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ACCA Paper F9 – Financial Management

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Paper F9 Financial Management

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+AddVanceData MapContentsISBM and Copyright statementFor the ladies only+AddVance Study textOur aimThere are 15 tutorialsReference icons and colour codesThe syllabus outline and our pathway along it ….Contents of an+AddVance tutorialA lighthearted but not lightweight approach to studyingWhy study from a computer screen?Electronic links within the databasePrint outs

SyllabusThe structure of the syllabusIntellectual levelsLearning hoursGuide to exam structureGuide to examination assessmentAimMain capabilitiesRelational diagram of main capabilitiesRationalDetailed syllabusApproach to examining the syllabus

Study guideA. Financial management functionB. Financial management environmentC. Working capital managementD. Investment appraisalE. Business financeF. Cost of capitalG. Business valuationsH. Risk management

PV tableAnnuity tableFormulae sheetSymbols and notations

Route maps Tutorial pathway

ACCA Paper F9Financial Management

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ActivityThis is a short problem that exercises your understanding of the topic concerned.

Activity answerA step by step answer that allows you to assess how well you have addressed the problem. The answer is positioned immediately after the activity.

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TUTORIAL 1THE

FINANCIAL MANAGEMENT

FUNCTION

TUTORIAL 2STAKEHOLDERS

AND THEIR IMPACT ON CORPORATE OBJECTIVES

TUTORIAL 3OBJECTIVES IN

NOT-FOR-PROFIT ORGANISATIONS

TUTORIAL 4FINANCIAL ANALYSIS

TUTORIAL 5THE ECONOMIC ENVIRONMENT FOR BUSINESS

TUTORIAL 6WORKING CAPITAL

MANAGEMENT

TUTORIAL 7WORKING CAPITAL

NEEDS, CASH MANAGEMENT AND FUNDING STRATEGIES

TUTORIAL 8THE NATURE AND ROLE OF FINANCIAL

MARKETS AND INSTITUTIONS

TUTORIAL 9BUSINESS FINANCE

TUTORIAL 10CAPITAL

INVESTMENT APPRAISAL:

NATURE AND TECHNIQUES

TUTORIAL 11CAPITAL

INVESTMENT APPRAISAL:

APPLICATIONS

TUTORIAL 12BUSINESS

VALUATIONS

TUTORIAL 13COST OF CAPITAL

TUTORIAL 14GEARING

AND CAPITAL STRUCTURE CONSIDERA-

TIONS

TUTORIAL 15RISK

MANAGEMENT

The syllabus outline and our pathway along it ….

‘Click and flick’ from this screen to your +AddVance tutorials.

SAMPLECHAPTER





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The syllabus outline and our pathway along it ….

Tutorial Link

TUTORIAL 1The financial management function

28

TUTORIAL 2Stakeholders and their impact on corporate objectives

54

TUTORIAL 3Objectives in not-for-profit organisations

80

TUTORIAL 4Financial analysis

91

TUTORIAL 5The economic environment for business

124

TUTORIAL 6Working capital management

158

TUTORIAL 7Working capital needs, cash management and funding strategies

209

TUTORIAL 8The nature and role of financial markets and institutions

256

TUTORIAL 9Business finance

299

TUTORIAL 10Capital investment appraisal: Nature and techniques

339

TUTORIAL 11Capital investment appraisal: Applications

382

TUTORIAL 12Business valuations

440

TUTORIAL 13Costs of capital

483

TUTORIAL 14Gearing and capital structure considerations

532

TUTORIAL 15Risk management

586

The beginning is the most important part of any work.

Plato370 B.C.





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List of important Symbols

d0 Current dividendd1 Next dividenddn Dividend in year ng Expected annual percentage growth in dividendsi Annual interest paymentP0 Current market value of a securityVe Market value of equityVd The market value of debtVb The market value of a bondVa Total market value of a firmT Rate of corporation (or corporate) taxke Cost of equitykp Cost of preference shareskd Cost of debtWACC Weighted average cost of capitalre Expected return of equityrp Expected return of preference sharesrd Expected return of debtrf Risk-free interest raterm Expected return on the market portfolioß Beta factorßa Asset betaße Equity betaßd Debt betaPV Present valueNPV Net present valeIRR Internal rate of returnEPS Earnings per shareROE Return on equityPBIT Profit before interest and taxR Real rate of returnM Nominal (or money) rate of returnP Inflation rate that affects purchasing powerCh Cost of holding inventoryC0 Cost of a purchase receiptD Annual demand for materialJIT Just in timeEOQ Economic order quantityF0 Expected spot rateS0 Current spot rateic Interest rate of country Cib Interest rate of country Bhc Interest rate of country Chb Interest rate of country B





