Investment Appraisal

CHAPTER 1
INVESTMENT APPRAISAL –
NET PRESENT VALUE
1. Investment decisions
When News Corporation bought Myspace for $580 million in 2006, it (Myspace) was
one of the hottest companies on Earth. When News Corporation sold Myspace for
$35 million in 2012, it had the marketability and popularity of a mouldy potato. This
was a bad investment decision.
Investment decisions are just one part of corporate financial strategy, along with
financing and dividend decisions. Let's take a look at these three types of decision
more closely.
Financing decisions
Businesses need funding to invest in capital (e.g. equipment, machinery, buildings,
etc.), to pay expenses and for working capital (e.g. salaries, inventories, utilities,
etc.).
Financing decisions relate to the decisions about where this money comes from,
and is primarily about balancing. This money can generally come from:
• Equity - Investment from owners/shareholders
• Debt – Money from lenders such as banks or bonds
• Retained earnings – Unspent/accumulated profits from prior periods
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Investment Appraisal – Net Present Value
Investment decisions
Once raised, the money needs to be invested, and investment decisions help the
organisation decide where to invest this money to repay debt (and interest payments)
and achieve a good rate of return for shareholders.
Strategic options are generated as part of the business strategy-setting process. As

part of the evaluation of the strategic options, investment decisions can be made
using techniques such as:
• Net present value (NPV) – This is the difference between the present value
of cash inflows and the present value of cash outflows for a project. The
present value aspect is useful for projects that last several years, since it takes
into account elements such as inflation.
• Internal rate of return (IRR) – This looks at an investment in terms of the

optimal rate of return for the company, rather than the net value. Higher
rates of return are generally preferable.
• Payback period – This is the length of the time taken for an investment to
make a return on the initial expenditure (e.g. a £50 investment with a £25
annual payback would have a two-year payback period).
• Return on capital employed (ROCE) – This compares a company's capital

with its earnings to measure how efficiently capital has been used to make
money.
Dividend decisions
Assuming investments were well made, funds can be returned to shareholders in
the form of dividend payments. The directors have to balance the payment of
dividends with retention of cash in the business to allow for future investment and
growth.
2. Net present value (NPV)

Imagine that it is 2005 and you are the finance manager at Apple Inc. Your research
and development team come to you with two ideas: one is a hand-held device with a
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touch screen that makes phone calls, sends emails and plays music. The other is a
new phone modelled on an existing phone on the market with a unique design.
The first is, of course, far more costly than the second, and obviously more risky too,
since it will be a novel idea. The second option would be safer and more likely to
bring a guaranteed return.
But, you are the financial manager, and you need to approach this more analytically
and with numbers. But where do you start with a project like this? Is there a way to
input some data and have a simple 'yes' or 'no' output?
Well, while we don't have anything quite that simple yet, we do have NPV.
Net present value (NPV) is a project appraisal technique which uses relevant net
cash flows generated by a project over its total lifetime to calculate a project’s net
contribution to an organisation. Basically, NPV tells us whether it's worth doing a
project or not.
Therefore, NPV calculates an organisation’s change in wealth if it undertakes a

particular project. A positive NPV is an increase in the total value of the company
from doing the project, while a negative NPV is a decrease in total value of the
company from doing the project.
Traditionally, therefore, a negative NPV for a project would suggest that it should not
be undertaken as it would not bring any profit for a business or investor. Likewise, a
positive NPV would bring profit so should be undertaken. However, there are other
factors that should be considered when making these decisions such as the
company strategy and business model. These may outweigh a decision based
purely on the NPV.
Therefore, if a project has a positive NPV, but undertaking it would, for example,
undermine the principles of the business, investors and customers may react
negatively. If it was felt that this would significantly damage the business, the project
shouldn’t be undertaken.
A project with a negative NPV shouldn’t be ruled out either. Sometimes, if

undertaken, such a project may build a foundation for future profitable
projects.
In summary, a project shouldn’t be automatically accepted just because it has a

positive NPV or rejected just because it has a negative NPV.
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Discounting and the time value of money

