 319
Chapter 16 Dividendpolicy 345
Chapter 17 Thecostofcapital 355
Chapter 18 Capitalstructure 403
Chapter 19 Financialratios 437
Chapter 20 Businessvaluationsandmarketefficiency 465
Chapter 21 Questions&Answers 505
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v
chapterIntroduction
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How to Use the Materials TheseKaplanPublishinglearningmaterialshavebeencarefullydesignedtomakeyourlearningexperienceaseasyaspossibleandtogiveyouthebestchancesofsuccessinyourexaminations.
Theproductrangecontainsanumberoffeaturestohelpyouinthestudyprocess.Theyinclude:
Thesectionsonthestudyguide,thesyllabusobjectives,theexaminationandstudyskillsshouldallbereadbeforeyoucommenceyourstudies.Theyaredesignedtofamiliariseyouwiththenatureandcontentoftheexaminationandgiveyoutipsonhowtobesttoapproachyourlearning.
Thecomplete text or essential textcomprisesthemainlearningmaterialsandgivesguidanceastotheimportanceoftopicsandwhereotherrelatedresourcescanbefound.Eachchapterincludes:
(1) Detailedstudyguideandsyllabusobjectives(2) Descriptionoftheexamination(3) Studyskillsandrevisionguidance(4) Completetextoressentialtext(5) Questionpractice
Thelearning objectivescontainedineachchapter,whichhavebeencarefullymappedtotheexaminingbody'sownsyllabuslearningobjectivesoroutcomes.Youshouldusethesetocheckyouhaveaclearunderstandingofallthetopicsonwhichyoumightbeassessedintheexamination.
Thechapter diagramprovidesavisualreferenceforthecontentinthechapter,givinganoverviewofthetopicsandhowtheylinktogether.
Thecontentforeachtopicareacommenceswithabriefexplanationordefinitiontoputthetopicintocontextbeforecoveringthetopicindetail.Youshouldfollowyourstudyingofthecontentwithareviewoftheillustration/s.Theseareworkedexampleswhichwillhelpyoutounderstandbetterhowtoapplythecontentforthetopic.
Introduction
vi KAPLAN PUBLISHINGvi KAPLAN PUBLISHING
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Qualityandaccuracyareoftheupmostimportancetoussoifyouspotanerrorinanyofourproducts,[email protected],orfollowthelinktothefeedbackforminMyKaplan.
OurQualityCoordinatorwillworkwithourtechnicalteamtoverifytheerrorandtakeactiontoensureitiscorrectedinfutureeditions.
Test your understandingsectionsprovideanopportunitytoassessyourunderstandingofthekeytopicsbyapplyingwhatyouhavelearnedtoshortquestions.Answerscanbefoundatthebackofeachchapter.
Summary diagramscompleteeachchaptertoshowtheimportantlinksbetweentopicsandtheoverallcontentofthepaper.Thesediagramsshouldbeusedtocheckthatyouhavecoveredandunderstoodthecoretopicsbeforemovingon.
Question practiceisprovidedatthebackofeachtext.
Icon Explanations
Definition Keydefinitionsthatyouwillneedtolearnfromthecorecontent.
Key PointIdentifiestopicsthatarekeytosuccessandareoftenexamined.
NewIdentifiestopicsthatarebrandnewinpapersthatbuildon,andthereforealsocontain,learningcoveredinearlierpapers.
Expandable TextExpandabletextprovidesyouwithadditionalinformationaboutatopicareaandmayhelpyougainabetterunderstandingofthecorecontent.Essentialtextuserscanaccessthisadditionalcontentonline(readitwhereyouneedfurtherguidanceorskipoverwhenyouarehappywiththetopic)
Test Your UnderstandingExercisesforyoutocompletetoensurethatyouhaveunderstoodthetopicsjustlearned.
IllustrationWorkedexampleshelpyouunderstandthecorecontentbetter.
KAPLAN PUBLISHING vii
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Tricky topicWhenreviewingtheseareascareshouldbetakenandallillustrationsandtestyourunderstandingexercisesshouldbecompletedtoensurethatthetopicisunderstood.
Online subscribers
Syllabus
Syllabus objectives
The examination
Examination format
Paperbased examination tips
Study skills and revision guidance
Preparing to study
Effective studying
Three ways of taking notes
Revision
Further reading
YoucanfindfurtherreadingandtechnicalarticlesunderthestudentsectionofACCA'swebsite.
Introduction
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KAPLAN PUBLISHING ix
FORMULAE AND TABLES
Economic order quantity
H
o
CDC2
=
Miller-Orr Model
Return point = Lower limit + ( 31 spread)
31
43
rate interestcashflowsofvariancecostntransactio
3=Spread
The Capital Asset Pricing Model
E(ri) = Rf + i(E(rm) Rf)
The asset beta formula
a =
d
de
de
de
e T))(1V+V
T)(1V+T))(1V+(V
V
The Growth Model
)gr()g1(DP
e
00
+=
Gordons growth approximation
g = bre
The weighted average cost of capital
)T(1k V+V
V+k V+V
V=WACC dde
de
de
e
The Fisher formula
(1+i) = (1+r)(1+h)
Purchasing power parity and interest rate parity
)h+(1)h+(1
xS=Sb
c01 )i+(1
)i+(1xS=F
b
c00
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Present value table
Present value of 1, i.e. (1 + r)n
Where r = discount rate
n = number of periods until payment
Discount rate (r)
Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
Discount rate (r)
Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
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KAPLAN PUBLISHING xi
Annuity table
Present value of an annuity of 1, i.e. r
r)+(11 n
Where r = discount rate
n = number of periods until payment
Discount rate (r)
Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 8.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
Discount rate (r)
Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.968 4.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
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xii KAPLAN PUBLISHING
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ThefinancialmanagementfunctionChapter learning objectives
Uponcompletionofthischapteryouwillbeableto:
explainthenatureandpurposeoffinancialmanagement distinguishbetweenfinancialmanagementandfinancialand
managementaccounting discusstherelationshipbetweenfinancialobjectives,corporate
objectivesandcorporatestrategy identifyanddescribeavarietyoffinancialobjectives,including:
shareholderwealthmaximisation profitmaximisation earningspersharegrowth
identifystakeholders,theirobjectivesandpossibleconflicts discussthepossibleconflictbetweenstakeholderobjectives discusstheroleofmanagementinmeetingstakeholder
objectives,includingtheuseofagencytheory explainwaystoencouragetheachievementofstakeholder
objectives,including: managerialrewardschemes regulatoryrequirements
discusstheimpactofnotforprofitstatusonfinancialandotherobjectives
discussthenatureandimportanceofValueforMoneyasanobjectiveinnotforprofitorganisations
discusswaysofmeasuringtheachievementofobjectivesinnotforprofitorganisations.
1
chapter
1
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1The nature and purpose of financial management
Financialmanagementisconcernedwiththeefficientacquisitionanddeploymentofbothshortandlongtermfinancialresources,toensuretheobjectivesoftheenterpriseareachieved.
Decisionsmustbetakeninthreekeyareas:
investmentbothlongterminvestmentinnoncurrentassetsandshortterminvestmentinworkingcapital
financefromwhatsourcesshouldfundsberaised? dividendshowshouldcashfundsbeallocatedtoshareholdersand
howwillthevalueofthebusinessbeaffectedbythis?
The financial management function
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An understanding of these three key areas is fundamental for the examination.
Intakingthesedecisions,thefinancialmanagerwillneedtotakeaccountof:
TheF9syllabuscoversallthesekeyaspectsoffinancialmanagement.
theorganisation'scommercialandfinancialobjectives thebroadereconomicenvironmentinwhichthebusinessoperates thepotentialrisksassociatedwiththedecisionandmethodsof
managingthatrisk.
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The investment decision
The dividend decision
The financing decision
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Financialmanagementshouldbedistinguishedfromotherimportantfinancialroles:
managementaccountingconcernedwithprovidinginformationforthemoredaytodayfunctionsofcontrolanddecisionmaking
financialaccountingconcernedwithprovidinginformationaboutthehistoricalresultsofpastplansanddecisions.
2The relationship between corporate strategy and corporate and financial objectives
Objectives/targetsdefinewhattheorganisationistryingtoachieve.Strategyconsidershowtogoaboutit.
3Financial objectives Shareholder wealth maximisation
Shareholderwealthmaximisationisafundamentalprincipleoffinancialmanagement.Youshouldseektounderstandthedifferentaspectsofthesyllabus(e.g.finance,dividendpolicy,investmentappraisal)withinthisunifyingtheme.
