CHAPTER 2

Investment appraisal

Introduction
Examination context
Topic List
1 Ranking of investment appraisal techniques
2 Relevant cash flows
3 Taxation
4 Inflation
5 Replacement analysis
6 Capital rationing
7 Investment appraisal in a strategic context
8 Investing overseas
Summary and Self-test
Answers to Interactive questions
Answers to Self-test

19
 Introduction

Learning objectives Tick off

 To explain the decision-making process

 To select and justify investment appraisal techniques
 To choose appropriate values for use in investment appraisal
 To take account of tax and inflation
 To recommend and justify a course of action based on the results of investment appraisal
 To consider relevant non-financial factors, including the limitations of the techniques

The syllabus references relevant to this chapter are 1j, 3a, b, d, g.

Syllabus links
This chapter develops the basic investment appraisal decisions introduced at knowledge level Management
Information. The strategic context of these decisions is taken further in Business Strategy. The underlying
techniques will be applied in exploring valuation methods in the Advanced level paper Business Change.

Examination context
In the examination you may be asked to set out the relevant cash flows of a decision, including tax and inflation
effects, decide whether or not to make an investment, and to discuss the financial and non-financial issues
surrounding it.

20 Financial Management
 1 Ranking of investment appraisal techniques

Section overview
 Financial management progresses the skills from knowledge level into application level in the area of
investment appraisal.
 Relative merits and demerits mean that discounted cash flow (DCF) techniques such as NPV and IRR are
superior.
C
H
1.1 Recap of investment appraisal techniques A
P
Investment appraisal was introduced at knowledge level in the Management Information paper. These techniques T
are taken further in this subject where they are applied to more involved scenarios. This allows for a progression of
E
skills from knowledge into application.
R

Summary of techniques
2
Payback The time taken for cash inflows from a project to equal the cash outflows.

Accounting rate of return Average annual profit from investment

ARR =  100
Initial investment

Average annual profit from investment

or  100
Average investment

Initial outlay  Scrap value

where average investment =
2

Note: profit is after depreciation

Net present value The maximum an investor would pay for a given set of cash flows (at his/her
cost of capital) compared to the actual amount he/she is being asked to pay.

The difference, the NPV, represents the change in wealth of the investor as a
result of investing in the project.

Internal rate of return A cost of capital at which the NPV of a project would be CU0.

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

Investment appraisal 21
 Interactive question 1: Revision of basic techniques [Difficulty level: Easy]
A company is considering expanding its business. The expansion will cost CU350,000 initially for the premises
and a further CU150,000 to refurbish the premises with new equipment. Cash flow projections from the project
show the following cashflows over the next six years.
Year Net cash flows
CU
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
The equipment will be depreciated to a zero resale value over the same period and, after the sixth year, it is
expected that the new business could be sold for CU350,000.
Requirements
Calculate
(a) The payback period for the project
(b) The ARR (using the average investment method)
(c) The NPV of the project. Assume the relevant cost of capital is 12%
(d) The IRR of the project
See Answer at the end of this chapter.

There are four basic investment appraisal techniques that are used in practice by companies. The reason why some
are used more than others is because of their relative merits and demerits.

Interactive question 2: Ranking of techniques [Difficulty level: Easy]

What are the relative merits and demerits of the following investment appraisal techniques and what conclusion
would you therefore draw about their relative attractiveness?

Merits Demerits Rank

Payback

Accounting rate of return

Net present value

Internal rate of return

See Answer at the end of this chapter.

22 Financial Management
 2 Relevant cash flows

Section overview
 Cash flows should be used in investment appraisal rather than profits as this more closely reflects the impact
on shareholders' wealth.
 Relevant cash flows are those which are affected by the decision.
 Opportunity costs reflect the cash forgone as a consequence of using resources.
C
2.1 Why cash flows rather than profits? H
A
When a firm makes a long-term investment in a project, rarely does the profit in any year of the project's life equal
the cash flow. For example, in cash flow terms the purchase of plant and equipment may be represented by an P
outflow at the start of the first year (ie the purchase) and an inflow at the end of the last year (ie the scrap value). In T
the annual income statements in between, what appears is the difference between the initial cost and the scrap E
value, ie depreciation, which is not a cash flow. R

In addition, profit measurement is concerned with the time period in which income and expenses are recognised.
Thus, while the income statements might show CU100,000 for sales, the actual cash receipts may be much less as
2
some cash is still to be received, ie there are receivables. This increase in receivables represents a further
'investment' in the project.
From a wealth point of view shareholders will be interested in when cash goes out and when it is returned to them
in the form of dividends, ie the amount and timing of the flows are important to them.
Over the life of a project the undiscounted net flows will equal the total accounting profit/loss but (because of the
above) the timing will be different.
It is also important to appreciate that not all cash flows are necessarily relevant. In Management Information the
behaviour of costs was introduced. Over a given period some costs are fixed and some variable. Whilst all of the
costs for a period will be reflected in the income statement ie they will influence the profit, they may not all be
relevant cash flows for a particular decision, eg depreciation.
The section below on relevant cash flows explores this idea further.

2.2 Profits to cash flows

If income statement information is provided, there are two adjustments which should be made to convert to cash
flows:
 Depreciation – as noted above, depreciation is not a cash flow and should be added back where it has been
deducted in arriving at profits. The initial outflow and scrap inflow will deal with depreciation at the
appropriate time
 Working capital – a project may involve not only investment in land, buildings etc but also investment in
working capital (inventory + receivables – payables). Increases in net working capital represent an outflow,
decreases an inflow.

Worked example: Working capital

Gorgon Ltd expects the following sales from a new project over its three year life:
CU
t1 150,000
t2 175,000
t3 200,000
Working capital equal to 10% of annual sales is required and it needs to be in place at the start of each year.
Calculate the working capital flows.

Solution
First, calculate the absolute amounts of working capital needed at the start of each year and then find the cash
flows.

Investment appraisal 23
 t0 t1 t2 t3
CU CU CU CU
Working capital at start 15,000 17,500 20,000 Nil
Cashflow (15,000) (2,500) (2,500) 20,000
Only the incremental flow is relevant, so for example at t1 an additional CU2,500 is required over and above the
CU15,000 already in place.
At the end of the project all working capital is assumed to be recovered, ie an inflow of CU20,000 at t3.

Interactive question 3: Changing working capital [Difficulty level: Easy]

A company plans to make sales of CU100,000 at t1, increasing by 10% per annum until t4. Working capital equal to
15% of annual sales is required at the start of each year.
Requirement
What are the working capital cash flows?
See Answer at the end of this chapter.

2.3 Relevant cash flows

The general rule is to include only those costs and revenues which can affect the decision or be affected by it. This
means using only future incremental cash flows. Future flows are used as no decision now can change past cash
flows; incremental, ie changed, cash flows are used because flows which continue into the future regardless of the
decision are irrelevant to the decision.

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 is not
The assessment of relevant cash flows needs to be done from the point of view of the business as a whole and not
individual divisions or departments.
Typical items which are excluded from the analysis as irrelevant are discussed below:
 Sunk costs – money already spent, eg when trying to determine whether an existing machine which cost
CU250,000 three years ago should be used on a new project, the analysis should ignore the CU250,000 as
nothing can be done about it; instead, the machine's current worth (either scrap value or cash benefits from
retention) should be included
 Accounting entries – eg depreciation (as discussed above) is not a cash flow
 Book values – eg FIFO/LIFO inventory values. This is similar to sunk costs above as the FIFO/LIFO
conventions merely deal with the treatment of money already spent
 Unavoidable costs – money already committed, eg a non-cancellable lease or apportioned fixed costs. As far
as fixed costs are concerned it is the total amount which is important (not any attempt to spread the fixed
cost, ie apportionment). If the total changes, then this is relevant; if not, the fixed costs are ignored as they
are unaffected by the decision. For example, if a firm can make a new product within its existing rented
factory, then any share of the rent apportioned to the new product should be ignored as the total rent bill is
unchanged. However, if a new factory needs to be rented, then the additional rent is relevant in the appraisal
of the new product
 Finance costs – eg interest (discounting deals with this by finding the present value of the flows allowing for
the time the finance is tied up and the interest rate)
Specifically include:
 All opportunity costs and revenues.

24 Financial Management
2.4 Opportunity costs and revenues

Definition
The opportunity cost of a resource may be defined as the cash flow forgone if a unit of the resource is used on the
project instead of in the best alternative way.

If there are scarcities of resources to be used on projects (eg labour, materials, machines), then consideration must
be given to revenues which could have been earned from alternative uses of the resources.
 Shareholders are concerned with the flows generated by the whole organisation in terms of assessing their C
impact on their wealth H
A
 The cash flows of a single department or division cannot therefore be looked at in isolation. It is always the P
cash flows of the whole organisation which must be considered
T
 For example, the skilled labour which is needed on the new project might have to be withdrawn from normal E
production causing a loss in contribution. This is obviously relevant to the project appraisal R

Worked example: Relevant cost of material

A new contract requires the use of 50 tonnes of metal ZX 81. This metal is used regularly on all the firm's projects.
2
At the moment there are in inventory 100 tonnes of ZX 81, which were bought for CU200 per tonne. The current
purchase price is CU210 per tonne, and the metal could be disposed of for net scrap proceeds of CU150 per tonne.
With what cost should the new contract be charged for the ZX 81?

Solution
The use of the material in inventory for the new contract means that more ZX 81 must be bought for normal
workings. The cost to the organisation is therefore the money spent on purchase, no matter whether existing
inventory or new inventory is used on the contract.
Assuming that the additional purchases are made in the near future, the relevant cost to the organisation is current
purchase price, ie 50 tonnes × CU210 = CU10,500.

Interactive question 4: Material with no alternative use [Difficulty level: Intermediate]

Suppose the organisation has no alternative use for the ZX 81 in inventory.
What is the relevant cost of using it on the new contract?
See Answer at the end of this chapter.

Interactive question 5: Material with a scrap value [Difficulty level: Intermediate]

Suppose again there is no alternative use for the ZX 81 other than a scrap sale, but that there are only 25 tonnes in
inventory.
See Answer at the end of this chapter.

Worked example: Relevant cost of labour

A mining operation uses skilled labour costing CU8 per hour, which generates a contribution of CU6 per hour,
after deducting these labour costs.
A new project is now being considered which requires 5,000 hours of skilled labour. There is a shortage of the
required labour. Any used on the new project must be transferred from normal working.
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?

Investment appraisal 25
 CU
Contribution per hour lost from normal working 6
Labour cost per hour which is not saved 8
Cash lost per hour as a result of the labour transfer 14
The contract should be charged with 5,000  CU14 CU70,000

Interactive question 6: Relevant cost of surplus labour [Difficulty level: Easy]

Facts as in the previous Worked example, but there is a surplus of skilled labour sufficient to cope with the new
project. The idle workers are being paid full wages.
See Answer at the end of this chapter.

Interactive question 7: Relevant costs [Difficulty level: Intermediate]

A research project, which to date has cost the company CU150,000, is under review.
If the project is allowed to proceed it will be completed in approximately one year, when the results are to be sold
to a government agency for CU300,000.
Shown below are the additional expenses which the managing director estimates will be necessary to complete the
work:
Materials. This material has just been purchased at a cost of CU60,000. It is toxic; if not used in this project, it
must be disposed of at a cost of CU5,000.
Labour. Skilled labour is hard to recruit. The workers concerned were transferred to the project from a production
department, and at a recent meeting the production manager claimed that if these people were returned to him they
could generate sales of CU150,000 in the next year. The prime cost of these sales would be CU100,000, including
CU40,000 for the labour cost itself. The overhead absorbed into this production would amount to CU20,000.
Research staff. It has already been decided that, when work on this project ceases, the research department will be
closed. Research wages for the year are CU60,000, and redundancy and severance pay has been estimated at
CU15,000 now, or CU35,000 in one year's time.
Equipment. The project utilises a special microscope which cost CU18,000 three years ago. It has a residual value
of CU3,000 in another two years and a current disposal value of CU8,000. If used in the project it is estimated that
the disposal value in one year's time will be CU6,000.
Share of general building services. The project is charged with CU35,000 per annum to cover general building
expenses. Immediately the project is discontinued, the space occupied could be sub-let for an annual rental of
CU7,000.
Requirement
Advise the managing director as to whether the project should be allowed to proceed, explaining the reasons for the
treatment of each item.
(Note: Ignore the time value of money.)
See Answer at the end of this chapter.

2.5 Deprival value

 When an asset which is currently owned by the business is required for another specific contract/project, the
existing activity is to be deprived of that asset. The value to be used in the investment appraisal is, therefore,
the asset's deprival value.

Worked example: Deprival value

A company has a printing press which needs to be used on a new contract.
The press could be sold for CU1,000 or made use of to service the needs of existing customers for business which
has a value (in present value terms) of CU1,500.
Requirements

26 Financial Management
(a) What is the opportunity cost of using the machine on a new contract?
(b) If the printing press could be replaced at a cost of either
(i) CU800
(ii) CU1,800
What would the relevant cost be?

Solution
(a) The existing customers create more value than selling the machine, so the machine would not be sold.
Hence the opportunity cost is the value in use of CU1,500 C
H
Note: if the value in use ever dropped below the net realisable value (NRV), then the asset would not be
worth keeping. A
P
(b) (i) If the new contract will make use of a currently owned machine then in principle the cost of using it will T
be the replacement cost. If the value in use is CU1,500, and the replacement cost is CU800, then the E
machine will be replaced. The equipment cost of the new contract would therefore be CU800. R
(ii) If however, the replacement cost is CU1,800 then it is not worth replacing. Thus the relevant cost of
equipment for the new contract will be the opportunity cost or benefit forgone – ie the CU1,500.
2
In each case therefore the relevant cost is the cash flow effect of the decision to use the existing resource –
either the replacement cost or the benefit in the next best case, ie the deprival value.

This can be summarised as follows.

Deprival value

= lower of

Replacement cost and Recoverable amount

ie the cost of replacing = higher of

the asset with one of a
similar age and condition Value in use/ Net realisable
and
Economic value value

ie the present value of ie the asset's worth if

the cash generated it were to be sold,
from using the asset net of selling costs

 If the asset has a net realisable value in excess of its economic value it should be sold, ie it is better to
discontinue using it. If the economic value is higher than the net realisable value it is worth keeping and
using. At this point, therefore, were the firm to be deprived of the asset, the best alternative forgone is the
higher of the net realisable value or economic value (the 'recoverable amount')

 However, if the recoverable amount is less than the replacement cost, then the recoverable amount is the
deprival value, ie the asset would not be replaced were the firm to be deprived of its use. If the recoverable
amount exceeds the replacement cost, the asset should be replaced as the latter represents its deprival value

Interactive question 8: Deprival value [Difficulty level: Intermediate]

Joe's car is not insured against theft.

He bought it two years ago for CU2,000. A similar vehicle would now cost CU1,000. He believes he could sell the
vehicle for CU1,000 after spending CU100 on advertising. The vehicle has two years of life remaining, and over
this period he believes it will save him taxi fares with a present value of CU800.

Investment appraisal 27
 Requirement

What is the loss to Joe if his car is stolen?

See Answer at the end of this chapter.

3 Taxation

Section overview
 Taxable profit and accounting profit may not be the same.
 Tax is charged on net cash flow.
 Capital allowances reduce the tax payable.

3.1 Basics
Income statement
Imagine an income statement drawn up at the end of the first year of a project's life using normal financial
accounting principles:

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
In calculating the taxable profit for investment appraisal purposes, what are the relevant cash flows to be
considered?

Solution
Corporation tax for year 1 of the project is not simply CU2,500 times the tax rate. Some adjustments need to be
made to the profit calculation before computing the tax charge:

 Only incremental relevant cash flows need be considered (as covered in section 2 above) and the incremental
tax charge. Thus some of the above costs – eg fixed costs, may not be relevant and therefore the tax effect of
these is not relevant

 Depreciation should be ignored (it is not allowed as a deduction from profits when calculating the tax – see
below)

 Interest should be ignored. The tax effect of interest is incorporated into the cost of capital

28 Financial Management
3.2 Effects
Taxation has two effects in investment appraisal, both giving rise to relevant cash flows.

C
H
OUTFLOW INFLOW A
P
Tax relief
Tax charged T
given on
on net cash E
assets
flows R
purchased via

2
CAPITAL
ALLOWANCES (CAs)

3.3 Capital allowances (CAs)

 This is National Board of Revenue (NBR) version of depreciation. For the purposes of the examination, only
CAs on plant and equipment are considered (though in practice there are other categories of non-current
assets that attract CAs).

 Unless otherwise stated:

– Calculate writing down allowances (WDAs) at 18% on a reducing balance basis

– There is no WDA in the year of sale; a balancing allowance/charge is calculated instead. The balancing
allowance relieves any unrelieved expenditure; the balancing charge claws back any excess relief given
– assume that there are sufficient profits available elsewhere in the business to utilise all tax benefits in
full and at once.

3.4 Other assumptions

 Although large companies make tax payments in four equal instalments during the accounting year, for
examination purposes the whole tax payment is assumed to be made at the end of the year to which it relates

 For this study manual purposes unless otherwise stated corporation tax is assumed to be paid at 21%
(although other rates are possible in the real world)

 The tax rate can be assumed to be constant over the life of the project (unlikely in practice)

 It should be assumed that working capital flows have no tax effects

Worked example: Capital allowances

Happy Ltd bought a machine for CU10,000 on 31 December 20X1, its accounting year end. The asset generated
cash flows of CU7,000 pa. It sold the asset on 31 December 20X3 for CU2,000.
20X1 20X2 20X3

Acquired Disposed
The company pays tax at 21%. Capital allowances are available at 18% on a reducing balance basis.

Investment appraisal 29
 Show the WDAs and any balancing charge or allowance.

Solution
Year ended 31 Dec Tax WDV (WDV = written down value)

CU
20X1 10,000
WDA @ 18% (1,800) Asset owned at end of each of 20X1
20X2 8,200 and 20X2.  18% WDA calculated
WDA @ 18% (1,476)
20X3 6,724 In 20X3 asset sold. As proceeds (in
Proceeds (2,000) this case) are less than WDV a
balancing allowance is given.
Balancing allowance 4,724
Total reliefs = CU(1,800 + 1,476 + 4,724) = CU8,000 (= cost – scrap). Tax payments, cash flows etc can then be
shown as follows:
Tax computation
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
Net inflows 7,000 7,000
WDA/Balancing allowance (1,800) (1,476) (4,724)
Taxable (1,800) 5,524 2,276
Tax @ 21% 378* (1,160) (478)
* Tax saved, assuming sufficient profits exist elsewhere in the business to obtain relief from WDA as soon as
possible (section 3.3 above).
Normally the tax effect is shown as two separate elements:

31 Dec 20X1 31 Dec 20X2 31 Dec 20X3

CU CU CU
Net inflows 7,000 7,000
(1) Tax paid @ 21% (1,470) (1,470)
WDAs/Balancing allowance (1,800) (1,476) (4,724)
(2) Tax saved @ 21%* 378 310 992
Total tax (above) (1) + (2) 378 (1,160) (478)
* ie being able to deduct the WDA from profit saves tax @ 21%.
The NPV calculation would show (rounding to the nearest CU):
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
CU CU CU
Net inflows 7,000 7,000
Tax (1,470) (1,470)
Asset purchase (10,000)
Scrap 2,000
Tax saved on WDAs 378 310 992
Net CF for discounting (9,622) 5,840 8,522

Interactive question 9: Capital allowances [Difficulty level: Intermediate]

1 A company buys an asset for CU10,000 at the end of its accounting period, 31 December 20X0, to undertake
a two year project.
2 Net trading inflows at t1 and t2 are CU5,000.

30 Financial Management
 3 The asset has a CU6,900 scrap value when it is disposed of at the end of year 2.
4 Tax is charged at 21%. WDAs are available at 18% pa.
Requirement
Calculate the net cash flows for the project.

See Answer at the end of this chapter. C

H
A
Interactive question 10: Timing issues [Difficulty level: Intermediate] P
T
As in Interactive question 9, except that the asset is now bought on 1 January 20X1. E
Requirement R
Calculate the net cash flows for the project.
2

See Answer at the end of this chapter.

4 Inflation

Section overview
 Inflation rate can be incorporated into both cash flow and discount rate ('money @ money').
 Inflation can be ignored in both cash flows and discount rate ('real @ real').

Inflation Rate in Bangladesh averaged 6.63 percent from 1994 until 2016, reaching an all-time high of 16.00
percent in September of 2011 and a record low of -0.03 percent in December of 1996. Consumer prices in
Bangladesh increased 5.38 percent year-on-year in November of 2016, following 5.57 percent growth in the
previous month. As inflation will continue to exist in the future, account needs to be taken of its effects, ie
increases in prices, when appraising projects. It creates two problems in investment appraisal:
 Estimating future cash flows – the rate of inflation must be taken into account
 The rate of return required by shareholders and lenders will increase as inflation rises – the discount rate is
therefore affected

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 of interest
 When real rates of interest are adjusted for the effect of general inflation, measured by the consumer prices
index (CPI), the results are referred to as money (or nominal) rates of interest

Worked example: Impact of inflation

Kuman is considering a choice. He can spend CU100 on consumables now or he can invest it for a year, but will
only do so if he can consume more of it at that time.
The underlying time value of money for Kuman is 10%, and inflation is 5%.
Requirement
What return in money terms does Kuman require?