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Economic order quantity

Miller-Orr Model

The capital Asset Pricing Model

The asset beta formula

The Growth Model

Gordon’s growth approximation

The weighted average cost of capital

The Fisher formula

Purchasing power parity and interest rate parity

HCD02C

=

+= spread x 31 limit Lower point Return

( ) ( )( )fR - mrEi fR irE β+=

31

rateinterest flowscash of ariancecost x vaction x trans4

3 3 Spread

=

( )( ) ( )( ) T - 1dV eVT) - (1 dV

T - 1dV eVeV a

++

++

= de βββ

( )( )g - er

g 1 0D 0P

+=

ebr =g

( ) ( ) ( ) T - 1 dk dV eV

dV ek

dV eVeV WACC

++

+=

( ) ( )( )h 1r 1 i 1 ++=+

( )( )

( )( )bi 1

ci 1 x 0s 1f bh 1ch 1 x 0s 1s +

+=++=





9

payment until periods ofnumber n ratediscount r here

n-r) (1 i.e. 1 of valuePresent

Table ValuePresent

==

+





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“It has always been an axiom of mine that the little things are infinitely the most important.”

Sherlock HolmesArthur Conan Doyle, 1859 - 1930

( )

periods ofnumber n ratediscount r Where

rn -r) 1 - 1 i.e. 1 of annuity an of valuePresent

Table Annuity

==

+





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Tutorial 10Investment appraisal –Nature and techniques

ACCA Paper F9 Financial Management





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In this tutorial:

The capital budgeting cycle. Types of capital expenditure. Working capital. Capital expenditure forecast. Capital Expenditure Committee. Capital expenditure decision. Authorisation of capital projects. Capital expenditure control. Evaluation of alternative investments. Determination of business strategy. Establishing investment funding implications. Undertake initiate initial investment feasibility study. Detailed business case. Project authorisation. Control of authorised projects. Post-implementation review. Introduction to capital investment appraisal Cashflows and their timing. Opportunity costs and cashflow. Main evaluative criteria. Three project scenarios. The payback method. Calculation of the payback period. The effect of tax on the payback period.; Limitations and strengths. The ARR method. Calculation of ARR. Limitations and strengths. Compound interest. Discounting. Annuities. Perpetuities. Different approaches. Risk adjustment. IRR method. Use of linear Interpolation. Projects with constant cash flows. Cash flows which are perpetuities. Multiple internal rates of return Implications of the IRR. Conflict between NPV and IRR. Advantages of DCF and advantages/limitations of IRR and NPV.





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The capital budgeting process

1. The capital budgeting cycle

An ongoing feature of business activity is the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn, in the future, an income greater than the funds committed. This indicates the need for an assessment of:

(a) the size of the outflows and inflows of funds, (b) the life or the investment, (c) the degree of risk attached (greater risk being justified perhaps by greater returns), and (d) the cost of obtaining funds.

Particularly in recent years many chief executives and boards of directors have made, or are still contemplating, major investments in advanced manufacturing technology as part of a world-class manufacturing strategy to strengthen or sustain their competitive position. Such decisions are particularly difficult in periods of cash shortage, but equally important if companies are going to hold or build their market share.

2. Types of capital expenditure

Reasons for capital expenditure vary widely. Projects may be classified into the following categories:(a) Maintenance - replacement of worn out or obsolete assets, safety and security, etc.(b) Profitability - increasing profit by cost savings, quality improvement, productivity, relocation, etc.(c) Expansion - new products, new outlets, research and development, etc.(d) Indirect - office building, welfare facilities, etc.

A particular investment project, of course, could combine any number or all of the above classifications.Note that not all expenditure will be termed capital according to accepted accountancy definitions. For example, it may be decided to write off expenditure in the year in which it is incurred, rather than capitalising it and then writing it off over a period of years, In this context, most organisations have a de minimus rule, under which any asset costing under a given sum is not capitalised but is written off in the year of purchase, despite the fact that it may be used for several years to come; relevant accounting standards will of course need to be observed. However, the important consideration is that cash is being spent now in the expectation of future cash profits. For example, whether the decision is to spend on a new machine or to relocate an existing machine, identical considerations will apply: size of cash outflows and inflows, timing of cash flows, life of project, etc.

Even projects unlikely to earn profits must be subjected to investment appraisal, in order to choose the best way of achieving the project's objectives. For example, investment appraisal can be used to find the cheapest method for constructing a staff canteen, although such a project is unlikely to earn profits.