Manyotherobjectivesarealsosuggestedforcompaniesincluding:
profitmaximisation growth marketshare socialresponsibilities
The financial management function
4 KAPLAN PUBLISHING
Financial rolesObjectives and strategyMaximising and satisficingAdditional question Objective s and strategyFinancial objectives
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4Stakeholder objectives and conflicts
Astakeholdergroupisonewithavestedinterestinthecompany.
Typicalstakeholdersforanorganisationwouldinclude:
Internal
Connected
External
Manyarguethatmanagersshouldbalancetheneedsandobjectivesofallstakeholders.
companyemployees companymanagers/directors
equityinvestors(ordinaryshareholders) customers suppliers financeproviders(debtholders/bankers) competitors
thegovernment thecommunityatlarge pressuregroups regulators.
Conflictbetweenandwithingroupsofstakeholdersandtheneedformanagementtobalancethevariousinterestsisakeyissue.
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Additional question Stakeholder conflicts
The stakeholder view
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5The role of management and goal congruence Agency theory
Agencytheoryisoftenusedtodescribetherelationshipsbetweenthevariousinterestedpartiesinafirmandcanhelptoexplainthevariousdutiesandconflictsthatoccur:
Agencyrelationshipsoccurwhenoneparty,the principal,employsanotherparty,the agent,toperformataskontheirbehalf.Inparticular,directors(agents)actonbehalfofshareholders(principals).
How to reduce the problems caused by agency relationships
Findingwaystoreducetheproblemsoftheagencyrelationshipandensurethatmanagerstakedecisionswhichareconsistentwiththeobjectivesofshareholdersisakeyissue.
Managerial reward schemes
Onewaytohelpensurethatmanagerstakedecisionswhichareconsistentwiththeobjectivesofshareholdersistointroducecarefullydesignedremunerationpackages.Theschemesshould:
Commontypesofrewardschemesinclude:
beclearlydefined,impossibletomanipulateandeasytomonitor linkrewardstochangesinshareholderwealth matchmanagerstimehorizonstoshareholderstimehorizons encouragemanagerstoadoptthesameattitudestoriskas
shareholders.
remunerationlinkedto: minimumprofitlevels economicvalueadded(EVA) revenuegrowth
executiveshareoptionschemes(ESOP).
The financial management function
6 KAPLAN PUBLISHING
Agency theory
Additional question Managerial reward schemes
Managerial reward schemes
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Corporate governance codes
Thedirector/shareholderconflicthasalsobeenaddressedbytherequirementsofanumberofcorporategovernancecodes.Thefollowingkeyareasrelatetothisconflict.
Nonexecutivedirectors(NEDs) importantpresenceontheboard mustgiveobligationtospendsufficienttimewiththecompany shouldbeindependent.
Executivedirectors separationofchairmanandchiefexecutiveofficer(CEO) submitforreelection cleardisclosureoffinancialrewards outnumberedbytheNEDs.
Remunerationcommittees. Nominationcommittees. Annualgeneralmeeting(AGM).
Stock exchange listing requirements and other regulations
Althoughadherencetotheprinciplesofthecorporategovernancecodesisvoluntary,theyareoftenreferredtointhelistingrequirementsofstockexchanges.
6Measuring achievement of corporate objectives
Itisnecessaryformanagers,shareholdersandotherstakeholderstohavewaysofmeasuringtheprogressofthecompanytowardsitsobjectives. Thisiscommonlydoneviaratioanalysis.
Ratioanalysiscomparesandquantifiesrelationshipsbetweenfinancialvariables.
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Corporate governance codes
Other regulations
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Ratioanalysiscanbegroupedintofourmaincategories:
ThespecificratioscoveredintheF9syllabuswillbelookedatindetailinchapter19althoughsomeofthemmayalreadybefamiliartoyoufrompreviouspapers.
Profitabilityandreturn Debtandgearing Liquidity Investor
7Objective setting in not for profit organisations
Theprimaryobjectiveofnotforprofitorganisations(NFPsorNPOs)isnottomakemoneybuttobenefitprescribedgroupsofpeople.
Aswithanyorganisation,NFPswilluseamixtureoffinancialandnonfinancialobjectives.
However,withNFPsthenonfinancialobjectivesareoftenmoreimportantandmorecomplexbecauseofthefollowing.
Mostkeyobjectivesareverydifficulttoquantify,especiallyinfinancialterms,e.g.qualityofcaregiventopatientsinahospital.
MultipleandconflictingobjectivesaremorecommoninNFPs,e.g.qualityofpatientcareversusnumberofpatientstreated.
Value for money (VFM) and the 3 Es
VFMcanbedefinedasachievingthedesiredlevelandqualityofserviceatthemosteconomicalcost.
The financial management function
8 KAPLAN PUBLISHING
Objective setting in NFPs
VFM
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The three Es
Assessingwhethertheorganisationprovidesvalueformoneyinvolveslookingatallfunctioningaspectsoftheorganisation.Performancemeasureshavebeendevelopedtopermitevaluationofeachpartseparately.
VFM
Economy:Minimisingthecostsofinputsrequiredtoachieveadefinedlevelofoutput.
Efficiency:Ratioofoutputstoinputsachievingahighlevelofoutputinrelationtotheresourcesputin(inputdriven)orprovidingaparticularlevelofserviceatreasonableinputcost(outputdriven)
Effectiveness:Whetheroutputsareachievedthatmatchthepredeterminedobjectives.
Useofthe3EsasaperformancemeasureandawaytoassessVFMisakeyissueforexaminationquestionsthatrelatetoNFPsandpublicsectororganisations.
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KAPLAN PUBLISHING 9
3Es
Measuring the achievement of objectives in NFPs
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Asubsidisedcollegecanteenserviceistobeevaluatedbythelocalcounciltoassessamongstotherthings,whetheritisfinanciallysoundandoffersvalueformoney.
Suggest appropriate measures of achievement that could be set for the service.
Which of the following is NOT one of the three main types of decision facing the financing manager in a company?
A DividenddecisionB InvestmentdecisionC EconomicdecisionD Financingdecision
Theagencyproblemisadrivingforcebehindthegrowingimportanceattachedtosoundcorporategovernance.
In this context, the 'agents' are the:
A CustomersB ShareholdersC ManagersD Auditors
The financial management function
10 KAPLAN PUBLISHING
Test your understanding 1 Not for profit organisations
Test your understanding 3
Test your understanding 2
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Which of the following is an example of a financial objective that a company might choose to pursue?
A ProvisionofgoodwagesandsalariesB DealinghonestlyandfairlywithcustomersonalloccasionsC ProducingenvironmentallyfriendlyproductsD Restrictingthelevelofgearingtobelowaspecifiedtargetlevel
In the context of managing performance in 'not for profit' organisations, which of the following definitions is incorrect?
A Valueformoneymeansprovidingaserviceinawaywhichiseconomical,efficientandeffective
B Economymeansdoingthingscheaply: notspending$2whenthesamethingcanbeboughtfor$1
C Efficiencymeansdoingthingsquickly: minimisingtheamountoftimethatisspentonagivenactivity
D Effectivenessmeansdoingtherightthings: spendingfundssoastoachievetheorganisation'sobjectives
Which of the following is a problem associated with managerial reward schemes?
A Byrewardingperformance,aneffectiveschemecreatesanorganisationfocusedoncontinuousimprovement
B Schemesbasedonsharescanmotivateemployees/managerstoactinthelongterminterestsofthecompany
C Selfinterestedperformancemaybeencouragedattheexpenseofteamwork
D Effectiveschemesattractandkeeptheemployeesvaluabletoanorganisation
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KAPLAN PUBLISHING 11
Test your understanding 5
Test your understanding 6
Test your understanding 4
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Chapter summary
The financial management function
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chapter 1
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The financial management function
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chapter 1
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Answer to additional question Objectives and strategy
Answer to additional question Managerial reward schemes
Answer to additional question Stakeholder conflicts
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Test your understanding answers
Financialmeasures:
Economytargets:
Efficiencytargets:
Effectivenesstargets:
proportionofoverallfundsspentonadministrationcosts abilitytostaywithinbudget/breakeven revenuetargetsmet.
costsofpurchasingprovisionsofsuitablenutritionalquality costsofnegotiatingforandpurchasingequipment negotiationofbulkdiscounts payratesforstaffofappropriatelevelsofqualification.
numbersofportionsproduced costpermealsold levelsofwastageofunpreparedandofcookedfood staffutilisation equipmentlife.
numbersusingthecanteen customersatisfactionratings nutritionalvalueofmealsserved.
