Revision 2 – Investment Appraisal

Topics List
1. Investment Appraisal Methods Exam Question
Reference
a. Payback period
 Computation & comment
 Advantages and disadvantages
 Discounted payback period Jun 09 Q2b
Jun 11 Q1c
b. Accounting rate of return (ARR)
 Computation & comment Pilot Q4b
Jun 09 Q2b
 Advantages and disadvantages
c. Net present value (NPV)
 Computation & comment Jun 09 Q2b
Dec 10 Q1a,b
 Advantages and disadvantages
d. Internal rate of return (IRR)
 Computation & comment Dec 07 Q2b
Jun 08 Q4b
Jun 09 Q2b
 Advantages and disadvantages Pilot Q4c
Jun 10 Q3c
2. Stages in Capital Investment Projects Jun 09 Q2a

3. Determination of relevant and non-relevant cash flows

4. Allowing for Tax, Inflation and Working Capital

a. Inflation
 Specific inflation and general inflation Pilot Q4a
Jun 08 Q4a
Jun 09 Q2b
Dec 10 Q1a
Jun 11 Q1a
 Real and money interest rate – Fisher’s equation Pilot Q4a
Jun 10 Q3b
b. Taxation Pilot Q4a

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 Dec 07 Q2a
Jun 08 Q4a
Dec 08 Q3b
Jun 10 Q3b
Dec 10 Q1a
Jun 11 Q1a
c. Working capital Jun 08 Q4a
Dec 08 Q3b
Jun 11 Q1a
5. Project Appraisal and Risk
a. Risk and uncertainty Dec 07 Q2c
Jun 11 Q1c
b. Probability analysis Dec 07 Q2c
Jun 11 Q1c
c. Sensitivity analysis Dec 07 Q2c
Jun 11 Q1c
d. Simulation
e. Risk-adjusted discount rate Jun 10 Q3c(iii)
Jun 11 Q1c
6. Asset Investment Decisions
a. Lease or buy
 Numerical analysis Dec 09 Q1a,b
 Finance lease meaning
 Operating lease meaning
 Attractions of finance lease
 Attractions of operating lease
b. Asset acquisition by NPV Pilot Q4a
Dec 07 Q2a
Jun 08 Q4a
Dec 08 Q3b
c. Replacement cycles Dec 09 Q1b
Jun 10 Q3c
d. Capital rationing
 Hard (external) and soft (internal) capital rationing
 Single period capital rationing Dec 09 Q1d
 Multi-period capital rationing

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Part IV Investment Appraisal

Jun-11 Dec-10 Jun-10 Dec-09 Jun-09 Dec-08 Jun-08 Dec-07 Pilot

Topics
I. Nature of Investment Decisions and Appraisal Process
1. Distinguish between capital & revenue expenditure,
between non-current assets and working capital management
2. Explain the role of investment appraisal in the capital budgeting process
3. Discuss the stages of the capital budgeting process 2a

II. Non-discounted Cash Flow Techniques

4. Identify and calculate relevant cash flows 1a 1a 3b 1a,b 2b 3b 4a 2a 4a
5. Calculate payback period and its usefulness
6. Calculate ARR and its usefulness 2b(iii),c 4b

III. Discounted Cash Flow (DCF) Techniques

7. Explain and apply concepts relating to interest and discounting, including:
a. Relationship between interest rates and inflation,
real and nominal interest rates
b. Calculation of future values and application of the annuity
c. Calculation of present values of annuity and perpetuity 1b
d. Time value of money
8. Calculate NPV and discuss its usefulness 1a 1a,b 3a,b 1a,b 2b(i),c 3b 4a 2a 4a
9. Calculate IRR and discuss its usefulness 2b(ii),c 4b 2b 4c
10. Discuss the superiority of DCF methods over non-DCF methods
11. Discuss the relative merits of NPV and IRR 3c(ii) 4c 2b 4c

IV. Allowing for Inflation and Taxation in DCF

12. Apply and discuss the real-terms and nominal-terms to DCF
13. Calculate the taxation effects of relevant cash flows,
including tax benefits of capital allowances and tax liabilities 1a 1a 3b 1a 3b 4a 2a 4a
14. Calculate and apply before- and after-tax discount rates

V. Adjusting for Risk and Uncertainty in Investment Appraisal

15. Difference between risk and uncertainty 3c(iii) 2c
16. Apply sensitivity analysis and discuss the usefulness 1c 2c
17. Apply probability analysis and discuss the usefulness 1c 2c
18. Apply and discuss other techniques of adjusting for risk and uncertainty
a. Simulation
b. Adjusted payback 1c 2b(iv),c
c. Risk-adjusted discount rates 1c