3. Working capital

In most industrial projects, investment is required in working capital as well as fixed asset capital, although the risk attached to working capital is less than that for fixed asset capital. Working capital normally does not depreciate. Values of land and buildings may appreciate and so present less risk, but money invested in machinery is a sunk cost, which is unlikely to be recovered, save for perhaps minimal scrap values.

4. Capital expenditure forecast

(a) Allocation of fundsIn preparing capital budgets, it is necessary to consider how much money can or must be allocated to capital expenditure. Capital development schemes may be started because a surplus of cash resources is revealed by the long-term plan, but usually management decide on a capital development scheme and seek the means to finance it.





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(b) Reasons why funds are requiredInitially, the budget will be an expression of management's intention to allocate funds for certain broad purposes. In the budget period, money will be required for

(i) existing projects previously authorised; and(ii) new projects, full details of which may not yet be available.

The forecasts will indicate whether sufficient funds are available, and perhaps when additional funds will need to be obtained. It is advisable, therefore, for managers to submit long-term capital expenditure forecasts, say for two to five years ahead; consequently, the possibility of obsolescence (and the direction of the future development of the firm) must be borne in mind.

(c) A dual processThe capital budget is the outcome of a dual process:

(i) higher management allocating funds to various areas in relation to the corporate plan, i.e. according to the long-term strategic objectives of the company; and

(ii) individual managers seeking to utilise the funds for specific projects.

(d) Capital budgeting is importantThe importance of this aspect of planning cannot be over-emphasised, because present capital investment will determine the structure and profitability of the company in the near future. Errors made in forecasting and planning will, therefore, have serious results, and may prove difficult to rectify.

(e) The capital budget 'rolls‘The capital budget usually 'rolls' on an annual basis. As an extra year of budget is added the first year (past year) is removed. Figure 10.1illustrates the rolling nature of the budget. The Capital Budget

normally ‘rolls’ period by period.

2010 2011 2012 2013 2014

2011 2012 2013 2014 2015

1st year of budget

2nd year of budget

3rd year of budget

4th year of budget

5th year of budget

Ist year of budget

2nd year of budget

3rd year of budget

4th year of budget

5th year of budget

The Capital Budgeting model shown below assumes a FIVE year budget period.

CAPITAL EXPENDITURE ITEMS AND PROJECTS

The Capital Budget “rolls”, perhaps on an annual basis.

The first year is “removed” from the budget and the remaining four years are updated in light of new (“ex post”) information. A “new” fifth year is added to the budget period.

The ‘rolling’ capital budget system

Figure 10.1: The ‘rolling’ capital budget system





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5. Capital expenditure committee

(a) The committeeAssuming a large company, a capital expenditure committee may be formed, either as a sub-committee of the budget committee or as a separate meeting of the entire budget committee. In a small/medium sized company it is usually the board of directors.

(b) The functions of the committeeThe functions of such a committee are to:

(i) Co-ordinate capital expenditure policy.(ii) Appraise and authorise capital expenditure on specific projects.(iii) Review actual expenditure on capital projects against the budget.

(c) Project teamsOften, multi-disciplinary teams, or working parties, are set up to investigate individual proposals and report back to top management on their findings. Such a team might comprise:

(i) project engineer,(ii) production engineer,(iii) accountant,(iv) relevant specialist, e.g.:

- human resources officer, say for a project involving sports facilities or canteen facilities; and/or- safety officers, etc.,

(v) economist.

Figure 10.2 shows the stages involved in the capital budgeting cycle, the position of the expenditure committee and the support expected from accountants at the different stages of the cycle.

6. Capital expenditure decision

(a) The capital investment decision is criticalThe crucial importance of all decisions relating to capital expenditure must be stressed. Decisions made at this time will affect the direction and pace of the company's future growth or, indeed, its very survival. If a wrong decision is made, it will be difficult to correct, particularly where special-purpose plant is involved.

(b) The organisation becomes committedIt has frequently been reported that in both the private and public sectors, investment decisions are made rather casually and this laxity has been one of the causes of lack of growth in the UK economy. Of all the decisions taken by management, those concerned with investment are the most crucial: once made, they may fix the future of the company in terms of its technological role, cost structure and market effort required, i.e. once the product has been selected and the plant built, the company is committed to the specific cost structure which accompanies that particular type of plant and product made.

7. Authorisation of capital projects

(a) Detailed proposals are submittedThe capital budget will be based on a detailed analysis of required projects. It is likely that managers will be asked to forecast their capital expenditure requirements for inclusion in the budget and it is necessary for detailed proposals to be submitted to the committee before the project may be started.