NPV takes account of the time value of money by ‘discounting’ future cash
flows so the further they are away the less value they have. To put this into
context, the same amount of money received in one year’s time will not be as
valuable as money that is received now. One reason for this is because in one year,
you will not be able to purchase as much of a product with the same funds due to
inflation. Another way of thinking about this is that those funds, if invested now, will
be worth more in one year as they would have earned interest in that year.
To take you through the process of calculating NPV, we’ll use an example company:
Buzzing Batteries (BB), a mobile phone and MP3 lithium battery manufacturer. The
company is UK-based, profitable and has been in business since 1999.
Given that any company needs to achieve a percentage return equivalent to the cost
of capital to satisfy investors, the effective rate used is the cost of capital.
For BB the cost of capital is 10%. This means that £110 received in one year’s time has
a present value of £110/1.1 = £100, or in other words, the investor would need £110
in 1 year to give them a 10% return on £100 now.
Taking account of the time value of money and all relevant cash flows (both incoming
and outgoing) means NPV is considered a superior project appraisal technique
compared to others such as ARR, payback periods and IRR (but we’ll come to
these later on!)
The timing of cash flows

When completing NPV calculations, it is vital that the timing of cash flows is clearly
recorded, as amounts received at later times need to have a greater discounting
factor applied to them. Therefore it is important that a standardised approach is used
in these calculations, including a standard NPV proforma.
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You will need to become familiar with the following approximate proforma for NPV
calculations:
Year 0 Year 1 Year 2 Year 3 Year 4

Sales receipts Xj Xj Xj
Costs (X) (X) (X)
Sales less costs Xj Xj Xj
Taxation based on net income (X) (X) (X) (X)
Capital expenditure (X)
Scrap value Xj
Working capital (X) Xj
Tax benefit of tax depreciation Xj Xj Xj Xj
Net cash flow (X) Xj Xj Xj (X)
Discount factors @ post tax cost
Xj Xj Xj Xj Xj
of capital
Present value (X) Xj Xj Xj (X)
This is a lot to take in visually, but having this proforma will really help you in the
exam! The good news is that you should have seen plenty of NPV calculations by
then. There are also some key points that it's worth noticing about the presentation
of an NPV:
• Cash outflows that occur at the beginning of a project occur now (Year 0),
meaning that these outflows are already at their nominal value.
• Cash outflows or inflows that occur during any particular year are all
treated as if they occurred at the end of that financial year. For instance,
revenue will be earned over a full 12-month period, but for the purpose of
NPV calculations we treat revenue as if it occurred all in month 12. This
assumption is used to keep calculations straightforward.
If you are specifically told that a cash outflow or inflow occurs at the start of a
year, include it as the end of the previous year. For instance, a cash flow received
at that start of Year 2 is deemed to have occurred at the end of Year 1 and should be
included in Year 1 cash flows in your calculation.
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Again this is an understood assumption that ensures consistent treatment of inflows/

outflows across different NPV calculations.
Example – basic NPV

Buzzing Batteries is looking to expand operations by opening up three retail shops
selling batteries directly to the public. It has decided upon a company policy of
acquiring all of its store locations. The following cash flows are forecast:

£’000 £’000 £’000 £’000 £’000
Land and buildings (4,225)
Fittings and equipment (910)
Gross revenue 2,340 3,250 3,640 3,900
Cost of capital is 12%, so we can now calculate the NPV.
We start by completing a table over a number of years (which will look like the one
above), and also find the net cash flow for each year:

£’000 £’000 £’000 £’000 £’000
Gross revenue 2,340 3,250 3,640 3,900
Net cash flow (5,135) 2,340 3,250 3,640 3,900
Next use the discount tables, (which can be found at the end of this study text), to
look up the relevant discount factors to use. Add a row to your table to note the
discount rate of 12%:
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£’000 £’000 £’000 £’000 £’000
Gross revenue 2,340 3,250 3,640 3,900
Net cash flow (5,135) 2,340 3,250 3,640 3,900
Discount factor 1.00j 0.893 0.797 0.712 0.636
Next up is the calculation of the present value of each year, to do this we multiply the
discount factor by the net cash flow for the relevant year. So for example:
To find the present value for Year 1:
2,340 x 0.893 = 2,089.62
Here, the number is rounded to the nearest thousand for ease of calculation.
Continue to find the present value for all years.

