ICAEW Investment Appraisal

The Institute of Chartered Accountants in England and Wales
FINANCIAL MANAGEMENT
Professional Stage Application Level
Study Manual
www.icab.org.bd
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
chapter 2
Investment Appraisal
Contents
Introduction
Examination context
Topic List
1 Ranking of investment appraisaltechniques
2 Relevant cashflows
3 Taxation
4 Inflation
5 Replacementanalysis
6 Capitalrationing
7 Investment appraisal in a strategiccontext
8 Investing overseas
Summary and Self-test
Answers toSelf-test
Answers to Interactive questions
20 ©TheInstituteofCharteredAccountantsinEnglandandWales,March2009
Introduction
Learning objectives Tick off

To explain the decision-makingprocess
To select and justify investment appraisaltechniques
To choose appropriate values for use in investmentappraisal
To take account of tax andinflation
To recommend and justify a course of action based on the results of investmentappraisal
Toconsiderrelevantnon-financialfactors,includingthelimitationsofthetechniques The syllabus
references relevant to this chapter are 3a, b, d, h,k.
Practical significance
Investmentdecisionssuchasdevelopinganewproductormovingintoanewmarketarerequiredbyany
businessovertimeiftheyaretogeneratenewgrowth.Suchdecisionswilldependuponananalysisofthe
costsandbenefitsoftheoptionsunderreview,inparticularthefinancialpayoffs.Thetechniquesrequired
forthisarecoveredinthischapter.
Stop and think

What criteria would you use to judge an investment decision against?
Working context
Accountantsinvolvedindiscountingfuturecashflowswillfindthetechniquesinthischapteruseful.This
includesthoseworkinginauditing,treasuryandcorporatefinance.
Syllabus links
ThischapterdevelopsthebasicinvestmentappraisaldecisionsintroducedatknowledgelevelManagement
Information.ThestrategiccontextofthesedecisionsistakenfurtherinBusinessStrategy.Theunderlying
techniqueswillbeappliedinexploringvaluationmethodsintheAdvancedlevelpaperBusinessAnalysis .
1 Ranking of investment appraisaltechniques
Section overview
Financialmanagementprogressestheskillsfromknowledgelevelintoapplicationlevelintheareaof
investmentappraisal.
Relativemeritsanddemeritsmeanthatdiscountedcashflow(DCF)techniquessuchasNPVandIRR
aresuperior.
1.1 Recap of investment appraisaltechniques

InvestmentappraisalwasintroducedatknowledgelevelintheManagementInformationpaper.These
techniquesaretakenfurtherinthissubjectwheretheyareappliedtomoreinvolvedscenarios.Thisallows
foraprogressionofskillsfromknowledgeintoapplication.
Summary of techniques
Payback Thetimetakenforcashinflowsfromaprojecttoequalthecash outflows.
Accountingrateofreturn Averageannualprofitfrominvestment
ARR= ×100
Initialinvestment
Averageannualprofitfrominvestment
or ×100
Averageinvestment
Initialoutlay Scrapvalue 2
whereaverageinvestment=
Note: profit is after depreciation
Netpresentvalue Themaximumaninvestorwouldpayforagivensetofcashflows(at
his/hercostofcapital)comparedtotheactualamounthe/sheisbeing asked
topay.
Thedifference,theNPV,representsthechangeinwealthoftheinvestor as a result of
investing in the project.
Internal rateofreturn AcostofcapitalatwhichtheNPVofaprojectwouldbeCU0.
IRR is usually found via interpolation using two discount rates.
NPVa
IRR = a + (b-a)
NPVa – NPVb
Where a is the first discount rate giving NPVa
b is the second discount rate giving NPVb
Interactivequestion1:Revisionofbasictechniques [Difficulty level:Easy]
Acompanyisconsideringexpandingitsbusiness.TheexpansionwillcostCU350,000initiallyforthe
premisesandafurtherCU150,000torefurbishthepremiseswithnewequipment.Cashflowprojections
fromtheprojectshowthefollowingcashflowsoverthenextsixyears.
Year Net cash flows
CU
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
Theequipmentwillbedepreciatedtoazeroresalevalueoverthesameperiodand,afterthesixthyear,it
isexpectedthatthenewbusinesscouldbesoldforCU350,000.
Requirements
Calculate
(a) The payback period for theproject
(b) TheARR(usingtheaverageinvestmentmethod)
(c) TheNPVoftheproject.Assumetherelevantcostofcapitalis12%
(d) The IRR of theproject
Answer to Interactive question 1
Therearefourbasicinvestmentappraisaltechniquesthatareusedinpracticebycompanies.Thereason
whysomeareusedmorethanothersisbecauseoftheirrelativemeritsanddemerits.
Interactivequestion2:Rankingoftechniques [Difficulty level:Easy]
Whataretherelativemeritsanddemeritsofthefollowinginvestmentappraisaltechniquesandwhat
conclusionwouldyouthereforedrawabouttheirrelativeattractiveness?
Merits Demerits Rank

Payback
Accounting rate of
return
Net present value
Internal rate of return

Payback period Simple to understand Unsophisticated Useful as an initial
filtering device
Quick for initial No account is taken
screening of projects of the time value of
money
Considers risk (very
crudely) Cash flows
received/paid after
payback are ignored
Accounting rate of Use of profit Not consistent with Unlikely to be useful

return consistent with wealth maximisation as a decision making
ROCE and EPS tool
No account is taken
Use of balance sheet of time value of
values (asset backing) money
Relative score is easy Percentage figure
to understand may give misleading
advice when
choosing between
alternatives
Profits can be
manipulated
Net present value Takes into account The need to Technically superior
the time value of estimate a cost of technique
money capital
Gives an absolute Difficulty in obtaining
measure, allowing all relevant
for comparison of costs/benefits
projects
Assumes cash flows
Considers all cash occur at annual
flows of projects intervals
Internal rate of return Takes into account May conflict with Easier to use and
the time value of NPV decision communicate
money practically
Assumes cash
Represents a reinvested at IRR
breakeven point so
does not need an
exact cost of capital
Considers all cash
flows of projects
Theaboveexampleemphasisestheideaofprogression–thetechniquesintroducedatknowledgelevelwill
beappliedheretosolverealworldproblems.
2 Relevant cashflows
Section overview
Cashflowsshouldbeusedininvestmentappraisalratherthanprofitsasthismorecloselyreflectsthe
impact on shareholders'wealth.
Relevantcashflowsarethosewhichareaffectedbythedecision.
Opportunitycostsreflectthecashforgoneasaconsequenceofusingresources.
2.1 Why cash flows rather thanprofits?

Whenafirmmakesalong-terminvestmentinaproject,rarelydoestheprofitinanyyearoftheproject's
lifeequalthecashflow.Forexample,incashflowtermsthepurchaseofplantandequipmentmaybe
representedbyanoutflowatthestartofthefirstyear(i.e.thepurchase)andaninflowattheendofthe
lastyear(i.e.thescrapvalue).Intheannualincomestatementsinbetween,whatappearsisthedifference
betweentheinitialcostandthescrapvalue,i.e.depreciation,whichisnotacashflow.
Inaddition,profitmeasurementisconcernedwiththetimeperiodinwhichincomeandexpensesare
recognised.Thus,whiletheincomestatementsmightshowCU100,000forsales,theactualcashreceipts
maybemuchlessassomecashisstilltobereceived,i.e.therearereceivables.Thisincreaseinreceivables
representsafurther'investment'intheproject.
Fromawealthpointofviewshareholderswillbeinterestedinwhencashgoesoutandwhenitisreturned
tothemintheformofdividends,i.e.theamountandtimingoftheflowsareimportanttothem.
Overthelifeofaprojecttheundiscountednetflowswillequalthetotalaccountingprofit/lossbut(because
oftheabove)thetimingwillbedifferent.
Itisalsoimportanttoappreciatethatnotallcashflowsarenecessarilyrelevant.InManagementInformation
thebehaviourofcostswasintroduced.Overagivenperiodsomecostsarefixedandsomevariable.Whilst
allofthecostsforaperiodwillbereflectedintheincomestatementi.e.theywillinfluencetheprofit,they
maynotallberelevantcashflowsforaparticulardecision,e.g.depreciation.
The section below on relevant cash flows explores this idea further.
2.2 Profits to cashflows