VI. Specific Investment Decisions

19. Evaluate leasing and borrowing to buy using the before- and
after-tax cost of debt 1a
20. Evaluate asset replacement decisions using equivalent annual cost 3c(i) 1c
21. Evaluate investment decisions under single-period capital rationing
a. Calculation of profitability indexes for divisible projects
b. Calculation of NPV of combinations of non-divisible projects
c. Discuss the reasons for capital rationing 1d

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1. Investment Appraisal Methods

1.1 Payback period

1.1.1 Time it takes the project to payback its initial investment.

1.1.2 When is useful?
 seeking to claw back cash from investments as quickly as possible
 commonly used for initial screening of investment alternatives
1.1.3 A long payback period is considered risky because it relies on cash flows that are in
the distant future.
1.1.4 Decision rule:
 only select projects which payback within the specified time period
 choose between options on the basis of the fastest payback
 provides a measure of liquidity
1.1.5 General approach:
Year Cash flows ($) Cumulative cash flows ($)
0 (100,000) (100,000)
1 20,000 (80,000)
2 30,000 (50,000)
3 40,000 (10,000)
4 30,000 20,000
5 40,000

Payback period = 3 years + 10,000/30,000

= 3.33 years or 3 years 4 months

1.1.6 Discounted payback period:

Year Cash flow Discounted Cumulative cash
($000) Cash flow @10% flow
($000) ($000)
0 (2,000) (2,000) (2,000)
1 600 545 (1,455)
2 500 413 (1,042)
3 600 451 (591)
4 600 410 (181)
5 300 186 5
6 200 113 118

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 The payback period is about 5 years.
1.1.7 Advantages and disadvantages of payback period

Advantages Disadvantages
 It is simple  It ignores overall profitability after
 It is useful in certain situations: the payback period
 Rapidly changing technology  It ignores time value of money
 Improving investment  It is subjective – no definitive
conditions investment signal
 It favours quick return:
 Helps company growth
 Minimizes risk
 Maximizes liquidity
 It uses cash flows, not accounting
profit.

1.2 Accounting Rate of Return (ARR)

1.2.1 Also known as ROCE or ROI.

1.2.2 Decision rule:
 ARR > target return or hurdle rate, accept the project
 Take the project with the highest ARR
1.2.3 Calculation of ARR – three version
 Annual basis –
Profit for the year
ARR = × 100%
Asset book value at start of year

Then, take average of each year’s ARR to find the average ARR.

 Total investment basis –

Average annual profit
ARR = × 100%
Initial capital invested

 Average investment basis –

Average annual profit
ARR = × 100%
Average capital invested

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 Initial investment + Scrap value
Average capital invested =
2

1.2.4 Advantages and disadvantages of ARR

Advantages Disadvantages
 It is a quick and simple  It is based on accounting profit
calculation and not cash flows.
 It involves the familiar concept of  It depends on accounting policies
a percentage return and this can make comparison of
 It looks at the entire project life ARR being difficult.
 It is a relative measure rather
than an absolute measure and
hence takes no account of the size
of the investment
 Like the payback method, it
ignores the time value of money.

1.3 Net Present Value (NPV)

1.3.1 PV of cash inflows compare with the PV of cash outflows to obtain a NPV.
1.3.2 The discount rate equals its cost of capital or WACC.
1.3.3 Decision rule:
 NPV > 0, the project is financially viable, i.e. accepted.
 NPV = 0, the project breaks even.
 NPV < 0, the project is not financially viable, i.e. rejected.
1.3.4 If the company has two or more mutually exclusive projects under consideration it
should choose the one with the highest NPV.
1.3.5 The NPV gives the impact of the project on shareholder wealth.
 All acceptable investment project should have positive NPV
 The market value of the company, theoretically at least, increases by the
amount of the NPV
 The share price of the company should theoretically increase as well
 Objective of maximizing the wealth of shareholders is usually substituted
by the objective of maximizing the share price of a company

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1.3.6 Advantages and disadvantages of NPV

Advantages Disadvantages
 Considers the time value of money  It is difficult to explain to managers
 Is an absolute measure of return, and relatively complex
i.e. absolute increase in corporate  It requires knowledge of the cost of
value capital
 Is based on cash flows not profits
 Considers the whole life of the
project
 Should lead to maximization of
shareholder wealth
 Can accommodate changes in
discount rate
 Has a sensible re-investment
assumption
 Can accommodate non-
conventional cash flows

1.3.7 Why NPV is superior to other methods?

 NPV considers cash flows
 NPV considers the whole life of an investment project
 NPV considers the time value of money
 NPV is an absolute measure of return
 NPV directly links to the objective of maximizing shareholders’ wealth
 NPV offers the correct investment advice
 NPV can accommodate changes in the discount rate
 NPV has a sensible re-investment assumption
 NPV can accommodate non-conventional cash flows

1.4 Internal Rate of Return (IRR)

1.4.1 IRR is defined as the discount rate at which the NPV equals zero. In other words, the
IRR represents the breakeven discount rate for the investment.