£’000 £’000 £’000 £’000 £’000
Gross revenue 2,340 3,250 3,640 3,900
(5,135) 2,340 3,250 3,640 3,900
Discount factor 1.00 0.893 0.797 0.712 0.636
Present value (5,135) 2,090 2,590 2,592 2,480
Finally, we simply add up all of these present values to create the net present value:
(5,135) + 2,090 + 2,590 + 2,592 + 2,480 = 4,617
Therefore, £4,617,000 is the projected revenue of Buzzing Batteries over the four
years. As you can see, the NPV of the project is a positive figure. This means it will
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give investors a return above the 12% cost of capital, and so the opening of the new
shops should be undertaken.
It’s also worth noting that effectively this is saying that doing this project increases
the total value of the company by £4,617,000. If the stock market was efficient, as
soon as the announcement of the project was made to the market, BB share prices
would increase!
Example – NPV including relevant costs and scrap

value.
Using the same BB example we can add in additional factors to demonstrate other
concepts you will need to be familiar with when completing NPV calculations. Here
we introduce a range of other costs (some of which are relevant and some which are
not) and scrap value.
We are looking to calculate the NPV of this project where cost of capital is 12% with
the following information:

£’000 £’000 £’000 £’000 £’000
Gross revenue 2,340j 3,250j 3,640j 3,900j
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Office overheads (165) (165) (165) (165)
• The cost of land and buildings includes £100,000 which has been spent on
legal fees
• 55% of the office overhead is a charge made for head office services
• BB anticipates selling the new stores at the end of year four for £4 million
which includes £75,000 for fixtures and fittings
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To find the NPV we need to first recognise which costs are relevant – you will
have encountered how to distinguish between relevant and non-relevant costs earlier
in your studies.
The legal fees are a sunk cost because they have already been paid whether the
project to open the retail units goes ahead or not. We therefore reduce land and
buildings fees by £100,000: 4,225 – 100 = 4,125. Remember that this is a cost and
must therefore be represented on the table as (4,125).
The allocated overhead charge (that is calculated as 55% of the full cost) is also
irrelevant to this project for the same reason; the head office will be maintained
whether this project happens or not. As such, we can adjust the given cost of
office overheads accordingly: 165 x 45% = 74.25.
We are told that BB can sell the new stores at the end of year 4 and this additional
factor (£4 million) has also been included in the solution below as a gain. The net
cash flow for each year can then be calculated:

£’000 £’000 £’000 £’000 £’000
Gross revenue 2,340) 3,250) 3,640) 3,900)
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Office overheads (45%) (74) (74) (74) (74)
Resale value 4,000)
Net cash flow (5,035) 1,071) 1,421) 1,356) 5,486)
We can then do exactly what we did in the previous example, which is to apply the
discount factor based on a 12% cost of capital:
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£’000 £’000 £’000 £’000 £’000
Gross revenue 2,340) 3,250) 3,640) 3,900)
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Resale value 4,000)
Net cash flows (5,035) 1,071) 1,421) 1,356) 5,486)
Discount factor 1.00) 0.893) 0.797) 0.712) 0.636)
PV of future cash flows (5,035) 956) 1,133) 965) 3,489)
Net present value 1,508)
We can see that the NPV is positive and so the project should be undertaken. A lot of
the work with NPV calculations is about being methodical, ensuring that you cover all
of the criteria and working through each factor carefully. While parts of an NPV
calculation can become quite involved, there are also a lot of easy marks available in
your exam!
3. NPV and working capital

Projects obviously require capital and you can be asked as part of an NPV calculation
to build in working capital requirements. This means we need to have an
understanding of how much it will cost in order to keep BB's new retail stores
operational.
As we are only dealing with relevant cash flows, the full amount of working capital is
recorded in Year 0 of your calculation and then only the incremental amounts are
recorded in subsequent years. At the end of the project the full amount invested
will be released.
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Year 0 working capital requirements

You will often find that working capital requirements are given as a percentage of
turnover. For example, in another retail project BB requires 20% of turnover as
working capital:

£’000 £’000 £’000 £’000 £’000
Turnover 3,320 3,600 4,000 4,700
This means, for example, that the working capital requirement for Year 1 is £664,000
(£3.32 million x 20%).
A key point to remember is that working capital is required at the start of the year.
Therefore the £664,000 goes in Year 0 in preparation for Year 1 and so on.