Ifincomestatementinformationisprovided,therearetwoadjustmentswhichshouldbemadetoconvert to
cashflows:
Depreciation–asnotedabove,depreciationisnotacashflowandshouldbeaddedbackwhereit
hasbeendeductedinarrivingatprofits.Theinitialoutflowandscrapinflowwilldealwithdepreciation at the
appropriatetime
Workingcapital–aprojectmayinvolvenotonlyinvestmentinland,buildingsetcbutalso
investmentinworkingcapital(inventory+receivables–payables).Increasesinnetworkingcapital
representanoutflow,decreasesaninflow.
Worked example: Working capital
GorgonLtdexpectsthefollowingsalesfromanewprojectoveritsthreeyearlife:
CU
t1 150,000
t2 175,000
t3 200,000
Workingcapitalequalto10%ofannualsalesisrequiredanditneedstobeinplaceatthestartofeachyear. Calculate the
working capitalflows.
Solution
First,calculatetheabsoluteamountsofworkingcapitalneededatthestartofeachyearandthenfindthe cashflows.
t0 t1 t2 t3
CU CU CU CU
Working capital at start 15,000 17,500 20,000 Nil
Cash flow (15,000) (2,500) (2,500) 20,000
Onlytheincrementalflowisrelevant,soforexampleatt 1anadditionalCU2,500isrequiredoverand above the
CU15,000 already inplace.
At the end of the project all working capital is assumed to be recovered, i.e. an inflow of CU20,000 at t 3.
Interactive question 3: Changingworkingcapital [Difficulty level:Easy]

AcompanyplanstomakesalesofCU100,000att 1,increasingby10%perannumuntilt 4.Workingcapital
equalto15%ofannualsalesisrequiredatthestartofeachyear.
Requirement
Whataretheworkingcapitalcashflows?

t0 t1 t2 t3 t4
CU CU CU CU CU
Sales 100,000 110,000 121,000 133,100
Workingcapitalrequired 15,000 16,500 18,150 19,965 0
Cashflow (15,000) (1,500) (1,650) (1,815) 19,965
2.3 Relevant cashflows

Thegeneralruleistoincludeonlythosecostsandrevenueswhichcanaffectthedecisionorbeaffectedby
it.Thismeansusingonlyfutureincrementalcashflows.Futureflowsareusedasnodecisionnowcanchange
pastcashflows;incremental,i.e.changed,cashflowsareusedbecauseflowswhichcontinueintothefuture regardless of the
decision are irrelevant to thedecision.
Definition
The relevant cash flows are future, incremental, cash flows arising from the decision being made.
The relevant cash flow is the difference between:
The cash flow if the course of action is taken,and
The cash flow if it isnot
Theassessmentofrelevantcashflowsneedstobedonefromthepointofviewofthebusinessasawhole and not
individual divisions ordepartments.
Typical items which are excluded from the analysis as irrelevant are discussed below:
Sunkcosts–moneyalreadyspent,e.g.whentryingtodeterminewhetheranexistingmachinewhich
costCU250,000threeyearsagoshouldbeusedonanewproject,theanalysisshouldignorethe
CU250,000asnothingcanbedoneaboutit;instead,themachine'scurrentworth(eitherscrapvalue
orcashbenefitsfromretention)shouldbeincluded
Accountingentries–e.g.depreciation(asdiscussedabove)isnotacashflow
Bookvalues–e.g.FIFO/LIFOinventoryvalues.ThisissimilartosunkcostsaboveastheFIFO/LIFO
conventionsmerelydealwiththetreatmentofmoneyalreadyspent
Unavoidablecosts–moneyalreadycommitted,e.g.anon-cancellableleaseorapportionedfixed
costs.Asfarasfixedcostsareconcerneditisthetotalamountwhichisimportant(notanyattemptto
spreadthefixedcost,i.e.apportionment).Ifthetotalchanges,thenthisisrelevant;ifnot,thefixed
costsareignoredastheyareunaffectedbythedecision.Forexample,ifafirmcanmakeanew
productwithinitsexistingrentedfactory,thenanyshareoftherentapportionedtothenewproduct
shouldbeignoredasthetotalrentbillisunchanged.However,ifanewfactoryneedstoberented,
thentheadditionalrentisrelevantintheappraisalofthenewproduct
Financecosts–e.g.interest(discountingdealswiththisbyfindingthepresentvalueoftheflows
allowingforthetimethefinanceistiedupandtheinterestrate)
Specifically include:
All opportunity costs andrevenues.
2.4 Opportunity costs andrevenues
Definition
Theopportunitycostofaresourcemaybedefinedasthecashflowforgoneifaunitoftheresourceis
usedontheprojectinsteadofinthebestalternativeway.
Iftherearescarcitiesofresourcestobeusedonprojects(e.g.labour,materials,machines),thenconsideration
mustbegiventorevenueswhichcouldhavebeenearnedfromalternativeusesoftheresources.
Shareholdersareconcernedwiththeflowsgeneratedbythewholeorganisationintermsofassessing their
impact on theirwealth
Thecashflowsofasingledepartmentordivisioncannotthereforebelookedatinisolation.Itis
alwaysthecashflowsofthewholeorganisationwhichmustbeconsidered
Forexample,theskilledlabourwhichisneededonthenewprojectmighthavetobewithdrawn
fromnormalproductioncausingalossincontribution.Thisisobviouslyrelevanttotheproject appraisal
Worked example: Relevant cost of material

Anewcontractrequirestheuseof50tonnesofmetalZX81.Thismetalisusedregularlyonallthefirm's
projects.Atthemomentthereareininventory100tonnesofZX81,whichwereboughtforCU200per
tonne.ThecurrentpurchasepriceisCU210pertonne,andthemetalcouldbedisposedoffornetscrap proceeds of
CU150 pertonne.
With what cost should the new contract be charged for the ZX 81?
Solution
TheuseofthematerialininventoryforthenewcontractmeansthatmoreZX81mustbeboughtfor
normalworkings.Thecosttotheorganisationisthereforethemoneyspentonpurchase,nomatter
whetherexistinginventoryornewinventoryisusedonthecontract.
Assumingthattheadditionalpurchasesaremadeinthenearfuture,therelevantcosttotheorganisationis
currentpurchaseprice,i.e.50tonnes CU210=CU10,500.
Interactive question 4: Material with no alternativeuse

[Difficulty level: Intermediate]
SupposetheorganisationhasnoalternativeusefortheZX81ininventory.
Whatistherelevantcostofusingitonthenewcontract?

Nowtheonlyalternativeuseforthematerialistosellitforscrap.Touse50tonnesonthecontractisto
giveuptheopportunityofsellingitfor50 CU150=CU7,500.Thecontractshouldthereforebecharged with
thisamount.
Interactivequestion5:Materialwithascrapvalue [Difficulty level:Intermediate]

SupposeagainthereisnoalternativeusefortheZX81otherthanascrapsale,butthatthereareonly25 tonnes
ininventory.

Therelevantcostof25tonnesisCU150pertonne.Theorganisationmustthenpurchaseafurther25
tonnesand,assumingthisisinthenearfuture,itwillcostCU210pertonne.
The contract must be charged with:
CU
25 tonnes@CU150 3,750
25 tonnes@CU210 5,250
9,000
Worked example: Relevant cost of labour

AminingoperationusesskilledlabourcostingCU8perhour,whichgeneratesacontributionofCU6per
hour,afterdeductingtheselabourcosts.
Anewprojectisnowbeingconsideredwhichrequires5,000hoursofskilledlabour.Thereisashortageof
therequiredlabour.Anyusedonthenewprojectmustbetransferredfromnormalworking.
What is the relevant cost of using the skilled labour on the project?
Solution
What is lost if the labour is transferred from normal working?
CU
Contribution per hour lost fromnormalworking 6
Labourcostperhourwhichisnotsaved 8
Cashlostperhourasaresultofthelabourtransfer 14
Thecontractshouldbechargedwith5,000 CU14 CU70,000
Interactivequestion6:Relevantcostofsurpluslabour [Difficulty level:Easy]

FactsasinthepreviousWorkedexample,butthereisasurplusofskilledlaboursufficienttocopewiththe
newproject.Theidleworkersarebeingpaidfullwages.