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1.4.2 Decision rule:
 IRR > cost of capital, project accepts
 The higher IRR is the better
1.4.3 Steps in calculating the IRR using linear interpolation:
1. Calculate two NPV at two different discount rates. One must be positive and
another one must be negative.
2. Using the following formula to find the IRR

NL
IRR = L +  ( H  L)
NL  NH

where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest

1.4.4 Advantages and disadvantages of IRR

Advantages Disadvantages
 Considers the time value of money  It is not a measure of absolute
 Is a percentage and therefore increase in company value.
easily understood  Interpolation only provides an
 Uses cash flows not profits estimate and an accurate estimate
 Considers the whole life of the requires the use of a spreadsheet
project program
 Means a firm selecting projects  It is fairly complicated to calculate
where the IRR exceeds the cost of  Non-conventional cash flows may
capital should increase give rise to multiple IRRs
shareholders’ wealth.  Can offer conflicting advice
between IRR and NPV in the
evaluation of mutually exclusive
projects
 Assume cash inflows being
reinvested at the IRR rate, this is
unrealistic when IRR is high.

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2. Stages in the Capital Investment Projects
(June 2009)
2.1 Stages can be summarized as follows:

Stages Explanation
Identify investment  Arise from analysis of strategic choice, business
opportunities environment, R&D or legal environment, etc.
 Key requirement is to achieve the organizational
objectives.
Screen investment  Select those proposals with best strategic fit and the
proposals most appropriate use of economic resources.
Analyse and evaluate  Analyse and evaluate which proposal(s) offer the
investment proposals most attractive opportunities to achieve company
objectives, e.g. increase shareholder wealth.
 Investment appraisal plays a key role here, e.g.
choose highest NPV among different proposals.
Approve investment  Pass to relevant level of authority for approval.
proposals  Large proposals approve by board of directors,
smaller proposals approve by divisional level.
Implementation  Responsibility for the project is assigned to a project
manager or other responsible person.
 Resources will be available and specific target should
be set.
Monitoring  Progress must be monitored to check whether there
are any big variances and unforeseen events.
Post-completion audit  To facilitate organizational learning and to improve
future investment decisions.

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3. Determination of the Cash Flows

3.1 Relevant cash flows

3.1.1 The following principles should be applied when identifying costs that are relevant to
a period.

Relevant costs Explanation

Future costs  Future cost arises as a direct consequence of a
decision.
 Sunk costs should not be included because it is past
and so irrelevant to any decision.
Cash flows  Future costs which are in the form of cash should be
included.
 So depreciation should be ignored because it is not
cash spending.
Incremental costs  Increase in costs results from making a particular
decision.
Opportunity costs  It is the value of a benefit foregone as a result of
choosing a particular course of action.

3.2 Non-relevant costs

3.2.1 Other non-relevant costs:

 Committed costs – they are future cash flow but will be incurred anyway,
regardless of what decision will be taken.
 Interest costs – they have already been included in the discount rate, if
counted, it will be double counted.

4. Allowing for Tax, Inflation and Working Capital

4.1 Inflation

4.1.1 Inflation has two impacts on NPV:

 Specific inflation – cash flow rises by the rate of inflation
 General inflation – cost of capital (or discount rate) rises by the rate of
inflation.

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4.1.2 Real and money (nominal) interest rate
 It has the following relationship between real interest rate and nominal interest
rate under Fisher’s equation.

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

Where h = inflation rate

r = real interest rate
i = nominal interest rate

4.2 Taxation

4.2.1 Taxation has the following two effects on cash flow:

Effects Explanation
Tax on profits  Calculate the taxable profits (before capital
allowances) and calculate tax at the rate given.
 The effect of taxation will not necessarily occur in
the same year, often one year in arrears in the
examination.
Tax benefits from  Normally 25% writing-down allowances on plant and
WDAs machinery (can be straight-line)
 Remember the balancing allowance or balancing
charge in the final year.