Investment appraisal 31
 Solution
The total return must compensate Kuman for his consumption preference ie the fact that he would prefer to
consume now. He must therefore earn 10% to reflect his time value of money. In addition, the rate must
compensate Kuman for the fact that prices are rising by 5% pa.
This can be illustrated as follows.
Now 1 year later
t0 Underlying t1
'Real' return
required
Consume CU100 CU110 is the amount
r = 10% required to satisfy
the consumption
preference ie Kuman needs
to be able to purchase
10% more goods

Inflation 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
In order to be satisfied with not consuming now, Kuman needs CU115.50 of money in a year
CU100 × (1.10)(1.05) = CU115.50
£15.50
cu
Overall money return (m) required =  15.5%
£100
cu

Money rates, real rates and general inflation (CPI) are linked by the following:
(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 cash flows

As examination questions are normally answered using the money method (see section 4.4 below) it is vital to
determine whether the cash flows are given in money or current terms.

 Money (or nominal) cash flows are cash flows where any inflationary effects have already been taken into
account

 Current cash flows are cash flows expressed in today's terms which will be affected by inflation in the future
and have not yet been adjusted

4.3 General and specific inflation rates

It is also important in examination questions to determine what sort of inflation rate is applicable to the items in the
question.

 A general inflation rate is a weighted average of many specific inflation rates, eg CPI, and is normally
applied to the real rate in order to derive the money rate (section 4.1 above)

32 Financial Management
  A specific inflation rate is the rate of inflation on an individual item or service, eg the rate at which labour
costs per hour will increase
 Examples:

Individual item Specific inflation

Bread 1% pa
Milk 3% pa CPI is a weighted average of these rates
Cheese 2% pa
etc. C
H
A
 Economic forecasters will regularly publish estimates of general inflation. Estimating individual rates is
P
much more difficult, and decision makers should recognise that they are just that – estimates, and subject to a T
degree of error E
R
4.4 Discounting
Money method ('money @ money') 2

It is essential to match like with like when performing NPV calculations. In the real world money flows are the
easiest to deal with as they are the everyday flows people are used to. So to use the money method:

 Adjust the individual cash flows, eg sales/revenue, materials, labour using their specific inflation rates to
convert to money cash flows, ie the flows which will actually occur

 Discount these money flows using the money rate, ie the rate of interest which will actually occur.

This is the simplest technique. Use wherever possible unless a question directs otherwise.

Real method ('real @ real')

An alternative way of reaching the same NPV and again matching like with like, is to use the real method. The
problem with this method is that real cash flows and interest rates are not directly identifiable in the way that
money flows and rates are. For example, banks regularly publish money interest rates on savings accounts,
overdrafts, etc. The unpublished real rate needs to be derived by stripping out the general inflation used to
determine the money rate (as in section 4.1 above). So to use the real method:

 Remove the effects of general inflation from money cash flows to generate real cash flows
 Discount using real rate.

Although this achieves the same NPV as the money method, it is often very long winded and would only be useful
in a question where the real flows and interest rate were already given.

Interactive question 11: Money @ money [Difficulty level: Intermediate]

Project Invest CU10,000 at t0 in new plant and equipment

Returns CU5,000 pa in current terms for three years, inflating at 7% pa
Money rate of interest is 10%

Requirement

Calculate the project's NPV using the money method.

See Answer at the end of this chapter.

Effective method

Investment appraisal 33
  This method can sometimes be a short cut for the money method, eg for long projects with annuity or
perpetuity cash flows

 To use the effective method leave cash flows in current (t0) terms and adjust the discount rate as shown below
to incorporate both inflating and discounting

 Discount current terms cash flows using effective rate (e):

1 m
1+e=
1  is

where is = inflation specific to given cash flow

Interactive question 12: Effective rate [Difficulty level: Intermediate]

Labour costs inflate at 8% pa in perpetuity
Money rate = 10%
Labour currently costs CU10,000 in t0 terms
Requirement
Calculate the present value of labour costs.
See Answer at the end of this chapter.

4.5 Practical considerations

 General inflation may not be constant, thus the money discount rate may vary year on year. In order to
discount cash flows with a different money interest rate in each year, the money @ money approach
discussed above should be used

 The impact of inflation is more significant for longer periods as the increase in prices is compounded year on
year. However, as noted earlier, the further into the future the more difficult it is to estimate specific inflation
rates, so errors in estimates will be compounded

4.6 NPV proforma

The following proforma summarises the topics dealt with so far and provides a layout for NPV calculations useful
in 95%+ of situations:
t0 t1 t2 t3
CU CU CU CU
Operating cash flows
Adjust for inflation Sales/revenue X X X
Include only relevant cash flows Costs (X) (X) (X)
Net X X X
Tax (X) (X) (X)
Asset
Purchase (X)
Scrap X
Tax on WDAs X X X X
Working capital (X) (X) (X) X
Net flows (X) X X X
* Discount factor 1 X X X
PV of cash flows (X) X X X
PV = NPV
* Use discount factors for the after-tax cost of capital

34 Financial Management
 5 Replacement analysis
Section overview
 The optimal replacement cycle is the one with the lowest equivalent annual cost.
 The analysis assumes the replacement decision will apply indefinitely.

 So far it has been assumed that investment in an asset is a one-off decision. However, a project is likely to
involve commitment to long-term production, and machinery will therefore need to be replaced
 A business needs to know how often to replace such assets. Replacing after a long time means not replacing C
as often, so delaying the cost of a new replacement machine. However this invariably means keeping an asset H
whose value is declining and which costs more to maintain. These costs and benefits need to be balanced A
P
Worked example: Replacement decision T
E
A decision has to be made on replacement policy for vans. A van costs CU12,000. Vans can be replaced after 1,2,
R
or 3 years. The following additional information applies:

Interval between Trade-in Age at Maintenance cost

replacement allowance Year end paid at end of year 2
(years) CU (years) CU
1 9,000 Year of replacement Nil
2 7,500 1 2,000
3 7,000 2 3,000
Calculate the optimal replacement policy at a cost of capital of 15%. There are no maintenance costs if the van is
replaced after one year. Ignore taxation and inflation.

Solution
NPVs
9,000
1 year cycle NPV = (12,000) + = CU(4,174)
1.15

(2,000) 7,500
2 year cycle NPV = (12,000) + + = CU(8,068)
1.15 1.152

(2,000) (3,000) 7,000

3 year cycle NPV = (12,000) + + + = CU(11,405)
1.15 1.152 1.153
These costs are not comparable, because they refer to different time periods. The reason the one year cycle appears
cheaper is because it only reflects the cost of having a machine for one year, whereas the CU11,405 for the 3 year
cycle is the cost to the business of keeping the resource for three years. There are two possible approaches to
making the costs comparable.

5.1 Lowest common multiple approach

One method of comparing the different replacement options is to evaluate the costs over a time frame which makes
them consistent.
In the above example, this will be achieved if the costs incurred under each cycle were compared over the same
number of years for each.

For example:

1 Year 2 Year 3 Year

Time cycle cycle cycle
CU'000 CU'000 CU'000
0 (12) (12) (12)

Investment appraisal 35
 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
In order to be comparable, the analysis has to be continued for six years (the lowest common multiple of the asset
lives). Stopping before this means one of the options would be part way through a cycle. At the end of six years is
the earliest occasion that all three cycles come to an end at the same time (ie a new van is required under each
cycle). The lowest common multiple approach will give a solution, but is rather long winded. The Equivalent
Annual Cost approach is a better method, and is discussed below.

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
This can be applied here to restate the present value of the costs over a life cycle into an annuity – the equivalent
annual cost – over the life cycle, as follows:
The NPVs calculated above are converted into equivalent annual costs, ie the equivalent constant annual sum
payable at the end of each year for any given cycle.
The equivalent annual costs can be compared.

1 year cycle (4,174) = X × AF 1 year @ 15%

(4,174) = X × 0.870

X = CU(4,798)

2 year cycle (8,068) = X × AF 2 years @ 15%

(8,068) = X × 1.626

X = CU(4,962)

3 year cycle (11,405) = X × AF 3 years @ 15%

(11,405) = X × 2.283

X = CU(4,996)

Thus it is cheapest to replace the vans every year, because this cycle has the lowest cost in NPV terms.

So the method can be summarised as:

1 Calculate the NPV of each replacement strategy

2 Calculate the annual equivalent cost of the NPV for each strategy
3 Choose the strategy with the lowest annual equivalent cost.

Interactive question 13: Replacement cycle [Difficulty level: Intermediate]

A machine costs CU20,000 and it can be replaced every year or every two years. Delaying the replacement causes
the running costs to increase and the scrap proceeds to decrease as follows:
Running costs Scrap proceeds
CU CU
Year 1 5,000 16,000
Year 2 5,500 13,000

Company's cost of capital = 10%.

36 Financial Management
 Requirement
Should the machine be replaced every one or every two years?
See Answer at the end of this chapter.

5.3 Limitations of the replacement analysis performed

This method assumes that a firm is continually replacing like with like, and therefore determines a once-and-for-all
optimal replacement cycle. In practice this is unlikely to be valid due to:

 Changing technology, which can quickly make machines obsolete and shorten replacement cycles. This C
means that one asset is not being replaced by one exactly similar H
A
 Inflation, which by altering the cost structure of assets means that the optimal replacement cycle can vary P
over time T
E
 If inflation affects all variables equally it is best excluded from the analysis by discounting real cash flows at R
a real interest rate – the optimal replacement cycle will remain valid

 Differential inflation rates mean that the optimal replacement cycle varies over time
2
 The effects of taxation (ignored in the analysis but they could be incorporated)

 The fact that production is unlikely to continue in perpetuity

6 Capital rationing
Section overview
 Scarce capital means that projects have to be ranked according to how efficiently they use the limiting
factor.
 Divisible projects are ranked using NPV per CU of scarce capital.
 Indivisible projects are ranked using trial and error by finding the combination of projects that maximises
NPV.

Definition
Capital rationing is the situation where insufficient funds exist to undertake all positive NPV projects, so a choice
must be made between projects.

6.1 Two types of rationing

 Hard rationing: where the external capital market (banks, stock exchange, etc) limit the supply of funds
 Soft rationing: where internally the firm imposes its own constraint on the amount of funds raised. This may
be as a surrogate for other constraints, eg insufficient managerial capacity to handle all positive NPV projects
Soft rationing may also arise where it is impractical for the firm to go to the market and raise a small amount
of finance, and where raising the funds in large amounts is more practical and cost effective.

6.2 Single period rationing

When funds are scarce in one year only, but freely available otherwise, the basic NPV approach to project selection
is modified.
Projects are ranked by NPV per CU capital outlay in the rationed period. (This can be referred to as the
'profitability index'.) This is an extension of key factor analysis covered at the knowledge level of the professional
stage examinations.
The situation where funds are rationed in more than one time period (multi-period capital rationing) is beyond the
syllabus.

Investment appraisal 37
 Interactive question 14: Capital rationing [Difficulty level: Intermediate]
A business has CU50,000 available at t0 for investment.
Four divisible projects are available:
Project NPV Funds required at t0
CU CU
A 100,000 (50,000)
B (50,000) (10,000)
C 84,000 (10,000)
D 45,000 (15,000)

38 Financial Management
 Requirement
Which project(s) should be undertaken?

See Answer at the end of this chapter.

6.3 Indivisible projects

The solution to Interactive question 14 assumes it is possible to accept half of project A, ie that projects are
perfectly divisible so half the outlay gives half the NPV, etc.
C
In reality projects may be indivisible, ie all or nothing, in which case trial and error is necessary to find the optimal H
combination. A
In Interactive question 14 above, possible combinations are: P
T
NPV Funds E
CU CU R
A 100,000 50,000
C and D 129,000 25,000
2
Therefore choose C and D.

6.4 Mutually exclusive projects

It may be the case that projects are mutually exclusive, ie it is not possible to undertake both at the same time,
perhaps because management would be overstretched in trying to run both projects.

Imagine that a firm facing single period capital rationing is trying to choose between five projects – P, Q, R, S and
T. P and Q are mutually exclusive, ie either P or Q but not both could be undertaken. In order to make the choice it
should apply the procedures in sections 6.2 or 6.3 above to two separate groupings

P, R, S, T Q, R, S, T

and see which produces the higher overall NPV.

6.5 Project synergy

So far projects have been considered independently. It may be the case that by undertaking certain combinations of
projects, some synergy (extra NPV) is created, eg from cost savings.

Interactive question 15: Project synergy [Difficulty level: Intermediate]

A firm has CU100,000 available for investment at t0.
Three divisible projects are available:

Project NPV Funds required at t0

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?

Investment appraisal 39
 See Answer at the end of this chapter.

7 Investment appraisal in a strategic context

Section overview
 Investment appraisal needs to be considered in a strategic context
 Shareholder value analysis (SVA) focuses on decisions which maximise shareholder wealth
 Investment may give rise to new opportunities, known as real options.

7.1 Project generation, decision making and control

Investment projects will normally be identified as part of a firm's strategic planning process. This is covered in
detail in the Business Strategy paper. In outline the process is as follows:

Analyse the current position of the business by examining

the external (eg competitors) and internal (eg human
resources) environment. Normally summarised by SWOT
analysis (strengths, weaknesses, opportunities, threats)

Determine mission and objectives (here

assumed to be wealth maximisation)

Identify and select strategies (eg

new products, new markets, etc)

Implement and control

 Once potential projects are identified, eg replacing an existing product with a new one, the relevant costs and
revenues associated with the proposal must be determined. Care must be taken to avoid bias in estimates, eg
from managers closely associated with the proposal

 The relevant costs and revenues should be assessed using NPV to determine whether wealth increases. Where
there are competing projects, those that offer the best NPV should be chosen (capital rationing may need to
be considered at this point)

 Chosen projects are then implemented and performance monitored, eg actual outcomes v budget etc

7.2 Shareholder value analysis

Definition
Shareholder value analysis (SVA) is the process of analysing the activities of a business to identify how they will
result in increasing shareholder wealth.

40 Financial Management
 Managers may sometimes be influenced to act in a manner which is inconsistent with maximising shareholder
wealth. The claimed advantage of SVA, as a philosophy of business decision-making, is that the actions of
managers can be directly linked to value generation and the outcomes of decisions can be assessed in that context.

Interactive question 16: SVA [Difficulty level: Easy]

Explain what possible problems are created when using the following measures to assess management
effectiveness.
Return on capital employed
Earnings per share
C
See Answer at the end of this chapter. H
A
P
7.3 The principles of SVA
T
A business has a particular value at a particular time because of the projected cash flows from its activities. The E
particular value will be based on their timings and riskiness. According to the philosophy of SVA, the value of the R
business is affected or 'driven' by just seven factors, known as 'value drivers'. To increase the value of the business,
ie to generate additional value, one or more of these seven will need to alter in a favourable direction. The value
drivers, and their effect on shareholder value, are shown below.
2

Cost Life of Sales

of projected growth
capital cash flows rate

Investment Operating
in working
Shareholder profit
capital wealth margin

Investment
in non- Corporation
current tax rate
assets

These seven factors all impact on the operating cash flows and through them the value of the business and the
wealth of the shareholders.

Investment appraisal 41
 These will be examined in turn and related to individual parts of the business.

Sales growth If a greater level of sales can be generated in the future than was expected, this should create
rate more cash flows and, therefore, value. The greater level of sales could come from a new
product and, provided that this did not have an adverse effect on one of the other value
drivers, greater value would necessarily be created. Similarly, arresting an expected decline in
sales levels for some existing product has the potential to generate value.
Operating profit The operating profit margin is the ratio of net profit, before financing charges and tax, to
margin sales. The higher this ratio the more cash flows there are for each sale. Thus if costs can be
controlled more effectively, more cash will tend to flow from each sale and value will be
enhanced.
Corporation tax This clearly affects cash flows and value because, broadly, tax is levied directly on operating
rate cash flows. Management's ability to affect the tax rate and the amount of tax paid by the
business tends, at best, to be marginal.
Investment in Normally cash has to be spent on additional non-current assets in order to enhance
non-current shareholder value. Wherever managers can find ways of reducing the outlay on plant etc
assets without limiting the effectiveness of the business, this will tend to enhance shareholder value.
Investment in Nearly all business activities give rise to a need for working capital: inventories, receivables,
working capital payables and cash. Amounts tied up in working capital can be considerable. Steps that can be
taken, for example, to encourage trade receivables to pay more quickly than expected, will
bring cash flows forward and tend to generate value, as long as the benefits of quicker
payment outweigh the cost of delivering it.
Cost of capital The cost of funds used to finance the activities of the business will typically be a major
determinant of shareholder value. So if the business can find alternative, cheaper, sources of
long-term finance, value would tend to be enhanced.
Life of projected Clearly, the longer that the life of any cash generating activity can continue, the longer its
cash flows potential to generate value.

7.4 How can SVA be used?

Where SVA is seen to be most useful is in highlighting the key drivers of value. This enables managers to set
targets for achieving value enhancing strategies in each area. It can help to create an environment where value
enhancement is at the top of the agenda for managers in all areas of the business. In this way the primary financial
objective of the business can be achieved. SVA can also be used to value a business (see chapter 8).

7.5 Real options

One problem of NPV analysis is that it only considers cash flows related directly to the project. It is possible that a
project with a negative NPV is accepted for 'strategic' reasons. This is because management accept that there are
options associated with a particular project which outweigh the conventionally calculated negative NPV.
The revised decision model becomes:

Project worth = Traditional NPV + value of any options

Worked example: Real options

Situation Real option

Follow on options Launching this project would give a later opportunity to

launch a second (and third and so on) version which could be
A firm is considering investing in a project to highly profitable or could lose money.
manufacture microcomputers. The initial NPV is
negative. Launching the first version effectively gives the right to
invest in later versions. The right to invest or buy is known as
a call option.

Abandonment options Both projects offer the right to abandon the project if things

42 Financial Management
 Situation Real option

A firm is considering investing in two projects, go wrong, by selling the assets. The value of the second
both having the same expected NPV. The first option is much greater and could well be preferred by
uses a highly specialised machine with little resale management.
value or alternative use. The second involves The right to sell is known as a put option.
expenditure mainly on highly marketable land and
buildings. Some projects such as those in the natural resource industry
(timber, mining etc) have inbuilt options to reduce capacity
or suspend operations temporarily.

Timing options Projects where commencement can be delayed are often C

attractive. In a volatile market a project that can be delayed is H
A firm has the development rights over a piece of like a call option with a long period of expiry. If the company A
land. The rights can be exercised any time over can delay investment it can wait and see what happens to the P
the next five years. market before investing or not (exercising the option or not). T
The longer the delay, the more valuable the option. E
R
The option to delay is only valuable if it offsets any loss from
delaying eg delaying results in a competitor establishing a
loyal customer base that makes it difficult for the company to
2
enter later. Patents and other barriers to entry can offer some
protection against this.

Growth options Choices might include

New technology, deregulation etc present  Full investment and hope it pays off (high risk)
uncertain growth opportunities for firms –
investing could produce substantial losses.  Wait and see but competitors might take a lead

 Acquire 'growth option'

Growth options include

 Start with small capacity, expanding later if market

conditions are good

 Joint ventures and strategic alliances as entry strategies

into emerging markets, eg China

 R&D avoiding 'wait and see' risk and, if prospects look

poor, no full investment, eg pharmaceutical companies

 Follow on options noted above

Flexibility options A more expensive station capable of using gas or coal or oil
gives greater flexibility. This flexibility option has a value
A power station could be constructed to generate which must be included in the evaluation.
electricity using only gas as the input fuel. Whilst
this might be the cheapest option it lacks
flexibility in the face of volatile gas prices.

The above refers to options associated with investments – so called 'real' options. Chapters 9 and 10 will introduce
how options to buy and sell currency, shares, bonds, etc can be used to manage risks such as interest rates and
exchange rates.

8 Investing overseas

Section overview
 Overseas investment carries additional risks, including political and cultural.
 The methods of financing overseas subsidiaries will depend on the length of investment period envisaged,

Investment appraisal 43
 also the local finance costs, taxation systems and restrictions on dividend remittances.

When deciding what types of country a company should enter (in terms of environmental factors, economic
development, language used, cultural similarities and so on), the major criteria for this decision should be as
follows.
(a) Market attractiveness. This concerns such indicators as GNP/head and forecast demand.
(b) Competitive advantage. This is principally dependent on prior experience in similar markets and having a
cultural understanding.
(c) Risk. This involves an analysis of political stability, the possibility of government intervention and similar
external influences.