Whatrevenueislostifthelabouristransferredtotheprojectfromdoingnothing?Nothing. The relevant cost
is zero.
Interactive question 7:Relevantcosts [Difficulty level:Intermediate]

A research project, which to date has cost the company CU150,000, is under review.
Iftheprojectisallowedtoproceeditwillbecompletedinapproximatelyoneyear,whentheresultsareto
besoldtoagovernmentagencyforCU300,000.
Shownbelowaretheadditionalexpenseswhichthemanagingdirectorestimateswillbenecessaryto complete
thework:
Materials.ThismaterialhasjustbeenpurchasedatacostofCU60,000.Itistoxic;ifnotusedinthis
project,itmustbedisposedofatacostofCU5,000.
Labour.Skilledlabourishardtorecruit.Theworkersconcernedweretransferredtotheprojectfroma
productiondepartment,andatarecentmeetingtheproductionmanagerclaimedthatifthesepeoplewere
returnedtohimtheycouldgeneratesalesofCU150,000inthenextyear.Theprimecostofthesesales
wouldbeCU100,000,includingCU40,000forthelabourcostitself.Theoverheadabsorbedintothis production
would amount toCU20,000.
Researchstaff.Ithasalreadybeendecidedthat,whenworkonthisprojectceases,theresearch
departmentwillbeclosed.ResearchwagesfortheyearareCU60,000,andredundancyandseverancepay
hasbeenestimatedatCU15,000now,orCU35,000inoneyear'stime.
Equipment.TheprojectutilisesaspecialmicroscopewhichcostCU18,000threeyearsago.Ithasa
residualvalueofCU3,000inanothertwoyearsandacurrentdisposalvalueofCU8,000.Ifusedinthe
projectitisestimatedthatthedisposalvalueinoneyear'stimewillbeCU6,000.
Shareofgeneralbuildingservices.TheprojectischargedwithCU35,000perannumtocovergeneral
buildingexpenses.Immediatelytheprojectisdiscontinued,thespaceoccupiedcouldbesub-letforan annual rental
ofCU7,000.
Requirement
Advisethemanagingdirectorastowhethertheprojectshouldbeallowedtoproceed,explainingthe
reasonsforthetreatmentofeachitem.
(Note: Ignore the time value of money.)
Costs and revenues of proceeding with the project.
CU
(1) CoststodateofCU150,000aresunkcosts,thereforeignore.
(2) Materials – purchase price of CU60,000 is also sunk.
Thereisanopportunitybenefitofthedisposalcostssaved. 5,000
(3) Labourcost–thedirectcostofCU40,000willbeincurredregardlessof
whethertheprojectisundertakenornot–andsoisnotrelevant.
Opportunitycostoflostcontribution=150,000–(100,000–40,000) (90,000)
Theabsorptionofoverheadsisirrelevant–itismerely
anapportionmentofexistingcostswhichdonotchange.
(4) Research staffcosts
Wagesfortheyear (60,000)
Increase in redundancy pay (35,000 – 15,000) (20,000)
(5) Equipment
Deprival value if used in the project = disposal value (8,000)
Disposal proceeds in one year 6,000
(All book values and depreciation figures are irrelevant)
(6) General building services
Apportioned costs – irrelevant
Opportunitycostsofrentalforgone (7,000)
(174,000)
Sales value of project 300,000
Increased contribution from project 126,000
Advice. Proceed with the project.
2.5 Deprivalvalue
When an asset which is currently owned by the business is required for another specific
contract/project,theexistingactivityistobedeprivedofthatasset.Thevaluetobeusedinthe investment
appraisal is, therefore, the asset's deprivalvalue.
Worked example: Deprival value

A company has a printing press which needs to be used on a new contract.
ThepresscouldbesoldforCU1,000ormadeuseoftoservicetheneedsofexistingcustomersfor
businesswhichhasavalue(inpresentvalueterms)ofCU1,500.
Requirements
(a) Whatistheopportunitycostofusingthemachineonanewcontract?
(b) Iftheprintingpresscouldbereplacedatacostofeither
(i) CU800
(ii) CU1,800
What would the relevant cost be?
Solution
(a) Theexistingcustomerscreatemorevaluethansellingthemachine,sothemachinewouldnotbesold.
HencetheopportunitycostisthevalueinuseofCU1,500
Note:ifthevalueinuseeverdroppedbelowthenetrealisablevalue(NRV),thentheassetwouldnot be worth keeping.
(b) (i) Ifthenewcontractwillmakeuseofacurrentlyownedmachinetheninprinciplethecostof
usingitwillbethereplacementcost.IfthevalueinuseisCU1,500,andthereplacementcostis
CU800,thenthemachinewillbereplaced.Theequipmentcostofthenewcontractwould therefore
beCU800.
(ii) Ifhowever,thereplacementcostisCU1,800thenitisnotworthreplacing.Thustherelevantcost
ofequipmentforthenewcontractwillbetheopportunitycostorbenefitforgone–i.e.the CU1,500.
Ineachcasethereforetherelevantcostisthecashfloweffectofthedecisiontousetheexisting resource–
eitherthereplacementcostorthebenefitinthenextbestcase,i.e.thedeprivalvalue.
This can be summarised as follows.
Deprival value
= lower of
Replacement cost and Recoverable amount
iethecostofreplacing the = higher of

asset with one of a
similarageandcondition Value in use/ Net
and
Economic value realisablev
alue
iethepresentvalueof the ietheasset'sworthif
cash generated itweretobesold,net of
fromusingtheasset sellingcosts
Iftheassethasanetrealisablevalueinexcessofitseconomicvalueitshouldbesold,i.e.itisbetterto
discontinueusingit.Iftheeconomicvalueishigherthanthenetrealisablevalueitisworthkeepingand
using.Atthispoint,therefore,werethefirmtobedeprivedoftheasset,thebestalternativeforgone
isthehigherofthenetrealisablevalueoreconomicvalue(the'recoverableamount')
However,iftherecoverableamountislessthanthereplacementcost,thentherecoverableamountis
thedeprivalvalue,i.e.theassetwouldnotbereplacedwerethefirmtobedeprivedofitsuse.Ifthe
recoverableamountexceedsthereplacementcost,theassetshouldbereplacedasthelatter represents its
deprivalvalue
Interactive question 8:Deprivalvalue [Difficulty level:Intermediate]

Joe'scarisnotinsuredagainsttheft.
HeboughtittwoyearsagoforCU2,000.AsimilarvehiclewouldnowcostCU1,000.Hebelieveshecould
sellthevehicleforCU1,000afterspendingCU100onadvertising.Thevehiclehastwoyearsoflife
remaining,andoverthisperiodhebelievesitwillsavehimtaxifareswithapresentvalueofCU800.
Requirement
WhatisthelosstoJoeifhiscarisstolen?

The recoverable amount is the CU900 NRV (which is higher than the CU800 economic value). As this is lower than the
CU1,000 replacement cost, CU900 is the deprival value.
3 Taxation
Section overview
Taxableprofitandaccountingprofitmaynotbethesame.
Tax is charged on net cashflow.
Tax depreciation reduce the taxpayable.
3.1 Basics
Income statement
Imagineanincomestatementdrawnupattheendofthefirstyearofaproject'slifeusingnormalfinancial
accountingprinciples:
Worked example: Taxable profit

CU CU
Sales 10,000
Materials 1,000
Labour 1,500
Variable overheads 500
Fixed overheads
Depreciation 1,000
Other 500
(4,500)
5,500
Interest on loan to finance project (3,000)
Profit 2,500
Requirement
Incalculatingthetaxableprofitforinvestmentappraisalpurposes,whataretherelevantcashflowstobe considered?
Solution
Corporationtaxforyear1oftheprojectisnotsimplyCU2,500timesthetaxrate.Someadjustmentsneed
tobemadetotheprofitcalculationbeforecomputingthetaxcharge:
Onlyincrementalrelevantcashflowsneedbeconsidered(ascoveredinsection2above)andthe
incrementaltaxcharge.Thussomeoftheabovecosts–e.g.fixedcosts,maynotberelevantand
thereforethetaxeffectoftheseisnotrelevant
Depreciationshouldbeignored(itisnotallowedasadeductionfromprofitswhencalculatingthetax
– see below)
Interestshouldbeignored.Thetaxeffectofinterestisincorporatedintothecostofcapital
3.2 Effects
Taxation has two effects in investment appraisal, both giving rise to relevant cash flows.
OUTFLOW INFLOW
Tax Tax relief

chargedon givenonassetsp
net cash urchasedvia
flows
Tax Depreciation (TD)
3.3 Tax Depreciation(TDs)