4.3 Working capital

4.3.1 New project requires an additional investment in working capital.

4.3.2 The treatment of working capital is as follows:
 Initial investment is a cost at the start of the project, i.e. cash outflow.
 If increasing during the project, the increase is a relevant cash outflow.
 Working capital is released at the end of the project and treated as cash
inflow.

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4.4 General layout of cash flow preparation

4.4.1 The general layout can be shown as follows:

Year 0 1 2 3 4
$000 $000 $000 $000 $000
Sales X X X
Costs (X) (X) (X)
Operating cash flows X X X
Taxation (X) (X) (X)
Tax benefit of CAs X X X
Capital expenditure and scrap value (X) X
Working capital changes (X) (X) (X) (X) X
Net cash flows (X) X X X X
Discount factor X X X X X
Present value (X) X X X X

Question 1
The following draft appraisal of a proposed investment project has been prepared for the fi
nance director of OKM Co by a trainee accountant. The project is consistent with the current
business operations of OKM Co.

Net present value = 1,645,000 – 2,000,000 = ($355,000) so reject the project.

The following information was included with the draft investment appraisal:

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1. The initial investment is $2 million
2. Selling price: $12/unit (current price terms), selling price inflation is 5% per year
3. Variable cost: $7/unit (current price terms), variable cost inflation is 4% per year
4. Fixed overhead costs: $500,000/year (current price terms), fixed cost inflation is 6% per
year
5. $200,000/year of the fixed costs are development costs that have already been incurred
and are being recovered by an annual charge to the project
6. Investment financing is by a $2 million loan at a fixed interest rate of 10% per year
7. OKM Co can claim 25% reducing balance capital allowances on this investment and
pays taxation one year in arrears at a rate of 30% per year
8. The scrap value of machinery at the end of the four-year project is $250,000
9. The real weighted average cost of capital of OKM Co is 7% per year
10. The general rate of inflation is expected to be 4·7% per year

Required:

(a) Identify and comment on any errors in the investment appraisal prepared by the trainee
accountant. (5 marks)
(b) Prepare a revised calculation of the net present value of the proposed investment project
and comment on the project’s acceptability. (12 marks)
(c) Discuss the problems faced when undertaking investment appraisal in the following
areas and comment on how these problems can be overcome:
(i) assets with replacement cycles of different lengths;
(ii) an investment project has several internal rates of return;
(iii) the business risk of an investment project is significantly different from the
business risk of current operations. (8 marks)
(25 marks)
(ACCA F9 Financial Management June 2010 Q3)

5. Project Appraisal and Risk

5.1 Risk and uncertainty

5.1.1 Risk refers to the situation where probabilities can be assigned to a range of
expected outcomes, so it can be quantified.
5.1.2 Uncertainty refers to the situation where probabilities cannot be assigned to

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 expected outcomes, so it is unquantifiable. It can only be described.

5.2 Probability analysis (December 2007)

5.2.1 It refers to the assessment of the separate probabilities of a number of specified

outcomes of an investment project.
5.2.2 The NPV from combinations of future economic conditions could be assessed and
linked to the joint probabilities of those combinations. The expected NPV could be
calculated.
5.2.3 The expected value (EV) is the weighted average of all possible outcomes, with the
weightings based on the probability estimates.

EV =  px
Where: p = the probability of an outcome
x = the value of an outcome

5.3 Sensitivity analysis (December 2007)

5.3.1 Sensitivity analysis assesses how the NPV of an investment project is affected by
changes in project variables. The purpose is to identify the key or critical
variables so that management can concern more.
5.3.2 The change in one variable required to make the NPV to be zero.
5.3.3 Or alternatively, the change in NPV arising from a fixed change in the given project
variable.
5.3.4 However, sensitivity analysis does not assess the probability of changes in project
variables.
5.3.4 A simple approach to deciding which variables the NPV is particularly sensitive to is
to calculate the sensitivity of each variable:

NPV
Sensitivity = %
PV of project variable

5.3.5 The lower the percentage, the more sensitive is NPV to that project variable as the
variable would need to change by a smaller amount to make the project non-viable.

5.4 Simulation

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5.4.1 An analysis of how changes in more than one variable (e.g. market share and sales
price) may affect the NPV of a project.