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Business strategy

Typical strategic objectives:

Cost reduction Quality improvement Market penetration Market development Product development Product-market diversification Acquisition

Implementationof strategy

calls forinvestments

Identifying investment need

- Senior managers- Business unit managers- Other managers

Investments are required for:

Replacement of technology Maintenance of asset level

(with growth) New technology Acquisition Market development

(advertising, etc.) Staffing costs

The Capital budgeting process

Managers are aided by financial

specialists

Businesscase

Investmentproposal

Business case includes details of:

Initial investment costs Useful earning life of investment Running costs – year by year Benefits of the investment

- detailed Consequences of not investing

- detailed Financial evaluations, including:

- payback period- accounting rate of return (ARR)

- net present value (NPV) - accounting rate of return- sensitivity projections- risk assessment- tax implications

Decision unitsay, ‘Expenditure Committee’

Decision

Investment proposal rejected

Managers are aided by financial

specialists

Modification required

Investment proposal approved

Entered as part of strategic (capital)

budget

Expenditure controlled by

normal budget disciplines

Financial specialists control the strategic (capital) budget

Capitalexpenditureappraisaltechniques

Figure 10.2: The Capital budgeting process





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(b) Independent investment decisionsMany projects will incur fairly small expenditure and, in order not to involve the committee in unnecessary detail, broad guidelines ought to be laid down regarding the amounts of expenditure which may be committed by each level of management. Top management must see that the types of expenditure to be treated as capital are clearly defined, and that every subordinate or committee knows precisely the limits to which s/he or they can approve capital expenditure.

(c) The detail requiredCapital expenditure requiring approval by the committee must be formulated by the managers. The amount of detail should be stipulated by the committee. Major projects would probably be subjected to a comprehensive financial evaluation, as part of the committee's consideration; less important projects could be submitted, accompanied by an economic justification.

8. Capital expenditure control

(a) Strict control must be maintainedStrict control of large projects must be maintained and the accountant should submit periodic reports to senior management on progress and cost. A typical report would include such data as:

(i) Budgeted cost of the project, date started and scheduled completion date.(ii) Cost and over or under, expenditure to date.(iii) Estimated cost to completion, and estimated final over or under, expenditure.(iv) Estimated completion date and details of any penalties, if any.

(b) Overspending needs to be explainedThe capital expenditure committee will seek explanations for any overspending that may have arisen. Where projects are incomplete and actual expenditure exceeds the authorisation, additional authority needs to be sought to complete the projects. In so doing, the committee must consider the value of the project as it then stands and the additional value that will be gained by completing it, compared with the additional expenditure to completion.

A vital consideration is the adequacy of funds available. Where existing projects are overspending their allocation, other perhaps more desirable projects, may be delayed. When reviewing progress, therefore, the committee must consider the funds available, in the light of which it may become necessary to revise the order of priority in which funds are awarded to projects.

The approach to project appraisal

1. Evaluation of alternative investments

(a) The crucial first stageThe careful evaluation of alternative investments then is a crucial first stage in successfully employing capital budgeting, and financial managers should make a significant input as part of a structured team approach. Decisions made will substantially affect the business's performance when implemented, and if incorrect judgments are made it is unlikely the decision process could be easily reversed, and therefore a damaging, negative business performance is likely to be the outcome.

Remember the‘application > appraisal > authorisation’

cycle.





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(b) Eight steps are involved We now examine eight major steps involved in successfully evaluating and controlling proposed major capital investments. The financial manager will make effective inputs to the work of 'expert teams/committees' created to oversee the selection, implementation and maintenance of the investments. The steps are:

(i) Determination of business strategy.(ii) Establishing investment funding implications and prioritising investment cases.(iii) Undertake initial investment feasibility study.(iv) Prepare detailed business case.(v) Project authorisation.(vi) Effective control of authorised projects.(vii) Undertake post-implementation review.(viii) Develop action plans for continuous improvement.

We look at each step below.

(i) Determination of business strategy.The strategic decision to invest in large capital projects should flow from an assessment of the business strategy; in particular how to create and sustain competitive advantage in the marketplace. This must be a board-level decision based on hard-nosed strategic analysis rather than detailed investment appraisal.

The assessment of business strategy should lead to the formulation of inter-linking product-market, research and design, manufacturing and financial strategies. A full discussion of strategy formulation is beyond the scope of this syllabus but it will be recognised that capital investment policy should flow from the assessment of business strategy.

(ii) Establishing investment funding implications and prioritising investment casesSocial and environmental pressure are resulting in an increasing proportion of many companies' capital investment programmes being in respect of non-profit adding projects, e.g. improved welfare facilities, safety and environmental expenditure etc. It is important to establish the likely scale of investments required overall for the company, and whether adequate funding will be available.