£’000 £’000 £’000 £’000 £’000
Turnover 3,320j 3,600j 4,000j 4,700j
Working capital (664) (720) (800) (940)
Relevant cash flow (664) (56) (80) (140) 940j
Mid-project working capital requirements

Relevant cash flows measure the incremental increases in working capital. Take a
look. Between Year 0 and Year 1, working capital requirements went from £664,000 to
£720,000.
Because the project has already had £664,000 invested, we simply calculate £720,000
– £664,000 to discover what extra investment is required to maintain the required
working capital. So, £720,000 – £664,000 = £56,000, hence £56,000 extra is required
in working capital.
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Final year working capital requirements

As we can see, however, this isn't the case in the final year. In the last year of the
project the full amount of working capital invested is released. In the above example
Year 0-3 cash flows are added up to get £940,000 which is treated as an inflow in that
final year. It's almost as if BB's new project stops after year 4 - they're able to reclaim
that working capital.
4. Tax in an NPV calculation

Much of the NPV calculations we’ve looked at so far should be familiar from your
earlier studies. However, there is another element that needs to be considered: tax. In
your exam it is important to read the question requirement very carefully when
dealing with NPVs. This is because it’s easy to be caught out by tax.
That said, tax is usually a simple part of the NPV calculation and you will simply
need to follow the instructions given. You will be given a rate (e.g. 30%) and told if
the tax is collected in the year in which it is due, or often you will be given scenarios
where it is collected a year in arrears.
Example – NPV with working capital and tax

We're going back to BB and the opening of its new retail shops, only this time we're
going to add in tax and working capital calculations.

£’000 £’000 £’000 £’000 £’000
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
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legal fees
• BB anticipates selling the new stores at the end of year four for £4 million
which includes £75,000 for fixtures and fittings
• Working capital requirements are forecast to be 10% of revenue at the start of

each year
• BB is charged corporation tax at 30%, It is collected one year in arrears
In the following table, let's start off with our cash flows. Land and buildings costs have
been reduced by £100,000 to reflect that legal costs are sunk costs, whilst office
overheads have been reduced by the 55% relating to head office.
We can see that the resale value of the shops (£4 million) has been calculated as part
of Year 4. A year 5 column will eventually be added in order to accommodate tax
(which will be collected one year after year 4).

£’000 £’000 £’000 £’000 £’000
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Resale value 4,000j
We're not done yet though. Next we need to calculate working capital, which is given
in the question as 10% of revenue each year:
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£’000 £’000 £’000 £’000 £’000
Working capital (10%) 234j 325j 364j 390j
Relevant cash flows 234j 91j 39j 26j 390j
Remember, however, that working capital is required at the end of the previous
year. We can therefore incorporate the relevant cash flows as follows, remembering
that we effectively recoup working capital at the end of the project! This means we
add up our cash flows and add this as a cash flow to year 4:
234 + 91 + 39 + 26 = 390

£’000 £’000 £’000 £’000 £’000
Gross revenue 2,340) 3,250) 3,640) 3,900)
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Resale value 4,000)
Working capital (234) (91) (39) (26) 390)
Net cash flows (5,269) 980) 1,382) 1,330) 5,876)
See how the working capital requirement has slightly altered net cash flows.
We're nearly there! Finally we need to calculate tax. The notes tell us this is charged at
30% and collected the following year. Remember that tax is charged against net
income and not cash flows:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£’000 £’000 £’000 £’000 £’000 £’000
Tax (30%) (321) (426) (407) (446)
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We can now add this to our calculations:

£’000 £’000 £’000 £’000 £’000 £’000
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Resale value 4,000j
Working capital (234) (91) (39) (26) 390j
Tax (30%) (321) (426) (407) (446)
We now have all of the relevant income and cost information we require, and can
therefore calculate the net cash flows and present values as a result:

£’000 £’000 £’000 £’000 £’000 £’000
Gross revenue 2,340) 3,250) 3,640) 3,900)
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Resale value 4,000)
Working capital (234) (91) (39) (26) 390)
Tax 30% (321) (426) (407) (446)
Net cash flows (5,269) 980) 1,061) 904) 5,469) (446)
Discount factor 1.00) 0.893) 0.797) 0.712) 0.636) 0.567)
Present value (5,269) 875) 846) 644) 3,478) (253)
Net present value 321)
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And that's the end of our calculations! Overall the project of the new retail stores still
has a positive NPV. This means we should still recommend that BB pursue the project.
Tax benefit
In some countries it is possible for an organisation to reduce its tax bill by deducting
an allowance from the value of certain purchased items. In the UK this is known as a
capital allowance. The value of this saving is specified through government-advised
rates.
For example, in the UK a company car is an allowable capital allowance: the company
gets money back to offset the car's depreciation in value. Capital allowance rates are
usually 25%, but make sure you check the question to see if it gives a specific rate!
The question may also specify a certain item which the capital allowance refers to, for
example, machinery; although The Guardian reported in 2015 that, in the UK, capital
allowances had been extended to a range of objects including bowling alleys and fish
tanks!
Finally, the annual amount claimed each year (which is taken off the total asset
value for the following year’s balance) is called a ‘writing down allowance’. For
example, if BB (a UK-based business) has a £400,000 machine asset which is given a
25% allowance, it has a first year writing down allowance of £100,000. This leaves a
balance of £300,000 to be recorded in Year 1 and claimed against in the following
year.
Let's take a look at a slightly more complex example:
Example
Buzzing Batteries purchases a battery making machine for £1,000,000 and the capital
allowance rate is 25%. The machine is sold for £100,000 in Year 4. We need to
calculate the annual capital allowances.
We start by calculating the year 1 capital allowance:
Year 1 capital allowance: £1,000,000 x 25% = £250,000
Then we work out the balance which has yet to be claimed against for tax:
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New balance = £1,000,000 - £250,000 = £750,000
We then use £750,000 as the new starting figure and repeat the process for Year
2:
Year 2 capital allowance: £750,000 x 25% = £187,500
New balance = £750,000 - £187,500 = £562,500
Getting the hang of it? We then use £562,500 as the new starting figure and
repeat for Year 4:
Year 3 capital allowance: £562,500 x 25% = £140,625
New balance = £562,500 - £140,625 = £421,875
In the final year (Year 4), the remaining balance can be charged for tax less any
scrap value. This is called the balancing allowance:
Year 4 balancing allowance: Current balance - scrap value
£421,875 - £100,000 = £321,875
This can therefore be summarised as follows, and the 30% tax allowance applied to it:
Year Capital allowances Tax savings (allowance x 30%)

1 £250,000 £75,000
2 £187,500 £56,250
3 £140,625 £42,188
4 £321,875 £96,563
That’s the capital allowances calculated, whilst the annual tax savings would be
recorded as a source of capital and incorporated into the NPV calculation. The annual
capital allowances are then multiplied by the tax rate, which here we will assume is
30%, to give the actual annual tax savings which go into your NPV calculation.
When inputting these values into your calculation treat them on the same basis
as you have been directed to treat your tax. In our earlier example, tax was
charged the following year, so we would record capital allowances in this year.
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To illustrate this, let's put the figures back into the example. Capital allowances have
been calculated based on the £910k cost of fixture and fittings, at a written down
allowance of 25% and against a corporation tax charge of 30%:

£’000 £’000 £’000 £’000 £’000 £’000
Gross revenue 2,340) 3,250) 3,640) 3,900)
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
1,071) 1,421) 1,356) 1,486)
30% Tax 1 year in arrears (321) (426) (407) (446)
Tax saved (W1 Cap Allow) 68) 51) 38) 92)
Resale/Scrap value 4,000)
Working capital (W2) (234) (91) (39) (26) 390)
Net cash flows (5,269) 980) 1,129) 955) 5,507) (354)
Discount factor @ 12% 1.000) 0.893) 0.797) 0.712) 0.636) 0.567)
PV of future cash flows (5,269) 875) 900) 680) 3,502) (200)
£’000 £’000 £’000 £’000 £’000 £’000
Capital allowances (W1) 228 171 128 308
Claims
Balancing allowance
(Cost £910K – scrap value – claims to date) 308
Tax saved 68 51 38 92
Working capital (W2) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£’000 £’000 £’000 £’000 £’000 £’000
Turnover 2,340) 3,250) 3,640) 3,900
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Working capital (10%

of turnover) (234) (325) (364) (390)
Relevant cash flows (234) (91) (39) (26) 390
5. NPV with inflation

Cash flows with inflation
There's a famous picture of a worker in 1920's Germany using bails of money to fuel
his fire. This was due to horrible levels of hyperinflation because the money became
worthless, and illustrates the dangerous impact inflation could have on an NPV. Okay,
we probably won't be burning money in the near future, but if a project is taking
place in a country with an unstable currency, inflation will have a huge impact on the
project's profitability.
You may be given the cash flows in 'real terms', known as real cash flows. That's
the amount that you would spend if you were to buy a product today.
Let's say the cost of a product in one year's time is £110, and inflation is 10%, that
means that the product in 'real terms' costs £100.
The actual amount you will actually pay in one year is £110, and this is known as the
nominal cash flow, and it's this cash flow that must be included in most NPV
calculations.
Cost of capital with inflation

Another issue can be the use of real and nominal cost of capital figures.
If we are using real cash flows (no inflation), then we will also be calculating real
costs of capital (no inflation).
If we're using nominal cash flows (with inflation) for our NPV, however, we will
also need to use nominal costs of capital (with inflation).
To calculate the nominal cost of capital we use the Fisher Equation (named after
American economist Irving Fisher) to calculate a nominal cost of capital:
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(1 + real cost of capital) x (1 + general inflation rate) =

(1 + nominal cost of capital)
Or in algebraic form...
(1 + r) x (1 + i) = (1 + n)
Where:
r = Real cost of capital
i = General inflation rate
n = Nominal cost of capital
Example
Here’s a very quick, simple example using some random figures to demonstrate the
process. The real cost of capital for a company is 8% and general inflation rate is 3%.
What is the nominal cost of capital (that should be used in a typical NPV calculation?)
Nice and simple! We know that the Fisher equation is given as:
(1 + r) x (1 + i) = (1 + n)
We also know that r is 8%, i is 3%, and n is the nominal cost of capital. Therefore:
(1 + 0.08) x (1 + 0.03) = 1 + n
1.08 x 1.03 = 1 + n
1.1124 = 1 + n
0.1124 = n
The nominal cost of capital is therefore 11.24%
NPV and Inflation

Now that we know how to calculate inflation, let’s factor this into our running
example of Buzzing Batteries:
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£’000 £’000 £’000 £’000 £’000
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
legal fees
• BB anticipates selling the new stores at the end of year four for
£4 million which includes £75,000 for fixtures and fittings
• Working capital requirements are forecast to be 10% of revenue at the start of

each year
• BB is charged corporation tax at 30%. It is collected one year in arrears
• BB’s real cost of capital is 7.7% and there is currently inflation of 4%. Inflation
has not been factored into the revenue generated or the costs accumulated
The first requirement is to calculate the nominal cost of capital as this should be used
as the discount rate using the Fisher equation:
(1 + r) x (1 + i) = (1 + n)
We also know that r is 7.7%, i is 4%, and n is the nominal cost of capital:
(1 + 0.077) x (1 + 0.04) = 1 + n
1.077 x 1.04 = 1 + n
1.12008 = 1 + n
0.12008 = n
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The nominal cost of capital is therefore 12%. This is the rate already being used so
there is no change needed!
However, the impact of inflation needs to be factored in. This impacts the costs and
revenues. The quickest way to calculate this is to multiply the total relevant cash
flows by the inflation rate of 4%. This is represented in the first year by 1.04 and in
the second by 1.042 as this is two year’s worth of inflation (1.04 x 1.04) and so on.