Question 2
Umunat plc is considering investing $50,000 in a new machine with an expected life of five
years. The machine will have no scrap value at the end of five years. It is expected that
20,000 units will be sold each year at a selling price of $3·00 per unit. Variable production
costs are expected to be $1·65 per unit, while incremental fixed costs, mainly the wages of a
maintenance engineer, are expected to be $10,000 per year. Umunat plc uses a discount rate
of 12% for investment appraisal purposes and expects investment projects to recover their
initial investment within two years.

Required:

(a) Explain why risk and uncertainty should be considered in the investment appraisal
process. (5 marks)
(b) Calculate and comment on the payback period of the project. (4 marks)
(c) Evaluate the sensitivity of the project’s net present value to a change in the following
project variables:
(i) sales volume;
(ii) sales price;
(iii) variable cost;
and discuss the use of sensitivity analysis as a way of evaluating project risk.
(10 marks)
(d) Upon further investigation it is found that there is a significant chance that the
expected sales volume of 20,000 units per year will not be achieved. The sales
manager of Umunat plc suggests that sales volumes could depend on expected
economic states that could be assigned the following probabilities:

Economic state Poor Normal Good

Probability 0.3 0.6 0.1
Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project.(6 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control December 2004 Q5)

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6. Asset Investment Decisions

6.1 Lease or buy

6.1.1 DCF techniques can also be used to assess whether to finance an investment with a
lease or a bank loan.
6.1.2 Numerical analysis
 The benefits of leasing vs purchasing (with a loan) can be assessed by an
NPV approach:
Step 1: the cost of leasing (payments, lost capital allowances and lost scrap
revenue)
Step 2: the benefits of leasing (savings on loan repayments = PV of loan =
initial outlay)
Step 3: discounting at the after tax cost of debt
Step 4: calculate the NPV – if positive it means that the lease is cheaper than
the after tax cost of a loan.
 Alternative method – to evaluate the NPV of the cost of the loan and the
NPV of the cost of the lease separately, and to choose the cheapest option.
6.1.3 Finance lease:
 Transfer substantially all of the risks and rewards of ownership to lessee.
 Lessee can use the asset for all or most of its useful economic life.
 It cannot be cancelled or with severe financial penalties even when
cancelled. Therefore, it is a kind of medium- to long-term source of debt
finance.
 Leased asset must be capitalized together with the amount of obligations
for the lease payments.
6.1.4 Operating lease:
 It’s renal agreement and the lease period is shorter than the asset’s useful
economic life.
 Maintenance and similar costs are borne by the lessor.
 Cancelled without penalty at short notice. It can avoid the obsolescence
problem, so suitable for high-tech assts.
 No need to be capitalized and no liabilities need to be recognized.
6.1.5 Attractions of finance lease for lessee:
 Not enough cash and also difficult to obtain bank loan.

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  Interest may be cheaper than a bank loan.
 Having tax relief such as the interest expenses and depreciation
allowance (but refer to the examination question, it may not have).
6.1.6 Attractions of operating lease for lessee:
 No effect on assets and liabilities, so no increase in its gearing ratio.
 Can have the up-to-date assets at all time because the lessee can replace
with no cost.
 Higher flexibility with cancellation at short notice
 Suitable for small companies who may find it difficult to raise debt
 Cheaper than borrow to buy
 Off-balance sheet financing
6.1.7 Attractions of operating lease for lessor:
 Leased asset can be recovered if the lessee default on lease rentals
 Lessor can take advantage of bulk buying
 Lessor can have access to lower cost finance by virtue of being a much larger
company.
 Enjoy tax benefits such as depreciation allowance and other allowable
expenses.

Question 3
Leaminger Inc has decided it must replace its major turbine machine on 31 December 2008.
The machine is essential to the operations of the company. The company is, however,
considering whether to purchase the machine outright or to use lease financing.

Purchasing the machine outright

The machine is expected to cost $360,000 if it is purchased outright, payable on 31
December 2008. After four years the company expects new technology to make the machine
redundant and it will be sold on 31 December 2012 generating proceeds of $20,000. Capital
allowances for tax purposes are available on the cost of the machine at the rate of 25% per
annum reducing balance. A full year’s allowance is given in the year of acquisition but no
writing down allowance is available in the year of disposal. The difference between the
proceeds and the tax written down value in the year of disposal is allowable or chargeable
for tax as appropriate.