8.1 Political risks

Definition
Political risk is the risk that political action will affect the position and value of a company.

When a multinational company invests in another country, eg by setting up a subsidiary, it may face a political risk
of action by that country's government which restricts the multinational's freedom.
If a government tries to prevent the exploitation of its country by multinationals, it may take various measures,
including the following:

Quotas Import quotas could be used to limit the quantities of goods that a subsidiary can buy from its
parent company and import for resale in its domestic markets.
Tariffs Import tariffs could make imports (such as from parent companies) more expensive and
domestically produced goods therefore more competitive.
Non-tariff Legal standards of safety or quality (non-tariff barriers) could be imposed on imported goods
barriers to prevent multinationals from selling goods through a subsidiary which have been banned as
dangerous in other countries.
Restrictions A government could restrict the ability of foreign companies to buy domestic companies,
especially those that operate in politically sensitive industries such as defence contracting,
communications, energy supply and so on.
Nationalisation A government could nationalise foreign-owned companies and their assets (with or without
compensation to the parent company).
Minimum A government could insist on a minimum shareholding in companies by residents. This would
shareholding force a multinational to offer some of the equity in a subsidiary to investors in the country
where the subsidiary operates.

8.1.1 Assessment of political risk

There are a large number of factors that can be taken into account when assessing political risk, for example:
 Government stability
 Political and business ethics
 Economic stability/inflation
 Degree of international indebtedness
 Financial infrastructure
 Level of import restrictions
 Remittance restrictions
 Evidence of expropriation
 Existence of special taxes and regulations on overseas investors, or investment incentives

44 Financial Management
 In addition micro factors, factors only affecting the company or the industry in which it invests, may be more
significant than macro factors, particularly in companies such as hi-tech organisations.

8.1.2 Dealing with political risks

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

Negotiations with The aim of these negotiations is generally to obtain a concession agreement. This would
host government cover matters such as the transfer of capital, remittances and products, access to local
finance, government intervention and taxation, and transfer pricing.
Insurance In Bangladesh Government has introduced Export Credit Guarantee Schemes (ECGS) to
deal with credit risks associated with the export trade ECGS provides protection against
various threats including nationalisation, currency conversion problems, war and revolution. C
See Chapter 10 where overseas trade is explored. H
A
Production It may be necessary to strike a balance between contracting out to local sources (thus losing
strategies control) and producing directly (which increases the investment and hence increases the P
potential loss). Alternatively it may be better to locate key parts of the production process or T
the distribution channels abroad. Control of patents is another possibility, since these can be E
enforced internationally. R
Management Possible methods include joint ventures or ceding control to local investors and obtaining
structure profits by a management contract.
2

Investment appraisal 45
 8.2 Cultural risk
The following areas may be particularly important depending upon the location of the overseas investment:

(a) The cultures and practices of customers and consumers in individual markets

(b) The media and distribution systems in overseas markets

(c) The different ways of doing business in overseas markets

(d) The degree to which national cultural differences matter for the product concerned (a great deal for some
consumer products, eg washing machines where some countries prefer front-loading machines and others
prefer top-loading machines, but less so for products such as gas turbines)

8.3 Factors influencing the choice of finance for an overseas subsidiary

In determining how an overseas investment should be financed, the following considerations need to be made:

(a) The local finance costs, and any subsidies which may be available

(b) Taxation systems of the countries in which the subsidiary is operating. Different tax rates can favour
borrowing in high tax regimes, and no borrowing elsewhere. Tax-saving opportunities may be maximised by
structuring the group and its subsidiaries in such a way as to take the best advantage of the different local tax
systems

(c) Any restrictions on dividend remittances

(d) The possibility of flexibility in repayments which may arise from the parent/subsidiary relationship

(e) Access to capital. Obtaining capital from foreign markets may increase liquidity, lower costs and make it
easier to maintain optimum gearing

46 Financial Management
Summary and Self-test

Summary

C
H
A
P
T
E
R

Investment appraisal 47
 Self-test
Answer the following questions.

1 A company is considering investing in a two-year project. Machine set-up costs will be CU150,000 payable
immediately. Working capital of CU4,000 is required at the beginning of the contract and will be released at
the end.

Given a cost of capital of 10%, what is the minimum acceptable contract price to be received at the end of the
contract?

2 A company is considering investing CU520,000 in machinery to manufacture a new product. The machinery
has a lifetime of five years and will be depreciated on a straight-line basis to its scrap value of CU20,000. The
new product will produce annual income of CU350,000, receivable annually in arrears. Variable production
costs, payable annually in advance, amount to CU100,000 per annum. Fixed costs, other than depreciation,
will increase by CU10,000 per annum, payable in arrears.

What (to the nearest CU1,000) is the net present value of the proposal discounting at 15%?

3 A project has a life of three years. In the first year it is expected to generate sales of CU200,000, increasing at
the rate of 10% per annum over the remaining two years. At the start of each year working capital is required
equal to 10% of the sales revenue for that year. All working capital will be released at the end of the project.

What is the net present value (to the nearest CU000) of the working capital cash flows of the project
discounting at a rate of 20%?

4 Allen Ltd wishes to use a machine for one month on a new contract. The machine cost CU120,000 six years
ago. When purchased it had an estimated life of ten years and it is being fully depreciated using the straight
line method. It is currently valued at CU39,000 and its estimated value at the end of the year is CU15,000.
The machine is under-used and stands idle for perhaps 30% of its time, but it must be retained for use on
similar contracts.

What is the relevant cost of using the machine on the new contract?

5 A company is considering undertaking project X which will require 100 kg of a special material Q. The
company has 100 kg of Q in inventory but there is no possibility of obtaining any more. If project X is not
undertaken, then the company can undertake project Y which will also require 100 kg of Q. The revenues and
costs associated with project Y are as follows:

Project Y revenues and costs

CU CU
Revenues 10,000
Less Costs
Original purchase cost of 100 kg of Q 3,000
Other direct costs 5,000
(8,000)
Profit 2,000

The 100 kg of Q can also be sold as it is for CU4,000. What is the relevant cost of using 100 kg of Q when
deciding whether to accept project X?

6 Sark is tendering for contract M. The cost estimate includes CU2,750, the price paid for 100 units of part KL.
These are currently held in inventory and will not be required for any other future jobs. However, if CU75
were spent on their conversion, they could be used on other work as substitutes for 100 units of part XB.
These would otherwise have to be bought in at a cost of CU22 each. Alternatively, the KL parts could be sold
for CU20 each.

Given that Sark's objective is to maximise its net cash inflow, what figure should be included in the cost
estimate in respect of part KL?

48 Financial Management
7 Sherburn Ltd has sufficient material Y in inventory for a year's production of 'Stringfree'. Material Y cost
CU8,000 but is subject to major price variations; the current market value is double the original cost. It could
be sold at the market price less 15% selling expenses. An alternative is to retain it for later use by which time
the market price is expected to be CU11,200.

What is the relevant cost of using material Y on the Stringfree contract?

8 A company is about to quote a price for manufacturing a special machine which will require 1,500 kg of
material X and 2,000 kg of material Y. The following information is available about these resources:
Original cost
Type of Amount in price of inventory Current purchase Net realisable
C
material inventory now per kg price per kg value now per kg H
kg CU CU CU A
X 1,000 5 6 4 P
Y 2,000 8 10 7 T
E
The inventory of X cannot be used by the company for any other purpose; material Y is used frequently by R
the company.

What is the relevant cost of the materials for the manufacture of the special machine?
2
9 The following data relate to 200 kg of material ZX in inventory and needed immediately for a contract:
CU
Standard cost 2,300
Replacement cost 2,200
Realisable value 2,000

Within the firm the 200 kg of material ZX can be converted into 200 kg of material RP at a cost of CU100.
Material RP has many uses in the firm, and 200 kg cost CU2,200.

What cost should be included for material ZX when assessing the viability of the contract?

10 The following data relate to material held in inventory and needed immediately for a contract:

CU
Replacement cost 4,000
Realisable value 3,900
Storage costs for this quantity for one month 200

There will be no alternative use for this material until one month later when the replacement cost will be
CU4,300.

What cost should be included for the material when assessing the viability of the contract?
11 The following data apply to a non-current asset:

CU
Net realisable value 5,000
Historic cost 6,000
Net present value in use 7,500
Replacement cost 10,000
What is the deprival value?

12 In the recently prepared annual accounts of Evy, closing inventory of finished goods includes CU4,800 for
item X, calculated as follows:
CU
Materials at cost 1,800
Direct labour 2,000
Production overhead

Investment appraisal 49
 Variable with labour cost 400
Fixed 600
Factory cost of producing item X 4,800
Soon after the year end item X was stolen and the management wishes to know its deprival value. A
replacement could be made during normal working hours as Evy has spare capacity. Labour is paid on the
basis of hours worked. The cost of replacement would be as in the schedule above except for materials, the
replacement cost of which is now CU2,200. The item sells for CU7,000.
What is the deprival value of item X?

13 In order to manufacture a new product a firm needs two materials, S and T. There are ample quantities of
both in inventory. S is commonly used within the business, whereas T is now no longer used for other
products. Relevant information for the two types of material is as follows:

Material Quantity per unit Original cost Replacement cost Scrap value
kg CU/kg CU/kg CU/kg
S 2 2.40 4.20 1.80
T 3 1.00 1.40 0.40
What is the opportunity cost of materials to be used in making one unit of the new product?

14 Jason Ltd makes a product, the Elke, which sells for CU35. Its standard cost is made up as follows:

CU
Material 11
Direct labour (2 hours) 12
Variable overhead (2 hours) 6
29
All labour time is fully utilised. A customer approaches Jason Ltd to make a special order for which he will
pay CU10,000. To carry out the order, materials will need to be purchased for CU3,000, extra fixed costs of
CU500 will be incurred, and 500 hours of labour time will be required.
What is the effect of the order on profit?

15 Jones Ltd plans to spend CU90,000 on an item of capital equipment on 1 January 20X2. The expenditure is
eligible for 18% writing down allowances, and Jones pays corporation tax at an effective rate of 21%. The
equipment will produce savings of CU30,000 per annum for its expected useful life deemed to be receivable
every 31 December. The equipment will be sold for CU25,000 on 31 December 20X5. Jones has a 31
December year end and has a 10% post-tax cost of capital.

What is the present value at 1 January 20X2 of the tax savings that result from the capital allowances?

16 A company has 31 March as its accounting year end. On 1 April 20X6 a new machine costing CU2,000,000
is purchased. The company expects to sell the machine on 31 March 20X8 for CU500,000.

The effective rate of corporation tax for the company is 21%. Writing down allowances are obtained at 18%
on the reducing balance basis, and a balancing allowance is available on disposal of the asset. The company
makes sufficient profits to obtain relief for capital allowances as soon as they arise.

If the company's cost of capital is 10% per annum, what is the present value at 1 April 20X6 of the effect on
tax cash flows of capital allowances (to the nearest CU000)?

17 A company is considering investment in new labour-saving equipment costing CU1 million. One major
saving is expected to be semi-skilled labour which in the year 20X0 is paid CU5 per hour. However, the firm
expects to have to increase this labour cost at 5% per annum into the foreseeable future. If purchased, the
equipment would expect to save 20,000 labour hours per year, and would be in place from the start of 20X1.

The company's money cost of capital is 15.5%.

Assuming that savings arise at the end of each year, what (to the nearest CU000) is the present value at the
beginning of 20X1 of the savings over a ten year planning period?

50 Financial Management
18 A company is commencing a project with an initial outlay of CU50,000 on 1 January 20X1. It is estimated
that the company will sell 1,000 items on 31 December 20X1 and at the end of each subsequent year until 31
December 20X3. The contribution per unit on 31 December 20X1 will be CU33, and is expected to rise by
10% per year over the life of the project.

At the end of the project scrap sales are expected to realise a cash amount of CU15,000. This will be received
by the company on 31 December 20X3. At an inflation rate of 10% pa the real cost of capital is 10% pa.

What is the net present value of the project's cash flows at 1 January 20X1 (to the nearest CU1,000)?

19 Ackford is contemplating spending CU400,000 on new machinery. This will be used to produce a
revolutionary type of lock, for which demand is expected to last three years. Equipment will be bought on 31 C
December 20X1 and revenue from sale of locks would be receivable on 31 December 20X2, 20X3 and 20X4. H
Labour and labour-related costs for the three years, payable in arrears, are estimated at CU500,000 per annum A
in current terms. These figures are subject to inflation at 10% per annum. P
T
Materials required for the three years are currently in inventory. They originally cost CU300,000; they would E
cost CU500,000 at current prices although Ackford had planned to sell them for CU350,000. The sales R
revenue from locks in the first year will be CU900,000. This figure will rise at 5% per annum over the
product life.

If Ackford has a money cost of capital of 15.5%, what is the net present value of the lock project at 31 2
December 20X1?

20 Calder Inc has been told that its 'real' cost of capital is 10%. The twin benefits from a prospective project
have been estimated at CU50,000 and CU80,000 per annum. Both types of benefit are receivable in arrears
and for an indefinite period; both are expressed in current terms, the former subject to 4% inflation, the latter
to 8% inflation.

If the Consumer Prices Index indicates general inflation running at 7%, what is the present value of the
estimated benefits?

21 Paisley Ltd plans to purchase a machine costing CU13,500. The machine will save labour costs of CU7,000
in the first year. Labour rates in the second year will increase by 10%. The estimated average annual rate of
inflation is 8%, and the company's real cost of capital is estimated at 12%.

The machine has a two year life with an estimated actual salvage value of CU5,000 receivable at the end of
year 2. All cash flows occur at the year end.

What is the NPV (to the nearest CU10) of the proposed investment?

22 Four projects, P, Q, R and S, are available to a company which is facing shortages of capital over the next
year but expects capital to be freely available thereafter.
Project
P Q R S
CU'000 CU'000 CU'000 CU'000
Total capital required over life of project 20 30 40 50
Capital required in next year 20 10 30 40
Net present value of project at company's
cost of capital 60 40 100 80
In what sequence should the projects be selected if the company wishes to maximise net present values?

Questions 23 and 24
With reference to the following information, answer questions 23 and 24.
A company has identified a number of independent investment projects, each of which lasts two years. It is
estimated that the cash flows and net present values of the projects are as follows:

Time NPV
t0 t1 t2
CU CU CU CU

Investment appraisal 51
 Project H (500) +250 +260 (49)
Project I (2,000) +1,500 +1,500 +603
Project J +500 +650 (1,250) +58
Project K +350 (750) +375 (22)
Project L (1,000) +600 +1,200 +537
Cash flows in t1 and t2 occur at the end of each year, and t0 is the immediate inflow/outflow. Inflows from one
project can be used to finance outflows for another project in the same period.
23 If the cash available for investment projects at t0 is limited to CU2,850 and projects are indivisible, what is
the maximum net present value that could be generated from projects?
24 If the cash available for investment projects at t0 is limited to CU2,000 and projects are infinitely divisible,
what will be the net present value generated from projects accepted?

25 Plum Ltd wishes to replace its existing pressing machine with a new model immediately. The new model
would be replaced by the same model in perpetuity. Three new models are available as follows:

Model I II III
Purchase price CU50,000 CU40,000 CU70,000
Estimated life 5 years 4 years 6 years
Annual running costs
(payable at the end of each year) CU4,000 CU6,000 CU3,500
If model I were purchased, its life could be extended to eight years by incurring repair costs of CU30,000
after five years of use. Annual running costs of CU7,000 would be incurred at the end of each of the three
years of extended life. Plum Ltd has a cost of capital of 10% per annum. Plum has the following options
regarding purchasing the machine and the replacement policy.
(i) Purchase model I and replace every five years
(ii) Purchase model I and replace every eight years
(iii) Purchase model II and replace every four years
(iv) Purchase model III and replace every six years
Which new model should Plum Ltd choose, and what replacement policy should it follow if it wishes to
minimise the present value of its costs?
26 A machine costing CU150,000 has a useful life of eight years, after which time its estimated resale value will
be CU25,000. Annual running costs will be CU5,000 for the first three years of use and CU8,000 for each of
the next five years. All running costs are payable on the last day of the year to which they relate.
Using a discount rate of 20% per annum, what would be the annual equivalent cost of using the machine if it
were bought and replaced every eight years in perpetuity (to the nearest CU100)?
27 MR DIPSTICK
Mr Dipstick has been asked to quote a price for a special contract. He has already prepared his tender but has
asked you to review it for him.
He has pointed out to you that he wants to quote the minimum price as he believes this will lead to more
lucrative work in the future.
Mr Dipstick's tender
CU
Material
A, 2,000 kgs @ CU10 per kg 20,000
B, 1,000 kgs @ CU15 per kg 15,000
C, 500 kgs @ CU40 per kg 20,000
D, 50 litres @ CU12 per litre 600
Labour
Skilled 1,000 hrs @ CU25 per hr 25,000
Semi-skilled 2,000 hrs @ CU15 per hr 30,000
Unskilled 500 hrs @ CU10 per hr 5,000
Fixed overheads 3,500 hrs @ CU12 per hr 42,000
Costs of preparing the tender

52 Financial Management
 Mr Dipstick's time 1,000
Other expenses 500
Minimum profit (5% of total costs) 7,725
Minimum tender price 166,825
Other information

Material A. 1,000 kgs of this material is in inventory at a cost of CU5 per kg. Mr Dipstick has no alternative
use for this material and intends selling it for CU2 per kg. However, if he sold any he would have to pay a
fixed sum of CU300 to cover delivery costs. The current purchase price is CU10 per kg.

Material B. There is plenty of this material in inventory at a cost of CU18 per kg. The current purchase price C
has fallen to CU15 per kg. This material is constantly used by Mr Dipstick in his business. H
A
Material C. The total amount in inventory of 500 kgs was bought for CU10,000 some time ago for another P
one-off contract which never happened. Mr Dipstick is considering selling it for CU6,000 in total or using it T
as a substitute for another material, constantly used in normal production. If used in this latter manner it E
would save CU8,000 of the other material. Current purchase price is CU40 per kg.
R
Material D. There are 100 litres of this material in inventory. It is dangerous and if not used in this contract
will have to be disposed of at a cost to Mr Dipstick of CU50 per litre. The current purchase price is CU12 per
litre. 2

Skilled labour. Mr Dipstick only hires skilled labour when he needs it. CU25 per hour is the current hourly
rate.

Semi-skilled labour. Mr Dipstick has a workforce of 50 semi-skilled labourers who are currently not fully
employed. They are on annual contracts and the number of spare hours currently available for this project is
1,500. Any hours in excess of this will have to be paid for at time and a half. The normal hourly rate is CU15
per hour.

Unskilled labour. These are currently fully employed by Mr Dipstick on jobs where they produce a
contribution of CU2 per unskilled labour hour. Their current rate is CU10 per hour, although extra could be
hired at CU20 an hour if necessary.

Fixed overheads. This is considered by Mr Dipstick to be an accurate estimate of the hourly rate based on his
existing production.

Costs of preparing the tender. Mr Dipstick has spent ten hours working on this project at CU100 per hour,
which he believes is his charge-out rate. Other expenses include the cost of travel and research spent by Mr
Dipstick on the project.

Profit. This is Mr Dipstick's minimum profit margin which he believes is necessary to cover 'general day to
day expenses of running a business'.
Requirement
Calculate and explain for Mr Dipstick what you believe the minimum tender price should be.
(16 marks)
28 TINOCO LTD

In January 20X3 Tinoco Ltd gave the go-ahead to its research and development department to pursue work
on a major new product line, code-named 'Product Z'. The cash expenditure to date on this development has
totalled CU200,000, consisting of CU70,000 during 20X3 and CU130,000 during 20X4. The work is now
complete, resulting in a marketable product.

In order to market this product the company will need to build and equip a new factory specifically for the
purpose. A suitable site has been found which, if the company decides to go ahead with production, will be
purchased on 1 January 20X5 at a cost of CU270,000. Construction of the factory will then commence
immediately and take an estimated two years at a total cost of CU2.5 million. Half of this sum will be payable
as a stage payment at the end of the first year of construction, the balance being payable on completion.
Installation of the necessary machinery can be done during the last two months of construction and will cost a
total of CU1,250,000. CU250,000 of this will be paid upon delivery and the balance in two equal annual
instalments on the anniversary of delivery.

Investment appraisal 53
 The company intends to undertake a significant advertising campaign for this new product, which will
commence twelve months before completion of the factory. During its first year this campaign will cost
CU150,000 and will then continue for the next two years at a cost of CU250,000 and CU100,000 respectively
in each of those years. Payment will be made at the end of each of the three years. As a consequence of this
campaign the company is forecasting an annual demand for Product Z of 400,000 units and expects this
demand level to continue for ten years after production commences. Initial production will commence
immediately upon completion of the factory at an annual rate to match demand.