This is the National Board of Revenue (NBR) version of depreciation. For the purposes of the
examination,onlyTDsonplantandequipmentareconsidered(thoughinpracticethereareother
categoriesofnon-currentassetsthatattractTDs).
Unless otherwisestated:
– Calculatetaxdepreciationallowances(TDAs)at25%onareducingbalancebasis
– ThereisnoTDAintheyearofsale;abalancingallowance/chargeiscalculatedinstead.The
balancingallowancerelievesanyunrelievedexpenditure;thebalancingchargeclawsbackany
excessreliefgiven–assumethattherearesufficientprofitsavailableelsewhereinthebusinessto
utilisealltaxbenefitsinfullandatonce.
3.4 Otherassumptions
Although large companies make tax payments in four equal instalments during the income year, for
examinationpurposesthewholetaxpaymentisassumedtobemadeattheendoftheyeartowhichitrelates
Forexaminationpurposescorporationtaxisassumedtobepaidat30%(althoughotherratesare possible in
the realworld)
Thetaxratecanbeassumedtobeconstantoverthelifeoftheproject(unlikelyinpractice)
©TheInstituteofCharteredAccountantsinEnglandandWales,March2009 35
Itshouldbeassumedthatworkingcapitalflowshavenotaxeffects
Worked example: Tax Depreciation
HappyLtdboughtamachineforCU10,000on31December20X1,itsaccountingyearend.Theasset generated cash
flows of CU7,000 pa. It sold the asset on 31 December 20X3 for CU2,000.
20X1 20X2 20X3
Acquired Disposed
Thecompanypaystaxat30%.TaxDepreciationisavailableat25%onareducingbalancebasis.
ShowtheTDAsandanybalancingchargeorallowance.
Solution
Year ended 31 Dec Tax WDV (WDV = written down value)
CU
20X1 10,000
TDA@25% (2,500)
Asset owned at end of each of
20X2 7,500 20X1and20X2. 25%TDA
TDA @ 25% (1,875) calculated
20X3 5,625 In 20X3 asset sold. As proceeds
Proceeds (2,000) (inthiscase)arelessthanWDVa
Balancing allowance 3,625 balancing allowance is given.
Totalreliefs=CU(2,500+1,875+3,625)=CU8,000(=cost–scrap).Taxpayments,cashflowsetccan then be
shown asfollows:
Tax computation
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
Net inflows 7,000 7,000
TDA/Balancingallowance (2,500) (1,875) (3,625)
Taxable (2,500) 5,125 3,375
Tax @ 30% 750* (1,537.50) (1,012.50)
*Taxsaved,assumingsufficientprofitsexistelsewhereinthebusinesstoobtainrelieffromTDAassoonas possible
(section 3.3above).
Normally the tax effect is shown as two separate elements:
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
(1) Tax paid @ 30% (2,100) (2,100)
TDAs/Balancingallowance (2,500) (1,875) (3,625)
(2) Tax saved @ 30%* 750 562.50 1,087.50
Total tax (above) (1) + (2) 750 (1,537.50) (1,012.50)
* i.e. being able to deduct the TDA from profit saves tax @ 30%.
The NPV calculation would show (rounding to the nearest CU):
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
Tax (2,100) (2,100)
Asset purchase (10,000)
Scrap 2,000
Tax saved on TDAs 750 562 1,088
Net CF for discounting (9,250) 5,462 7,988
Interactive question 9:TaxDepreciation [Difficulty level:Intermediate]
1 AcompanybuysanassetforCU10,000attheendofitsaccountingperiod,31December20X0,to undertake a two
yearproject.
2 Nettradinginflowsatt1andt2areCU5,000.
3 TheassethasaCU6,000scrapvaluewhenitisdisposedofattheendofyear2.
4 Taxischargedat30%.TDAsareavailableat15%pa
Requirement
Calculatethenetcashflowsfortheproject.

t0 t1 t2
CU CU CU
Net trading revenue 5,000 5,000
Tax @ 30% (1,500) (1,500)
Asset (10,000) 6,000
TDA (W) 750 562.50 (112.50)
Net cash flow (9,250) 4,062.50 9,387.50
Working
Interactive question 10:Timingissues [Difficulty level:Intermediate]

Asininteractivequestion9,exceptthattheassetisnowboughton1January20X1.
Requirement
Calculate the net cash flows for the project.

t0 t1 t2
CU CU CU
Net trading revenue 5,000 5,000
Tax @ 30% (1,500) (1,500)
Asset (10,000)
Scrapproceeds 6,000
Tax savings on TDAs (W) 750 450
Net cash flow (10,000) 4,250 9,950
WORKING
Tax computation
t0 PROFITS t1 t2
IN
YEAR 1
Asset purchased 1 Jan 20X1which Asset sold 31 Dec20X2

is effectively (for discounting
purposes) the same as 31 December
20X0,i.e.t0
FirstTDAwillbesetoffagainst No TDA in year ofsale
profits earned in year 1 (t0 t1) – balancing adjustment instead
First tax relief at t1
Tax relief at Timing
CU 30%
1Jan 20X1 Investment inasset 10,000
31Dec20X1 TDA @25% (2,500) 750 t1
7,500
31Dec20X2 Proceeds 6,000
Balancing allowance (1,500) 450 t2
4 Inflation
Section overview
Inflationratecanbeincorporatedintobothcashflowanddiscountrate('money@money').
Inflationcanbeignoredinbothcashflowsanddiscountrate('real@real').
InflationinBangladeshhasvariedbetween1%and25%pasince1972.Asinflationwillcontinuetoexistin
thefuture,accountneedstobetakenofitseffects,i.e.increasesinprices,whenappraisingprojects.It
createstwoproblemsininvestmentappraisal:
Estimating future cash flows – the rate of inflation must be taken intoaccount
Therateofreturnrequiredbyshareholdersandlenderswillincreaseasinflationrises–thediscount rate is
thereforeaffected
4.1 Real and money (or nominal)rates
The rates of interest that would be required in the absence of inflation in the economy are referred to as the real
rates ofinterest
Whenrealratesofinterestareadjustedfortheeffectofgeneralinflation,measuredbytheconsumer
pricesindex(CP1),theresultsarereferredtoasmoney(ornominal)ratesofinterest
Worked example: Impact of inflation

Kumanisconsideringachoice.HecanspendCU100onconsumablesnoworhecaninvestitforayear,but
willonlydosoifhecanconsumemoreofitatthattime.
The underlying time value of money for Kuman is 10%, and inflation is 5%.
Requirement
What return in money terms does Kuman require?
Solution
ThetotalreturnmustcompensateKumanforhisconsumptionpreferencei.e.thefactthathewouldprefer
toconsumenow.Hemustthereforeearn10%toreflecthistimevalueofmoney.Inaddition,theratemust
compensateKumanforthefactthatpricesarerisingby5%pa.
This can be illustrated as follows.
Now 1 yearlater
t0 Underlying
t1'Real'return
required
ConsumeCU100 CU110 is theamount
r=10%
requiredtosati
sfytheconsumption
preference i.e. Kuman needs to
be able to purchase
10% more goodsInflation
i = 5%
The impact of inflation means

that in order to be able to
purchase 10% more goods,
Kuman needs
CU110 1.05 = CU115.50
Inordertobesatisfiedwithnotconsumingnow,KumanneedsCU115.50ofmoneyinayear CU100
(1.10)(1.05) =CU115.50
CU15.50
Overallmoneyreturn(m)required= =15.5%
CU100
Moneyrates,realratesandgeneralinflation(CPI)arelinkedbythefollowing:
(1+m)=(1+r)(1+i)
where m = money rate
r = real rate
i = general inflation
Thus in the example above
(1+m) = (1.10) (1.05) =1.155
m =15.5%
4.2 Money and current cashflows

Asexaminationquestionsarenormallyansweredusingthemoneymethod(seesection4.4below)itisvital
todeterminewhetherthecashflowsaregiveninmoneyorcurrentterms.
Money(ornominal)cashflowsarecashflowswhereanyinflationaryeffectshavealreadybeentaken intoaccount
Currentcashflowsarecashflowsexpressedintoday'stermswhichwillbeaffectedbyinflationinthe future and
have not yet beenadjusted
4.3 General and specific inflationrates