Answer C
Financialmanagementaimstoensurethatthemoneyisavailabletofinanceprofitableprojectsandtoselectthoseprojectswhichthecompanyshouldundertake. Onceprofitshavebeenmadethedecisionthenneedstobemadeabouthowmuchtodistributetotheownersandhowmuchtoreinvestforthefuture.
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Test your understanding 1 Not for profit organisations
Test your understanding 2
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Answer C
Theseparationofownershipandcontrolcreatesasituationwheremanagersactastheagentsoftheowners(shareholders).
Answer D
Thisisafinancialobjectivethatrelatestothelevelofriskthatthecompanyaccepts.
Answer C
Efficiencymeansdoingthingswell: gettingthebestuseoutofwhatmoneyisspenton.
Answer C
Thisidentifiesatypicalproblemassociatedwithmanymanagerialrewardschemes.
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Test your understanding 4
Test your understanding 6
Test your understanding 3
Test your understanding 5
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The financial management function
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BasicinvestmentappraisaltechniquesChapter learning objectives
Uponcompletionofthischapteryouwillbeableto:
definearelevantcashflow(anddistinguishitfromanaccountingprofit)
identifyandcalculaterelevantcashflowsinascenario calculatethepaybackperiodanduseittoappraisean
investment discusstheusefulnessofpaybackasaninvestmentappraisal
method calculatereturnoncapitalemployed(ROCE)(accountingrateof
return)anduseittoappraiseaninvestment discusstheusefulnessofROCEasaninvestmentappraisal
method.
19
chapter
2
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1Investment appraisal process
Onestageinthecapitalbudgetingprocessis investment appraisal.Thisappraisalhasthefollowingfeatures:
assessmentofthelevelofexpectedreturnsearnedforthelevelofexpendituremade
estimatesoffuturecostsandbenefitsovertheprojectslife.
Twobasicappraisaltechniquesarecoveredinthischapter:
Moresophisticatedmethodsofinvestmentappraisalaredealtwithinthenextchapter.
ROCE Payback.
Examinationquestionsmayaskyoutocompareandcontrasttheuseofthesetwobasictechniques.
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2ROCE
Thisisalsoknownasaccountingrateofreturn(ARR).
oralternatively:
Theaverageinvestmentcanbecalculatedas:
AverageannualprofitsbeforeinterestandtaxROCE= 100%
Initialcapitalcosts
AverageannualprofitsbeforeinterestandtaxROCE= 100%
Averagecapitalinvestment
Initialinvestment +scrapvalueAveragecapitalinvestment=
2
Intheexamyoushouldusetheinitialcapitalcostunlessyouaretoldotherwise. However,theROCEcalculationbasedontheaveragecapitalinvestmentisthemethodmostcommonlyaskedforintheexam. Thiswillbemadeclearinthequestion.
Decision rule:
IftheexpectedROCEfortheinvestmentisgreaterthanthetargetorhurdlerate(asdecidedbymanagement)thentheprojectshouldbeaccepted.
Aprojectinvolvestheimmediatepurchaseofanitemofplantcosting$110,000.Itwouldgenerateannualcashflowsof$24,400forfiveyears,startinginYear1.Theplantpurchasedwouldhaveascrapvalueof$10,000infiveyears,whentheprojectterminates.Depreciationisonastraightlinebasis.
Determine the project's ROCE using:
(a) initialcapitalcosts(b) averagecapitalinvestment
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Test your understanding 1 ROCE
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Aprojectrequiresaninitialinvestmentof$800,000andthenearnsnetcashinflowsasfollows:
Inaddition,attheendofthesevenyearprojecttheassetsinitiallypurchasedwillbesoldfor$100,000.
Determine the projects ROCE using:
Year 1 2 3 4 5 6 7Cashinflows($000) 100 200 400 400 300 200 150
(a) initialcapitalcosts(b) averagecapitalinvestment.
3Advantages and disadvantages of ROCE
Advantagesinclude:
Disadvantagesinclude:
simplicity linkswithotheraccountingmeasures.
noaccountistakenofprojectlife noaccountistakenoftimingofcashflows itvariesdependingonaccountingpolicies itmayignoreworkingcapital itdoesnotmeasureabsolutegain thereisnodefinitiveinvestmentsignal.
IntheexaminationitisimportantthatyoucandiscussthefeaturesofROCEasaninvestmentappraisaltechnique,inadditiontobeingabletocalculateit.
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Advantages and disadvantages of ROCE
Initial capital cost
Test your understanding 2 ROCE
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4Accounting profits and cash flows
Incapitalinvestmentappraisalitismoreappropriatetoevaluatefuturecashflowsthanaccountingprofits,because:
profitscannotbespent profitsaresubjective cashisrequiredtopaydividends.
5Cash flows and relevant costs
Forallmethodsofinvestmentappraisal,withtheexceptionofROCE,onlyrelevantcashflowsshouldbeconsidered.Theseare:
Ignore:
future incremental cashbased.
sunkcosts committedcosts noncashitems allocatedcosts.
Amanufacturingcompanyisconsideringtheproductionofanewtypeofwidget.Eachwidgetwilltaketwohourstomake.
Fixedoverheadsareapportionedonthebasisof$1perlabourhour.
Ifthenewwidgetsareproduced,thecompanywillhavetoemployanadditionalsupervisoratasalaryof$15,000pa.Thecompanywillproduce10,000widgetspa.
What are the relevant cash flows?
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Relevant costs
Test your understanding 3 Relevant costs
Profits versus cash flows
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6Payback method of appraisal
Thepaybackperiodisthetimeaprojectwilltaketopaybackthemoneyspentonit.Itisbasedonexpectedcashflowsandprovidesameasureofliquidity.
Decision rule:
Constant annual cash flows
onlyselectprojectswhichpaybackwithinthespecifiedtimeperiod choosebetweenoptionsonthebasisofthefastestpayback
initialinvestmentPayback period=
annualcashflow
Anexpenditureof$2millionisexpectedtogeneratenetcashinflowsof$500,000eachyearforthenextsevenyears.
What is the payback period for the project?
Apaybackperiodmaynotbeforanexactnumberofyears. Tocalculatethepaybackinyearsandmonthsyoushouldmultiplythedecimalfractionofayearby12tothenumberofmonths.
Aprojectwillinvolvespending$1.8millionnow.Annualcashflowsfromtheprojectwouldbe$350,000.
What is the expected payback period?
Uneven annual cash flows
Inpractice,cashflowsfromaprojectareunlikelytobeconstant.Wherecashflowsareuneven,paybackiscalculatedbyworkingoutthecumulativecashflowoverthelifeoftheproject.
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24 KAPLAN PUBLISHING
Test your understanding 4 Payback with constant annual cash
Test your understanding 5 Payback in years and months
Additional question Relevant costs
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Aprojectisexpectedtohavethefollowingcashflows:
What is the expected payback period?
Year Cash flow$000
0 (1,900)1 3002 5003 6004 8005 500
Calculate the payback period in years and months for the following project:
Year Cash flow$000
0 (3,100)1 1,0002 9003 8004 5005 500
7Advantages and disadvantages of payback
Advantagesinclude:
itissimple itisusefulincertainsituations:
rapidlychangingtechnology improvinginvestmentconditions
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Test your understanding 6 Payback with uneven cash flows
Test your understanding 7 Payback with uneven cash flows
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Disadvantagesinclude:
itfavoursquickreturn: helpscompanygrowth minimisesrisk maximisesliquidity
itusescashflows,notaccountingprofit.
itignoresreturnsafterthepaybackperiod itignoresthetimingsofthecashflows itissubjectivenodefinitiveinvestmentsignal itignoresprojectprofitability.
Intheexaminationitisimportantthatyoucandiscussthefeaturesofpaybackasaninvestmentappraisaltechniqueaswellasbeingabletodothecalculation.
Which of the following is an example of a relevant cash flow to be considered in an investment appraisal process for a new project?
A MarketresearchexpenditurealreadyincurredB AdditionaltaxthatwillbepaidonextraprofitsgeneratedC Centrallyallocatedoverheadsthatarenotaconsequenceof
undertakingtheprojectD Taxallowabledepreciation
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Advantages and disadvantages of payback
Test your understanding 8
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Garfieldplcisconsideringwhethertoenterintoanewproject. Themachinerywhichwouldbeusedtoproducethegoodsforthecontractwaspurchasedsevenyearsagoatacostof$80,000,withanestimatedlifeoftenyears. Depreciationisonastraightlinebasis. Themachineryhasbeenidleforsometime,andifnotusedonthiscontractwouldbescrappedandsoldimmediatelyforanestimated$5,000. Afteruseonthiscontractthemachinerywouldhavenovalue,andwouldhavetobedismantledanddisposedofatacostof$1,500.