Production costs will consist of CU4 per unit of variable costs and annual fixed costs of CU300,000. After
five years of production the equipment within the factory will need replacement. The old machinery will be
sold for CU250,000 and new equipment acquired at the same cost and on the same terms as the original
equipment. This replacement can be achieved without disruption to production.

At the end of the ten-year production period the product will be abruptly discontinued, and the production
facility will then be surplus to the company's requirements. It is expected that the machinery can be sold at
that time for CU250,000 and that the factory and site will command a price of CU3 million.

Despite extensive market research during the last six months at a cost of CU50,000 the company remains
uncertain as to the price it will be able to charge for this new product. However, the sales director is currently
suggesting a selling price of CU7.50 per unit.

The company's discount rate is 15% per annum.

Requirements
(a) Calculate the net present value of the proposed new production, assuming the sales director's forecast
selling price is correct. (12 marks)
(b) Calculate the minimum selling price that must be set in order to make Product Z a viable proposition.(3 marks)
(15 marks)
29 SHAW SECURITY SYSTEMS LTD

Shaw Security Systems Ltd, a company financed by a mixture of equity and debt capital, manufactures
devices which seek to deter the theft of motor vehicles. The company's development department has recently
produced a new type of anti-theft device. This device, which will be known as an Apollo, will be fitted to
private motor vehicles. The Apollo emits an electronic signal which can be picked up by an electronic sensor
fitted to police cars, enabling the police to locate stolen cars and, possibly, apprehend the thief. Development
costs totalled CU500,000. These were all incurred in 20X5.

A decision now needs to be taken as to whether to go ahead with producing and marketing Apollos. This is to
be based on the expected net present value of the relevant cash flows, discounted at the company's estimate of
the 20X5 weighted average cost of capital of 8% (after tax). The company's management believes that a three
year planning horizon is appropriate for this decision, so it will be assumed that sales will not continue
beyond 20X8.

Following discussions with a number of police forces, the company has reached agreement that, if it decides
to go ahead with the project, one of the Midland forces will trial the Apollo system, and the sensors will be
fitted to its police cars.

The cost of providing and fitting the sensors to the police cars would be borne by the company, which would
retain ownership. The police force would bear the cost of maintenance. The sensors would be manufactured
and fitted by a sub-contractor, who has offered to do this work by the end of 20X5 for a total cost of CU1
million, payable immediately on completion of the work. This cost would attract the normal capital
allowances for plant and equipment at 18% reducing balance. If the company were to make the investment, it
would elect for the sensors to be treated as a short-life asset. At the end of three years the sensors would be
scrapped.

The first sales of Apollos would be expected to be made during the year ending 31 December 20X6. There is
uncertainty as to the level of sales which could be expected, so a market survey has been undertaken at a cost
of CU100,000.

The survey suggests that, at the company's target ex-works price of CU200 per Apollo, there would be a 60%
chance of selling 10,000 Apollos and a 40% chance of selling 12,000 during 20X6.

54 Financial Management
 If the 20X6 sales were to be at the lower level, 20X7 sales would be either 8,000 Apollos (30% chance) or
10,000 (70% chance). If 20X6 sales were to be at the higher level, 20X7 sales would be estimated at 12,000
Apollos (50% chance) or 15,000 (50% chance).

20X8 sales would be expected to be 50% of whatever level of sales were to occur in 20X7.

Sales of Apollos would be expected to have an adverse effect on sales of the Mercury, a less sophisticated
device produced by the company, to the extent that for every two Apollos sold one less Mercury would be
sold. This effect would be expected to continue throughout the three years.

Materials and components would be bought in at a cost of CU70 per Apollo. Manufacture of each Apollo
would require three hours of labour. This labour would come from staff released by the lost Mercury
C
production. To the extent that this would provide insufficient hours, staff would work overtime, paid at a
H
premium of 50% over the basic pay of CU6 an hour.
A
P
The Mercury has the following cost structure.
T
CU per unit E
R
Selling price (ex-works) 100
Materials 20
Labour (4 hours) 24 2
Fixed overheads (on a labour hour basis) 33
The management team currently employed by the company would be able to manage the Apollo project
except that, should the project go ahead, four managers, who had accepted voluntary redundancy from the
company, would be asked to stay until the end of 20X8. These managers were due to leave the company on
31 December 20X5 and to receive lump sums of CU30,000 each at that time. They were also due to receive
an annual fee of CU8,000 each for consultancy work, which the company would require of them from time to
time. If they were to agree to stay on, they would receive an annual salary of CU20,000 each, to include the
consultancy fee. They would also receive lump sums of CU35,000 each on 31 December 20X8. It is
envisaged that the managers would be able to fit any consultancy requirements round their work managing
the Apollo project. These payments would all be borne by the company and would qualify for full tax relief.

Apollo production and sales would not be expected to give rise to any additional operating costs beyond
those mentioned above.

Working capital to support both Apollo and Mercury production and sales would be expected to run at a rate
of 15% of the ex-works sales value. The working capital would need to be in place by the beginning of each
year concerned. There would be no tax effects from changes in the level of working capital.
The company's accounting year end is 31 December. Sales should be assumed to occur on the last day of the
relevant year. The company's corporation tax rate is expected to be 21% throughout the planning period. Tax
cash flows occur at the end of the accounting period to which they relate.
Requirements
(a) Prepare a schedule which derives the annual expected net cash flows from the Apollo project, and use it
to assess the project on the basis of its expected net present value.
(18 marks)
(b) Comment on the assessment of the project made in requirement (a) and any reservations you have about
using it as the basis for making a decision as to whether to proceed with the project. (4 marks)
Ignore inflation.
Work to the nearest CU1,000. (22 marks)
30 FIORDILIGI LTD
Fiordiligi Ltd is evaluating a potential new product, the ottavio, in which the following costs are involved.

(a) Labour

Each ottavio requires 1/2 hour of skilled labour and 2 hours of unskilled labour. During the next year
Fiordiligi expects to have a surplus of skilled labour, retained on contracts under which the minimum
wage is guaranteed. This surplus is sufficient to complete the budgeted quantity of ottavios in the first
year, but there will be no surplus thereafter. All unskilled labour will be taken on as required.

Investment appraisal 55
 The wage rates are CU4.00 per hour for skilled labour and CU2.50 per hour for unskilled.

(b) Materials

(i) Material 'Ping' is used in the ottavios, 2 kgs per unit. No inventories of Ping are held by the
company.

(ii) Material 'Pang' is used at the rate of 0.5 kg per unit of ottavio. Sufficient of this material to meet
the entire budgeted production is already in inventory; it has no other use.

(iii) Material 'Pong' is also used; 1.5 kgs are required per unit. Some inventories are already held;
further supplies may readily be purchased. Pong is used in the manufacture of another product, the
masetto, which earns a contribution of CU0.85 per kg of Pong, net of the cost of Pong, and
depreciation at an estimated CU0.06 per kg.

The value of the various materials may be summarised as follows.

Ping Pang Pong
CU CU CU
Cost of material in inventory (per kg) – CU2.00 CU0.70
Current replacement cost (per kg) CU1.40 CU2.20 CU0.80
Current realisable value (per kg) CU1.10 CU1.80 CU0.65
Any materials requiring purchase will be bought in advance of the year for which they are needed.
(c) Overheads
(i) Variable overheads are expected to be incurred at the rate of CU1.40 per skilled labour hour. This
represents the extra cash cost expended.
(ii) Fixed overheads will be affected by the project as follows.
(1) A new factory will be leased at an annual rental of CU2,000 in advance for the life of the
project.
(2) Rates on the factory (payable in arrears) will be CU1,000 per annum.
(3) The equipment (see below) will be written down to its realisable value over the life of the
project.
(4) The central management accounting department will absorb administration costs into
production on the basis of CU0.50 per unskilled labour hour. Direct administration of the
project will be carried out by management without any increase in overtime or staffing
levels.
It is expected that ottavios will be produced for three years at the rate of 10,000 units per annum, and then for
a further two years at the rate of 8,000 units per annum. The selling price will be CU18 per unit in the first
three years and CU14 thereafter.
Special machinery will be purchased at the start of the project for CU60,000. It will be sold at the end of the
fifth year for CU6,000.

Requirement
Calculate the net present value of the projected production of ottavios, and hence advise the directors whether
or not to proceed. The company's cost of capital for investments of this nature is 15%. (15 marks)
Note: Ignore taxation.

31 GIOVANNI LTD
Giovanni Ltd is considering investing in an ice cream plant to operate for the next four years. After that time
the plant will be worn out, and Giovanni, the owner of the company, wishes to retire in any case. The plant
will cost CU5,000 and is expected to have no realisable value after four years. If worthwhile the plant will be
purchased at the end of an accounting period. Capital allowances at the rate of 18% per annum (reducing
balance) will be available in respect of the expenditure.
Revenue from the plant will be CU7,000 per annum for the first two years and CU5,000 per annum
thereafter. Incremental costs will be CU4,000 per annum throughout.

56 Financial Management
 You may assume that all cash flows occur at the end of the financial year to which they relate. Assume
Giovanni Ltd pays corporation tax at 21% and has a cost of capital of 10%.
Requirements
(a) Calculate the tax saved through capital allowances and show when the savings arise.
(3 marks)
(b) Advise Giovanni Ltd on whether or not to proceed with investment in the ice cream plant.
(4 marks)
(c) Show what difference it would make if the plant were to be purchased and sold at the beginning of the
accounting period. Comment on the wisdom of disposing of an asset on the first day of an accounting
C
period. (3 marks)
H
(10 marks) A
P
32 SHAREHOLDER VALUE
T
(a) The following statements appear in the objectives of two well-known public limited companies. E
'We never confuse why we exist – to create the maximum possible returns to our shareholders.' R

'In everything the company does, it is committed to creating wealth, always with integrity, for our
employees, customers, suppliers and the community in which we operate.' 2
Requirement
Discuss these two different perspectives of the operation of a firm, and explain why they are not
necessarily contradictory. (5 marks)
(b) The managing director of the first company believes that the best external measure of shareholder
wealth maximisation is growth in earnings per share (EPS).
Requirement
Critically evaluate this belief. Suggest three value drivers on which a business can focus, and why their
management will increase shareholder wealth. (6 marks)
(11 marks)
33 PACKERS LTD
Packers Ltd has been offered a contract to manufacture a batch of chemicals. The company's managers
estimate that it will take two years to produce the chemicals. The price offered is CU235,000 expressed in
current pounds sterling. This price will be increased in line with increases in the Consumer Price Index
during the contract period, and the adjusted amount will be paid in full when the chemicals are delivered at
the end of two years.
Production of the chemicals will require the following resources.
(1) A machine will be purchased immediately for CU75,000 for exclusive use on this contract. The
machine will have a two-year life and no scrap or resale value.
(2) Ten workers who are currently employed by the company will each work for two years on production
of the chemicals. The total cost of employing one worker is currently CU6,000 per annum, based on
wage rates which have recently been agreed for the coming year. The managers expect to negotiate
wage rates at the end of one year; as a result they expect that total employment costs for the second year
of the contract will rise by 12.5%. You may assume that all employment costs are payable on the last
day of the year to which they relate.
If the chemicals contract is not accepted, there will be no work within the company for the ten workers
during the coming two years and they will be made redundant. The company will incur a net
redundancy cost of CU200 for each worker payable immediately. The managers expect new orders after
two years and the company will re-employ the ten workers at the end of the second year. Administrative
and advertising costs associated with the re-employment are expected to be CU500 per person. This
amount will not be affected by inflation during the next two years.
(3) 2,000 units of raw material D will be needed immediately and 2,000 units will be needed at the end of
one year. Packers Ltd has 2,000 units of D in inventory. These units originally cost CU18 per unit and
have a current replacement cost of CU20 per unit. The company has no use for material D other than on
the contract offered and, if the contract is rejected, the units in inventory will be disposed of at an

Investment appraisal 57
 immediate cost of CU1.50 per unit. (The material is highly specialised and cannot be re-sold.) The cost
of buying material D is expected to rise by 15% during the coming year.
Packers Ltd has a discount rate of 15% per annum, which reflects the inflation expected over the life of
the contract, and the Consumer Price Index rise is 10% per annum.
Requirement
Calculate the net present value of the contract which has been offered to Packers Ltd. (10 marks)
34 AINSDALE LTD
Ainsdale Ltd, an all equity company, manufactures a single product, an item of exercise equipment for use in
the home. The company is considering moving one of its factories to a new site.
Moving to new premises would take place on 1 January 20X1. It would cause significant disruption to
existing sales and production, and incur substantial initial costs. The new site would mean, however that
output would no longer be constrained by the size of the factory and hence, when there is sufficient demand,
higher output and sales can be achieved.
If the move takes place the existing premises would be leased out indefinitely for an annual rental of
CU450,000 payable in advance commencing 1 January 20X1. Lease rentals would be subject to corporation
tax.
The cost of new premises would be CU10 million payable on 1 January 20X1. Assume that the premises
would not qualify for industrial buildings allowances.
Improved machinery for the new factory would be purchased at 31 December 20X0 at a cost of
CU1 million. This machinery would be expected to be sold on 31 December 20X4 for CU300,000. The old
machinery, which has a zero written down value, would need to be scrapped at 31 December 20X0 if the new
factory is purchased but, due to its specialist nature, would not generate any proceeds. It would, however,
continue to be used if the company were not to move to the new factory.
Machinery is subject to a 'short-life' asset election and excluded from the general pool (ignore re-pooling).
This means that it attracts 18% (reducing balance) tax allowances in the year of its acquisition and in every
subsequent year of its being owned by the company, except the last year. In the last year the difference
between the machinery's written down value for tax purposes and its disposal proceeds will either be allowed
to the company as an additional tax relief, if the disposal proceeds are less than the written down value, or be
charged to the company if the disposal proceeds are more than the tax written down value.
The maximum production capacity of the new factory would normally be 10 million units per year and that of
the existing factory is 6 million units per year. Due to setting-up time and disruption from moving, however,
the capacity of the new factory in 20X1 would be only 5 million units. Potential demand for the company's
output in the years ending 31 December is estimated as follows.
Units
(millions)
20X1 8
20X2 9
20X3 10
20X4 9
20X5 and thereafter 6
Given that projected sales and output are equal for both factories in the year 20X5 and thereafter, no
incremental manufacturing costs or revenues will arise from the move after 20X4.
Labour is employed under flexible contracts. It is thus estimated that labour costs will vary directly with
output, being CU1 per unit of output. This is the case at both the existing and the new factory.
Material quantities per unit of output and costs per kg are as follows.
Quantity Cost per kg
kgs CU
Material XM2 2 1.50
Material TS4 1 1.25
Material XM2 would only be available from an overseas supplier during 20X1 and 20X2, and this would lead
to a transport cost on material purchases of CU1.75 per kg in addition to the basic CU1.50 per kg during
those two years. From 20X3, however, it is expected that a UK supplier will be able to provide the material
for CU1.50 per kg.

58 Financial Management
 The selling price per unit is set to achieve a contribution of 40% of selling price. For this purpose
contribution is defined as selling price less labour and material costs. It excludes transport costs, training and
redundancy costs.
If the company decides to move site, some employees are expected to refuse to move. This is expected to lead
to redundancy payments of CU200,000 which will be made on 1 January 20X1. Retraining costs of
CU100,000 will be incurred on 31 December 20X0 in respect of the replacement employees.
The corporation tax rate can be assumed to be 21%. Assume that tax is paid at the end of the accounting year
in which the transaction occurs. There are expected to be sufficient taxable profits available to set off all
allowances.
The annual after-tax cost of capital is 10%. The company prepares its accounts to 31 December each year. All C
cash flows can be assumed to arise at year ends unless otherwise specified. H
A
Requirements
P
(a) Identify the annual net incremental cash flows that would arise from Ainsdale Ltd's decision to move T
the location of its factory, and use them to calculate the net present value at 1 January 20X1. (18 marks) E
(b) Calculate the payback period in respect of the incremental cash flows which would arise from Ainsdale R
Ltd's decision to move the location of its factory. (3 marks)
Ignore inflation. (21 marks)
2
35 ARCADIAN PRODUCTS LTD
The management of Arcadian Products Ltd is considering the introduction of a new product, code named
NP14. The company's finance department has undertaken some investigations and has assembled the
following information relating to NP14 production.
(1) Annual contributions from NP14s are expected to be as follows.
Year CUm
20X1 2.5
20X2 3.5
20X3 3.5
20X4 2.5
Production and sales would be expected to cease at the end of 20X4. Sales and operating expenses are
assumed to occur on the last day of the relevant year. The company's accounting year is to 31
December.
(2) Production of NP14s would require the use of some new equipment.
This equipment could be bought and paid for at the end of 20X0 at a cost of CU12 million. It would be
scrapped at the end of 20X4 for an estimated CU2 million. Under the contract to buy this equipment
there would be an obligation for the supplier to maintain the equipment throughout its four-year life at
no cost to the company.
Alternatively, production could use existing equipment already owned by the company. This equipment
is currently not in use and would be sold on 31 December 20X0 for an estimated CU3 million, were it
not to be used in NP14 production. It was bought for CU10 million and first used during 20W8. It
would be expected to continue to operate effectively in the production of NP14s until the end of 20X4,
when it would be expected to be scrapped (zero sales proceeds).
You should assume that all items of equipment are treated as 'short-life' assets and excluded from the
'pool'. This means that the equipment attracts a 18% (reducing balance) tax allowance in the year of
acquisition and in every subsequent year of ownership by the company, except the last year. In the last
year the difference between the equipment's written-down value for tax purposes and its disposal
proceeds is expected to be treated as an additional relief, if the disposal proceeds are less than the
written-down value; or be charged to the company, if the disposal proceeds are more than the tax
written-down value.
A problem with using the existing equipment is that it would require a relatively high level of
maintenance to enable it to operate as effectively as the new equipment. The annual maintenance costs
of the old equipment are estimated to be as follows.

Investment appraisal 59
 Year CUm
20X1 0.5
20X2 1.5
20X3 2.0
20X4 2.5
(3) Labour for NP14 production, included in calculation of the contributions, would be hired for the
duration of the production period.
(4) NP14 production would require the support of working capital equal to 10% of the contributions. This
would need to be in place by the start of each year. It has no tax implications. The maintenance costs,
were the existing plant to be used, would not give rise to any working capital requirement.
(5) The corporation tax rate is expected to be 21% for the foreseeable future. Assume that tax will be paid
at the end of the year in which the event giving rise to it occurs.
(6) All operating cash flows are expected to increase by an annual factor of 3%, due to general inflation.
Except for the expected disposal proceeds of the equipment, all of the financial information given above
is expressed in terms of 1 January 20X1 prices.
The company's real cost of capital, on all of its activities, is estimated at 10% per annum.
(7) There are no incremental costs or benefits other than those to which reference is made above.
Requirements
(a) Assuming that NP14 production and sales would be economically viable, produce a schedule of annual
cash flows and use it to indicate whether the company should use the existing equipment or acquire new
equipment. (13 marks)
(b) Taking account of the decision reached in (a), produce a schedule of annual cash flows and use it to
indicate whether NP14 production would be economically viable. (8 marks)
Work to the nearest CU000. (21 marks)

36 JUNO PRODUCTS LTD

Juno Products Ltd leases a factory in North Wales where, among other products, it makes a component,
known as the MC15, which is used in the manufacture of civil airliners and sold to aircraft manufacturers
worldwide. The factory's lease expires on 31 December 20Y2, so the company intends to review the future of
all of its production there in anticipation of that event. Meanwhile the immediate future of MC15 production
is in doubt. Some members of the company's management team believe that recent developments in aircraft
design have rendered the MC15 an uneconomic prospect for the company during the four years 1 January
20X9 to 31 December 20Y2. As a member of the company's finance staff you have been asked to make an
assessment of the economic viability of the MC15 over the next four years on the basis of net present value.
It seems fairly certain that, irrespective of the short-term future of the MC15, its manufacture will not be
continued beyond 20Y2.
Estimated sales demand for the MC15 over the next four years ending 31 December at a unit selling price of
CU35,000 is as follows.

Year Units
20X9 500
20Y0 500
20Y1 400
20Y2 300
It is believed, however, that were a modification to be made to the design of the MC15, demand could be
raised to 700 units in each of the first two years, but this modification would have no effect on demand for
20Y1 and 20Y2. The modification could be effected by 31 December 20X8.

It would cost CU8 million, payable on 31 December 20X8, and this amount would be fully allowable for
corporation tax for the year in which this expenditure would be incurred.
The factory is leased for a fixed CU6 million per annum payable annually in advance.
The direct, variable manufacturing costs of each MC15 are as follows.