Itisalsoimportantinexaminationquestionstodeterminewhatsortofinflationrateisapplicabletothe items in
thequestion.
Ageneralinflationrateisaweightedaverageofmanyspecificinflationrates,e.g.CPI,andisnormally
appliedtotherealrateinordertoderivethemoneyrate(section4.1above)
Aspecificinflationrateistherateofinflationonanindividualitemorservice,e.g.therateatwhich labour costs
per hour willincrease
Examples:
Individualitem Specificinflation
Bread 1%pa
Milk 3%pa CPIisaweightedaverageoftheserates
Cheese 2%pa
etc.
Economicforecasterswillregularlypublishestimatesofgeneralinflation.Estimatingindividualratesis
muchmoredifficult,anddecisionmakersshouldrecognisethattheyarejustthat–estimates,and subject to a
degree oferror
4.4 Discounting
Moneymethod('money@money')
ItisessentialtomatchlikewithlikewhenperformingNPVcalculations.Intherealworldmoneyflowsare
theeasiesttodealwithastheyaretheeverydayflowspeopleareusedto.Sotousethemoneymethod:
Adjusttheindividualcashflows,e.g.sales/revenue,materials,labourusingtheirspecificinflationrates to convert to
money cash flows, i.e. the flows which will actuallyoccur
Discountthesemoneyflowsusingthemoneyrate,i.e.therateofinterestwhichwillactuallyoccur.
This is the simplest technique. Use wherever possible unless a question directs otherwise.
Real method ('real @ real')
AnalternativewayofreachingthesameNPVandagainmatchinglikewithlike,istousetherealmethod.
Theproblemwiththismethodisthatrealcashflowsandinterestratesarenotdirectlyidentifiableinthe
waythatmoneyflowsandratesare.Forexample,banksregularlypublishmoneyinterestratesonsavings
accounts,overdrafts,etc.Theunpublishedrealrateneedstobederivedbystrippingoutthegeneral
inflationusedtodeterminethemoneyrate(asinsection4.1above).Sotousetherealmethod:
Remove the effects of general inflation from money cash flows to generate real cashflows
Discount using realrate.
AlthoughthisachievesthesameNPVasthemoneymethod,itisoftenverylongwindedandwouldonlybe
usefulinaquestionwheretherealflowsandinterestratewerealreadygiven.
Interactive question 11: Money@money [Difficulty level:Intermediate]
Project InvestCU10,000att0innewplantandequipment
ReturnsCU5,000paincurrenttermsforthreeyears,inflatingat7%pa Money
rate of interest is10%
Requirement
Calculatetheproject'sNPVusingthemoneymethod.

t0 t1 t2 t3
CU CU CU CU
Invest (10,000)
Returns inflated at 7% 5,350 5,725 6,125
Net CF (10,000) 5,350 5,725 6,125
DF @ 10% 1 0.909 0.826 0.751
PV (10,000) 4,863 4,729 4,600
NPV = CU4,192
Effective method
Thismethodcansometimesbeashortcutforthemoneymethod,e.g.forlongprojectswithannuity or perpetuity
cashflows
Tousetheeffectivemethodleavecashflowsincurrent(t 0)termsandadjustthediscountrateas
shownbelowtoincorporatebothinflatinganddiscounting
Discount current terms cash flows using effective rate(e):
1 m
1+e=
1 is
where is = inflation specific to given cash flow
Interactivequestion12:Effectiverate [Difficulty level:Intermediate]

Labourcostsinflateat8%painperpetuity
Money rate =10%
Labour currently costs CU10,000 in t0 terms
Requirement
Calculatethepresentvalueoflabourcosts.

(1) Calculate effective rate:
(1 + m) = (1 + e) (1 + is)
1.1 = (1 + e) (1.08)
e = 1.9%
(2) Discount perpetuity using the effective

rate:
𝐶𝑈10,000
= CU526,316
0.019
Practicalconsiderations
Generalinflationmaynotbeconstant,thusthemoneydiscountratemayvaryyearonyear.Inorder
todiscountcashflowswithadifferentmoneyinterestrateineachyear,themoney@money approach
discussed above should beused
Theimpactofinflationismoresignificantforlongerperiodsastheincreaseinpricesiscompounded
yearonyear.However,asnotedearlier,thefurtherintothefuturethemoredifficultitistoestimate
specificinflationrates,soerrorsinestimateswillbecompounded
4.5 NPVProforma
ThefollowingproformasummarisesthetopicsdealtwithsofarandprovidesalayoutforNPVcalculations useful in 95%+
ofsituations:
t0 t1 t2 t3
CU CU CU CU
Operating cash flows
Adjust for inflation Sales/revenue X X X
Include only relevant cash flows Net Costs (X) (X) (X)
Tax X X X
Asset (X) (X) (X)
Purchase
Scrap (X)
Tax on TDAs X
X X X X
Working capital Net (X) (X) (X) X
flows (X) X X X
* Discount factor 1 X X X
PVofcashflows (X) X X X
PV = NPV
* Usediscountfactorsfortheafter-taxcostofcapital
5 Replacementanalysis
Section overview
Theoptimalreplacementcycleistheonewiththelowestequivalentannualcost.
Theanalysisassumesthereplacementdecisionwillapplyindefinitely.
Sofarithasbeenassumedthatinvestmentinanassetisaone-offdecision.However,aprojectislikely
toinvolvecommitmenttolong-termproduction,andmachinerywillthereforeneedtobereplaced
Abusinessneedstoknowhowoftentoreplacesuchassets.Replacingafteralongtimemeansnot
replacingasoften,sodelayingthecostofanewreplacementmachine.Howeverthisinvariablymeans
keepinganassetwhosevalueisdecliningandwhichcostsmoretomaintain.Thesecostsandbenefits need to
bebalanced
Worked example: Replacement decision

Adecisionhastobemadeonreplacementpolicyforvans.AvancostsCU12,000.Vanscanbereplaced
after1,2,or3years.Thefollowingadditionalinformationapplies:
Interval between Trade-in Age at Maintenance cost
replacement allowance Year end paidatendofyear
(years) CU (years) CU
1 9,000 Year of replacement Nil
2 7,500 1 2,000
3 7,000 2 3,000
Calculatetheoptimalreplacementpolicyatacostofcapitalof15%.Therearenomaintenancecostsifthe
vanisreplacedafteroneyear.Ignoretaxationandinflation.
Solution
NPVs
9,000
1yearcycle NPV = (12,000)+ = CU(4,174)
1.15
(2,000) 7,500
2yearcycle NPV=(12,000)+ + = CU(8,068)
1.15 1.152
(2,000) (3,000) 7,000
3yearcycle NPV = (12,000)+ + + = CU(11,405)
1.15 1.152 1.153
Thesecostsarenotcomparable,becausetheyrefertodifferenttimeperiods.Thereasontheoneyearcycleappearsch
eaperisbecauseitonlyreflectsthecostofhavingamachineforoneyear,whereasthe
CU11,405forthe3yearcycleisthecosttothebusinessofkeepingtheresourceforthreeyears.Thereare
twopossibleapproachestomakingthecostscomparable.
5.1 Lowest common multipleapproach

Onemethodofcomparingthedifferentreplacementoptionsistoevaluatethecostsoveratimeframe which makes
themconsistent.
Intheaboveexample,thiswillbeachievedifthecostsincurredundereachcyclewerecomparedover
thesamenumberofyearsforeach.
For example:
1 Year 2 Year 3 Year
Time cycle cycle cycle
CU’000 CU’000 CU’000
0 (12) (12) (12)
1 9 + (12) (2) (2)
2 9 + (12) 7.5 + (12) (3)
3 9 + (12) (2) 7 + (12)
4 9 + (12) 7.5 + (12) (2)
5 9 + (12) (2) (3)
6 9 7.5 7
Inordertobecomparable,theanalysishastobecontinuedforsixyears(thelowestcommonmultipleof
theassetlives).Stoppingbeforethismeansoneoftheoptionswouldbepartwaythroughacycle.Atthe
endofsixyearsistheearliestoccasionthatallthreecyclescometoanendatthesametime(i.e.anewvan
isrequiredundereachcycle).Thelowestcommonmultipleapproachwillgiveasolution,butisratherlong
winded.TheEquivalentAnnualCostapproachisabettermethod,andisdiscussedbelow.
5.2 Equivalent annual cost(EAC)

In Management Information, the method for finding the present value of an annuity was introduced.
PV of an annuity = Annuity Annuity Factor (AF) for n periods at a discount rate r
Thiscanbeappliedheretorestatethepresentvalueofthecostsoveralifecycleintoanannuity–the
equivalentannualcost–overthelifecycle,asfollows:
TheNPVscalculatedaboveareconvertedintoequivalentannualcosts,i.e.theequivalentconstantannual
sumpayableattheendofeachyearforanygivencycle.
The equivalent annual costs can be compared.
1 yearcycle (4,174) = X AF 1 year @15%
(4,174)=X 0.870 X
=CU(4,798)
2 yearcycle (8,068) = X AF 2 years @15%
(8,068)=X 1.626 X
=CU(4,962)
3 yearcycle (11,405) = X AF 3 years @15%
(11,405)=X 2.283
X=CU(4,996)
Thusitischeapesttoreplacethevanseveryyear,becausethiscyclehasthelowestcostinNPVterms.
Sothemethodcanbesummarisedas:
1 CalculatetheNPVofeachreplacementstrategy
2 CalculatetheannualequivalentcostoftheNPVforeachstrategy
3 Choosethestrategywiththelowestannualequivalentcost.
Interactive question 13:Replacementcycle [Difficulty level:Intermediate]

AmachinecostsCU20,000anditcanbereplacedeveryyearoreverytwoyears.Delayingthereplacement
causestherunningcoststoincreaseandthescrapproceedstodecreaseasfollows:
Running costs Scrap proceeds
CU CU
Year 1 5,000 16,000
Year 2 5,500 13,000
Company's cost of capital = 10%.