Leasing
The company has approached its bank with a view to arranging a lease to finance the
machine acquisition. The bank has offered two options with respect to leasing which are as

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follows:
Finance lease Operating lease
Contract length (years) 4 1
Annual rental $135,000 $140,000
First rent payable 31 December 2009 31 December 2008

General
For both the purchasing and the finance lease option, maintenance costs of $15,000 per year
are payable at the end of each year. All these rentals (for both finance and operating options)
can be assumed to be allowable for tax purposes in full in the year of payment. Assume that
tax is payable one year after the end of the accounting year in which the transaction occurs.
For the operating lease only, contracts are renewable annually at the discretion of either
party. Leaminger Inc has adequate taxable profits to relieve all its costs. The rate of
corporation tax can be assumed to be 30%. The company’s accounting year-end is 31
December. The company’s annual after tax cost of capital is 10%.

Required:

(a) Calculate the net present value at 31 December 2008, using the after tax cost of
capital, for:
(i) purchasing the machine outright
(ii) using the finance lease to acquire the machine
(iii) using the operating lease to acquire the machine.
Recommend the optimal method. (12 marks)
(b) Assume now that the company is facing capital rationing up until 30 December 2009
when it expects to make a share issue. During this time the most marginal investment
project, which is perfectly divisible, requires an outlay of $500,000 and would
generate a net present value of $100,000. Investment in the turbine would reduce
funds available for this project. Investments cannot be delayed.

Calculate the revised net present values of the three options for the turbine given
capital rationing. Advise whether your recommendation in (a) would change.
(5 marks)
(c) As their business advisor, prepare a report for the directors of Leaminger Inc that
assesses the issues that need to be considered in acquiring the turbine with respect to
capital rationing. (8 marks)
(Total 25 marks)

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 (Adapted ACCA Paper 2.4 Financial Management and Control December 2002 Q4)

6.2 Asset replacement

6.2.1 NPV can be applied to situations of assets replacement.

6.2.2 Compare the purchase cost with the cost savings or benefits,
 Cost savings or benefits > purchase cost, replace the old one.

6.3 Replacement cycles

6.3.1 How frequently should an asset be replaced? The equivalent annual cost (EAC) or
annual equivalent annuity (AEA) can be used for evaluation.

NPV of costs
EAC =
Annuity factor for the number of years in the cycle

The best decision is to choose the option with the lowest EAC.

6.3.2 Is it worth paying more for an asset that has a longer expected life? The equivalent
annual benefit (EAB) can be applied.

NPV of project
EAB =
Annuity factor for the life of project

The best decision is to choose the option with the highest equivalent annual
benefit.

Question 4
Bread Products Ltd is considering the replacement policy for its industrial size ovens which
are used as part of a production line that bakes bread. Given its heavy usage each oven has
to be replaced frequently. The choice is between replacing every two years or every three
years. Only one type of oven is used, each of which costs $24,500. Maintenance costs and
resale values are as follows:

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 Year Maintenance per annum Resale value
$ $
1 500
2 800 15,600
3 1,500 11,200

Original cost, maintenance costs and resale values are expressed in current prices. That is,
for example, maintenance for a two year old oven would cost $800 for maintenance
undertaken now. It is expected that maintenance costs will increase at 10% per annum and
oven replacement cost and resale values at 5% per annum. The money discount rate is 15%.

Required:

(a) Calculate the preferred replacement policy for the ovens in a choice between a two
year or three year replacement cycle. (12 marks)
(b) Identify the limitations of Net Present Value techniques when applied generally to
investment appraisal. (13 marks)
(25 marks)

6.3 Capital rationing

6.3.1 In a perfect capital market, a company can raise funds as and when it needs them.
6.3.2 However, in practice, it is not the case. The capital available is always to be limited or
rationed. There are two types of rationing:
6.3.3 External (hard) capital rationing:
 Cannot raise external finance due to too risky.
 Financial risk – the company’s gearing may be seen as too high.
 Business risk – lenders may be uncertain on the company’s future profits
whether it can meet the interest and principal payments
6.3.4 Internal (soft) capital rationing:
 Managers impose restrictions on the funds. The reasons are as follows:
 Managers may not want to raise new external finance, for example
 Not wish to raise new debt to increase future interest payments
 Not wish to issue new equity to avoid dilution of control.
 Managers may prefer slower organic growth in order to remain in control of
the growth process and so avoid rapid growth.

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  Managers may want to make capital investments compete for funds in order
to week out weaker or marginal projects.
6.3.5 Single period capital rationing
 Rationing occurs when limits are placed for only one year or one period.
 Two types of single-period rationing:
 Divisible projects – a proportion rather than the whole investment can
be undertaken and use profitability index (PI) to rank the project for
priority.