Ignoring the time value of money (covered later in Chapter 3), what is the relevant cost of the machine to the new contract?
A $3,500B $5,000C $6,500D $24,500
Which of the following is an advantage of the payback method of investment appraisal?
A Ittakesaccountofthetimingofthecashflowswithinthepaybackperiod
B ItusesaccountingprofitsratherthancashflowsC Ittakesaccountofthecashflowsaftertheendofthepayback
periodandthereforethetotalprojectreturnD Itcanbeusedasascreeningdeviceasafirststageineliminating
obviouslyinappropriateprojectspriortomoredetailedevaluation
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Test your understanding 10
Test your understanding 9
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Which of the following statements is not true?
A Thereturnoncapitalemployedmethodofinvestmentappraisaltakesaccountofthelengthoftheproject
B FocusonanearlypaybackperiodcanenhanceliquidityC InvestmentriskisincreasedifthepaybackperiodislongerD Shortertermforecastsarelikelytobemorereliable
Acornplcisconsideringpurchasinganewmachineatacostof$110,400thatwillbeoperatedforfouryears,afterwhichtimeitwillbesoldforanestimated$9,600. Acornusesastraightlinepolicyfordepreciation.
Forecastoperatingprofitstobegeneratedbythemachineareasfollows:
Select the payback period (PP) and the average return on capital employed (ROCE), calculated as average annual profits divided by the average investment.
Year $1 39,6002 19,6003 22,4004 32,400
A PP:2.02years ROCE:47.5%B PP:3.89years ROCE:25.8%C PP:3.89years ROCE:47.5%D PP:2.02years ROCE:25.8%
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Test your understanding 11
Test your understanding 12
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Chapter summary
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Basic investment appraisal techniques
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Answer to additional question Relevant costs
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Test your understanding answers
Annualcashflowsaretakentobeprofitbeforedepreciation.
Using average capital investment:
Averageannualprofits(asbefore)=$4,400
Averageannualdepreciation
= ($110,000$10,000)5
= $20,000Averageannualprofit
= $24,400$20,000
= $4,400Using initial cost:
AverageannualprofitROCE = 100%
Initialcapitalcost
$4,400= 100% =4%
$110,000
Initialcost+Finalscrapvalue
Averagebookvalueofassets
=
2
$110,000+$10,000= =$60,000
2
AverageannualprofitROCE = 100%
Averagebookvalueofassets
$4,400
= 100% =7.33%$60,000
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Test your understanding 1 ROCE
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Thisusesprofitsratherthancashflows.
(a)
Averageannualinflows=$1,750,0007 =$250,000Averageannualdepreciation=($800,000$100,000)7 =$100,000(Anet$700,000isbeingwrittenoffasdepreciationover7years.)Averageannualprofit=$250,000$100,000 =$150,000Theaveragecapitalinvestedis(800,000+100,000)2 =$450,000
Averageannualprofit $150,000ROCE= 100= 100=18.75%
Initialcapitalcost $800,000 (b)
Averageannualprofit $150,000ROCE= 100= 100=33.33%
Averagecapitalinvestment $450,000
Onlythe$15,000salaryisrelevant.Thefixedoverheadsarenotincrementaltothedecisionandshouldbeignored.
$2,000,000Payback period= =4years
$500,000
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Test your understanding 4 Payback with constant annual cash
Test your understanding 3 Relevant costs
Test your understanding 2 ROCE
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$1,800,000Payback= =5.1429years
$350,000
0.1429ofayear12months=1.7months(rounded=2months)
Theanswercanthereforebestatedaseither:
assumingcashflowsoccurevenlythroughouttheyear.
5.1years 5years2months
Year Cash flow Cumulative cash flow
$000 $0000 (1,900) (1,900)1 300 (1,600)2 500 (1,100)3 600 (500)4 800 3005 500 800
Inthetableaboveacolumnisaddedforcumulativecashflowsfortheprojecttodate.Figuresinbracketsarenegativecashflows.
Eachyearscumulativefigureissimplythecumulativefigureatthestartoftheyearplusthefigureforthecurrentyear.Thecumulativefigureeachyearisthereforetheexpectedpositionasattheendofthatyear.
PaybackisbetweentheendofYear3andtheendofYear4thatisduringYear4.Thisisthepointatwhichthecumulativecashflowchangesfrombeingnegativetopositive.Ifweassumeaconstantrateofcashflowthroughouttheyear,wecouldestimatethatpaybackwillbethreeyearsplus($500/800)ofYear4.Thisisbecausethecumulativecashflowisminus$500atthestartoftheyearandtheYear4cashflowwouldbe$800.
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Test your understanding 5 Payback in years and months
Test your understanding 6 Payback with uneven cash flows
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$500/800=0.625
Thereforepaybackisafter3.625years.
Paybackinyearsandmonthsiscalculatedbymultiplyingthedecimalfractionofayearby12months.Inthisexample,0.625years=7.5months(0.62512months),whichisroundedto8months.Sotherefore,paybackoccursafter3years8months.
Notethatifcashflowsweredeemedtoariseattheendoftheyearthenthepaybackperiodwouldbe4years.
Thepaybackperiodwouldbecalculatedasfollows.
PaybackisbetweentheendofYear3andtheendofYear4,inotherwordsduringYear4.
Ifweassumeaconstantrateofcashflowthroughtheyear,wecouldestimatethatpaybackwillbethreeyears,plus($400/500)ofYear4,whichis3.8years.
0.8years=10months(0.812)
Wecouldthereforeestimatethatpaybackwouldbeafter3years10months.
Year Cash flow Cumulative cash flow
$000 $0000 (3,100) (3,100)1 1,000 (2,100)2 900 (1,200)3 800 (400)4 500 1005 500 600
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Test your understanding 7 Payback with uneven cash flows
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Answer B
Anycostincurredinthepast(A),oranycommittedcostswhichwillbeincurredregardlessofwhetherornotaninvestmentisundertaken(C),arenotrelevantcashflows. Theyhaveoccurred,orwilloccur,whateverinvestmentdecisionistaken. Anycostswhichdonotrepresentanactualcashflow(D)shouldalsobeignored.
Answer C
$Lossofopportunitytogainrevenue 5,000Payfordismantle 1,500
6,500
Answer D
Thepaybackmethodignoresboththetimingofthecashflowswithinthepaybackperiod(A)andthecashflowsaftertheendofthepaybackperiod(C). Thepaybackmethodusescashflowsratherthanaccountingprofits(B).
Answer A
TheROCEmethodfailstotakeaccountofthelifeoftheproject.
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Test your understanding 9
Test your understanding 10
Test your understanding 11
Test your understanding 8
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Answer A
PP:
Depreciationmustbeaddedbacktotheannualprofitfiguretoderivetheannualcashflows.
Annualdepreciation($110,400$9,600)/4years=$25,200
Adding$25,200toeachyear'sprofitfigureproducesthefollowingcashflows.
Paybackperiod=2years+(800/(47,600)1year)=2.02years
Ifyouselectedapaybackperiodof3.89yearsyoubasedyourcalculationsontheaccountingprofitsafterthedeductionofdepreciation.Thecalculationofthepaybackperiodshouldbebasedoncashflows.
ROCE:
Averageprofit=$(39,600+19,600+22,400+32,400)/4=$28,500Averageinvestment=$(110,400+9,600)/2=$60,000ROCE=$(28,500/60,000)100%=47.5%
IfyouselectedaROCEof25.8%youcalculatedtheROCEusingtheopeninginvestmentratherthantheaverageinvestment.
Cash flow
Cumulative cash flow
$ $Initialinvestment (110,400) (110,400)Year1 64,800 (45,600)Year2 44,800 (800)Year3 47,600 46,800
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Test your understanding 12
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InvestmentappraisaldiscountedcashflowtechniquesChapter learning objectives
Uponcompletionofthischapteryouwillbeableto:
explaintheconceptofthetimevalueofmoney calculatethefuturevalueofasumbycompounding calculatethepresentvalue(PV)ofasinglesumusingaformula calculatethePVofasinglesumusingdiscounttables calculatethePVofanannuityusingaformula calculatethePVofanannuityusingannuitytables calculatethePVofaperpetuityusingaformula calculatethePVofadvancedannuitiesandperpetuities calculatethePVofdelayedannuitiesandperpetuities explainthebasicprinciplebehindtheconceptofacostofcapital calculatethenetpresentvalue(NPV)ofaninvestmentanduseit
toappraisetheproposal discusstheusefulnessofNPVasaninvestmentappraisal
methodanditssuperiorityovernondiscountedcashflows(DCF)methods
calculatetheinternalrateofreturn(IRR)ofaninvestmentanduseittoappraisetheproposal
discusstheusefulnessofIRRasaninvestmentappraisalmethodanditssuperiorityovernonDCFmethods
discusstherelativemeritsofNPVandIRR.