Once the strategic decisions have been taken, funding availability determined and investment policy formulated, the evaluation of the different business and other investment proposals prior to final approval is the key stage. In large companies it is preferable to undertake initial investment feasibility studies on major investments before giving agreement to move to more detailed evaluation of alternative proposals.

(iii) Undertake initial investment feasibility study

It is probable that not only will limited funds be available for investment, but so also the resources to evaluate and successfully implement projects. Therefore, it is essential that only key important investments are worked upon.

It is advisable that prior to any detailed technical and financial work being undertaken, an outline of the proposed investment should be submitted to the investment committee or its equivalent.

(iv) Prepare detailed business case

The preparation of a business case for each major investment proposal is the crucial stage in the successful evaluation of the company's investment policy. Motteram and Sizer suggest that a detailed financial evaluation will comprise a number of components. These are summarised in Table 10.1.





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Table 10.1COMPONENTS OF FINANCIAL EVALUATION OF BUSINESS CASE

1 INVESTMENT COSTS- including costs of planning, purchasing, installing, commissioning plant and

machinery and related computer hardware and software.

2 RUNNING COSTS

3 BENEFITS OF INVESTMENT- Cost savings- Increased flexibility- Reductions in working capital- Market factor benefits- Taxation and investment grants

4 CONSEQUENCES OF NOT INVESTING

5 APPRAISAL- including sensitivity of cashflows, DCF returns or NPVs and payback periods to

variations in key assumptions.

The important aspects of each element in Table 10.1 are discussed below.

- Investment costs

Investment costs include costs of planning, purchasing, installing and commissioning plant and machinery, and related computer hardware and software. Overspends tend to occur because of these expenditures and it is advisable to test the sensitivity of cashflows and measures of profitability in both initial spend and time scales.

- Running costs

When building the model of estimated running costs it is necessary to build in operating cycle times, learning curves, fixed and variable costs, support costs, costs of maintenance and any other costs which are peculiar to an individual proposal. The assumptions in the forecast need to be tested for sensitivities.

- Benefits of the investment

When evaluating benefits to be derived from the capital investment proposal it is useful to differentiate between: cost savings (such as reductions in direct costs, savings in scrap and space, and increased versatility), reductions in working capital (inventory and other current assets items), and benefits arising from increased competitive advantages.

- Consequences of not investing

When evaluating the financial and other implications of a capital investment it is always useful to consider the zero-change position, and to evaluate its possible effects. It is possible that the company is facing a reduced competitive strength and thus a loss of market share, also rising costs, falling real selling prices and squeezed contributions. It is important not to be over-pessimistic about the consequences of not investing. Over pessimism is often the political consequence of the eagerness of the project champion to get the project authorised.





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- Taxation and investment grantsInvestment projects should be assessed on post-tax and investment-grant basis. In international business it is important to consider different tax regimes, rates of capital allowances and tax and timings of payments. These can vary significantly between one country state and another. The effects of possible future political changes within the life-cycle time of the proposal may be built into the evaluation model, but in practice this is often difficult to accomplish.

- Test sensitivity of cashflows, DCF rates of return, and payback periodsBy this stage in the preparation of the business case it is possible to produce cashflows and financial evaluations in the forms of payback periods, accounting rate of return (ARR), net present value (NPV) and the internal rate of return (IRR). It is important that the key assumptions which underpin these financial evaluations are identified, and the sensitivity of these assumptions are tested, so that the committee is presented with a complete picture of the range of possible project outcomes. The expenditure committee should not be presented with a single 'most likely', or worst, or 'most optimistic' set of cash flow and profitability measures.

(v) Project authorisationThe completed business case should be presented to the investment committee, and subsequently to the board of directors, for approval.

It must be recognised that the business case evaluation data will be couched in both financial and non-financial terms and therefore management judgment will be the predominant arbitration.

(vi) Effective control of authorised projectsTo repeat what was discussed previously. Strict control of large projects must be maintained and the accountant should submit periodic reports to senior management on progress and cost.

(vii) Undertake post-implementation reviewAfter implementation of the project, audit(s) should be undertaken to examine its profitability and compare it with the plan. Also a post-completion audit should be undertaken which will take the character of a post-mortem. There are three main reasons for undertaking these audits:

- To discourage managers from spending money on doubtful projects, because they know they may be called to account at a later date.

- It may be possible over a period of years to discern a trend of reliability in the estimates of various managers.

- A similar project may be undertaken in the future, and then the recently completed project will provide a useful basis for estimation.