Requirement
Shouldthemachinebereplacedeveryoneoreverytwoyears?
INVESTMENT APPRAISAL 2

Replace after two years
Cash Discount factor Present
Time Narrative flow @ 10% value
CU CU
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
2 Running costs (5,500) 0.826 (4,543)
2 Scrap proceeds 13,000 0.826 10,738
NPV = (18,350)
CU18,350 CU18,350
Annual equivalent = = = CU10,570
AF2 years @10% 1.736
Replace after one year

Cash Discount factor Present
Time Narrative flow @ 10% value
CU CU
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
2 Scrap proceeds 16,000 0.909 14,544
NPV = (10,001)
CU10,001 = CU10,001 = CU11,002

Annual equivalent =
AF1year @10% 0.909
5.3 Limitations of the replacement analysisperformed

Thismethodassumesthatafirmiscontinuallyreplacinglikewithlike,andthereforedeterminesaonce - and-for-
alloptimalreplacementcycle.Inpracticethisisunlikelytobevaliddueto:
Changingtechnology,whichcanquicklymakemachinesobsoleteandshortenreplacementcycles.This
meansthatoneassetisnotbeingreplacedbyoneexactlysimilar
Inflation,whichbyalteringthecoststructureofassetsmeansthattheoptimalreplacementcyclecan vary overtime
Ifinflationaffectsallvariablesequallyitisbestexcludedfromtheanalysisbydiscountingrealcash
flowsatarealinterestrate–theoptimalreplacementcyclewillremainvalid
Differential inflation rates mean that the optimal replacement cycle varies overtime
The effects of taxation (ignored in the analysis but they could beincorporated)
The fact that production is unlikely to continue inperpetuity
6 Capitalrationing
Section overview
Scarcecapitalmeansthatprojectshavetoberankedaccordingtohowefficientlytheyusethelimiting
factor.
DivisibleprojectsarerankedusingNPVperCUofscarcecapital.
Indivisibleprojectsarerankedusingtrialanderrorbyfindingthecombinationofprojectsthat
maximisesNPV.
Definition
CapitalrationingisthesituationwhereinsufficientfundsexisttoundertakeallpositiveNPVprojects,so
achoicemustbemadebetweenprojects.
6.1 Two types ofrationing

Hardrationing:wheretheexternalcapitalmarket(banks,stockexchange,etc)limitthesupplyoffunds
Softrationing:whereinternallythefirmimposesitsownconstraintontheamountoffundsraised.
Thismaybeasasurrogateforotherconstraints,e.g.insufficientmanagerialcapacitytohandleall positive
NPVprojects
Softrationingmayalsoarisewhereitisimpracticalforthefirmtogotothemarketandraiseasmall
amountoffinance,andwhereraisingthefundsinlargeamountsismorepracticalandcosteffective.
6.2 Single periodrationing

Whenfundsarescarceinoneyearonly,butfreelyavailableotherwise,thebasicNPVapproachtoproject selection
ismodified.
ProjectsarerankedbyNPVperCUcapitaloutlayintherationedperiod.(Thiscanbereferredtoasthe
'profitabilityindex'.)Thisisanextensionofkeyfactoranalysiscoveredattheknowledgelevelofthe professional
stageexaminations.
Thesituationwherefundsarerationedinmorethanonetimeperiod(multi-periodcapitalrationing)is beyond
thesyllabus.
Interactive question 14:Capitalrationing [Difficulty level:Intermediate]

AbusinesshasCU50,000availableatt 0forinvestment.
Fourdivisibleprojectsareavailable:
Project NPV Funds required att0
CU CU
A 100,000 (50,000)
B (50,000) (10,000)
C 84,000 (10,000)
D 45,000 (15,000)
Requirement
Which project(s) should be undertaken?
Project NPV ÷ outlay Rank

A 100,000 ÷ 50,000 = 2 3
C 84,000 ÷10,000 = 8.4 1
D 45,000 ÷15,000 = 3 2
ProjectBisrejectedbecauseofitsnegativeNPV. Plan:
NPV Funds
CU CU
Accept C 84,000 10,000
Accept D 45,000 15,000
25,000
Accept ½ A 50,000 25,000
179,000 50,000available
ThesolutionassumesitispossibletoaccepthalfofprojectA,i.e.projectsareperfectlydivisiblesothathalf
theoutlaygiveshalftheNPV,etc.
6.3 Indivisibleprojects
ThesolutiontoInteractivequestion14assumesitispossibletoaccepthalfofprojectA,i.e.thatprojects
areperfectlydivisiblesohalftheoutlaygiveshalftheNPV,etc.
Inrealityprojectsmaybeindivisible,i.e.allornothing,inwhichcasetrialanderrorisnecessarytofindthe
optimalcombination.
In Interactive question 14 above, possible combinations are:
NPV Funds
CU CU
A 100,000 50,000
C and D 129,000 25,000
ThereforechooseCandD.
6.4 Mutually exclusiveprojects

Itmaybethecasethatprojectsaremutuallyexclusive,i.e.itisnotpossibletoundertakebothatthesame
time,perhapsbecausemanagementwouldbeoverstretchedintryingtorunbothprojects.
Imaginethatafirmfacingsingleperiodcapitalrationingistryingtochoosebetweenfiveprojects–P,Q,R,
SandT.PandQaremutuallyexclusive,i.e.eitherPorQbutnotbothcouldbeundertaken.Inorderto
makethechoiceitshouldapplytheproceduresinsections6.2or6.3abovetotwoseparategroupings
P, R, S, T Q,R,S,T
andseewhichproducesthehigheroverallNPV.
6.5 Projectsynergy
Sofarprojectshavebeenconsideredindependently.Itmaybethecasethatbyundertakingcertain
combinationsofprojects,somesynergy(extraNPV)iscreated,e.g.fromcostsavings.
Interactive question 15:Projectsynergy [Difficulty level:Intermediate]

AfirmhasCU100,000availableforinvestmentatt 0.
Threedivisibleprojectsareavailable:
Project NPV Funds required att0
CU CU
X 25,000 100,000
Y 11,000 50,000
Z 8,000 40,000
If Y and Z were undertaken together an extra CU4,400 of NPV could be earned.
Requirement
Which project(s) should be undertaken?

ConsideringX,YandZindependently
Project NPV ÷ outlay Rank
X 25,000 ÷ 100,000 = 0.25 1
Y 11,000 ÷ 50,000 = 0.22 2
Z 8,000 ÷ 40,000 = 0.20 3
ProjectXusingallCU100,000available,NPVCU25,000.
Considering X and Y +Z
Project NPV÷outlay Rank
X 25,000 ÷ 100,000=0.25 2
Y+Z (11,000+8,000+4,400)÷(50,000+40,000)=0.26 1
Plan:
NPV Funds
CU CU
Accept Y+Z 23,400 90,000
AcceptonetenthofX 2,500 10,000
25,900 100,000
Accept Y + Z + one tenth of X
7 Investment appraisal in a strategiccontext
Section overview
Investmentappraisalneedstobeconsideredinastrategiccontext
Shareholdervalueanalysis(SVA)focusesondecisionswhichmaximiseshareholderwealth
Investmentmaygiverisetonewopportunities,knownasrealoptions.
7.1 Project generation, decision making andcontrol

Investmentprojectswillnormallybeidentifiedaspartofafirm'sstrategicplanningprocess.Thisiscovered
indetailintheBusinessStrategypaper.Inoutlinetheprocessisasfollows:
Analysethecurrentpositionofthebusinessbyexaminingthe
external(egcompetitors)andinternal(eghumanresources)
environment.NormallysummarisedbySWOTanalysis
(strengths,weaknesses,opportunities,threats)
Determinemissionandobjectives(here
assumedtobewealthmaximisation)
Identifyandselectstrategies(egn
ewproducts,newmarkets,etc)
Implement and control