£’000 £’000 £’000 £’000 £’000 £’000
Gross revenue 2,340) 3,250) 3,640) 3,900)
Direct costs (975) (1,430) (1,950) (2,080)
Marketing (220) (325) (260) (260)
Real cash flows 1,071) 1,421) 1,356) 1,486)
Inflation 1.04) 1.04) 1.04) 1.04)
Nominal cash flows 1,114) 1,537) 1,525) 1,738)
30% Tax 1 year in arrears
(real cash flow) (321) (426) (407) (446)
Tax saved 68) 51) 38) 92)
Resale/scrap value 4,000)
Working capital (234) (91) (39) (26) 390)
Net cash flows (5,269) 1,023) 1,245) 1,124) 5,759) (354)
Discount factor @ 12% 1.000) 0.893) 0.797) 0.712) 0.636) 0.567)
PV of future cash flows (5,269) 914) 992) 800) 3,663) (200)
And that is how inflation can impact the total net present value of a project!
22
6. Perpetuities
After looking at all the figures, the management accountant at Buzzing Batteries has
a thought. Yes, the project analysed throughout this chapter has a positive NPV (this
means undertaking the project will have a positive impact on the value of the
company). It does assume, however, that the company will sell the shops for
£4,000,000 in year 4. If this £4,000,000 figure were removed from the NPV calculation
above the NPV would be negative as it would dramatically reduce the present value
of year 4.
However, what if the shops were to remain open and keep generating revenue? The
shops, in theory, could remain open forever and keep generating revenue for Buzzing
Batteries.
There is a problem though: How would an accountant calculate this value? They
couldn’t just sit there and calculate a present value for every year from now until
forever… they’d be there, forever.
Luckily to for the accountant, there is a calculation they could perform to find the
value of a project in perpetuity (over an infinite lifetime). A caveat to remember
though, a perpetuity calculation relies on a constant and consistent cash flow
that continues forever. This means that the cash flow (all incoming and outgoings)
must be identical every single year. Any inconsistencies and it cannot be a perpetuity.
The present value (how much a future figure is worth in today’s money when
considering the time value of money – see section 2 for a recap if needed) of a
perpetuity is found using the following formula:
Cash flow
Present value =
r
Or
1
Cash flow x r
Where
r = the interest rate
23
1
r = the perpetuity factor.
Before we look at how perpetuities can help Buzzing Batteries to consider whether to
keep its shops or not, let’s work through a simple example to show how a perpetuity
is used.
Example
You have just won £10,000,000 on the lottery – congratulations! Despite the appeal of
spending it all on fast cars and an island in the Bahamas, you have wisely decided to
put some of it away to give you a guaranteed yearly income.
You decide that £240,000 per year would be a nice amount for a comfortable lifestyle.
After some research, you’ve found an account with a princely interest rate of 12%,
how much would you need to deposit there to ensure an annual return of £240,000?
Solution
This question is asking us to find the amount we need to pay into that account today,
in order to receive a set amount each year, forever. This means we have to find the
present value, and we know that the formula for this is:
Cash flow
Present value =
r
The cash flow (or the amount you want to receive per annum) is £240,000 and r or
the interest rate is 12%. Let’s put this all into our formula:
240,000
Present value = = £2,000,000
0.12
As we can see here, if you wanted to receive £240,000 per annum it would require an
initial investment of £2,000,000 into that account.
You’ve now got £8,000,000 left over from your winnings to spend on cars and houses.
Lucky you!
24
So that’s how it works for a lottery win for example, how can perpetuities translate to
Buzzing Batteries’s accounts to see if the company keeps the shops or not? Let’s take
a look at the figures:
The nominal discount rate is still 12% (this is the cost of capital the company uses to
account for the time value of money – it is the same discount factor used throughout
the running Buzzing Batteries example). As such:
1
= 8.33
0.12
This is the perpetuity factor used when the discount rate is 12%. The default
perpetuity factor assumes the perpetuity starts here and now (year 0) and continues
over an infinite lifetime.
The management accountant at BB estimates that revenue and costs (cash flow) will
remain consistent each year from year 4 (in the real world consistent cash flows are
unlikely – but it is assumed they are for the purposes of this example) and there will
be no further working capital requirements or capital allowance after Year 5.
What does this mean for the perpetuity? Perpetuities require a constant and
consistent cash flow and the default perpetuity factor starts at year 0. Can this
perpetuity begin at year 0? No, because cash flows are not consistent until year 4.
Can it begin in year 4 or 5? No, because there are accounting adjustments in year 5
(working capital and capital allowance). This is known as a delayed perpetuity.
This example is only constant and consistent from year 6 onwards, so the perpetuity
can only begin from this year. As such the perpetuity discount factor needs to be
adjusted to take this into account.
This is because the start date is 6 years from now. Discount factors from years 1-5
cannot be included because this would provide a result from year 0 and give an
overinflated present value for the perpetuity.
Looking back at the running example, the discount factors from years 1-5 at at a 12%
rate are (from years 1 to 5) 0.893, 0.797, 0.712, 0.636 and 0.567 respectively. These
discount are deducted from the perpetuity factor to provide the perpetuity factor
from year 6:
8.333 – (0.893 + 0.797 + 0.712 + 0.636 + 0.567) = 4.728
25
Therefore, 4.728 is the perpetuity factor from year 6 to infinity, so… Returning to
the running example (see sections 2-5 if you need to refresh your memory) this year 6
to infinity factor can be added in. Note, the £4,000,000 resale value has now been
removed as this resale value will not be received if the shops remain open.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