8 steps for developing an investment strategy

1 Business strategy2 Prioritising investment need 3 Feasibility study4 Detailed business case5 Project authorisation6 Control7 Post-implementation review8 Planning for continuous improvement





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Capital investment appraisal techniques

1. Introduction

We have seen as part of the capital budgeting process that there are various techniques available to determine if new investments or projects should be undertaken. The techniques can be applied to any type of investment (made by individuals or corporations) where the financial implications can be identified. We shall, however, examine them exclusively in relation to corporate investments made with the objective of maximising the benefit to ordinary shareholders, i.e. maximising shareholders' wealth. We are not concerned here with different types of investment, examining how cashflows can be identified or whether cashflows are relevant or not for a particular investment; we will consider these in a later study. An investment will simply mean something which involves an initial capital outlay and which produces future cash inflows. We shall also assume, at this stage, that there are no constraints on the investments which can be undertaken; for example, there will be no limitation on the amount of capital available.

2. Cashflows and their timing

The following "sign" conventions will apply to all investments:

(a) Cash outflows or expenditure are represented by negative figures.(b) Cash inflows or income are represented by positive figures.

The timing of cashflows is very important in an investment appraisal; for convenience an annual time scale is used where:

0 represents the date of making an investment (i.e. 'present' time)1 represents the date one year after the initial investment. It is the last day of the first year in

the life of the investment and also is the beginning of the second year.2 represents the last day of the second year and beginning of the third year of an investment, and

so on.

It is important to remember that 0, 1, 2 etc., represent points in time. Many cashflows will, however, cover periods of time, e.g. wages, overheads and sales. It is usual to aggregate these and treat them as arising at the end ( last day) of the year in which they occur.

3. Opportunity costs and cash flow

(a) Incremental costAn incremental cost is the additional cost incurred as a result of the investment. It is therefore important to identify cash flows (both sales and cash costs) which occur specifically because of the investment or project.

(b) Opportunity costAn opportunity cost (or ‘relevant cost’ ) is the amount of income foregone or the amount of cost savings foregone if one alternative were chosen instead of another. In other words, it is the economic benefit (income or cost savings) that was foregone by choosing one alternative over another. There is no actual payment for an opportunity cost nor is it usually recorded in accounting records. However, an opportunity cost is relevant to certain capital investment decisions because it meets the following relevant cash flow conditions:

(i) it is an expected future payment caused by the investment, or(ii) it is a sales receipt foregone because of the investment,

both of which will reduce the firm's future cash flow.





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An example for demonstrating an opportunity cost is factory capacity. There is either an alternative use for the factory capacity or there is no alternative use. An opportunity cost exists if there is an alternative use for the factory capacity that can generate income or cost savings.

The following two lists provide a quick revision of your previous studies in the topic of opportunity costing:

(i) Costs not affecting future cash flow:- sunk cost- committed cost- allocated or absorbed fixed overhead

(ii) Costs that would affect future cash flow:- payment made as a result of the project- cash receipt foregone because of the investment- incremental cost- avoidable cost- differential cost- opportunity cost.

Definitions

Relevant costRelevant cost analysis involves the identification and comparison of the relevant costs and revenues for each alternative being considered in the decision process. The costs and revenues that affect a decision are relevant. The costs and revenues that do not affect a decision are irrelevant.

Sunk costA cost which has already been incurred (or committed) is considered sunk and is not relevant in the decision process. A sunk cost is always irrelevant because it is not a future expected cost and will not affect a firm's future cash flow.

Incremental costAn incremental cost is the extra cost incurred as a result of the decision.

Avoidable costAn avoidable cost is the specific cost of an activity which could be avoided if the activity did not exist.

Differential costA differential cost arises from the comparison of the relevant costs of two options and the identification of the difference.

End of definitions

Activity 10.1

Buckland Company is a manufacturer of medical equipment and is proposing to start project BK, a new product line. This project would be for the four years from the 1 January 2010 to the 31 December 2013. There would be no production of the new product after 2013.

You have recently joined the company's accounting and finance team and have been provided with the following information relating to the project.

Continued on the next screen





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Activity 10.1 (continued)

Capital expenditureA feasibility study costing $45,000 was completed and paid for last year. This study recommended that the company buy new plant and machinery costing $1,640,000 to be paid for at the start of the project. The machinery and plant would be depreciated at 20% of cost per annum and sold during the year 2014 for $242,000 receivable at the end of 2014.

As a result of the proposed project it was also recommended that an old machine be sold for cash at the start of the project for its book value of $16,000. This machine had been scheduled to be sold for cash at the end of 2011 for its book value of $12,000.