Oncepotentialprojectsareidentified,e.g.replacinganexistingproductwithanewone,therelevant costs and
revenues associated with the proposal must be determined. Care must be taken to avoid bias in estimates, e.g.
from managers closely associated with theproposal
TherelevantcostsandrevenuesshouldbeassessedusingNPVtodeterminewhetherwealth
increases.Wheretherearecompetingprojects,thosethatofferthebestNPVshouldbechosen
(capitalrationingmayneedtobeconsideredatthispoint)
Chosenprojectsarethenimplementedandperformancemonitored,e.g.actualoutcomesvbudgetetc
7.2 Shareholder valueanalysis
Definition
Shareholdervalueanalysis(SVA)istheprocessofanalysingtheactivitiesofabusinesstoidentifyhow
theywillresultinincreasingshareholderwealth.
Managers may sometimes be influenced to act in a manner which is inconsistent with maximising
shareholderwealth.TheclaimedadvantageofSVA,asaphilosophyofbusinessdecision-making,isthatthe actions of
managers can be directly linked to value generation and the outcomes of decisions can be assessed in
thatcontext.
Interactive question16:SVA [Difficulty level:Easy]
Explainwhatpossibleproblemsarecreatedwhenusingthefollowingmeasurestoassessmanagement
effectiveness.
Return on capital employed
Earnings per share
Traditional accounting-based measures of management effectiveness, like the return on capital employed ratio (ROCE)
and the earnings per share value (EPS), have been criticised for not focusing sufficiently on what businesses ultimately
seek to do, namely to generate wealth for their shareholders.
The problems with the accounting measures is that they tend to focus on sales and profit increases, not on value
generation.
For example, it is always open to a business to increase its ROCE and EPS, at least in the short term, by taking on more
risky activities. Such activities may well have the effect of reducing value.
The increasing emphasis on the wealth of the shareholders as a corporate goal, has led to the emergence of ideas like
shareholder value analysis (SVA). SVA is based on the totally logical principle that the value of the business overall is equal
to the sum of the present values (PVs) of all of its activities. The shareholders' financial stake in the business is the value of
the business, less the value of its outstanding debt. Thus if the value of the PVs of the various activities of the business can
be increased, this should mean greater value for shareholders, either to be paid out as dividends or reinvested in other
projects that will, in turn, result in still more shareholder value.
7.3 The principles ofSVA

Abusinesshasaparticularvalueataparticulartimebecauseoftheprojectedcashflowsfromitsactivities.
Theparticularvaluewillbebasedontheirtimingsandriskiness.AccordingtothephilosophyofSVA,the
valueofthebusinessisaffectedor'driven'byjustsevenfactors,knownas'valuedrivers’.Toincreasethe
valueofthebusiness,i.e.togenerateadditionalvalue,oneormoreofthesesevenwillneedtoalterina
favourabledirection.Thevaluedrivers,andtheireffectonshareholdervalue,areshownbelow.
Cost Life of Sales

of projected growth
capital cashflows rate
Investment Operating
in working
Shareholder profit
capital wealth margin
Investment
in non- Corporation
current tax rate
assets
Thesesevenfactorsallimpactontheoperatingcashflowsandthroughthemthevalueofthebusinessand the wealth of

theshareholders.
These will be examined in turn and related to individual parts of the business.
Sales growth
rate
Ifagreaterlevelofsalescanbegeneratedinthefuturethanwasexpected,thisshould
createmorecashflowsand,therefore,value.Thegreaterlevelofsalescouldcome
Operating fromanewproductand,providedthatthisdidnothaveanadverseeffectononeof
profit margin theothervaluedrivers,greatervaluewouldnecessarilybecreated.Similarly,arresting
anexpecteddeclineinsaleslevelsforsomeexistingproducthasthepotentialto
generatevalue.
Corporation Theoperatingprofitmarginistheratioofnetprofit,beforefinancingchargesandtax,
tax rate tosales.Thehigherthisratiothemorecashflowsthereareforeachsale.Thusif
costscanbecontrolledmoreeffectively,morecashwilltendtoflowfromeachsale and value
will beenhanced.
Thisclearlyaffectscashflowsandvaluebecause,broadly,taxislevieddirectlyon
operatingcashflows.Management'sabilitytoaffectthetaxrateandtheamountoftax
paidbythebusinesstends,atbest,tobemarginal.
Investment in Normallycashhastobespentonadditionalnon-currentassetsinordertoenhance
non-current shareholdervalue.Wherevermanagerscanfindwaysofreducingtheoutlayonplant etc
assets without limiting the effectiveness of the business, this will tend to enhance
shareholdervalue.
Investment in Nearly all business activities give rise to a need for working capital: inventories,
working capital receivables, payables and cash. Amounts tied up in working capital can be
considerable.Stepsthatcanbetaken,forexample,toencouragetradereceivablesto
paymorequicklythanexpected,willbringcashflowsforwardandtendtogenerate
value,aslongasthebenefitsofquickerpaymentoutweighthecostofdeliveringit.
Cost of capital
Thecostoffundsusedtofinancetheactivitiesofthebusinesswilltypicallybeamajor
determinantofshareholdervalue.Soifthebusinesscanfindalternative,cheaper,
Life of
sourcesoflong-termfinance,valuewouldtendtobeenhanced.
projected cash
flows Clearly,thelongerthatthelifeofanycashgeneratingactivitycancontinue,thelonger its potential to
generatevalue.
7.4 How can SVA beused?

WhereSVAisseentobemostusefulisinhighlightingthekeydriversofvalue.Thisenablesmanagerstoset
targetsforachievingvalueenhancingstrategiesineacharea.Itcanhelptocreateanenvironmentwhere
valueenhancementisatthetopoftheagendaformanagersinallareasofthebusiness.Inthiswaythe
primaryfinancialobjectiveofthebusinesscanbeachieved.
7.5 Realoptions
One problem of NPV analysis is that it only considers cash flows related directly to the project. It is
possiblethataprojectwithanegativeNPVisacceptedfor'strategic'reasons.Thisisbecausemanagement
acceptthatthereareoptionsassociatedwithaparticularprojectwhichoutweightheconventionally
calculatednegativeNPV.
The revised decision model becomes
Projectworth=TraditionalNPV+valueofanyoptions
Worked example: Real options
Situation Realoption
Follow on options Launching this project would give a later

opportunitytolaunchasecond(andthirdandso
Afirmisconsideringinvestinginaprojectto
on)versionwhichcouldbehighlyprofitableor could
manufacturemicrocomputers.TheinitialNPVis
losemoney.
negative.
Launching the first version effectively gives the
righttoinvestinlaterversions.Therighttoinvest
orbuyisknownasacalloption.
Situation Realoption
Abandonment options Both projects offer the right to abandon the
projectifthingsgowrong,bysellingtheassets.
Afirmisconsideringinvestingintwoprojects,
Thevalueofthesecondoptionismuchgreater
bothhavingthesameexpectedNPV.Thefirstuses
andcouldwellbepreferredbymanagement.
ahighlyspecialisedmachinewithlittleresalevalue or
alternative use. The second involves The right to sell is known as a put option.
expendituremainlyonhighlymarketablelandand
Some projects such as those in the natural
buildings.
resourceindustry(timber,miningetc)haveinbuilt
optionstoreducecapacityorsuspendoperations
temporarily.
Timing options Projectswherecommencementcanbedelayedare
oftenattractive.Inavolatilemarketaprojectthat
Afirmhasthedevelopmentrightsoverapieceof
canbedelayedislikeacalloptionwithalong period of
land.Therightscanbeexercisedanytimeoverthe next
expiry. If the company can delay
fiveyears.
investmentitcanwaitandseewhathappenstothe
market before investing or not (exercising the
optionornot).Thelongerthedelay,themore valuable
theoption.
Theoptiontodelayisonlyvaluableifitoffsetsany loss
from delaying e.g. delaying results in a
competitorestablishingaloyalcustomerbasethat
makesitdifficultforthecompanytoenterlater.
Patentsandotherbarrierstoentrycanoffersome
protection againstthis.
Growth options Choices might include
Newtechnology,deregulationetcpresent Full investment and hope it pays off (high risk)
uncertaingrowthopportunitiesforfirms– Wait and see but competitors might take a lead
investing could produce substantiallosses. Acquire 'growth option' Growth
options include
Start with small capacity, expanding later if
market conditions are good
Jointventuresandstrategicalliancesasentry
strategiesintoemergingmarkets,e.g.China
R&D avoiding 'wait and see' risk and, if prospects
look poor, no full investment, e.g. pharmaceutical
companies
Follow on options noted above
Flexibility options Amoreexpensivestationcapableofusinggasor