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1The time value of money
Moneyreceivedtodayisworthmorethanthesamesumreceivedinthefuture,i.e.ithasatime value.
Thisoccursforthreereasons:
potentialforearninginterest/costoffinance impactofinflation effectofrisk.
ThisisakeyconceptthroughouttheF9syllabus.
Discountedcashflow(DCF)techniquestakeaccountofthistimevalueofmoneywhenappraisinginvestments.
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The time value of money
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2Compounding
Asuminvestedtodaywillearninterest.Compoundingcalculatesthefutureorterminalvalueofagivensuminvestedtodayforanumberofyears.
Tocompoundasum,thefigureisincreasedbytheamountofinterestitwouldearnovertheperiod.
Aninvestmentof$100istobemadetoday.Whatisthevalueoftheinvestmentaftertwoyearsiftheinterestrateis10%?
Solution
The$100willbeworth$121intwoyearsataninterestrateof10%.
Thisisafairlystraightforwardcalculation. However,ifthequestionaskedforthevalueoftheinvestmentafter20years,itwouldtakealotlonger.
$Valueafteroneyear 1001.1= 110Valueaftertwoyears 1101.1= 121
So,tospeeduptheprocess,wecanuseaformulatocalculatethefuturevalueofasuminvestednow. Theformulais:
F=P(1+r)n
whereF=Futurevalueafternperiods
P=PresentorInitialvalue
r=Rateofinterestperperiod
n=Numberofperiods
Theterminalvalueisthevalue,innyears'time,ofasuminvestednow,ataninterestrateofr%.
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Illustration 1 Compounding
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Youhave$5,000toinvestnowforsixyearsataninterestrateof5%pa.
What will be the value of the investment after six years?
3Discounting
Inapotentialinvestmentproject,cashflowswillariseatmanydifferentpointsintime.Tomakeausefulcomparisonofthedifferentflows,theymustallbeconvertedtoacommonpointintime,usuallythepresentday,i.e.thecashflowsarediscounted.
Discounting a single sum
Thepresentvalue(PV)isthecashequivalentnowofmoneyreceivable/payableatsomefuturedate.
ThePVofafuturesumcanbecalculatedusingtheformula:
Thisisjustarearrangementoftheformulaweusedforcompounding.
(1+r)niscalledthediscountfactor(DF).
FP= = F(1+r)n
(1+r)n
WhatisthePVof$115,000receivableinnineyears'timeifr=6%?
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Test your understanding 2 Discounting a single sum
Test your understanding 1 Compounding
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4The cost of capital
Intheabovediscussionswereferredtotherateofinterest.Thereareanumberofalternativetermsusedtorefertotherateafirmshouldusetotakeaccountofthetimevalueofmoney:
costofcapital discountrate requiredreturn.
Whatevertermisused,therateofinterestusedfordiscountingreflectsthecostofthefinancethatwillbetiedupintheinvestment.
5The Net Present Value (NPV)
ToappraisetheoverallimpactofaprojectusingDCFtechniquesinvolvesdiscountingalltherelevantcashflowsassociatedwiththeprojectbacktotheirPV.
Ifwetreatoutflowsoftheprojectasnegativeandinflowsaspositive,theNPVoftheprojectisthesumofthePVsofallflowsthatariseasaresultofdoingtheproject.
TheNPVrepresentsthesurplusfunds(afterfundingtheinvestment)earnedontheproject,therefore:
iftheNPVispositivetheprojectisfinanciallyviable iftheNPViszerotheprojectbreakseven iftheNPVisnegativetheprojectisnotfinanciallyviable ifthecompanyhastwoormoremutuallyexclusiveprojectsunder
considerationitshouldchoosetheonewiththehighestNPV theNPVgivestheimpactoftheprojectonshareholderwealth.
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What does the NPV actually mean?
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Assumptions used in discounting
Unlesstheexaminertellsyouotherwise,thefollowingassumptionsaremadeaboutcashflowswhencalculatingthenetpresentvalue:
Alsonote,youshouldneverincludeinterestpaymentswithinanNPVcalculationasthesearetakenaccountofbythecostofcapital.
allcashflowsoccuratthestartorendofayear initialinvestmentsoccurT0 othercashflowsstartoneyearafterthat(T1).
Thecashflowsforaprojecthavebeenestimatedasfollows:
Thecostofcapitalis6%.
Convert these cash flows to a PV.
Calculate the net present value (NPV) of the project to assess whether it should be undertaken.
Year $0 (25,000)1 6,0002 10,0003 8,0004 7,000
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Assumptions used in discounting
Test your understanding 3 Net present value
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Anorganisationisconsideringacapitalinvestmentinnewequipment.Theestimatedcashflowsareasfollows.
Thecompanyscostofcapitalis9%.
Calculate the NPV of the project to assess whether it should be undertaken.
Year Cash flow$
0 (240,000)1 80,0002 120,0003 70,0004 40,0005 20,000
6Advantages and disadvantages of using NPV
Advantages
TheoreticallytheNPVmethodofinvestmentappraisalissuperiortoallothers.Thisisbecauseit:
Disadvantages
considersthetimevalueofmoney isanabsolutemeasureofreturn isbasedoncashflowsnotprofits considersthewholelifeoftheproject shouldleadtomaximisationofshareholderwealth.
Itisdifficulttoexplaintomanagers Itrequiresknowledgeofthecostofcapital Itisrelativelycomplex.
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Test your understanding 4 Net present value
Advantages and disadvantages of NPV
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7Timesaving in the exam
AlthoughyouwillbeabletoperformalmostanyNPVcalculationusingtheaboveinformation,thereareanumberoftimesavingtechniquesthatcanhelpyouintheexam.
Present Value Tables
(1+r)niscalledthediscountfactor(DF). IntheexamyouwillbeprovidedwithaPresentValuetablethatgivesthediscountfactorsforvariousdifferentdiscountratesovervarioustimeperiod. So,tofindtheDF,forexampleifr=10%andn=5,youcan:
Whatamountshouldbeinvestednowtoreceive$10,000infouryears'timeifr=8%pa.
Showyourworkingsusingtheformulaapproachandthencomparethiswithusingthepresentvaluetable.
Discounting annuities
Anannuityisaconstantannualcashflowforanumberofyears.
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Test your understanding 5 Discounting using tables
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Apaymentof$1,000istobemadeeveryyearfor3years,thefirstpaymentoccurringinoneyearstime.Theinterestrateis10%.WhatisthePVoftheannuity?
Solution
ThePVofanannuitycouldbefoundbyaddingthePVsofeachpaymentseparately.
However,youcanseefromthetablethatthesumofalltheDFis2.486.
ThereforethePVcanbefoundmorequickly:
$1,0002.486=$2,486.
Time Payment DF @ 10% (from tables)
PV
$ $T1 1,000 0.909 909T2 1,000 0.826 826T3 1,000 0.751 751
2.486 2,486
Theannuity factor(AF)isthenamegiventothesumoftheindividualDF.
ThePVofanannuitycanthereforebequicklyfoundusingtheformula:
PV=AnnualcashflowAF
Likewithcalculatingadiscountfactor,theAFcanbefoundusingaformula.
Theformulais:
1(1+r)nAF=
r
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Illustration 2 Discounting annuities
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Apaymentof$3,600istobemadeeveryyearforsevenyears,thefirstpaymentoccurringinoneyearstime.Theinterestrateis8%.WhatisthePVoftheannuity.
Annuity Tables
JustasyouareprovidedwithaPresentValueTableintheexamshowingprecalculateddiscountfactors,youwillalsobeprovidedwithanAnnuityTable(sometimesreferredtoasaCumulativePresentValueTable),whichprovidesprecalculatedannuityfactorsforvariousdifferentdiscountratesovervariousperiods.
Soagain,youhaveachoice. Forexample,forathreeyearannuityat10%:
Note:theremightbeasmalldifferenceduetoroundings.
Thetablesshouldnotbeusedasasubstituteforknowinghowtousetheformula. Remember,thetablesonlycoverasmallrangeofdiscountratesandtimeperiodsandyoumayberequiredtocalculateadiscountfactororannuityfactorforvariablesoutsideofthisrange.
Apaymentof$11,400istobemadeeveryyearfor13years,thefirstpaymentoccurringinoneyearstime.Theinterestrateis5%.WhatisthePVoftheannuity.
Showyouworkingsusingboththeformulaapproachandtheannuitytable.