Other data relating to the new product line:

2010 2011 2012 2013$'000 $'000 $'000 $'000

Sales 1,000 1,300 1,500 1,800Accounts receivable (at the year end) 84 115 140 160Lost contribution on

existing products 30 40 40 36Purchases 400 500 580 620Accounts payable (at the year end) 80 100 110 120Payments to sub-contractors, 60 90 80 80including prepayments of 5 10 8 8

Net tax payableassociated with this project 96 142 174 275

Fixed overheads and advertising:With new line 1,330 1,100 990 900Without new line 1,200 1,000 900 800

Notes

- The year-end accounts receivable and accounts payable are received and paid in the following year.

- The net tax payable has taken into account the effect of any capital allowances. There is a one year time-lag in the payment of tax.

- The company's cost of capital is a constant 10% per annum.

- It can be assumed that operating cash flows occur at the year end.

- Apart from the data and information supplied there are no other financial implications after 2013.

Labour costs

From the start of the project, three employees currently working in another department and earning $24,000 each would be transferred to work on the new product line, and an employee currently earning $20,000 would be promoted to work on the new line at a salary of $30,000 per annum. The effect of the transfer of employees from the other department to the project is included in the lost contribution figures given above.

Continued on the next screen





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Activity 10.1 (continued)

As a direct result of introducing the new product line, four employees in another department currently earning $20,000 each would have to be made redundant at the end of 2010 and paid redundancy pay of $31,000 each at the end of 2011.

Agreement had been reached with the trade unions for wages and salaries to be increased by 5% each year from the start of 2011.

Material costs

Material UCK which is already in stock, and for which the company has no other use, cost the company $6,400 last year, and can be used in the manufacture of the new product. If it is not used the company would have to dispose of it at a cost to the company of $2,000 in 2010.

Material LAN is also in stock and will be used on the new line. It cost the company $11,500 some years ago. The company has no other use for it, but could sell it on the open market for $3,000 in 2010.

Required

(a) Prepare and present an opportunity cash flow budget for project BK, for the period 2010 to 2014.

(b) Write a short report for the board of directors which explains why certain figures which were provided in (a) were excluded from your cash flow budget.

End of Activity 10.1

Tutorial comment

The Examiner at the time stated that the objectives of this question were to prepare and discuss the concept of incremental/relevant cash flows (parts (a) and (b) and that there was some confusion on the part of some candidates between whether to attempt to do a cash budget or an incremental cash flow budget. Candidates do need to appreciate that for investment appraisal, it should be the incremental/relevant cash flows that are used. The candidates who performed well in this area were those who demonstrated a good understanding of the subject in the report which was called for in part (b). However, although many candidates were able to explain why sunk costs, depreciation and the feasibility study were not relevant costs they were unable to apply the same kind of logic to some of the other costs. In the computation section (part (a)) some candidates did not attempt to calculate the amount of cash from sales or paid out for purchases.

A step by step answer plan would be useful here.

Step 1 Read the question carefully and make sure that you understand precisely what is required. This case study involves a manufacturing company which is evaluating a new investment project.

Step 2 To determine the relevant cash flows for inclusion in the cash budget for subsequent capital investment appraisal, you need to work carefully through the data to identify the avoidable, incremental and future cashreceipts and payments. So, for example, sales need to be converted to cash receipts using opening and closing accounts receivable; tax paid is one year later than payable; only the extra fixed costs should be included, and feasibility study costs are excluded. Whilst doing this, note the figures that you decide to exclude, for your answer to part (b).





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Activity 10.1: AnswerProject BK

(a) Budgeted Incremental Cash Flows

Inflows: 2010 2011 2012 2013 2014$'000 $'000 $'000 $'000 $'000

Sales (Note 1) 916 1,269 1,475 1,780 160Savings, employeesmade redundant 84 88.2 92.6Residual value new machine 242 Material UCK, savingon cost of disposal 2

918 1,353 1,519.1 1,826.3 402

Outflows:Purchases (Note 2) 320 480 570 610 120Sale of old machinenot received 12Labour:Employee promoted 10 10.5 11.03 11.58 Redundancy pay 124Materials:Material LAN, lostresidual value 3Sub-contractors 60 90 80 80Lost contribution fromexisting product 30 40 40 36Overheads andadvertising 130 100 90 100Taxation 96 142 174 275

553 852.5 933.03 1,011.58 395

Incremental Cash flow 365 500.5 586.07 814.72 7

WorkingsNote 1: Cash from sales

2010 2011 2012 2013 2014$'000 $'000 $'000 $'000 $'000

Opening accounts receivable - 84 115 140 160Add sales 1,000 1,300 1,500 1,800 -

1,000 1,384 1,615 1,940 160Less closing accounts receivable 84 115 140 160 -

Cash from sales 916 1,269 1,475 1,780 160

Tutorial comment (continued)

Step 3 As well as the contents specified, your report must include a proper heading and introduction. A conclusion is not required in this case. Start the main explanation by summarising the criteria for inclusion of a figure in the cash flow budget. Then go through the specific items in the question where a figure has been excluded, to show the reasons why they have been excluded.