PV of future cash flows

PI =
Initial investment

 Indivisible projects – use trial and error to find the affordable

combination that maximizes NPV
6.3.6 Multi-period capital rationing
 Limits are placed for more than one period, in this case, linear
programming should be employed. More complex linear programming
problems require the use of computers.
6.3.7 Practical steps to deal with capital rationing include:
 Leasing
 Entering into a joint venture with a partner
 Delaying projects to a later period
 Raising new capital if possible

Question 5
Basril plc is reviewing investment proposals that have been submitted by divisional
managers. The investment funds of the company are limited to $800,000 in the current year.
Details of three possible investments, none of which can be delayed, are given below.

Project 1
An investment of $300,000 in work station assessments. Each assessment would be on an
individual employee basis and would lead to savings in labour costs from increased
efficiency and from reduced absenteeism due to work-related illness. Savings in labour costs
from these assessments in money terms are expected to be as follows:

Year 1 2 3 4 5
Cash flows ($000) 85 90 95 100 95

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Project 2
An investment of $450,000 in individual workstations for staff that is expected to reduce
administration costs by $140,800 per annum in money terms for the next five years.

Project 3
An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per
annum are expected in current price terms and these are expected to increase by 3·6% per
annum due to inflation during the five-year life of the machines.

Basril plc has a money cost of capital of 12% and taxation should be ignored.

Required:

(a) Determine the best way for Basril plc to invest the available funds and calculate the
resultant NPV:
(i) on the assumption that each of the three projects is divisible;
(ii) on the assumption that none of the projects are divisible. (10 marks)
(b) Explain how the NPV investment appraisal method is applied in situations where
capital is rationed. (3 marks)
(c) Discuss the reasons why capital rationing may arise. (7 marks)
(d) Discuss the meaning of the term ‘relevant cash flows’ in the context of investment
appraisal, giving examples to illustrate your discussion. (5 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control December 2003 Q3)

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 Additional Examination Style Questions

Question 6 – WACC, NPV and Project-specific Discount Rate

Rupab Co is a manufacturing company that wishes to evaluate an investment in new
production machinery. The machinery would enable the company to satisfy increasing
demand for existing products and the investment is not expected to lead to any change in the
existing level of business risk of Rupab Co.

The machinery will cost $2·5 million, payable at the start of the first year of operation, and is
not expected to have any scrap value. Annual before-tax net cash flows of $680,000 per year
would be generated by the investment in each of the five years of its expected operating life.
These net cash inflows are before taking account of expected inflation of 3% per year. Initial
investment of $240,000 in working capital would also be required, followed by incremental
annual investment to maintain the purchasing power of working capital.

Rupab Co has in issue five million shares with a market value of $3·81 per share. The equity
beta of the company is 1·2. The yield on short-term government debt is 4·5% per year and the
equity risk premium is approximately 5% per year.

The debt finance of Rupab Co consists of bonds with a total book value of $2 million. These
bonds pay annual interest before tax of 7%. The par value and market value of each bond is
$100.

Rupab Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-
allowable depreciation) on machinery are on a straight-line basis over the life of the asset.

Required:

(a) Calculate the after-tax weighted average cost of capital of Rupab Co. (6 marks)
(b) Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms,
and calculate and comment on its net present value. (8 marks)
(c) Explain how the capital asset pricing model can be used to calculate a project-specific
discount rate and discuss the limitations of using the capital asset pricing model in
investment appraisal. (11 marks)
(25 marks)
(ACCA F9 Financial Management December 2008 Q3)

Question 7 – NPV and Project-specific Cost of Equity

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CJ Co is a profitable company which is financed by equity with a market value of $180
million and by debt with a market value of $45 million. The company is considering two
investment projects, as follows.

Project A
This project is an expansion of existing business costing $3·5 million, payable at the start of
the project, which will increase annual sales by 750,000 units. Information on unit selling
price and costs is as follows:

Selling price: $2.00 per unit (current price terms)

Selling costs: $0.04 per unit (current price terms)
Variable costs: $0.80 per unit (current price terms)

Selling price inflation and selling cost inflation are expected to be 5% per year and variable
cost inflation is expected to be 4% per year. Additional initial investment in working capital of
$250,000 will also be needed and this is expected to increase in line with general inflation.

Project B
This project is a diversification into a new business area that will cost $4 million. A company
that already operates in the new business area, GZ Co, has an equity beta of 1·5. GZ Co is
financed 75% by equity with a market value of $90 million and 25% by debt with a market
value of $30 million.

Other information
CJ Co has a nominal weighted average after-tax cost of capital of 10% and pays profit tax one
year in arrears at an annual rate of 30%. The company can claim capital allowances (tax-
allowable depreciation) on a 25% reducing balance basis on the initial investment in both
projects.