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Test your understanding 6 Discounting annuities
Test your understanding 7 Discounting annuities using tables
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Discounting perpetuities
A perpetuityisanannualcashflowthatoccursforever.
Itisoftendescribedbyexaminersasacashflowcontinuingfortheforeseeablefuture.
ThePVofaperpetuityisfoundusingtheformula
cashflowPV=
r or 1
PV=cashflow r
1 isknownastheperpetuityfactor. r
ThePVofagrowing perpetuityisfoundusingtheformula
1PV=cashflowatT1
r g1
isknownastheperpetuityfactor,withgrowthrg
Calculate the present value of the following, assuming a discount rate of 10%.
(1) $3,000receivedinoneyear'stimeandforever(2) $3,000receivedinoneyear'stime,thengrowingby2%perannum
inperpetuity
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Test your understanding 8 Discounting perpetuities
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Advanced and delayed annuities and perpetuities
Theuseofannuityfactorsandperpetuityfactorsbothassumethatthefirstcashflowwillbeoccurringinoneyear'stime.Annuityorperpetuityfactorswillthereforediscountthecashflowsbacktogivethevalueoneyearbeforethefirstcashflowarose.Forstandardannuitiesandperpetuitiesthisgivesthepresent(T0)valuesincethefirstcashflowstartedatT1.
Becareful:ifthisisnotthecase,youwillneedtoadjustyourcalculation.
Advanced annuities and perpetuities
Someregularcashflowsmaystartnow(atT0)ratherthaninoneyear'stime(T1).
CalculatethePVbyignoringthepaymentatT0whenconsideringthenumberofcashflowsandthenaddingonetotheannuityorperpetuityfactor.
Delayed annuities and perpetuities
SomeregularcashflowsmaystartlaterthanT1.
Thesearedealtwithby:
(1) applyingtheappropriatefactortothecashflowasnormal(2) discountingyouranswerbacktoT0.
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Delayed annuities: An illus trationAdvanced annuities: An illustrationAdvanced perpetuities : An illus trationAdditional question Adv anced annuities and perpetuitiesAdditional question Delayed annuities and perpetuities
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8The Internal Rate of Return (IRR)
TheIRRisanotherprojectappraisalmethodusingDCFtechniques.
TheIRRrepresentsthediscountrateatwhichtheNPVofaninvestmentiszero.Assuchitrepresentsabreakevencostofcapital.
Decision rule:
projectsshouldbeacceptediftheirIRRisgreaterthanthecostofcapital.
Calculating the IRR using linear interpolation
Thestepsinlinearinterpolationare:
where:
L=Lowerrateofinterest
H=Higherrateofinterest
NL=NPVatlowerrateofinterest
NH=NPVathigherrateofinterest.
(1) CalculatetwoNPVsfortheprojectattwodifferentcostsofcapital(2) UsethefollowingformulatofindtheIRR:
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IRR
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ThediagrambelowshowstheIRRasestimatedbytheformula.
ApotentialprojectspredictedcashflowsgiveaNPVof$50,000atadiscountrateof10%and$10,000atarateof15%.
Calculate the IRR.
FortheexaminationthechoiceofratestoestimatetheIRRislessimportantthanyourabilitytoperformthecalculationtoestimateit.
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Calculating the IRR
Test your understanding 9 IRR
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Abusinessundertakeshighriskinvestmentsandrequiresaminimumexpectedrateofreturnof17%paonitsinvestments.Aproposedcapitalinvestmenthasthefollowingexpectedcashflows:
Year 01234
$(50,000)18,00025,00020,00010,000
(1) CalculatetheNPVoftheprojectifthecostofcapitalis15%.(2) CalculatetheNPVoftheprojectifthecostofcapitalis20%.(3) UsetheNPVsyouhavecalculatedtoestimatetheIRRofthe
project.(4) Recommend,onfinancialgroundsalone,whetherthisprojectshould
goahead.
FindtheIRRofaninvestmentof$50,000iftheinflowsare:
(a) $5,000inperpetuity(b) $8,060foreightyears.
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Test your understanding 10 IRR
Test your understanding 11 IRR with even cash flows
Calculating the IRR with even cash flows
Calculating the IRR with perpetuities
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9Advantages and disadvantages of IRR
Advantages
TheIRRhasanumberofbenefits,e.g.it:
TheNPVmethodwouldsuggestthatProjectAmakesforabetterinvestment(itsimplycomparestheabsolutevalueoftheNPV). This,however,doesnotreflecttherelativesizeoftheinvestmenttobemadeinthisproject. A$20minvestmentislikelytohavehigherrisksandahigherreturnmightbeexpectedthanonly$0.2m. TheIRR,ontheotherhand,clearlyshowsthatProjectBprovidesamuchhigherreturnoninvestmentandaccountsforthefactthatProjectBinvolvesamuchsmallerscaleofinvestment.
Disadvantages
considersthetimevalueofmoney isapercentageandthereforeeasilyunderstood usescashflowsnotprofits considersthewholelifeoftheproject meansafirmselectingprojectswheretheIRRexceedsthecostof
capitalshouldincreaseshareholders'wealth isagoodwaytocompareprojectsofdifferentscales. Considerthe
followingtwoprojects: Project A Project B
Initialinvestment $20m $0.5mPresentvalueofreturns $20.2m $0.6mNPV $0.2m $0.1mIRR 2% 15%
Itisnotameasureofabsoluteprofitability. Interpolationonlyprovidesanestimateandanaccurateestimate
requirestheuseofaspreadsheetprogramme. Itisfairlycomplicatedtocalculate. NonconventionalcashflowsmaygiverisetomultipleIRRswhich
meanstheinterpolationmethodcan'tbeused.
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Advantages and disadvantages of IRR
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10NPV versus IRR
BothNPVandIRRareinvestmentappraisaltechniqueswhichdiscountcashflowsandaresuperiortothebasictechniquesdiscussedintheprevioussession.HoweveronlyNPVcanbeusedtodistinguishbetweentwomutuallyexclusiveprojects,asthediagrambelowdemonstrates:
TheprofileofprojectAissuchthatithasalowerIRRandapplyingtheIRRrulewouldpreferprojectB.Howeverinabsoluteterms,AhasthehigherNPVatthecompanyscostofcapitalandshouldthereforebepreferred.
NPVisthereforethebettertechniqueforchoosingbetweenprojects.
TheadvantageofNPVisthatittellsustheabsoluteincreaseinshareholderwealthasaresultofacceptingtheproject,atthecurrentcostofcapital.TheIRRsimplytellsushowfarthecostofcapitalcouldincreasebeforetheprojectwouldnotbeworthaccepting.
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PepperCoiscontemplatingthreeavailableinvestmentopportunities,thecashflowsofwhicharegivenbelow.
Ineachcasetheinitialinvestmentrepresentsthepurchaseofplantandequipmentwhoserealisablevaluewillbe20%ofinitialcost,receivableinadditiontotheaboveflowattheendofthelifeoftheproject.
Required:
Foreachofthethreeprojects:
Project Initial investment Cash flow
Y1 Y2 Y3 Y4 Y5
$000 $000 $000 $000 $000 $000
E (125) 50 50 50 50
F (120) 15 15 15 15 200
G (170) 120 80
(a) Calculatetheaccountingrateofreturn(basedontheaverageinvestmentmethod)
(b) Calculatethepaybackperiod(c) Calculatethenetpresentvalueusingadiscountrateof10%(d) Calculatetheinternalrateofreturn
The higher risk of a project can be recognised by decreasing
A thecostoftheinitialinvestmentoftheprojectB theestimatesoffuturecashinflowsfromtheprojectC theinternalrateofreturnoftheprojectD therequiredrateofreturnoftheproject
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Test your understanding 12 Appraisal techniques
Test your understanding 13
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Which of the following statements about net present value (NPV) and internal rate of return (IRR) methods are correct?
(i) AninvestmentwithapositiveNPVisfinanciallyviable(ii) NPVisasuperiormethodofinvestmentappraisaltoIRR(iii) ThegraphofNPVagainstdiscountratehasanegativeslopefor
mostprojects(iv) NPVisthepresentvalueofexpectedfuturenetcashreceiptsless
thecostoftheinvestmentA (i)and(ii)onlyB (ii)and(iv)onlyC (i),(ii)and(iii)onlyD (i),(ii),(iii)and(iv)
Which of the following is not an advantage of the IRR?
A ItconsidersthewholelifeoftheprojectB ItusescashflowsnotprofitsC ItisameasureofabsolutereturnD Itconsidersthetimevalueofmoney
Arburyplchasmadeaninvestmentwithanetpresentvalue(NPV)of$42,000at10%andanNPVof($22,000)at20%.