60 Financial Management
 CU
Direct labour 4,000
Raw material and bought-in parts 7,000
The company generally operates a 'just-in-time' inventory holding policy, which means that the inventories of
nearly all of the materials and parts are negligible. In the case of one bought-in part, however, there will be an
inventory of 1,000 units at 1 January 20X9. This arose because, early in 20X8, the company was offered a
special deal on this item provided that it was prepared to make a bulk purchase. This bought-in part is
included in the raw material and bought-in parts total above at its normal price of CU1,000 per unit. Each
MC15 requires the use of one of these parts and this part can be used only in the manufacture of MC15s. The
bulk purchase was made at a price of CU800 per unit. If MC15 production were not to continue, the C
inventory could be sold for CU600 per unit on 31 December 20X8 for immediate cash settlement. Any H
necessary tax adjustments resulting from this inventory can be ignored.
A
Ceasing MC15 production would release 25% of the factory space, but this could not be used for any other P
activity. The labour released could, however, be transferred to another department of the factory for work on T
another of the company's products. Demand for that product exceeds the ability of the company to meet it due E
to a shortage of labour, a shortage which would otherwise persist throughout the four years. For every CU1's R
worth of labour transferred, it is estimated that a contribution (sales revenue less direct labour and materials)
of CU3 could be generated. The possible additional sales of MC15s during 20X9 and 20Y0, should the
modification be undertaken, would not affect the output of the other product. 2
Plant, bought for CU10 million on 1 January 20X7, is used in the manufacture of MC15s. It could be
disposed of on 31 December 20X8 for an estimated CU6 million. By 31 December 20Y2 it would be
expected to have no market value. This plant was the subject of an election to be treated as a 'short-life asset'
and excluded from the 'pool'. This means that it attracted 18% (reducing balance) tax allowances in the year
of its acquisition and in every subsequent year of its being owned by the company, except the last year. In the
last year the difference between the plant's written down value for tax purposes and its disposal proceeds will
either be allowed to the company as an additional tax relief, if the disposal proceeds are less than the tax
written down value, or be charged to the company if the disposal proceeds are more than the tax written down
value.

It is estimated that overheads (excluding lease payments) apportioned to MC15 total CU5 million per annum.
Of this amount CU2 million can be avoided by ceasing MC15 production.

The company's accounting year end is 31 December. The corporation tax rate is expected to be 21%
throughout the period concerned. Tax can be assumed to be payable at the end of the year in which the event
giving rise to it occurs.

There are no other incremental cash flows associated with MC15 production and sales.

All cash flows can be treated as occurring on the last day of the year to which they relate, unless specified
otherwise.

The company uses its after-tax long-term borrowing rate of 5% per annum to assess projects, and you are
expected to follow this approach.
Requirements
(a) Assuming that MC15 production and sales continue until 20Y2, assess whether it would be
economically viable to pay for the modification to the design of the product.
(4 marks)
(b) Using the results from (a), prepare a statement which shows the annual relevant cash flows associated
with a decision on whether on the basis of net present value to cease production of MC15s at 31
December 20X8 or to continue production until 31 December 20Y2. (11 marks)
(c) Discuss the suitability of using the long-term borrowing rate as the discount rate for project evaluation.(3 marks)
Ignore inflation. (18 marks)

Investment appraisal 61
 37 REXAL LTD

Rexal Ltd is a small company that specialises in the manufacture of pit-props and supports.

Management see the maximisation of shareholders' wealth as the primary business objective. The company is
profitable and is able to utilise capital allowances obtained on new capital investment at the earliest
opportunity. The directors have never felt comfortable with debt finance and as a consequence there is
negligible long-term debt in the company's capital structure.

A local coal field has approached Rexal Ltd recently requesting the production of some special pit-props.
After researching the contract it emerged that there were two options available to the company.

These are outlined below.

Option 1

A new machine will be purchased for CU80,000, payable on 1 January 20X1. The machinery will be sold for
CU8,000 on 31 December 20X3.

Any labour required under this option will have to be recruited.

The net year-end operating cash inflows are budgeted as follows.

CU
20X1 60,000
20X2 74,000
20X3 88,000
These figures are stated in money terms and are before corporation tax.
Option 2
As an alternative to acquiring new equipment and extra labour, use could be made of existing resources.
A machine acquired many years ago for CU120,000 could be used on this project. It was to be sold on 1
January 20X1 for CU30,000. If used it is felt that its realisable value would be zero due to the three extra
years of use. The current tax written down value of this asset is nil; all available capital allowances on this
asset were taken as 100% first year allowances in its first year of use.
The net year-end operating cash inflows under option 2 are the same as for option 1, except for the following
two factors.
(a) Extra running costs of CU5,000 in 20X1, which will rise in line with inflation thereafter, will be
incurred due to using the old machinery.
(b) The labour used for option 2 will be moved from existing company operations. This will lead to a loss
of contribution on such operations of CU20,000, CU22,000 and CU23,500 in the three years
respectively.
Working capital equal to 10% of that year's net cash inflows, excluding tax flows, will be required at the
beginning of each year for both options. This will be released at the end of the project. There are no tax
effects associated with movements in working capital. (In the case of option 2, net cash inflows should be
taken as the values after adjustment for the machine and labour costs.)
The company's real cost of capital is estimated at 15% per annum and is expected to remain at that rate for
the foreseeable future.
Inflation rates have been estimated for the next four years as follows.

20X1 10%
20X2 8%
20X3 6%
20X4 4%
The company's financial year runs to 31 December. Corporation tax is payable at 21%.

62 Financial Management
 Requirements
(a) Calculate the net present values at 31 December 20X0 of each of the two options.
(15 marks)
(b) Indicate any reservations you might have in basing an investment decision on these figures.
(3 marks)
(18 marks)
38 SOUTHSEA LTD

Southsea Ltd (Southsea) manufactures high specification stretchers for its sole customer, HealthTrans Ltd C
(HealthTrans), which supplies ambulances and ancillary products to the UK National Health Service and a
H
range of private hospitals and firms.
A
P
HealthTrans is currently experiencing rapid growth in business levels. As a result, Southsea has recently been
T
offered a new five-year contract with HealthTrans which will start on 1 January 20X2. Under this contract
HealthTrans would guarantee to buy its entire stretcher requirements from Southsea, assuming that Southsea
E
were able to supply all of its needs. R

Demand from HealthTrans under the existing contract in the year ending 31 December 20X1 is expected to
be 1,000 stretchers. However, HealthTrans forecasts that this demand will rise at a compound rate of 10% pa 2
over the five years of the new contract.

At the present time Southsea has a production capacity of 1,050 stretchers pa, but the company is considering
making an investment in production facilities that would see its annual capacity rise to 1,500 stretchers pa.
However, the new contract with HealthTrans will go ahead, using existing production facilities, whether or
not Southsea decides to increase its production capacity. In any one year, Southsea will only ever produce
sufficient stretchers to meet that year’s annual demand ie, it will not hold inventory.

In the year ending 31 December 20X1, the price per stretcher is CU2,500, but the contract on offer contains a
commitment from HealthTrans to accept an increase in this price over the period of the contract at the UK
rate of inflation, which is expected to be 2% pa up to 31 December 20X4 and 3% pa thereafter.

The total cost of the component parts of each stretcher during the year ending 31 December 20X1 is
CU1,200. Due to the highly competitive nature of the market for these component parts, this cost will not be
subject to annual inflation, but rather is expected to fall at a compound rate of 1% pa over the life of the
contract due to the economies of scale that would arise from the increased levels of production.

Labour costs are also expected to be subject to efficiency gains which will be sufficient to cancel out the
effect of any wage inflation. The cost of labour is therefore expected to remain constant over the life of the
contract at CU300 per stretcher.

Anticipated efficiency gains associated with the increased production levels also mean that the impact on
working capital requirements and fixed costs will be negligible and can be ignored.

In order to achieve the proposed increase in production capacity, investment in production facilities of CU2
million would be required and this would take place on 31 December 20X1. The new facilities would have an
estimated useful life of five years at the end of which they are estimated to have no residual value.

The company’s corporation tax rate is expected to be 21% for the foreseeable future, and it can be assumed
that tax payments occur at the end of the accounting year to which they relate. The directors are also
assuming that the new facilities will attract full capital allowances at 18% pa on a reducing balance basis
commencing in the year of purchase and continuing throughout the company’s ownership of the new
facilities. A balancing charge or allowance will arise on disposal of the new facilities which can be assumed
to be on 31 December 20X6. Sufficient profits are available for the firm to claim all such tax allowances in
the year they arise.

The company’s real after-tax cost of capital is 7% pa, and its accounting year end is 31 December. Assume
that all annual operating cash flows arise at the year end.

Investment appraisal 63
 As the relationship between Southsea and HealthTrans has developed, directors of both companies have
increasingly considered the possibility of a merger between the two companies.

Requirements
(a) Calculate the net present value at 31 December 20X1 of the proposed investment in increased
production facilities and, on the basis of your calculation, state whether or not Southsea should proceed.(16 marks)
(b) Identify and explain the type of real option that might be most relevant to Southsea’s consideration of
its investment decision. (3 marks)
(c) Outline in general terms the potential advantages of a merger between Southsea and HealthTrans. (3 marks)
(22 marks)
39 RFA LTD
RFA Ltd (RFA), an all equity financed company, manufactures a limited range of sports equipment. Its
financial year end is 31 March. RFA’s board is considering replacing one of its machines (the RF13) which is
employed in the manufacture of golf balls. It is estimated that the RF13 has two more years of production
left, but the new machine (which, if purchased, would be known as the RF17) has an improved technical
specification and could produce a higher quality ball which, it is felt, would generate an increase in sales. The
new machine would be bought at the end of the current financial year, i.e. 31 March 20X9 and would cost
CU1.7 million. Technological advancement in RFA’s market is rapid and its board therefore has plans to use
the new machine for a maximum of three years to 31 March 20Y2. The estimated sales figures (expressed in
March 20X9 prices) from using the two machines are:

Existing machine (RF13) New machine (RF17)

CU'000 CU'000
Year ended 31 March 20Y0 620 1,150
20Y1 600 1,450
20Y2 0 1,320

Variable costs
The average variable costs of the two machines (as a percentage of sales revenue in 20X9 prices) are as
follows:

RF13 RF17
% %
Raw materials 10 12
Other variable costs 25 18

Labour costs
RFA uses contractors to operate its machines. The cost is CU150,000 per annum. If the RF17 is purchased
annual savings of 12% will be made on these contracted labour costs. All of these costs are expressed in
March 20X9 prices.

Estimated annual inflation rates (April 20X9 to March 20Y2)

%
General (applies to RFA’s sales and other variable costs above) 3
Raw materials 5
Contracted labour 2

Working capital
RFA’s policy is that, at the start of each financial year, it has working capital in place that is equivalent to
10% (in money terms) of the estimated sales for that year. RFA assumes that all working capital is
recoverable once the equipment is sold.

64 Financial Management
 Capital allowances
RFA’s machinery attracts capital allowances, but is/will be excluded from the general pool. The RF13 has a
negligible tax written down value and it has a current resale value of CU100,000. Its use would be
discontinued as soon as the RF17 was purchased. RFA’s board believes that the RF13 would have a resale
value of CU80,000 (in money terms) at 31 March 20Y1 and that the RF17 would have a resale value of
CU200,000 (in money terms) at 31 March 20Y2.
Assume that this means that the RF17 will attract 18% (reducing balance) tax allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year. In the final
year, the difference between the machinery’s written down value for tax purposes and its disposal proceeds
will be either (i) treated by the company as an additional tax relief, if the disposal proceeds are less than the
C
tax written down value, or (ii) be treated as a balancing charge to the company, if the disposal proceeds are
H
more than the tax written down value.
A
Corporation tax P
RFA assumes that the tax rate will remain at 21% per annum and is payable in the same year as the cash T
flows to which it relates. E
R
Cost of capital
RFA uses a money cost of capital of 11% per annum for appraising its investments.
2
Requirements
(a) Advise RFA’s management whether it is beneficial, in net present value terms, to acquire the RF17 and
dispose of the RF13. (20 marks)
(b) Compare sensitivity analysis and expected values as methods of dealing with uncertainty.
(4 marks)
(24 marks)
40 STICKY FINGERS LTD
After paying CU15,000 for a preliminary investigation, the costing department of Sticky Fingers Ltd was
able to calculate the cash flows for the following investment projects.

Net cash flows t0 t1 t2 t3 t4

Immediate
outlay
CU'000 CU'000 CU'000 CU'000 CU'000
Project A (1,500) (500) 1,200 600 300
Project B (2,000) (1,000) 2,500 2,500 2,500
Project C (1,750) 500 1,100 1,400 1,000
Project D (2,500) 700 900 1,300 300
Project E (1,600) (500) 200 2,800 2,300
Note. All cash flows take place at the end of the year.
You have only just taken up the appointment of financial analyst. The cash flows from the various projects,
as shown above, have been given to you with a memorandum from the managing director outlining your first
task.
Requirements
Advise the company in the following circumstances.
(a) The company's cost of capital has been calculated as 15%. Cash is freely available and all projects are
independent and divisible. Prepare calculations showing which projects should be accepted. (3 marks)
(b) The amount of cash available for investment at time 0 has been limited to CU3 million. None of the
projects can be delayed.
Which projects should be accepted? (3 marks)
(c) The amount of cash available for investment at time 1 has been limited to CU200,000. None of the
projects can be delayed. There is now no rationing at time 0.
Which projects should be accepted? (5 marks)

Investment appraisal 65
 (d) The situation is as in part (b) except that now all projects are independent but indivisible, and CU3.5
million is available.
Which projects should now be accepted? (2 marks)
(13 marks)
41 IGLOO LTD
Igloo Ltd has identified the following investment projects.
t0 t1 t2
Immediate Time 1 Time 2
outlay
CU'000 CU'000 CU'000
Project A (100) (100) 303.6
Project B (50) (100) 218.9
Project C (200) 100 107.8
Project D (100) (50) 309.1
Project E (200) (50) 345.4

Requirements

Advise in the following circumstances.

(a) The company faces a perfect capital market, where the appropriate discount rate is 10%. All projects are
independent and divisible.

Which projects should the firm accept? (2 marks)

(b) The company faces capital rationing at t0. There is only CU225,000 of finance available. None of the
projects can be delayed.

Which projects should the firm accept? (2 marks)

(c) The situation is as in part (b) above, except that you are now informed that projects A and B are
mutually-exclusive.

Which projects should now be accepted? (2 marks)

(d) The solution is as in part (b) above, except that you are now told that all projects are independent but
indivisible.

Which projects should be accepted? What will be the maximum NPV available to the company?(2 marks)

(e) All projects are independent and divisible. There is capital rationing at t1 only. No project can be
delayed or brought forward. There is only CU150,000 of external finance available at t1.

Which projects should be accepted? (3 marks)

(11 marks)
42 STAN BELDARK
Stan Beldark is a wholesaler of lightweight travelling aids. His company employs a large number of sales
representatives, each of whom is supplied with a company car. Each sales representative travels
approximately 40,000 miles per annum visiting customers. Stan wishes to continue his present policy of
always buying new cars for the sales representatives but wonders whether the present policy of replacing the
cars every three years is optimal. He believes that keeping the cars longer than three years would result in
unacceptable unreliability and wishes to consider whether a replacement period of either one year or two
years would be better than the present three year period. The company's fleet of cars is due for replacement in
the near future.
The cost of a new car, at current prices, is CU5,500. Resale values of used cars, which have travelled similar
mileages to those of Stan's firm, are CU3,500 for a one-year-old car, CU2,100 for a two-year-old car and
CU900 for a three-year-old car, all at current prices. Running costs at current prices, excluding depreciation,
are as follows.

66 Financial Management
 Road fund licence Fuel, maintenance
and insurance repairs, etc
CU CU
During first year of car's life 300 3,000
During second year of car's life 300 3,500
During third year of car's life 300 4,300
Stan uses a discount rate of 10% when making such decisions.
Running costs and resale proceeds are paid or received on the last day of the year to which they relate. New
cars acquired for use from the start of year 1 are purchased on the last day of the previous year. C
Requirement H
A
Prepare calculations for Stan Beldark showing whether he should replace the cars of sales representatives P
every one, two or three years. (7 marks) T
Note. Ignore taxation. E
R
43 TALEB LTD
Taleb Ltd is a manufacturing company which makes a wide range of products. One of these, the Bat, requires
the use of a special Dot machine. The company's present policy is to replace each Dot machine at the end of 2
its physical productive life of four years. The directors are now considering whether to replace the machine
more frequently than once every four years in view of the fact that its productive capacity declines as it gets
older and potential sales of Bats are lost. There is insufficient demand for the company's Bats to justify the
purchase of a second Dot machine.
Taleb Ltd charges a selling price of CU0.12 per Bat, at which price it is able to sell up to 500,000 per annum.
Variable costs, excluding machine depreciation and running costs, amount to CU0.04 per Bat. Details of
productive capacities and running costs (including maintenance) of the Dot machine are as follows.

Year of machine's life Productive capacity Running costs

(Bats) CU
First 500,000 6,000
Second 500,000 6,500
Third 400,000 7,500
Fourth 400,000 9,000
Annual running costs are independent of the number of Bats manufactured.
The directors wish to continue their present policy of always buying new Dot machines at a price of
CU60,000 each. Resale values of Dot machines are CU40,000 for one-year-old machines, CU25,000 for two-
year-old machines, CU10,000 for three-year-old machines and zero for four-year-old machines. The company
provides depreciation on all its non-current assets using the straight line method.
All costs and revenues are paid or received in cash at the end of the year to which they relate, with the
exception of the initial price of the Dot machine which is paid immediately on purchase. Taleb Ltd has an
annual cost of capital of 10%.
Requirement
Prepare calculations for the directors of Taleb Ltd showing whether they should replace the Dot machine
every one, two, three or four years. (10 marks)
Note. Ignore inflation and taxation.
Now go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.

Investment appraisal 67
 Answers to Interactive questions

Answer to Interactive question 1

(a)
Time Cumulative cash flow
CU
0 (500,000)
1 (430,000)
2 (360,000)
3 (280,000)
4 (180,000)
5 (80,000)
6 40,000  Payback = 5.67 years
(b) Profit calculation:
CU
Total cash flows from operations 540,000
Total depreciation (150,000)
Total profits 390,000
Average profits ( 6) = CU65,000 p.a.
Average investment calculation

500,000  350,000
= CU425,000
2
65
ARR =  15.3%
425
(c) NPV @ 12%
Time Discount Factor PV
CU'000 CU'000
0 (500) 1.000 (500.00)
1 70 0.893 62.51
2 70 0.797 55.79
3 80 0.712 56.96
4 100 0.636 63.60
5 100 0.567 56.70
6 (350 + 120) 470 0.507 238.29
NPV 33,850
(d) NPV at 15% p.a.
Time Discount Factor PV
CU'000 CU'000
0 (500) 1.000 (500.00)
1 70 0.870 60.90
2 70 0.756 52.92
3 80 0.658 52.64
4 100 0.572 57.20
5 100 0.497 49.70
6 470 0.432 203.04

at 15% NPV = (23,600)

at 12% NPV = 33,850
33,850
IRR = 12 + 33,850  23,600 (15 – 12)
= 13.8%

Answer to Interactive question 2

Merits Demerits Rank

Payback period  Simple to understand  Unsophisticated Useful as an initial

68 Financial Management
  Quick for initial  No account is taken of filtering device
screening of projects the time value of
money
 Considers risk (very
crudely)  Cash flows
received/paid after
payback are ignored
Accounting rate of return  Use of profit consistent  Not consistent with Unlikely to be useful as a
with ROCE and EPS wealth maximisation decision making tool
 Use of balance sheet  No account is taken of C
values (asset backing) time value of money H
 Relative score is easy  Percentage figure may A
to understand give misleading advice P
when choosing T
between alternatives E
R
 Profits can be
manipulated
Net present value  Takes into account the  The need to estimate a Technically superior 2
time value of money cost of capital technique
 Gives an absolute  Difficulty in obtaining
measure, allowing for all relevant
comparison of projects costs/benefits
 Considers all cash  Assumes cashflows
flows of projects occur at annual
intervals
Internal rate of return  Takes into account the  May conflict with Easier to use and
time value of money NPV decision communicate practically
 Represents a  Assumes cash
breakeven point so reinvested at IRR
does not need an exact
cost of capital
 Considers all cash
flows of projects

The above example emphasises the idea of progression – the techniques introduced at knowledge level will be
applied here to solve real world problems.

Answer to Interactive question 3

t0 t1 t2 t3 t4
CU CU CU CU CU
Sales 100,000 110,000 121,000 133,100
Working capital required 15,000 16,500 18,150 19,965 0
Cash flow (15,000) (1,500) (1,650) (1,815) 19,965
Answer to Interactive question 4
Now the only alternative use for the material is to sell it for scrap. To use 50 tonnes on the contract is to give up the
opportunity of selling it for 50 × CU150 = CU7,500. The contract should therefore be charged with this amount.