Risk-free rate of return: 4%

Equity risk premium: 6%
General rate of inflation: 4·5% per year

Directors’ views on investment appraisal

The directors of CJ Co require that all investment projects should be evaluated using either
payback period or return on capital employed (accounting rate of return). The target payback
period of the company is two years and the target return on capital employed is 20%, which is
the current return on capital employed of CJ Co. A project is accepted if it satisfies either of

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these investment criteria.

The directors also require all investment projects to be evaluated over a four-year planning
period, ignoring any scrap value or working capital recovery, with a balancing allowance (if
any) being claimed at the end of the fourth year of operation.

Required:

(a) Calculate the net present value of Project A and advise on its acceptability if the project
were to be appraised using this method. (12 marks)
(b) Critically discuss the directors’ views on investment appraisal. (7 marks)
(c) Calculate a project-specific cost of equity for Project B and explain the stages of your
calculation. (6 marks)
(25 marks)
(ACCA F9 Financial Management December 2010 Q1)

Question 8 – NPV, IRR and Maximization of Shareholders’ Wealth

SC Co is evaluating the purchase of a new machine to produce product P, which has a short
product life-cycle due to rapidly changing technology. The machine is expected to cost $1
million. Production and sales of product P are forecast to be as follows:

Year 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000 36,000

The selling price of product P (in current price terms) will be $20 per unit, while the variable
cost of the product (in current price terms) will be $12 per unit. Selling price inflation is
expected to be 4% per year and variable cost inflation is expected to be 5% per year. No
increase in existing fixed costs is expected since SC Co has spare capacity in both space and
labour terms.

Producing and selling product P will call for increased investment in working capital.
Analysis of historical levels of working capital within SC Co indicates that at the start of each
year, investment in working capital for product P will need to be 7% of sales revenue for that
year.

SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax
is reduced by capital allowances on machinery (tax-allowable depreciation), which SC Co can
claim on a straight-line basis over the four-year life of the proposed investment. The new

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machine is expected to have no scrap value at the end of the four-year period.

SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal
purposes.

Required:

(a) Calculate the net present value of the proposed investment in product P.
(12 marks)
(b) Calculate the internal rate of return of the proposed investment in product P.
(3 marks)
(c) Advise on the acceptability of the proposed investment in product P and discuss the
limitations of the evaluations you have carried out. (5 marks)
(d) Discuss how the net present value method of investment appraisal contributes towards
the objective of maximising the wealth of shareholders. (5 marks)
(Total 25 marks)
(ACCA F9 Financial Management June 2008 Q4)

Question 9 – NPV, IRR and Comparison of Investment Appraisal Methods

Charm plc, a software company, has developed a new game, ‘Fingo’, which it plans to launch
in the near future. Sales of the new game are expected to be very strong, following a
favourable review by a popular PC magazine. Charm plc has been informed that the review
will give the game a ‘Best Buy’ recommendation. Sales volumes, production volumes and
selling prices for ‘Fingo’ over its four-year life are expected to be as follows.

Year 1 2 3 4
Sales and production (units) 150,000 70,000 60,000 60,000
Selling price (£ per game) £25 £24 £23 £22

Financial information on ‘Fingo’ for the first year of production is as follows:

Direct material cost £5.40 per game

Other variable production cost £6.00 per game
Fixed costs £4.00 per game

Advertising costs to stimulate demand are expected to be £650,000 in the first year of
production and £100,000 in the second year of production. No advertising costs are expected
in the third and fourth years of production. Fixed costs represent incremental cash fixed

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production overheads. ‘Fingo’ will be produced on a new production machine costing
£800,000. Although this production machine is expected to have a useful life of up to ten
years, government legislation allows Charm plc to claim the capital cost of the machine
against the manufacture of a single product. Capital allowances will therefore be claimed on a
straight-line basis over four years.

Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year
in which they arise. Charm plc uses an after-tax discount rate of 10% when appraising new
capital investments. Ignore inflation.

Required:

(a) Calculate the net present value of the proposed investment and comment on your
findings. (11 marks)
(b) Calculate the internal rate of return of the proposed investment and comment on your
findings. (5 marks)
(c) Discuss the reasons why the net present value investment appraisal method is preferred
to other investment appraisal methods such as payback, return on capital employed and
internal rate of return. (9 marks)
(Total 25 marks)
(ACCA Paper 2.4 Financial Management and Control June 2006 Q5)

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