What is the internal rate of return of the project?
A 31.0%B 16.6%C 15.0%D 13.4%
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Test your understanding 16
Test your understanding 15
Test your understanding 14
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Acompanyisconsideringatwoyearprojectwhichhastwoannualinternalratesofreturn,namely10%and25%. Thesumoftheundiscountedcashflowsispositive.
The project will necessarily have a positive net present value, when the annual cost of capital is
A Morethan25%B Morethan10%C Between10%and25%D Lessthan25%
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Test your understanding 17
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Chapter summary
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Answer to additional question advanced
Answer to additional question delayed
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Test your understanding answers
F=$5,000(1+0.05)6
=$5,0001.3401
=$6,700
F 115,000P= = =$68,068
(1+r)n (1+0.06)9
Year Cash flow DF PV$ at 6% $
0 (25,000) 1.000 (25,000)1 6,000 0.943 5,6582 10,000 0.890 8,9003 8,000 0.840 6,7204 7,000 0.792 5,544
1,822
TheNPVoftheprojectispositiveat$1,822. Theprojectshouldthereforebeaccepted.
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Test your understanding 2 Discounting a single sum
Test your understanding 1 Compounding
Test your understanding 3 Net present value
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Year Cash flow DF at 9% PV$ $
0 (240,000) 1.000 (240,000)1 80,000 0.917 73,3602 120,000 0.842 101,0403 70,000 0.772 54,0404 40,000 0.708 28,3205 20,000 0.650 13,000
NPV +29,760
ThePVofcashinflowsexceedsthePVofcashoutflowsby$29,760,whichmeansthattheprojectwillearnaDCFreturninexcessof9%,i.e.itwillearnasurplusof$29,760afterpayingthecostoffinancing.Itshouldthereforebeundertaken.
TheamounttobeinvestedisthePVofthefuturesum.
P=$10,000/(1.08)4=$7,350
P=$10,0000.735=$7,350(usingtables).
Usingtheformula:
$3,6005.206=$18,741.60
1(1+r)n 1(1.08)7 = =5.206
r 0.08
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Test your understanding 6 Discounting annuities
Test your understanding 5 Discounting using tables
Test your understanding 4 Net present value
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Usingtheformula:
$11,4009.394=$107,091.60
Fromtheannuityfactortables,theAF=9.394.
1(1+r)n 1(1.05)13 = =9.394
r 0.05
$3,000(1) PV= =$30,000
0.1
$3,000(2) PV= =$37,500
0.10.02
50,000IRR= 10%+ (15%10%) =14.17%
50,000(10,000)
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Test your understanding 8 Discounting perpetuities
Test your understanding 9 IRR
Test your understanding 7 Discounting annuities using tables
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Year Cash flow
DF @ 15% PV @ 15% DF @ 20% PV @ 20%
$ $ $ 0 (50,000) 1.000 (50,000) 1.000 (50,000)1 18,000 0.870 15,660 0.833 14,9942 25,000 0.756 18,900 0.694 17,3503 20,000 0.658 13,160 0.579 11,5804 10,000 0.572 5,720 0.482 4,820
NPV +3,440 (1,256)
TheIRRisabove15%butbelow20%.
Usingtheinterpolationmethod:
(1) TheNPVis+3,440at15%.(2) TheNPVis1,256at20%.(3) TheestimatedIRRistherefore:
3,440IRR= 15%+ (2015)%
(3,440(1,256)= 15% +3.7%= 18.7%
(4) TheprojectisexpectedtoearnaDCFreturninexcessofthetargetrateof17%,soonfinancialgrounds(ignoringrisk)itisaworthwhileinvestment.
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Test your understanding 10 IRR
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Annualinflow $5,000(a) IRR= 100= 100=10%
Initialinvestment $50,000
(b) NPVcalculation
Cash flow DF(c) % PV$ $
Time0 Investment (50,000) 1 (50,000)18 Inflow 8,060 (b) (a)
NPV Nil
Theaimistofindthediscountrate(c)thatproducesanNPVofnil.
Thereforethepresentvalueofinflows(a)mustequalthepresentvalueofoutflows,$50,000.
Ifthepresentvalueofinflows(a)istobe$50,000andthesizeofeachinflowis$8,060,thediscountfactorrequiredmustbe50,0008,060=6.203.
Thediscountrate(c)forwhichthisisthe8yearfactorcanbefoundbylookingalongthe8yearrowofthecumulativediscountfactorsshownintheannuitytable.
Thefigureof$6.210appearsunderthe6%columnsuggestinganIRRof6%istheclosest.
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Test your understanding 11 IRR with even cash flows
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(a) Accounting rate of return
ForeachprojecttheARRhasbeencalculatedas:
anddepreciationhasbeencalculatedasinitialinvestmentscrapvalue.
Project E
Project F
Project G
Project E
Project F
$120k(4$15k)=$60k
$60k$200k=0.3
Paybackthereforehappensafter4.3yearsorapprox4years,4months
(Totalcashflowsdepreciation)projectlifeARR= 100%
(Initialinvestment+scrapvalue)2
($200k$100k)4ARR= 100% =33.3%
($125k+$25k)2
($260k$96k)5ARR= 100% =45.6%
($120k+$24k)2
($200k$136k)2ARR= 100% =31.4%
($170k+$34k)2 (b) Payback
$125kPayback= =2.5years
$50k
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Test your understanding 12 Appraisal techniques
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Project G
$170k$120k=$50k
$50k$80k=0.63
Paybackthereforehappensafter1.63years,orapprox1yearsand7months
Project E
NPV=($125k)+$50k3.170+$25k0.683=$50.6k
Project F
NPV=($120k)+$15k3.170+$200k0.621+$24k0.621=$66.7k
Project G
NPV=($170k)+$120k0.909+$80k0.826+$34k0.826=$33.2k
NPV@20%
Project E
NPV=($125k)+$50k2.589+$25k0.482=$16.5k
Project F
NPV=($120k)+$15k2.589+$200k0.402+$24k0.402=$8.9k
Project G
NPV=($170k)+$120k0.833+$80k0.694+$34k0.694=$9.1k
IRRs=
(c) NPV @ 10%
(d) Internal rate of return
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Project E
Project F
Project G
$50.6kIRR= 10%+ (20%10%) =24.8%
$50.6k$16.5k
$66.7kIRR= 10%+ (20%10%) =21.5%
$66.7k$8.9k
$33.2kIRR= 10%+ (20%10%) =23.8%
$33.2k$9.1k
Answer B
Theinternalrateofreturn(C)andthecostoftheinitialinvestment(A)areindependentoftheriskoftheproject. Thehighertheriskoftheproject,thegreater(notless)istherequiredrateofreturn(D).
Answer D
Allfourstatementsarecorrect. TheNPVmethodisextensivelyusedinpracticetoascertainwhetheraprojectisaviableinvestmentornot.
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Test your understanding 13
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Answer C
IRRisbasedondiscountedcashflowprinciples. Itthereforeconsidersallofthecashflowsinaproject(A),doesnotincludenotionalaccountingcostssuchasdepreciation(B)anditconsidersthetimevalueofmoney(D).
Itisnotanabsolutemeasureofreturn,however,astheIRRisexpressedasapercentage. TwoprojectscanhavethesameIRRbutverydifferentcashflows. Cisthereforeanincorrectstatement.
Answer B
TheIRRcanbecalculatedusingthefollowingformula.
If:
a=10%b=20%A=$42,000B=($22,000)
Then:IRR=a%+(A/(AB))(ba)%=10+0.6610=16.6%
Ifyouselected31.0%youdidnotaccountcorrectlyforthefactthattheNPVwasnegativeatadiscountrateof20%. Youtreatedthe$22,000NPVasapositivefigureinthecalculation. Ifyouselected13.4%youswappedAandBroundintheformula,usingA=$22,000andB=$42,000. Ifyouselected15.0%youhavesimplycalculatedthemidpointofthetworatesinsteadofusingtheIRRformula.
Answer A
ThegraphwouldbeUshapedwithanegativeNPVbetween10%and25%andpositiveNPVsatlessthan10%ormorethan25%.
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Test your understanding 16
Test your understanding 15
Test your understanding 17
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InvestmentappraisalfurtheraspectsofdiscountedcashflowsChapter learning objectives
Uponcompletionofthischapteryouwillbeableto:
explaintheimpactofinflationoninterestratesanddefineanddistinguishbetweenrealandnominal(money)interestrates
explainthedifferencebetweentherealtermsandnominaltermsapproachestoinvestmentappraisal
usethenominal(money)termsapproachtoappraiseaninvestment
usetherealtermsapproachtoappraiseaninvestment explaintheimpactoftaxonDCFappraisals calculatethetaxcashflowsassociatedwithtaxallowable
depreciationandincorporatethemintonetpresentvalues(NPV)calculations
calculatethetaxcashflowsassociatedwithtaxableprofitsandincorporatethemintoNPVcalculations
explaintheimpactofworkingcapitalonanNPVcalculationandincorporateworkingcapitalflowsintoNPVcalculations.