Answer to Interactive question 5

The relevant cost of 25 tonnes is CU150 per tonne. The organisation must then purchase a further
25 tonnes and, assuming this is in the near future, it will cost CU210 per tonne.
The contract must be charged with:
CU
25 tonnes @ CU150 3,750

Investment appraisal 69
 25 tonnes @ CU210 5,250
9,000

Answer to Interactive question 6

What revenue is lost if the labour is transferred to the project from doing nothing? Nothing.
The relevant cost is zero.

Answer to Interactive question 7

Costs and revenues of proceeding with the project.
CU
(1) Costs to date of CU150,000 are sunk costs, therefore ignore.
(2) Materials – purchase price of CU60,000 is also sunk.
There is an opportunity benefit of the disposal costs saved. 5,000
(3) Labour cost – the direct cost of CU40,000 will be incurred regardless of
whether the project is undertaken or not – and so is not relevant.
Opportunity cost of lost contribution = 150,000 – (100,000 – 40,000) (90,000)
The absorption of overheads is irrelevant – it is merely
an apportionment of existing costs which do not change.
(4) Research staff costs
Wages for the year (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
Opportunity costs of rental forgone (7,000)
(174,000)
Sales value of project 300,000
Increased contribution from project 126,000
Advice. Proceed with the project.

Answer to Interactive question 8

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.

Answer to Interactive question 9

t0 t1 t2
CU CU CU
Net trading revenue 5,000 5,000
Tax @ 21% (1,050) (1,050)
Asset (10,000) 6,900
WDA (W) 378 310 (37)
Net cash flow (9,622) 4,260 10,813
Tax computation
PROFITS t0 t1 t2
IN PRIOR
YEAR

70 Financial Management
 Asset purchased 31 Dec 20X0  Asset scrapped 31 Dec 20X2
 First WDA will be set off against  No WDA in year of sale
profits earned in y/e 31 Dec 20X0 – balancing adjustment instead
 First tax relief at t0
Tax relief at Timing
CU 21%
31 Dec 20X0 Investment in asset 10,000
WDA @ 18% (1,800) 378 t0
8,200
31 Dec 20X1 WDA @ 18% (1,476) 310 t1
6,724
31 Dec 20X2 Proceeds 6,900 C
Balancing charge (176) (37) t2 H
A
P
T
E
 Asset value dropped 10,000 – 6,900 3,100
R
 WDA claimed 1,800 + 1,476 (3,276)
 Relief reclaimed ('clawed back') 176

2
Answer to Interactive question 10
t0 t1 t2
CU CU CU
Net trading revenue 5,000 5,000
Tax @ 21% (1,050) (1,050)
Asset (10,000)
Scrap proceeds 6,900
Tax savings on WDAs (W) 378 273
Net cash flow (10,000) 4,328 11,123
WORKING
Tax computation
to t1 t2
PROFITS
IN
YEAR 1

 Asset purchased 1 Jan 20X1 which  Asset sold 31 Dec 20X2

is effectively (for discounting
purposes) the same as 31 December
20X0, ie t0
 First WDA will be set off against  No WDA in year of sale
profits earned in year 1 (t0  t1) – balancing adjustment instead
 First tax relief at t1
Tax relief at Timing
CU 21%
1 Jan 20X1 Investment in asset 10,000
31 Dec 20X1 WDA @ 18% (1,800) 378 t1
8,200
31 Dec 20X2 Proceeds 6,900
Balancing allowance (1,300) 273 t2

Answer to Interactive question 11

t0 t1 t2 t3
CU CU CU CU
Invest (10,000)

Investment appraisal 71
 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

Answer to Interactive question 12

(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:
cu
£10,000
= CU526,316
0.019

Answer to Interactive question 13

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)

£18,350
cu
cu
£18,350
AF2 years@10%
Annual equivalent = = 1.736 = CU10,570
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)
1 Scrap proceeds 16,000 0.909 14,544
NPV = (10,001)
cu cu
£10,001 £10,001
Annual equivalent = = = CU11,002
AF1year @10% 0.909

The machine should be replaced after two years because the cost is lower in NPV terms.

Answer to Interactive question 14

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

Project B is rejected because of its negative NPV.

Plan:
NPV Funds

72 Financial Management
 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 50,000 available

The solution assumes it is possible to accept half of project A, ie projects are perfectly divisible so that half the
outlay gives half the NPV, etc.

Answer to Interactive question 15 C

H
Considering X, Y and Z independently A
Project NPV ÷ outlay Rank P
X 25,000 ÷ 100,000 = 0.25 1 T
Y 11,000 ÷ 50,000 = 0.22 2 E
Z 8,000 ÷ 40,000 = 0.20 3 R

 Project X using all CU100,000 available, NPV CU25,000.

Considering X and Y + Z 2

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
Accept one tenth of X 2,500 10,000
25,900 100,000

 Accept Y + Z + one tenth of X

Answer to Interactive question 16

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 problem 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.

Investment appraisal 73
 Answers to Self-test

1 CPV = CU(150,000 + 4,000) – (CU4,000 × 0.826)

= CU150,696
TV = CU150,696 × 1.21
= CU182,342
2 t0 (520,000) × 1 (520,000)
t5 20,000 × 0.497 9,940
= CU244,120
t1–5 340,000 × 3.352 1,139,680
t0–4 (100,000) × (1 + 2.855) (385,500)
3
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Sales in the year 200 220.0 242.0
Working capital 20 22.0 24.2
WC cash flow (20) (2.0) (2.2) 24.2
Discount factor 1 0.833 0.694 0.579
Present value (20) (1.7) (1.5) 14.0
NPV = (CU9,200)
 (CU9,000) rounded
4 Has to be retained for use on other contracts  nil cost.
5 The original purchase cost of Q is irrelevant as it is sunk.
The choice is therefore to sell Q for CU4,000 or to use it in project Y to yield contribution of
CU10,000 – CU5,000 = CU5,000.
Hence choose project Y, the relevant cost being CU5,000.
6 (a) Historic cost of CU2,750 is sunk, therefore irrelevant.
(b) Used as substitute for XB.
CU
Purchase cost saved (100  CU22) 2,200
Less Conversion cost (75)
Net saving 2,125
(c) Resale value = 100 × CU20
= CU2,000
Therefore relevant cost estimate = CU2,125
7
CU
Market value 2  CU8,000 16,000
Current resale value CU16,000  85% 13,600
The opportunity cost is the value of the next best alternative forgone, which is the sales proceeds of
CU13,600.
8
CU
Material X
1,000 kg in inventory could be sold for 4,000
500 kg must be purchased for 3,000
Material Y
Since it has alternative uses, it must be replaced for 20,000
27,000

74 Financial Management
9 The deprival value is

Lower of

Replacement Higher of
cost CU2,200

C
Disposal value Economic value
CU 2,000 CU(2,200– - 100) = H
CU2,100 A
P
T
Therefore relevant cost of ZX is CU2,100 (the net saving to the company on material RP).
E
R
10 If we do not go ahead with the project the existing material will be stored with an incremental, future and
cash cost of CU200. (It would not be sold for CU3,900 only to be replaced a month later at CU4,300).
2
If we go ahead with the project the existing inventory will be used. As it is in constant use, then we follow the
cheaper option and replace it immediately at CU4,000. Storage costs of CU200 are not avoided and are
therefore not incremental as a result of the decision and are not relevant.

The relevant future, incremental cash cost is therefore the replacement cost of the inventory which is
CU4,000.

11 The deprival value is

Lower of

Replacement Higher of
cost CU10,000

Disposal value Economic value

CU5,000 CU7,500

Therefore deprival value = CU7,500

12 The deprival value is

Lower of

Re p lacement cost Hi gher of

CU£(2,200 + 2,000 + 400)=CU
= £4,600

Dis posal value Economic value

CU£7,000 ?

Investment appraisal 75
 (The economic value is not known, but it is irrelevant, since replacement cost is lower than the disposal
value.)

13 2 × CU4.20 + 3 × CU0.40 = CU9.60

14

CU CU
Price 10,000
Materials 3,000
Labour 3,000
Variable overhead 1,500
Fixed overhead 500
(8,000)
Benefit from order 2,000
CU
£6
(1,500)
Lost contribution 2 hrs  500 hrs
Net profit 500

15

Tax WDV Capital Tax 10%

allowance saved factor PV
CU CU CU CU
90,000
(16,200) 16,200 3,402 0.909 3,092
73,800
(13,284) 13,284 2,790 0.826 2,305
60,516
(10,893) 10,893 2,288 0.751 1,718
49,623
(25,000)
24,623 24,623 5,171 0.683 3,532
PV of tax savings 10,647
16 The investment is made on 1 April 20X6, so CAs can first be set off against profits for the accounting period
ended 31 March 20X7. The tax cash saving will therefore be at 31 March 20X7, or time 1.
Tax
Time Date saved time
CU CU
0 1 April 20X6 2,000,000
1 31 March 20X7
WDA (360,000) @ 21% = 75,600 1
1,640,000
2 31 March 20X8
Sale proceeds (500,000)
BA 1,140,000 @ 21% = 239,400 2

Present value = (CU75,600 × 0.909) + (CU239,400 × 0.826)

= CU266,465

76 Financial Management
17 Savings are discounted at an effective ('real') discount rate of 10% as it is advantageous to have non-inflating
cashflows (annuity) and the annuity tables/formula can be applied.

(1 + money rate) = (1 + effective rate) × (1 + inflation rate)

(1 + 0.155) = (1 + e) × (1+ 0.05)
(1+ e) = 1.155/1.05 = 1.1

The effective discount rate is 10%

We now need to find the non-inflated savings resulting from the saved labour hours. The current semi-skilled
labour rate is CU5. This is without the effects of inflation.
C
PV of savings = 20,000 hours p.a. × CU5 × 6.145 (CDF 10 years at 10%) H
= CU615,000 A
P
T
18
E
R
Time Cash flow DF at 21% PV
CU CU
0 (50,000) 1 (50,000) 2
1 33,000 0.826 27,258
2 36,300 0.683 24,793
3 39,930 0.564 22,521
3 15,000 0.564 8,460
NPV 33,032
Present value, using money cost of capital, is CU33,000 (to the nearest CU000).
1 m 1
Using the formula 1+ r = the money cost of capital is 21%. The DF is obtained using
1 i (1  r)n

The same answer could be obtained by applying the real cost of capital to flows expressed in current terms.
19
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Equipment (400.00)
Revenue – 900.00 945.00 992.25
Labour – (550.00) (605.00) (665.50)
Materials (350.00) – – –
(750.00) 350.00 340.00 326.75
PV @ 15.5% (750.00) 303.03 254.87 212.07
Net present value @ 15.5% = CU19,970

20 Money C of C = [(1.10 × 1.07) – 1] × 100 = 17.7%

 1.177 
Effective rates  – 1 × 100 = 13.17%
 1.04 

 1.177 
 – 1 × 100 = 8.98%
 1.08 

50 80
PV (CU000) =  = 1,270
0.1317 0.0898

21 Money cost of capital = [(1.08 × 1.12) – 1] × 100

= 20.96%
Time t0 t1 t2
CU CU CU
Outlay (13,500)

Investment appraisal 77
 Labour 7,000 7,700
Salvage 5,000
12,700
20.96% discount factor 1 0.8267 0.6835
Present value –13,500 5,787 8,680
NPV = CU970 rounded

22
P Q R S
NPV/CU of capital in restricted period 60  20 40  10 100  30 80  40
=3 =4 = 3.3 =2
The optimal sequence is QRPS.

23 For individual projects the maximum NPV must be found basically by trial and error, as follows:
(a) Project H is clearly not viable, since it has a negative NPV and requires investment at t0.
(b) It is not worthwhile considering project K unless its capital generated at t0 is required, since it has a
negative NPV.
(c) There is sufficient capital to undertake the remaining three projects without project K and so this must
be optimal.
NPV = 603 + 58 + 537
= CU1,198
24 Project H is not worthwhile, whereas project J definitely is worthwhile. This leaves the following.
NPV/CU at t0
Project I 0.30
Project K (0.06)
Project L 0.54
Project K could be worthwhile since the NPV lost/CU generated is less than the benefit/cost ratio of projects I
and L.
t0 Capital NPV
CU CU
Project J (500) 58
Project L 1,000 537
Project K (350) (22)
185
1,850 558
200 Project I
2,000 1,131
50  4  3.791
25 Model I every five years = 17.2
3.791
50  4  3.791  30  0.621  7  2.487  0.621
Model I every eight years = 17.7
5.335

40  6  3.170
Model II every four years = 18.6
3.170
70  3.5  4.355
Model III every six years = 19.6
4.355
Therefore Plum Ltd should purchase model I and replace every five years.
–£150,000
-CU  CU
£25,000  0.233 – CU
£5,000  2.106 – CU
£8,000  2.991 0.579
26 NPV =
3.837
= CU43,900 equivalent annual cost
27 MR DIPSTICK
Note CU CU
Minimum tender price

78 Financial Management
 1 Material A 1,000 kgs @ CU2 – CU300 1,700
1,000 kgs @ CU10 10,000
11,700
2 Material B 1,000 kgs @ CU15 15,000
3 Material C 500 kgs (opportunity cost) 8,000
4 Material D 50 litres @ CU50 (2,500)
5 Skilled labour 1,000 hrs @ CU25 25,000
6 Semi-skilled labour 500 hrs @ CU22.50 11,250
7 Unskilled labour 500 @ CU12 (opportunity cost) 6,000
Minimum tender price 74,450
Notes
C
(1) Presumably the 1,000 kgs in inventory would otherwise be sold at a net gain of CU1,700. This gain is H
therefore forgone as a result of using this material in the contract. (Note, however, that the gain forgone A
is less than the cost of buying the extra 1,000 kgs.) P
(2) As this material is constantly needed, the relevant cost is the cost of replacing it at the current purchase T
price. E
R
(3) How would this material be used if it were not required for the contract?
Option 1 – Sell it for CU6,000.
Option 2 – Use it as a substitute and save CU8,000. 2
Option 2 is preferable. This is therefore the opportunity cost of using it in the contract. (Also note that
this opportunity cost is much less than the cost of buying it and is therefore the correct decision.)
(4) The cost of disposing of 50 litres will be saved (@ CU50/litre, ie CU2,500). Saving this cost is a
relevant benefit.
(5) The incremental cost of paying for the labour needed.
(6) The assumption is that the 1,500 spare hours have already been paid for as the workforce are on annual
contracts. The additional cash flow is therefore the extra 500 hours that are needed at time and a half.
(7) For each hour diverted from their normal jobs contribution of CU2 will be forgone.
This together with the cost of paying the workers on the project amounts to a relevant cost of CU12 per
kg. They would not be hired at CU20 per hr as this is more expensive.
Alternatively
This typical problem can be looked at from the point of view of incremental cash flows.
Cash flow Cash flow
normally with project
CU CU
Revenue per hour 12 –
Labour per hour (10) (10)
Contribution 2 (10)
Therefore difference in cash flow is from positive CU2 to negative CU10, ie a negative cost of CU12
per hour.
(8) Fixed overheads can be ignored as they are not incremental.
(9) Costs of preparing the tender are all sunk costs and hence must be ignored.
(10) Profit element should be ignored.

28 TINOCO LTD
(a) NPV of new production
Time Cash flow 15% factor Present value
CU CU
0 Cost of site (270,000) 1 (270,000)
1 Factory, stage payment (1,250,000) 0.870 (1,087,500)
2 Balance for factory (1,250,000) 0.756 (945,000)
2 Deposit for machinery (250,000) 0.756 (189,000)
3–4 Instalment on machinery (500,000) 1.230 (615,000)
2 Advertising (150,000) 0.756 (113,400)
3 Advertising (250,000) 0.658 (164,500)
4 Advertising (100,000) 0.572 (57,200)

Investment appraisal 79
 3–12 Variable costs (1,600,000) 3.795* (6,072,000)
3–12 Fixed costs (300,000) 3.795 (1,138,500)
7 Scrap proceeds 250,000 0.376 94,000
7 Deposit for new (250,000) 0.376 (94,000)
8–9 Instalment on new (500,000) 0.611 (305,500)
12 Scrap proceeds 250,000 0.187 46,750
12 Value of factory 3,000,000 0.187 561,000
(10,349,850)
3–12 Sales revenue 3,000,000 3.795 11,385,000
Positive net present value 1,035,150
* DF1–12 – DF1–2 = 5.421 – 1.626
(b) Minimum selling price
Product Z is viable provided the present value of sales revenue is at least CU10,349,850.
CU10,349,850
3.795
Annual sales revenue must be at least = CU2,727,233
2,727,233
Selling price must be at least = CU6.82
400,000

29 SHAW SECURITY SYSTEMS LTD

(a) Investment appraisal schedule – Apollo project
t0 t1 t2 t3
Item CU'000 CU'000 CU'000 CU'000
Sales revenue (W1) 2,160 2,208 1,104
Materials and components (W2) (756) (773) (386)
Incremental labour costs (incl overtime) (W3) (97) (99) (50)
Management salaries (W4) (48) (48) (48)
Lost contribution (W5) (432) (442) (221)
Redundancy costs (W6) 120 (140)
Taxable cash flows 120 827 846 259
Tax (21%) (25) (174) (178) (54)
Production costs (1,000)
Working capital requirements (W7) (243) (5) 124 124
Tax saved on WDAs (W8) 38 31 25 116
Relevant cash flows (1,110) 679 817 445
DCF (8%) 1 0.926 0.857 0.794
Present values (1,110) 629 700 353
NPV of project = CU572,000
WORKINGS
(1) Expected sales – units at CU200
20X6 (0.6 × 10,000) + (0.4 × 12,000) 10,800 units
20X7 Expected sales (units)

1,440
8,000
0.3

10,000 10,000
0.7
0.6 4,200

2,400
12,000 12,000
0.4
0.5

15,000
0.5 3,000
11,040

20X8 11,040 × 50% 5,520 units

80 Financial Management
(2) Materials and components
CU'000
t1 10,800  CU70 756
t2 11,040  CU70 773
t3 5,520 × CU70 386

C
H
A
P
T
E
R

Investment appraisal 81
 (3) Incremental labour costs and overtime

Labour hours Labour hours Overtime hours

required by Apollo released by Mercury required by Apollo
20X6 (10,800  3) 32,400 (5,400  4) 21,600 10,800
20X7 (11,040  3) 33,120 (5,520  4) 22,080 11,040
20X8 (5,520  3) 16,560 (2,760  4) 11,040 5,520
Therefore, incremental labour costs

CU'000
20X6 10,800  CU9* 97
20X7 11,040  CU9 99
20X8 5,520 × CU9 50
*(CU6 × 150%)

(4) Management salaries

CU(20,000 – 8,000*) = CU12,000 × 4 = CU48,000 pa
* Consultancy fees saved/avoided as result of project.

(5) Lost contribution from lost Mercury sales

Sales lost Gross * CPU CU'000

20X6 5,400 × CU80 = (432)
20X7 5,520 × CU80 = (442)
20X8 2,760 × CU80 = (221)

* Direct labour costs treated as a 'fixed' cost, since they will be paid whether or not Apollo is
produced. Therefore, effect on cash flow of lost Mercury sale is (100 – 20) = CU80 per unit.

(6) Redundancy costs

t0 CU120,000 saved at t0 if Apollo is produced
t3 CU140,000 incurred at t3 if Apollo is produced.

(7) Working capital requirements

Sales (CU'000) t0 t1 t2 t3
New – 2,160 2,208 1,104
Old – 540 552 276
– 1,620 1,656 828
15% 243 248.4 124.2 –
 Cash flow effects of changes in working capital requirements are:
t0 t1 t2 t3
(243) (5.4) 124.2 124.2

(8) Tax saved on WDAs

(21%)
Time Item Tax saved Timing
CU000 CU000
t0 Production costs 1,000

82 Financial Management
 t0** WDA† (180) 38* t0
820
t1 WDA (148) 31* t1
672
t2 WDA (121) 25* t2
551
t3 Sale proceeds Nil
t3 Balancing allowance 551 116* t3
† WDA of 18% assumed. C
H
* Figures to nearest CU1,000 as required by question. A
P
** Payment of CU1m occurs at end of accounting period (ie 20X5); therefore first WDA occurs T
at t0. E
R
(b) Comments on the Apollo proposal
Based on the above cash flow projections, the project should be accepted as it has a positive NPV.
2

Reservations in connection with this recommendation

(i) Demand for Apollo is subject to great uncertainty. Sensitivity analysis could be carried out to see
how responsive the project's NPV is to fluctuations in the expected sales volume.

(ii) The project's sales are subject to uncertainty; consequently the Apollo project is risky and should
be appraised using a discount rate reflecting this level of risk. The company's current WACC is
therefore highly unlikely to be appropriate. Moreover, a suitably risk-adjusted discount rate may
result in the project having a negative NPV.

(iii) How reliable are the estimates of costs? For example, Apollo sales may affect sales of the
Mercury more severely than anticipated.

(iv) The attitude to risk of the directors/shareholders needs to be considered. Despite having a positive
NPV the project may be considered too risky and hence be rejected.