End of Tutorial comment





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4. Main evaluative criteria

Figure 10.3 provides an overview of the main criteria used for appraising investment projects. The criteria comprises two main categories:

Activity 10.1: Answer (continued)

Note 2: Purchase payments2010 2011 2012 2013 2014$'000 $'000 $'000 $'000 $'000

Opening accounts payable - 80 100 110 120Add purchases 400 500 580 620 -

400 580 680 730 120

Less closing accounts payable 80 100 110 120 -

Cash from purchases 320 480 570 610 120

(b) To : The Board of Directors of Buckland CompanyFrom : Project accountantDate :

Feasibility Report Re-The New Product Line

We have now prepared the cash flow budget enclosed herewith, and computed the net present value of the project.

The cash flows

The principal reason why certain figures were not included in the cash flows is that we have shown the incremental cash flows and therefore have only included the income and expenditure which will arise if the project goes ahead. The other figures are not relevant to the investment decision.

The following figures were not included in the incremental cash flow:

- the feasibility study which cost $45,000 had to be paid out whether or not the project went ahead.

- the depreciation is a non-cash movement item. The cash expended on the asset moves when it is paid over to the vendor.

- the three employees paid $24,000 each would continue to receive the amount whether or not the project goes ahead.

- the cost of materials UCK and LAN were paid for some time ago and is not therefore a relevant cash flow.

- the prepayments were already included in the amounts paid to the sub-contractors and did not require any adjustment to the cash flows. The relevant figures are the actual cash to be paid to them each year, e.g. 2010 $60,000, and so on.

End of Answer for Activity 10.1





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Capital investment appraisal techniques

CORPORATE MANAGERS

STRATEGY PROPOSALS

Often large sums of money are

involved

Evaluativecriteria

Sources of capital

Earnings per share

Gearing ratio

Effect on share price

The very large investments involved in these types of strategic

decisions are notevaluated by using traditional capital investment appraisal

techniques covered in this tutorial.

DEPARTMENTAL/FUNCTIONAL MANAGERS

INVESTMENT PROPOSALS

Often relatively small sums of

money are involved

Evaluativecriteria

CAPITAL INVESTMENT APPRAISAL

EVALUATIONCRITERIA

EARNINGS- BASED MEASURES

RISK- BASED MEASURES

Accounting Rate of Return (ARR)

Net Present Value (NPV)

Internal Rate of Return (IRR)

Payback period

Gearing

Breakeven(Not examined in this

syllabus)

Sensitivity of estimates

Taxation

Inflation

Capital rationing

Some investment appraisal techniques require the use of the cost of capital. How the cost of

capital is decided is dealt with later in our

e-publication

Figure 10.3: Capital investment appraisal techniques





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(i) Earnings potential- Accounting rate of return (ARR)- Net present value (NPV)- Internal rate of return (IRR).

(ii) Risk- Payback period (cash flow and discounted cash flow)- Gearing (financial and operating). We cover gearing in Tutorial 14.- Sensitivity analysis.

5. Three project scenarios

Table 10.2 provides three project scenarios which we will use to examine the main appraisal techniques.

Table 10.2 Scenario for the different assignments

The following information relates to three capital expenditure projects under review. Because of capital rationing only one project can be accepted.

The data provided here will illustrate the calculations used for:

- payback period- accounting rate of return (ARR)- net present value (NPV)- internal rate of return (IRR)

ProjectX Y Z

Initial cost $400,000 $460,000 $360,000Expected life 5 years 5 years 4 yearsScrap value expected $ 20,000 $ 30,000 $ 16,000

Expected net cash inflows (inflows - outflows)

$ $ $End year

1 160,000 200,000 110,0002 140,000 140,000 130,0003 130,000 100,000 190,0004 120,000 100,000 200,0005 110,000 100,000 -

The company estimates its cost of capital is 18%

Payback method

1. The payback method of investment appraisal

The payback method of project appraisal involves calculating the period of time that it is likely to take to recoup the initial outlay on a project, and then comparing this with what the company defines as an acceptable period. Often, the shorter the payback period the more valuable is the investment. If the payback period is less than that defined as acceptable, and provided that there are no other constraints, for example capital rationing, the project will be accepted.





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