69
chapter
4
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1The impact of inflation on interest rates
Inflationisageneralincreaseinpricesleadingtoageneraldeclineintherealvalueofmoney.
Intimesofinflation,thefundproviderswillrequireareturnmadeupoftwoelements:
Theoverallrequiredreturniscalledthemoneyornominalrateofreturn.
realreturnfortheuseoftheirfunds(i.e.thereturntheywouldwantiftherewerenoinflationintheeconomy)
additionalreturntocompensateforinflation.
Therealandmoney(nominal)returnsarelinkedbytheformula:
(1+i)=(1+r)(1+h)
where
i=moneyrate
r=realrate
h=inflation
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$1,000isinvestedinanaccountthatpays10%interestpa.Inflationiscurrently7%pa.
Find the real return on the investment.
Iftherealrateofinterestis8%andtherateofinflationis5%,whatshouldthemoneyrateofinterestbe?
2The impact of inflation on cash flows
Wherecashflowshavenotbeenincreasedforexpectedinflationtheyaredescribedasbeingin current prices,ortoday's prices.
Wherecashflowshavebeenincreasedtotakeaccountofexpectedinflationtheyareknownasmoney cash flows,ornominal cash flows.Remember,iftheydotakeinflationintoaccount,theyrepresentexpectedflowsofmoney,hencethetermmoneycashflows.
You can assume that cash flows you are given in the exam are the money cash flows unless told otherwise.
Iftheexaminerspecifiesthatthecashflowsareincurrentpricetermsyouwillgenerallyneedtoputtheseinmoneytermsbeforeyoucandiscountthem(althoughseeothermethodsofdealingwithinflationbelow).
Makesureyoureadthequestioncarefully.SometimesyouwillbegiventhecashflowsinYear1termswithsubsequentinflation.
Forexampleifthequestiontellsyouthatsalesforthenext3yearsare$100incurrenttermsbutareexpectedtoinflateby10%,thenwhatheactuallymeansisthatthesaleswillbe:Year1: $110Year2: $121 i.e.thesearethecashflowsinmoneytermsYear3: $133.10
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Illustration of relationship between inflation and interest rates
Test your understanding 2 Money and real returns
Test your understanding 1 Money and real returns
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Forexampleifthequestionsays"Saleswillbe$100inthefirstyear,butaretheygoingtoinflateby10%forthenexttwoyears",thenthesaleswillbe:Year1:$100Year2:$110 comparethesetothepreviousexamplemakesureYear3:$121 youunderstandwhytheyaredifferent!
TheimpactofinflationcanbedealtwithintwodifferentwaysbothmethodsgivethesameNPV.
StormCoisevaluatingProjectX,whichrequiresaninitialinvestmentof$50,000.Expectednetcashflowsare$20,000perannumforfouryearsattodaysprices.Howevertheseareexpectedtoriseby5.5%pabecauseofinflation.Thefirmsmoneycostofcapitalis15%.
Find the NPV by:
(a) discountingmoneycashflows(b) discountingrealcashflows.
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Test your understanding 3 Money and real methods
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Aprojecthasthefollowingcashflowsbeforeallowingforinflation,i.e.theyarestatedattheirT0values.
Thecompanysmoneydiscountrateis15.5%.Thegeneralrateofinflationisexpectedtoremainconstantat5%.
Evaluate the project in terms of:
Timing Cash flow$
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(a) realcashflowsandrealdiscountrates(b) moneycashflowsandmoneydiscountrates.
3Specific and general inflation rates
TheTYUs givenabovehadallcashflowsinflatingatthegeneralrateofinflation.Inpractice,inflationdoesnotaffectallcoststothesameextent.Insomeinvestmentappraisalquestionsyoumaybegiveninformationonmorethanoneinflationrate. Inthesesituationsyouwillhaveinformationonbothspecificinflationratesandgeneralinflationrates.
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Test your understanding 4 Money and real methods
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Insituationswhereyouaregivenanumberofspecificinflationrates,therealmethodoutlinedabovecannotbeused.
Thefollowinggivesausefulsummaryofhowtoapproachexaminationquestions.
Ifaquestioncontainsbothtaxandinflation,itisadvisabletousethemoneymethod.
Intheexamination,forashortlifeproject,withcashflowsinflatingatdifferentrates,itisbesttosettheNPVcalculationoutwiththecashflowsdownthesideandthetimeacrossthetop.
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Specific and general inflation rates
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Acompanyisconsideringacostsavingproject.Thisinvolvespurchasingamachinecosting$7,000,whichwillresultinannualsavings(inrealterms)onwagecostsof$1,000andonmaterialcostsof$400.
Thefollowingforecastsaremadeoftheratesofinflationeachyearforthenextfiveyears:
Thecostofcapitalofthecompany,inrealterms,is8.5%.
Evaluate the project, assuming that the machine has a life of five years and no scrap value.
Wagecosts 10%Materialcosts 5%Generalprices 6%
4Dealing with tax in NPV calculations
Sincemostcompaniespaytax,theimpactofcorporationtaxmustbeconsideredinanyinvestmentappraisal.
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Test your understanding 5 General and specific inflation rates
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The impact of taxation on cash flows
CorporationtaxchargedonacompanysprofitsisarelevantcashflowforNPVpurposes.Itisassumed,unlessotherwisestatedinthequestion,that:
operatingcashinflowswillbetaxedatthecorporationtaxrate operatingcashoutflowswillbetaxdeductibleandattracttaxreliefatthe
corporationtaxrate investmentspendingattractstaxallowabledepreciation thecompanyisearningnettaxableprofitsoverall(thisavoidsany
issuesofcarryinglossesforwardstoreducefuturetaxation). taxispaidoneyearaftertherelatedoperatingcashflowisearned
(unlesstoldotherwise)
Taxallowable depreciation
Fortaxpurposes,abusinessmaynotdeductthecostofanassetfromitsprofitsasdepreciation(inthewayitdoesforfinancialaccountingpurposes).
Insteadthecostmustbedeductedfromtaxableprofitsintheformoftaxallowabledepreciation.Thebasicrulesareasfollows:
taxallowabledepreciationiscalculatedbasedonthewrittendownvalueoftheassets(thiswilleitherbeonareducingbalanceorstraightlinebasisreadthequestioncarefully)
thetotalamountoftaxallowabledepreciationgivenoverthelifeofanassetwillequatetoitsfallinvalueovertheperiod(i.e.thecostlessanyscrapproceeds)
taxallowabledepreciationisclaimedasearlyaspossible taxallowabledepreciationisgivenforeveryyearofownershipexcept
theyearofdisposal intheyearofsaleorscrapabalancingallowance(BA)orbalancing
chargearises(BC).
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The impact of taxation on cash flows
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$Originalcostofasset XCumulativetaxallowabledepreciationclaimed (X)
Writtendownvalueoftheasset XDisposalvalueoftheasset (X)
Balancingallowanceorbalancingcharge X
Anassetisboughtfor$10,000andwillbeusedonaprojectforfouryearsafterwhichitwillbedisposedof.Taxispayableat30%,oneyearinarrears,andtaxallowabledepreciationisavailableat25%reducingbalance.
Required:
(a) Calculatethetaxallowabledepreciationandhencethetaxsavingsforeachyeariftheproceedsondisposaloftheassetare$2,500.
(b) Howwouldyouranswerchangeiftheassetwassoldfor$5,000?(c) Ifnettradingincomefromtheprojectis$8,000pa,basedonyour
answertopart(a)andacostofcapitalof10%,calculatetheNPVoftheproject.
Fortaxpurposescaremustbetakentoidentifytheexacttimeofassetpurchaserelativetotheaccountingperiodend. However,unlessyouaretoldotherwiseintheexamyoushouldassumethatanassetispurchasedonthefirstdayofanaccountingperiod(T0)andthatthefirstamountoftaxallowabledepreciationisgivenoneyearlateratT1.
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Test your understanding 6 Balancing allowance or charge
Timing of asset purchase and sale
Taxallowable depreciation
Additional question: Timing of asset purchase and sale
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5Incorporating working capital
Investmentinanewprojectoftenrequiresanadditionalinvestmentinworkingcapital,i.e.thediffer