(v) Have all costs associated with the project been identified and quantified? (Note that the project
has been appraised with reference to relevant costs only – sunk costs, eg development and
marketing costs, have been ignored.)

30 FIORDILIGI LTD
t0 t1 t2 t3 t4 t5
CU'00 CU'000 CU'00 CU'000
Labour CU'000 CU'000
0 0
Skilled 10,000  0.5  Nil –
10,000  0.5  20.0 20.0
CU4.00
8,000  0.5  16.0 16.0
CU4.00
Unskilled 10,000  2  50.0 50.0 50.0
CU2.50
8,000  2  CU2.50 40.0 40.0
Materials

Investment appraisal 83
 Ping 10,000  2  28.0 28.0 28.0
CU1.40
8,000  2  CU1.40 22.4 22.4
Pang 46,000  0.5  41.4
CU1.80
Pong 10,000  1.5  12.0 12.0 12.0
CU0.80
8,000  1.5  9.6 9.6
CU0.80
Overheads
Variable 10,000  0.5  7.0 7.0 7.0
CU1.40
8,000  0.5  5.6 5.6
CU1.40
Fixed
Rent 2.0 2.0 2.0 2.0 2.0
Rates 1.0 1.0 1.0 1.0 1.0
83.4 100.0 120.0 112.0 96.6 62.6
Revenue
10,000  CU18 180.0 180.0 180.0
8,000  CU14 112.0 112.0
Costs (as above) (83.4) (100.0) (120.0) (112.0) (96.6) (62.6)
Purchase of plant (60.0)
Resale 6.0
Net cash flow (143.4) 80.0 60.0 68.0 15.4 55.4
Discount factors at 15% 1.000 0.870 0.756 0.658 0.572 0.497
Present values (nearest CU000) (143.0) 70.0 45.0 45.0 9.0 28.0
NPV = +CU54,000
Therefore, accept.

84 Financial Management
31 GIOVANNI LTD
(a) Capital allowances
Tax saved Timing
at 21%
CU CU
Cost 5,000
Year 0 WDA (18%) (900) 189 t0
4,100
Year 1 WDA (738) 155 t1
3,362
Year 2 WDA (605) 127 t2 C
2,757
H
Year 3 WDA (496) 104 t3
2,261 A
Year 4 Sale proceeds – P
Balancing allowance 2,261 475 t4 T
E
(b) Investment decision
R
Cash flows t0 t1 t2 t3 t4
CU CU CU CU CU
Purchase of machine (5,000) 2
Tax saved through WDAs 189 155 127 104 475
Net revenues 3,000 3,000 1,000 1,000
Tax on net revenues (630) (630) (210) (210)
(4,811) 2,525 2,497 894 1,265
Discount factors 1.000 0.909 0.826 0.751 0.683
Present value (4,811) 2,295 2,063 671 864
NPV = + CU1,082
Therefore accept the project.
(c) Different timing of initial purchase
PV of tax savings as shown above
CU
CU189 + CU155  0.909 + CU127  0.826 + CU104  0.751 + CU475  0.683 837
Hence PV if delayed by one year CU837  0.909 761
Difference 76
Hence, new NPV = CU(1,082 – 76)
= CU1,006, ie project still worthwhile
Wisdom – fine if there is a balancing charge (delay it!)
– not so if there is a balancing allowance
32 SHAREHOLDER VALUE
(a) Business decisions
The first statement supports the view that the governing objective of a business should be to maximise
shareholder value. A classic view in corporate finance, this belief has gained much recent exposure with
the rise of shareholder value analysis (SVA) as a business tool. SVA suggests that all business
activities, including strategic decisions and performance evaluation, should be managed with the
objective of maximising the present value of the firm.
The second statement suggests that a business has a wider duty of care to a group of stakeholders who
have an interest in the business. These needs should be balanced, rather than maximising the needs of a
single group such as shareholders.
Certain authors have suggested that these views of business lie at opposite ends of the spectrum. This
view arises from the belief that stakeholder needs conflict, and maximising one group will by necessity
mean that other groups will suffer. This view is supported by high profile cases such as that of
Railtrack, which was accused of abandoning customer safety in the pursuit of shareholder value.
It is true that companies have in the past made short-term, uneconomical decisions in an attempt to
enhance share price that have resulted in other stakeholder groups suffering. Cost-cutting and employee
downsizing decisions would be examples.

Investment appraisal 85
 However, and as long as the long-term effects of business decisions are considered, the picture changes.
Companies that consistently destroy shareholder value will find themselves starved of capital as their
investors move elsewhere. Without capital they will not be able to invest in the future of their
customers, employees, etc, and these groups will suffer. To deliver value to these stakeholders, long-
term value will need to be delivered also to shareholders.
(b) Shareholder value analysis
Shareholders value the future cash returns that their investments will generate, and will also be
concerned with the level of risk inherent in those investments.
The discounted cash flow (DCF) model is consistent with this type of value. It focuses on future cash
flows and, by discounting them at an appropriate rate, it takes into account the investors' view of risk.
Many people believe that growth in earnings per share (EPS) is the best external measure to track
shareholder value creation. This is not necessarily the case, for the following reasons.
(i) Profit is not necessarily the same as cash flow, and cannot be 'spent' by investors.
(ii) Profit can be manipulated by use of different accounting policies.
(iii) EPS is historic focused, sunk as far as investors are concerned.
(iv) EPS growth does not incorporate an adequate risk hurdle. Value is created if businesses earn more
than the cost of equity. The only hurdle to be overcome before positive profit is obtained is the
debt bill.
The SVA approach to business focuses on identifying 'value drivers' which, if managed correctly, can
increase the PV of the firm and therefore increase shareholder value.
These drivers are as follows (choose three from seven).
(i) Sales growth rate – increasing the growth rate should generate larger future cash inflows which
could translate into greater value.
(ii) Operating profit margin – increasing this, perhaps via better cost control, will generate more net
cash flow from each extra sale.
(iii) Investment in non-current assets – if this outlay can be reduced without limiting effectiveness,
cash will be saved and value added.
(iv) Investment in working capital – reducing working capital releases cash back into the business. If
this can be done without compromising effectiveness, value will be added.
(v) Cost of capital – reducing the cost of capital, perhaps via use of debt finance, will increase the PV
of the cash flow stream and therefore value.
(vi) Life of projected cash flows – if the life of a potential cash flow stream can be extended (eg via
patent protection), the larger its potential to generate value.
(vii) Corporation tax rate – a lower tax rate will leave more cash available for the business. However,
management's ability to affect the tax rate may be limited.
33 PACKERS LTD
NPV of contract
Final receipts = CU235,000 × (1.10)2
= CU284,350
Second year labour = CU60,000 × 1.125
= CU67,500
Value of inventory of D = 2,000 × CU1.50
= CU3,000
Cost of more D = 2,000 × CU20 × 1.15
= CU46,000
Time 0 Time 1 Time 2
CU CU CU
Machinery (75,000)
Redundancy 2,000
Labour (60,000) (67,500)
Advertising 5,000
Material D 3,000 (46,000)

86 Financial Management
 Receipts 284,350
(70,000) (106,000) 221,850
DF @ 15% 1 0.870 0.756
PV (70,000) (92,220) 167,719
Net present value = CU5,499
 Proceed.
34 AINSDALE LTD
(a) Incremental NPV of moving the factory
Existing premises
C
450,000
Lease = 450,000 + = 4,950,000 H
0.1 A
4,950,000  0.21 P
After tax = 4,950,000 – = CU4,005,000
1.1 T
New premises E
Cash flows R

At 31 December 20X0 20X1 20X2 20X3 20X4

CU'000 CU'000 CU'000 CU'000 CU'000
2
Premises (10,000)
Machinery (1,000) 300
Labour (W1) 1,000 (3,000) (4,000) (3,000)
Materials (W2) 7,750 (23,250) (17,000) (12,750)
Sales (W3) (8,750) 26,250 35,000 26,250
Redundancies (200)
Retraining (100)
Tax (W4) 21 42 – (2,940) (2,205)
Capital allowances 38 31 25 21 32
(W5)
(11,241) 73 25 11,081 8,627
Discount factor @ 10% 1 0.909 0.826 0.751 0.683
Discounted cash flows (11,241) 66 21 8,322 5,892
Total NPV = CU3,060,000
Overall NPV
CU'000
NPV of lease 4,005
Per DCF statement 3,060
7,065
WORKINGS
(1) Labour costs
Unit
New Old labour Labour
factory factory Incremental cost cost
000 units 000 units 000 units CU CU'000
20X1 5,000 6,000 (1,000) 1.00 (1,000)
20X2 9,000 6,000 3,000 1.00 3,000
20X3 10,000 6,000 4,000 1.00 4,000
20X4 9,000 6,000 3,000 1.00 3,000
After 20X4 the sales are equivalent, so no incremental costs arise.

(2) Material costs

Unit
New Old material Materials
factory factory Incremental cost cost
000 units 000 units 000 units CU CU'000
20X1 5,000 6,000 (1,000) 7.75 (7,750)

Investment appraisal 87
 20X2 9,000 6,000 3,000 7.75 23,250
20X3 10,000 6,000 4,000 4.25 17,000
20X4 9,000 6,000 3,000 4.25 12,750
After 20X4 the sales are equivalent, so no incremental costs arise.

(3) Sales
40% margin on sales is equivalent to a 66.67% mark-up on cost.
Unit
material Material Labour Total Margin Sales
cost cost cost cost (66.67%)
CU CU'000 CU'000 CU'000 CU'000 CU'000
20X1 4.25 (4,250) (1,000) (5,250) (3,500) (8,750)
20X2 4.25 12,750 3,000 15,750 10,500 26,250
20X3 4.25 17,000 4,000 21,000 14,000 35,000
20X4 4.25 12,750 3,000 15,750 10,500 26,250

(4) Corporation tax

20X0 20X1 20X2 20X3 20X4
CU'000 CU'000 CU'000 CU'000 CU'000
Labour 1,000 (3,000) (4,000) (3,000)
Materials 7,750 (23,250) (17,000) (12,750)
Sales (8,750) 26,250 35,000 26,250
Redundancies/train (100) (200)
ing
Taxable profit (100) (200) 0 14,000 10,500
Tax payable (excl 21 42 0 (2,940) (2,205)
CAs)
(5) Capital allowances
If move premises
Year WDA Tax @ 21%
CU'000 CU'000 CU'000
20X0 1,000 180 38
20X1 820 148 31
20X2 672 121 25
20X3 551 99 21
20X4 452
Proceeds (300)
Balancing allowance 152 152 32
(b) Calculation of the payback period
20X0 20X1 20X2 20X3 20X4 20X5
CU'000 CU'000 CU'000 CU'000 CU'000 CU'000
Cash flows (11,241) 73 25 11,081 8,627
Lease 450 450 450 450 450 450
Lease tax (95) (95) (95) (95) (95)
(10,791) 428 380 11,436 8,982 355
Thus the payback period is three years (assuming year end cash flows).

Tutorial advice:
The likelihood of producing precisely the correct answer for requirement (a) is low, because there are many
opportunities to make errors, major and minor. There are however plenty of easy marks in this question and
you should be able to earn them.
Requirement (a). Make sure you approach the requirement in a logical and methodical way, as this will help
build up a good total of marks. A common pitfall in this question relates to the lease of the old premises. This
is perpetual, yet it is often treated as if it only lasts as long as there are incremental operating cash flows from
the move. Another common though more minor error relates to the tax payment timing. The question made
clear that tax should be assumed to be paid at the end of the year to which it relates so be careful not to lag
the payment a year.

88 Financial Management
35 ARCADIAN PRODUCTS LTD
(a) Retain existing equipment or buy new

Year 20X0 20X1 20X2 20X3 20X4

CU'000 CU'000 CU'000 CU'000 CU'000
New plant (12,000) 2,000
CAs (W3) 454 372 305 250 719
Old plant 3,000
CAs (W3) 782
(242) (198) (163) (133) (608)
C
Maintenance cost
H
money terms) (W1) 515 1,591 2,185 2,814 A
Tax thereon (108) (334) (459) (591) P
(8,006) 581 1,399 1,843 4,334 T
Discountfactor(W4) 1.0000 0.8826 0.7790 0.6875 0.6067 E
Present values (8,006) 513 1,090 1,267 2,629 R
Net present value = CU(2,507,000)
Thus retaining the existing equipment would be preferable to buying new. 2
WORKINGS

(1) Maintenance costs

20X1 20X2 20X3 20X4

CU'000 CU'000 CU'000 CU'000
Maintenance (real) 500 1,500 2,000 2,500
Maintenance (money) 515 1,591 2,185 2,814

(2) NP14 contributions

20X1 20X2 20X3 20X4

CU'000 CU'000 CU'000 CU'000
Contributions (real) 2,500 3,500 3,500 2,500
Contributions (money) 2,575 3,713 3,825 2,814

(3) Capital allowances

New plant

Year Tax @ 21%

CU'000 CU'000
20X0 Cost 12,000
WDA (2,160) 454
20X1 9,840
WDA (1,771) 372
20X2 8,069
WDA (1,452) 305
20X3 6,617
WDA (1,191) 250
20X4 5,426
Disposal (2,000)
Balancing allowance 3,426 719

Old plant

Investment appraisal 89
 Year Tax @ 21%
CU'000 CU'000
20W8 Cost 10,000
WDA (1,800)
20W9 8,200
WDA (1,476)
20X0 6,724
Disposal (3,000)
Balancing allowance 3,724 782

90 Financial Management
 or
Year Tax @ 21%
CU'000 CU'000
20X0 WDV b/f 6,400
WDA (1,152) 242
20X1 5,248
WDA (945) 198
20X2 4,303
WDA (775) 163
20X3 3,528
WDA (635) 133
C
20X4 2,893
Disposal 0
H
Balancing allowance 2,893 608 A
P
(4) Discount factors T
1 E
Year 1 = 0.8826 R
(1  0.10)(1  0.03)

1
Year 2 = 0.7790
(1  0.10) 2 (1  0.03) 2 2

1
Year 3 = 0.6875
(1  0.10)3 (1  0.03)3

1
Year 4 = 0.6067
(1  0.10) 4 (1  0.03) 4

(b) Viability of the NP14 product

Year 20X0 20X1 20X2 20X3 20X4
CU'000 CU'000 CU'000 CU'000 CU'000
Old plant (3,000)
CAs (W3) (782)
242 198 163 133 608
Contributions
(money terms) (W2) 2,575 3,713 3,825 2,814
Tax thereon (541) (780) (803) (591)
Maintenance costs
(money terms) (W1) (515) (1,591) (2,185) (2,814)
Tax thereon 108 334 459 591
Working capital (257) (114) (11) 101 281
(3,797) 1,711 1,828 1,530 889
Discount factor (W4) 1.0000 0.8826 0.7790 0.6875 0.6067
Present values (3,797) 1,510 1,424 1,052 539
Net present value = CU728,000
Thus using the existing equipment to produce NP14s would be viable.

Tutorial note:
A common pitfall on this question is confusing 'real' and 'money' values in the same assessment. Either
approach is equally correct, but it must be applied consistently in the same assessment. In practice the
'money' approach tends to be less difficult to apply.
In part (a), be careful not to overlook the balancing allowance that would arise should the existing equipment
be sold.

Investment appraisal 91
 36 JUNO PRODUCTS LTD
(a) Modification decision
Timing
31 December 20X8 20X9 20Y0
0 1 2
CU'000 CU'000 CU'000
Modification costs (8,000)
Extra contribution (excluding one
bought-in part) 200 units per
annum × CU25,000 per unit (W1) 5,000 5,000
Extra parts to be bought
(400 × 1,000) (W1) (400)
(8,000) 5,000 4,600
Tax effect at 21% 1,680 (1,050) (966)
(6,320) 3,950 3,634
Discount factors @ 5% 1 0.952 0.907
Present value (6,320) 3,760 3,296
NPV = 736 > 0
The modification should take place.
(b) Relevant CFs if continue
Timing of cash flows
31 December 20X8 20X9 20Y0 20Y1 20Y2
0 1 2 3 4
CU'000 CU'000 CU'000 CU'000 CU'000
Modification costs (8,000)
Contribution (excluding 11,500 11,500 5,200 3,900
bought-in part) (W2)
Cost of extra parts (400) (400) (300)
Opportunity cost of parts (600)
Overheads that would be
avoided if production
ceased (lease cost
Unavoidable) (2,000) (2,000) (2,000) (2,000)
Annual taxable net revenues (8,600) 9,500 9,100 2,800 1,600
Tax @ 21% 1,806 (1,995) (1,911) (588) (336)
Plant and equipment
Disposal proceeds avoided (6,000)
Balancing allowance
avoided (W3) (462)
Tax re WDAs if
continue (W3) 310 254 209 171 778
Net CFs (12,946) 7,759 7,398 2,383 2,042
DF @ 5% 1 0.952 0.907 0.864 0.823
PV (12,946) 7,387 6,710 2,059 1,681
NPV = 4,891 > 0 therefore continue
WORKINGS
(1) Contribution per unit for modification decision
CU
Selling price 35,000
Labour (4,000)
Materials (excluding the component type that is in inventory) (6,000)
25,000
There are enough bought-in parts in inventory to make 1,000 units. This will cover the first two
years of production if no modifications are made in the first year, and 300 units worth of
production in the second year if modifications are made. Thus an additional 400 units of parts
would have to be bought in year 2 if modifications were to take place.
(2) Contributions per unit (excluding bought-in part)
Years 1 and 2 First 500 units – need to take into account lost contribution from other
products that could have been sold.
CU

92 Financial Management
 Selling price 35,000
Labour (4,000  4) (16,000)
Materials (6,000)
13,000
Additional 200 units do not affect sales of the other product, therefore use
contribution per unit of CU25,000 as in (1) above.
Years 3 and 4 All units have contribution of CU13,000 per unit as calculated above.
Therefore contribution figures in total are:
CU'000
Year 1 500  13 + 200  25 11,500 C
Year 2 500  13 + 200  25 11,500 H
Year 3 400  13 5,200 A
Year 4 300  13 3,900 P
(3) Balancing allowance if sold on 31 December 20X8 T
E
Accounting period Narrative CU000 Tax relief Timing R
20X7 Bought 10,000
WDA @ 18% (1,800)
20X8 8,200
Disposal proceeds 6,000 2
Balancing allowance (2,200) Tax saving @
21% = 462 t0
WDAs if kept
Accounting period Narrative CU000 Tax relief Timing
@21%
20X8 B/f 8,200
WDA @ 18% (1,476) 310 t0
20X9 6,724
WDA @ 18% (1,210) 254 t1
20Y0 5,514
WDA @ 18% (993) 209 t2
20Y1 4,521
WDA @ 18% (814) 171 t3
20Y2 3,707
Disposal proceeds 0
Balancing allowance (3,707) 778 t4
(c) Discount rate
The long-term after-tax borrowing rate is not a suitable discount rate for the following reasons.
 It completely ignores the views and requirements of shareholders. The role of directors is to make
the shareholders wealthy, so a discount rate should be used that incorporates their required return
or cost of equity. Most firms do this by using a weighted average cost of capital (WACC).
 It is a risk-free (or at least a very low risk) discount rate. The project cash flows are uncertain, so a
higher discount rate should be used to reflect this. In particular, changes in risk – due to changes
in the type of activity undertaken or due to changes in gearing – need to be incorporated. Again,
looking at the cost of equity could help.

Tutorial note:

A good answer would correctly deduce whether it would be economically beneficial to modify a product
which would have the effect of increasing market demand for it (requirement (a)). It would then correctly
assess a decision on the cessation of manufacture of the products, taking account of the decision in
requirement (a) (requirement (b)). It would then go on to comment appropriately on the suitability of the
discount rate suggested in the question (requirement (c)).

For requirement (a) one complicated way of attacking the requirement is to carry out two sets of calculations,
one assuming the modification would take place and the other assuming that it would not. This is a
complicated way of dealing with the modification question which is more likely to lead to errors. Simply
picking up the cash flow differentials between each of the cases is a more straightforward approach.

Investment appraisal 93
 A common pitfall in this question is to omit the cashflows associated with operating costs and/or tax, both of
which varied with the decision.

In requirement (b) if you organise your answers in a logical way you should correctly pick up the relevant
areas of cash flows. Make sure that if you (correctly) concluded in requirement (a) that modification should
take place, don't ignore this in part (b).