coaloroilgivesgreaterflexibility.Thisflexibility
Apowerstationcouldbeconstructedtogenerate optionhasavaluewhichmustbeincludedinthe
electricityusingonlygasastheinputfuel.Whilst evaluation.
thismightbethecheapestoptionitlacksflexibility
inthefaceofvolatilegasprices.
Theabovereferstooptionsassociatedwithinvestments–socalled'real'options.Chapters9and10will
introducehowoptionstobuyandsellcurrency,shares,bonds,etccanbeusedtomanageriskssuchas interest rates and
exchangerates.
8 Investingoverseas
Section overview
Overseasinvestmentcarriesadditionalrisks,includingpoliticalandcultural.
Themethodsoffinancingoverseassubsidiarieswilldependonthelengthofinvestmentperiod
envisaged,alsothelocalfinancecosts,taxationsystemsandrestrictionsondividendremittances.
Whendecidingwhattypesofcountryitshouldenter(intermsofenvironmentalfactors,economic
development,languageused,culturalsimilaritiesandsoon),themajorcriteriaforthisdecisionshouldbeas follows.
(a) Marketattractiveness.ThisconcernssuchindicatorsasGNP/headandforecastdemand.
(b) Competitiveadvantage.Thisisprincipallydependentonpriorexperienceinsimilarmarketsandhaving a
culturalunderstanding.
(c) Risk.Thisinvolvesananalysisofpoliticalstability,thepossibilityofgovernmentinterventionand similar
externalinfluences.
8.1 Politicalrisks
Definition
Political Risk is the risk that political action will affect the position and value of a company.
Whenamultinationalcompanyinvestsinanothercountry,e.g.bysettingupasubsidiary,itmayfacea
politicalriskofactionbythatcountry'sgovernmentwhichrestrictsthemultinational'sfreedom.
Ifagovernmenttriestopreventtheexploitationofitscountrybymultinationals,itmaytakevarious measures,
including thefollowing:
Quotas Importquotascouldbeusedtolimitthequantitiesofgoodsthatasubsidiarycanbuy
fromitsparentcompanyandimportforresaleinitsdomesticmarkets.
Tariffs Importtariffscouldmakeimports(suchasfromparentcompanies)moreexpensive
anddomesticallyproducedgoodsthereforemorecompetitive.
Non-tariff Legal standards of safety or quality (non-tariff barriers) could be imposed on
barriers importedgoodstopreventmultinationalsfromsellinggoodsthroughasubsidiary
whichhavebeenbannedasdangerousinothercountries.
Restrictions Agovernmentcouldrestricttheabilityofforeigncompaniestobuydomestic
companies,especiallythosethatoperateinpoliticallysensitiveindustriessuchas
defencecontracting,communications,energysupplyandsoon.
Nationalisation Agovernmentcouldnationaliseforeign-ownedcompaniesandtheirassets(withor
withoutcompensationtotheparentcompany).
Minimum Agovernmentcouldinsistonaminimumshareholdingincompaniesbyresidents.
shareholding Thiswouldforceamultinationaltooffersomeoftheequityinasubsidiaryto
investorsinthecountrywherethesubsidiaryoperates.
8.1.1 Assessment of politicalrisk
Therearealargenumberoffactorsthatcanbetakenintoaccountwhenassessingpoliticalrisk,for example:
Governmentstability
Political and businessethics
Economicstability/inflation
Degree of internationalindebtedness
Financialinfrastructure
Level of importrestrictions
Remittance restrictions
Evidence ofexpropriation
Existenceofspecialtaxesandregulationsonoverseasinvestors,orinvestmentincentives
Inadditionmicrofactors,factorsonlyaffectingthecompanyortheindustryinwhichitinvests,maybe
moresignificantthanmacrofactors,particularlyincompaniessuchashi-techorganisations.
8.1.2 Dealing with politicalrisks

There are various strategies that multinational companies can adopt to limit the effects of political risk.
Negotiations with Theaimofthesenegotiationsisgenerallytoobtainaconcessionagreement.This

host government wouldcovermatterssuchasthetransferofcapital,remittancesandproducts, access to
local finance, government intervention and taxation, and transfer pricing.
Insurance SeeChapter10whereoverseastradeisexplored.
Production Itmaybenecessarytostrikeabalancebetweencontractingouttolocalsources
strategies (thuslosingcontrol)andproducingdirectly(whichincreasestheinvestmentand
henceincreasesthepotentialloss).Alternativelyitmaybebettertolocatekey
partsoftheproductionprocessorthedistributionchannelsabroad.Controlof
patentsisanotherpossibility,sincethesecanbeenforcedinternationally.
Management Possiblemethodsincludejointventuresorcedingcontroltolocalinvestorsand
structure obtainingprofitsbyamanagementcontract.
8.2 Culturalrisk
The following areas may be particularly important depending upon the location of the overseas investment:
(a) Theculturesandpracticesofcustomersandconsumersinindividualmarkets
(b) Themediaanddistributionsystemsinoverseasmarkets
(c) Thedifferentwaysofdoingbusinessinoverseasmarkets
(d) Thedegreetowhichnationalculturaldifferencesmatterfortheproductconcerned(agreatdealfor some
consumer products, e.g. washing machines where some countries prefer front-loading machines
andothersprefertop-loadingmachines,butlesssoforproductssuchasgasturbines)
(e) Thedegreetowhichafirmcanuseitsown'nationalculture'asasellingpoint
8.3 Factorsinfluencingthechoiceoffinanceforanoverseassubsidiary
Indetermininghowanoverseasinvestmentshouldbefinanced,thefollowingconsiderationsneedtobe made:
(a) Thelocalfinancecosts,andanysubsidieswhichmaybeavailable
(b) Taxationsystemsofthecountriesinwhichthesubsidiaryisoperating.Differenttaxratescanfavourborrowingin
hightaxregimes,andnoborrowingelsewhere.Tax-savingopportunitiesmaybe
maximisedbystructuringthegroupanditssubsidiariesinsuchawayastotakethebestadvantageof the different
local taxsystems
(c) Any restrictions on dividendremittances
(d) Thepossibilityofflexibilityinrepaymentswhichmayarisefromtheparent/subsidiaryrelationship
(e) Accesstocapital.Obtainingcapitalfromforeignmarketsmayincreaseliquidity,lowercostsandmake it easier to
maintain optimumgearing
Summary and Self-test
Summary
Taxation
- Taxchargedonnetca
flow
- tax depreciationgives
taxbenefit

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The Institute of Chartered Accountants in England and Wales

Learning objectives Tick off

To select and justify investment appraisaltechniques

To choose appropriate values for use in investmentappraisal

To take account of tax andinflation

To recommend and justify a course of action based on the results of investmentappraisal

Toconsiderrelevantnon-financialfactors,includingthelimitationsofthetechniques The syllabus

references relevant to this chapter are 3a, b, d, h,k.

Stop and think

1.1 Recap of investment appraisaltechniques

Answer to Interactive question 1

Merits Demerits Rank

Net present value

Answer to Interactive question 2

Accounting rate of Use of profit Not consistent with Unlikely to be useful

2.1 Why cash flows rather thanprofits?

2.2 Profits to cashflows

Interactive question 3: Changingworkingcapital [Difficulty level:Easy]

Answer to Interactive question 3

2.3 Relevant cashflows

2.4 Opportunity costs andrevenues

Worked example: Relevant cost of material

Interactive question 4: Material with no alternativeuse

Answer to Interactive question 4

Interactivequestion5:Materialwithascrapvalue [Difficulty level:Intermediate]

Answer to Interactive question 5

Worked example: Relevant cost of labour

Interactivequestion6:Relevantcostofsurpluslabour [Difficulty level:Easy]

Answer to Interactive question 6

Interactive question 7:Relevantcosts [Difficulty level:Intermediate]

Worked example: Deprival value

This can be summarised as follows.

Replacement cost and Recoverable amount

iethecostofreplacing the = higher of

Interactive question 8:Deprivalvalue [Difficulty level:Intermediate]

Answer to Interactive question 8

Worked example: Taxable profit

Tax Tax relief

Tax Depreciation (TD)

3.3 Tax Depreciation(TDs)

Answer to Interactive question 9

Interactive question 10:Timingissues [Difficulty level:Intermediate]

Answer to Interactive question 10

Asset purchased 1 Jan 20X1which Asset sold 31 Dec20X2

Worked example: Impact of inflation

The impact of inflation means

4.2 Money and current cashflows

4.3 General and specific inflationrates

Answer to Interactive question 11

Interactivequestion12:Effectiverate [Difficulty level:Intermediate]

Answer to Interactive question 12

(2) Discount perpetuity using the effective

Worked example: Replacement decision

5.1 Lowest common multipleapproach

5.2 Equivalent annual cost(EAC)

Interactive question 13:Replacementcycle [Difficulty level:Intermediate]

Company's cost of capital = 10%.

Answer to Interactive question 13

Answer to Interactive question 13

Replace after one year

CU10,001 = CU10,001 = CU11,002

5.3 Limitations of the replacement analysisperformed

6.1 Two types ofrationing