37 REXAL LTD
(a) Net present value calculations
Option 1

Time 0 1 2 3
31 December 20X0 20X1 20X2 20X3
CU CU CU CU
Capital outlay (80,000)
Scrap proceeds 8,000
Net cash inflows 60,000 74,000 88,000
Tax on net inflows (12,600) (15,540) (18,480)
Writing down
Allowances (W1) 3,024 2,480 9,616
Working capital (6,000) (1,400) (1,400) 8,800
Net cash flow (86,000) 49,024 59,540 95,936
Discount factor (W2) 1 0.791 0.636 0.522
(86,000) 38,778 37,867 50,079
NPV = CU40,724

Option 2
Time 0 1 2 3
31 December 20X0 20X1 20X2 20X3
CU CU CU CU
Opportunity cost –
disposal proceeds
forgone (W3) (30,000)
Balancing charge
avoided (W3) 6,300
Net cash inflows (W4) 35,000 46,600 58,776
Tax on inflows (7,350) (9,786) (12,343)
Working capital (3,500) (1,160) (1,218) 5,878
Net cash flow (33,500) 32,790 35,596 52,311
Discount factor (W2) 1 0.791 0.636 0.522
(33,500) 25,937 22,639 27,306
NPV = CU42,382
Both projects show a positive NPV. Since they are mutually exclusive, option 2 should be preferred
since it has the higher NPV.
(b) Reservations
Reservations in basing an investment decision on these figures concern the accuracy of the data and the
inherent assumptions.
(i) How reliable are the estimates of operating cash flows?
(ii) Are estimates of scrap proceeds appropriate?
(iii) Is the working capital requirement sufficient?

94 Financial Management
 (iv) Operating cash flows have allowed for inflation. These values can change significantly if the
estimates of inflation are incorrect.
(v) The real cost of capital is 15%. How reliable is this figure and should it remain static over the life
of the project?
(vi) All cash flows are assumed to arise at the year end. Is this appropriate?
(vii) Will the tax rates assumed and the available capital allowances materialise in the future? Clearly it
is difficult to predict with certainty the Government's future budgets.
(viii) The ultimate NPVs are fairly similar and make any decision taken between the projects somewhat
marginal.

WORKINGS C
H
(1) Option 1 – WDAs
A
A/c period ended CU CU Time P
31 Dec 20X1 Investment 80,000 T
WDA at 18% (14,400) Tax saved at 21% 3,024 1
E
65,600
31 Dec 20X2 WDA at 18% (11,808) Tax saved at 21% 2,480 2 R
53,792
31 Dec 20X3 Scrap proceeds (8,000)
Bal allowance 45,792 Tax saved at 21% 9,616 3 2
(2) Calculation of discount factors
Because the cash flows in the question are given in money terms (or, in the case of the machine
maintenance, costs that can easily be converted into money terms) the most efficient discounting
method is to discount net monetary values at a money cost of capital.
(Note An alternative is to convert all money terms into current terms and then discount at the real rate,
but this would be a far less efficient approach and is definitely not recommended.)
Using the relationship
1 + m = (1 + r)(1 + i) where m = money cost of capital
r = real cost of capital
i = inflation rate,
then, money cost for 20X1 = (1.15) × (1.1) – 1 = 0.265, ie 26.5%
for 20X2 = (1.15) × (1.08) – 1 = 0.242, ie 24.2%
for 20X3 = (1.15) × (1.06) – 1 = 0.219, ie 21.9%
for 20X4 = (1.15) × (1.04) – 1 = 0.196, ie 19.6%
The discount factors are as follows
1
Time 1 (31 Dec 20X1) = 0.791
1.265
1 1
Time 2 (31 Dec 20X2)  = 0.636
1.265 1.242
1 1 1
Time 3 (31 Dec 20X3)   = 0.522
1.265 1.242 1.219
1 1 1 1
Time 4 (31 Dec 20X4)    = 0.437
1.265 1.242 1.219 1.196
(3) Option 2 – Capital cost
This option utilised an existing machine. The cost to the business is the opportunity cost of the sale
proceeds forgone at 1 January 20X1 (ie Time 0).
However, by not selling the machine a balancing charge of CU30,000 × 0.21 = CU6,300 is avoided.
This flow would have arisen on 31 December 20X1 (ie Time 1) and not 31 December 20X0, since the
asset was to be sold on the first day of an accounting period.
(4) Option 2 – Net cash inflows
20X1 20X2 20X3
CU CU CU
Per question (Option 1) 60,000 74,000 88,000
Less: Additional machine costs (5,000)  1.08 = (5,400)  1.06 = (5,724)

Investment appraisal 95
 Lost contribution (20,000) (22,000) (23,500)
35,000 46,600 58,776
38 SOUTHSEA LTD
(a)
20X1 20X2 20X3 20X4 20X5 20X6
CU CU CU CU CU CU
Incr. Rev (W1) - 127,500 416,160 745,493 1,131,462 1,266,750
Components (W2) - (59,400) (188,160) (327,084) (477,342) (513,450)
Labour (W3) - (15,000) (48,000) (84,300) (124,200) (135,000)
Cash flows - 53,100 180,000 334,109 529,920 618,300
Tax @ 21% - (11,151) (37,800) (70,163) (111,283) (129,843)
Investment (2,000,000)
CA (W4) 75,600 61,992 50,833 41,683 34,180 155,711
NC (1,924,400) 103,941 193,033 305,629 452,817 644,168
DF (W5) 1 0.916 0.840 0.769 0.698 0.633
PV (1,924,400) 95,210 162,148 235,029 316,066 407,758
NPV (708,189)
On the basis of this negative NPV, the recommendation should be to reject the investment.
WORKINGS

W1: Sales (units): 20X2 20X3 20X4 20X5 20X6

With new facilities 1,100 1,210 1,331 1,464 1,500 (max.)
With old facilities 1,050 1,050 1,050 1,050 1,050
Increase in unit sales 50 160 281 414 450

Revenue:
Selling price/unit: (CU) 2,550 2,601 2,653 2,733 2,815
Incremental revenue 127,500 416,160 745,493 1,131,462 1,266,750
W2: Components:
Cost/unit 1,188 1,176 1,164 1,153 1,141
Incremental cost (59,400) (188,160) (327,084) (477,342) (513,450)

W3: Labour:
Labour (units × (15,000) (48,000) (84,300) (124,200) (135,000)
CU300)

Gross Figures would have been as follows (in CU):

Revenue:
20X2 20X3 20X4 20X5 20X6
With new facilities 2,805,000 3,147,210 3,531,143 4,001,112 4,222,500
Without facilities 2,677,500 2,731,050 2,785,650 2,869,650 2,955,750
127,500 416,160 745,493 1,131,462 1,266,750
Components:
20X2 20X3 20X4 20X5 20X6
With new facilities 1,306,800 1,422,960 1,549,284 1,687,992 1,711,500
Without facilities 1,247,400 1,234,800 1,222,200 1,210,650 1,198,050
(59,400) (188,160) (327,084) (477,342) (513,450)
Labour:
20X2 20X3 20X4 20X5 20X6

96 Financial Management
With new facilities 330,000 363,000 399,300 439,200 450,000
Without facilities 315,000 315,000 315,000 315,000 315,000
(15,000) (48,000) (84,300) (124,200) (135,000)

C
H
A
P
T
E
R

Investment appraisal 97
 W4: Capital CA (21%)
Allowances: CU CU
31 Dec 20X1 Cost 2,000,000
31 Dec 20X1 WDA 360,000 75,600
1,640,000
31 Dec 20X2 WDA 295,200 61,992
1,344,800
31 Dec 20X3 WDA 242,064 50,833
1,102,736
31 Dec 20X4 WDA 198,492 41,683
904,244
31 Dec 20X5 WDA 162,764 34,180
31 Dec 20X6 Bal. All. 741,480 155,711
W5: Discount Factors:
20X2: 1/(1.07 × 1.02) = 1/1.0914 = 0.916
20X3: 1/1.09142 = 0.840
20X4: 1/1.09143 = 0.769
20X5: 0.769 × 1/(1.07 × 1.03) = 0.769 × 1/1.1021 = 0.698
20X6: 0.769 × 1/1.10212 = 0.633
(b) The obvious problem is that the negative NPV arises principally because the almost 50% increase in
production capacity is not fully used until the final year of the project. However, the investment in
additional production capacity therefore comes with the real option of finding new customers for the
spare capacity in the first four years of the contract.
This is an example of a ‘follow-on’ (growth) option and if this could be achieved then the whole project
has the potential to be financially viable from a shareholder wealth perspective.
(c) Synergistic savings may be achieved (administration, leaner management structures)
Risk reduction (lower risk may create a lower WACC)
Backward vertical integration gives control over supply (quantity/quality)
39 RFA LTD
(a)
20X9 20Y0 20Y1 20Y2
t0 t1 t2 t3
CU CU CU CU
New machine (1,700,000) 200,000
CA’s on new machine (W1) 64,260 52,693 43,208 154,838
Old machine (W2) 79,000 (63,200)
Sales (W3) 545,900 901,765 1,442,400
Raw materials (W4) (79,800) (125,685) (183,368)
Other variable costs (W5) (53,560) (117,760) (259,632)
Wages (W6) 18,360 18,727 (140,079)
Tax (W7) (90,489) (142,180) (180,457)
Working capital (W8) (54,590) (35,587) (54,063) 144,240
Total cash flows (1,611,330) 357,517 460,812 1,177,942
Discount at 11% 1.000 0.901 0.812 0.731
PV (1,611,330) 322,123 374,179 861,076
NPV (53,952)

The NPV is negative and so RF 17 should not be purchased as this would reduce shareholder wealth.

98 Financial Management
WORKING
(1)

t0 t1 t2 t3
CU CU CU CU
Cost 1,700,000 1,394,000 1,143,080 937,326
WDA @ 18% (306,000) (250,920) (205,754) (737,326)
WDV 1,394,000 1,143,080 937,326 200,000

Capital Allowances @ 21% 64,260 52,693 43,208 154,838 C

H
(2) A
CU CU CU CU P
RF13 resale value 100,000 (80,000) T
E
Balancing charge (21,000) 16,800
R
79,000 (63,200)

(3)
2
CU CU CU
Sales RF17 (real) 1,150,000 1,450,000 1,320,000
Sales RF13 (real) 620,000 600,000 0
Increase (real) 530,000 850,000 1,320,000
Inflation 1.030 1.061 1.093
Increase (money) 545,900 901,765 1,442,400

(4)
CU CU CU
Raw materials RF17 (real) (138,000) (174,000) (158,400)
Raw materials RF13 (real) (62,000) (60,000) 0
Increase (real) (76,000) (114,000) (158,400)
Inflation 1.050 1.103 1.158
Increase (money) (79,800) (125,685) (183,368)

(5)

CU CU CU
Other VC RF17 (real) (207,000) (261,000) (237,600)
Other VC RF13 (real) (155,000) (150,000) 0
Increase (real) (52,000) (111,000) (237,600)
Inflation 1.030 1.061 1.093
Increase (money) (53,560) (117,760) (259,632)

(6)
CU CU CU
Labour saving (real) [CU150,000 × 12%] 18,000 18,000 18,000
Inflation 1.020 1.040 1.061
Labour saving (money) 18,360 18,727 19,102
Labour cost for extra year [150,000 × 1.023] 0 0 (159,181)
Net saving/(cost) 18,360 18,727 (140,079)
(7)
CU CU CU
Sales (W3) 545,900 901,765 1,442,400
Raw materials (W4) (79,800) (125,685) (183,368)
Other variable costs (W5) (53,560) (117,760) (259,632)

Investment appraisal 99
 Wages (W6) 18,360 18,727 (140,079)
Taxable profits 430,900 677,047 859,321
Tax @ 21% (90,489) (142,180) (180,457)
(8)
CU CU CU CU
Working capital required (sales × 10%) 54,590 90,177 144,240
Investment (54,590) (35,587) (54,063) 144,240

(b) Sensitivity analysis considers the degree of sensitivity of forecasts. It calculates the change necessary
for a project to break even.
(i) It is a simple approach and identifies those areas which are critical to the success of a project. It
enables management to decide the likelihood of the possible outcomes under consideration.
(ii) However, it assumes that changes to variables can be made independently of other variables.
(iii) It ignores probability.
(iv) It does not point directly to the correct decision.
The expected value is an average of possible outcomes, weighted by the probability of each outcome
occurring.
(i) Thus the information is reduced to a single number for each choice.
(ii) However it may be difficult to estimate the probabilities of the possible outcomes.
(iii) The average may not correspond to any of the possible outcomes.
(iv) The average ignores risk as it gives no indication of the spread of possible results.
40 STICKY FINGERS LTD
(a) No rationing
Present values
Year 0 1 2 3 4
Time t0 t1 t2 t3 t4
Discount factor 1 0.870 0.756 0.658 0.572
CU'000 CU'000 CU'000 CU'000 CU'000
Project A (1,500) (435) 907 395 172
Project B (2,000) (870) 1,890 1,645 1,430
Project C (1,750) 435 832 921 572
Project D (2,500) 609 680 855 172
Project E (1,600) (435) 151 1,842 1,316

NPV
CU'000
Project A (461)
Project B 2,095 Therefore, accepting all projects with a
Project C 1,010 positive NPV, accept projects B, C and E
Project D (184)
Project E 1,274
(b) Single-period capital rationing
Project A B C D E
NPV (CU000) (461) 2,095 1,010 (184) 1,274
Investment, t0 (CU000) 1,500 2,000 1,750 2,500 1,600
NPV/CU – CU1.05 CU0.58 – CU0.80
Rank – 1st 3rd – 2nd
Therefore, accept B and 10/16 E.
(c) Single-period capital rationing – inflows and outflows, negative NPVs
NPV
Using benefit cost ratios initial investment

100 Financial Management

 Benefit/cost NPV per Ranking
CU1 invested
Project A *
Project B CU2,095/CU1,000 CU2.10 2
Project C *
Project D CU(184)/CU700 CU(0.26) **
Project E CU1,274/CU500 CU2.55 1
Notes
* Project A would never be accepted because it has a negative NPV and uses up funds in the
restricted year.
Project C would always be accepted since it has a positive NPV and releases funds in the C
restricted year. A total of CU700,000 is then available. H
A
** Project D has a negative NPV but releases funds at t1.
P
If project D is accepted, this makes an extra CU700,000 available at t1. However, in doing so a T
negative NPV (–CU184,000) is incurred. Thus, it is necessary to examine whether the extra E
positive NPV generated by the additional investment finance outweighs this cost. R
(1) Available capital = CU200,000. Accept projects C, E and 20% B. Total NPV = CU2,703,000.
(2) If D is accepted the available capital becomes CU1,400,000 [CU200,000 + CU500,000 (from 2
project C) + CU700,000 (from project D)].
Accept projects C, D, E and 90% B. Total NPV = CU3,985,500. This is the optimal solution.
(d) Indivisible projects
Possible investment 'portfolios' are
B or C or E or (C and E)
The portfolio which has the highest NPV is C and E requiring an investment of CU3.35 million and
generating CU2.3 million.
41 IGLOO LTD
(a) No capital rationing
Accept all projects with NPV  0.
NPV
CU'000
Project A + 60
Project B + 40
Project C – 20 Therefore accept A, B, D and E
Project D + 110
Project E + 40
(b) Single period capital rationing
NPV
Using benefit cost ratios (NPV/CU) initial investment
NPV/CU Rank
Project A + 60  100 = 0.60 3
Project B + 40  50 = 0.80 2
Project C – 20  200 = (0.10) 5
Project D + 110  100 = 1.10 1
Project E + 40  200 = 0.20 4
CU225,000 available, therefore accept D, B, ¾ A.
(c) Mutually-exclusive investments
This problem is solved by trial and error, using the rankings from (b) above.
The two alternative project combinations are as follows,
D, B, 371/2 % E: NPV (CU000) = 110 + 40 + 15 = 165
D, A, 121/2 % E: NPV (CU000) = 110 + 60 + 5 = 175

Investment appraisal 101

 Therefore the better combination is D, A and 12½ % E.
(d) Integer restrictions
Again trial and error is required.
Possible combinations, given the limited finance available, are as follows.
A and B; A and D; B and D; or any single project.
Examining all the different whole project combinations shows that A and D produce the maximum
amount of total NPV, the amount being CU170,000.
(e) Restrictions with inflows, outflows and negative NPVs
Recalculating the benefit-cost ratios, now using t1 outlays.
NPV/CU Rank
Project A + 60  100 = 0.60 3
Project B + 40  100 = 0.40 4
Project C – 20  (100) = 0.20* ?
Project D + 110  50 = 2.20 1
Project E + 40  50 = 0.80 2
It is worth simplifying the problem with some rational analysis.
In this case not much can be done. However, it may be that some projects can automatically be
eliminated (with negative NPVs and using up funds in the restricted year). It may also happen that some
projects can be automatically elected (with positive NPVs and providing additional funds in the
restricted year). Here the problem concerns C (negative NPV but providing funds for time 1).
If project C is accepted, this makes an extra CU100,000 of investment finance available at t1. However,
in doing so a negative NPV (– CU20,000) is incurred. Thus one must consider whether the extra
positive NPV generated by the additional investment finance outweighs this cost.
CU150,000 of capital, accept D, E and 1/2 A. Total NPV = CU180,000.
CU150,000 + CU100,000 of capital, accept D, E, A, 1/2 B and C. Total NPV = CU(110,000 + 40,000 +
60,000 + 20,000 – 20,000) = CU210,000. This is the optimal combination.
Having found that, with CU150,000 available, the 'money dries up' half way through project A, it is
clear by comparing A's NPV/CU of CU0.60 with C's (strange) NPV/CU of CU0.20, that every CU1 C
provides at time 1 increases the NPV by a net CU0.40. It is also worth using C to supply funds for
project B.
42 STAN BELDARK
Optimal replacement period
The effects of increasing running costs and decreasing resale value have to be weighed up against capital
cost. Road fund licence etc can be ignored, since Stan will always pay CU300 per year per car.
The following table is one of the quickest ways to reach an answer.
Running PV Cum PV Resale PV of NPV of Cum EAC
cost of RC of RC value RV car discount
CU CU CU CU CU CU factor CU
Life 1 3,000 2,727 2,727 3,500 3,182 5,045* 0.909 5,550
Life 2 3,500 2,891 5,618 2,100 1,735 9,383 1.736 5,405
Life 3 4,300 3,229 8,847 900 676 13,671 2.487 5,497
* NPV = 5,500 cost + 2,727 running cost – 3,182 resale value = CU5,045
From the above table it can be seen that the optimal replacement period is every two years.
43 TALEB LTD
Summary showing the optimal replacement policy for Taleb's Dot machines
Replacement cycle Annual equivalent
net revenue
CU'000
One year 8.0
Two years 11.1 *
Three years 9.8

102 Financial Management

Four years 10.3
* optimal policy. Replacement of the Dot machine every two years results in the greatest annual
equivalent net revenue for the company (ie CU11,100) and therefore is the recommended replacement
policy.
WORKINGS

Annual production/sales (units) 500,000 400,000

CU CU
Annual revenue (CU0.12 per unit) 60,000 48,000
Less Annual variable costs (CU0.04 per unit) (20,000) (16,000)
C
Contribution 40,000 32,000 H
(1) One year replacement A
Year 0 Year 1 P
CU'000 CU'000 T
Machine outlay (60) E
Scrap value 40
R
Running costs (6)
Contribution 40
2
Net cash flow (60) 74
Net present values = –60 + 74 × 0.909
= 7.266
Annual equivalent = 7.266  0.909
 CU7,993
(2) Two year replacement
Year 0 Year 1 Year 2
CU'000 CU'000 CU'000
Machine outlay (60.0)
Scrap value 25.0
Running costs (6.0) (6.5)
Contribution 40.0 40.0
Net cash flow (60.0) 34.0 58.5
Net present values = –60 + 34 × 0.909 + 58.5 × 0.826
= 19.227
Annual equivalent = 19.227  1.736
 CU11,075
(3) Three year replacement
Year 0 Year 1 Year 2 Year 3
CU'000 CU'000 CU'000 CU'000
Machine outlay (60.0)
Scrap value 10.0
Running costs (6.0) (6.5) (7.5)
Contribution 40.0 40.0 32.0
Net cash flow (60.0) 34.0 33.5 34.5
Net present values = –60 + 34 × 0.909 + 33.5 × 0.826 + 34.5 × 0.751
= 24.4865
Annual equivalent = 24.4865  2.487
 CU9,846
(4) Four year replacement
Year 0 Year 1 Year 2 Year 3 Year 4
CU'000 CU'000 CU'000 CU'000
Machine outlay (60.0)
Scrap value 0
Running costs (6.0) (6.5) (7.5) (9.0)
Contribution 40.0 40.0 32.0 32.0

Investment appraisal 103

 Net cash flow (60.0) 34.0 33.5 24.5 23.0
Net present values = –60 + 34 × 0.909 + 33.5 × 0.826 + 24.5 × 0.751 + 23 × 0.683
= 32.6855
Annual equivalent = 32.6855  3.170
 CU10,311

Tutorial note:
The notable feature of this question is that it involves revenues as well as costs in the replacement decision.
Several approaches can be taken but the above is probably the simplest. Other approaches, including the
opportunity cost of contribution forgone, are acceptable and, although they will produce different figures,
they should give the same ranking.

104 Financial Management