£’000 £’000 £’000 £’000 £’000 £’000 to
infinity
£’000
Land and (4,125)
buildings
Fittings and (910)
equipment
Gross revenue 2,340 3,250 3,640 3,900 3,900 3,900
Direct costs (975) (1,430) (1,950) (2,080) (2,080) (2,080)
Marketing (220) (325) (260) (260) (260) (260)
Office overheads (74) (74) (74) (74) (74) (74)
1,071 1,421 1,356 1,486 1,486 1,486
30% Tax 1 year in
arrears (321) (426) (407) (446) (446)
Tax saved 68 51 38 92
Resale/scrap
value
Working capital (234) (91) (39) (26)
Net cash flows (5,269) 980 1,129 955 1,117 1,132 1,040
Discount factor
@12% 1.000 0.893 0.797 0.712 0.636 0.567 4.728
PV of future cash
flows (5,269) 875 900 680 710 642 4,917
Net present value 3,455
As the perpetuity is only active from year 6, the values between years 0-5 still need to
be considered. In year 6 the consistent net cash flow ‘£1,040,000’ is multiplied by the
perpetuity value from year 6 to infinity ‘4.728’ giving the perpetuity a present value
of:
26
£1,040,000 x 4.728 = £4,917,000 (rounded to the nearest ’000).
The £4,917,000 is then added to the other present values from years 0-5 providing a
net present value of £3,455,000.
Meaning that undertaking this project and keeping a hold of the shops adds
£3,455,000 in value to the company. Significantly more than the £789,000 added to
the company by selling the shops at the end of year 4 (see running example from
sections 2-5). So, provided that the cash flow remains constant and consistent, BB will
generate more value by keeping hold of the shops!
This is an example of how using NPVs and perpetuities can help you (as the
management accountant) make decisions that benefit the business you work for!
7. Annuities
Last but not least in this chapter on NPVs we talk about annuities. This is another
method of calculating value over a period of time. Essentially an annuity is a financial
instrument which is purchased for an initial sum which then pays out the same
amount each and every year until a definitive end date.
For example, Emily purchases an annuity at a cost of £10,000 that pays her
£1,000 per year, every year, for the next 20 years. By the time the annuity has
finished she’ll have received £20,000 from it (£1,000 x 20). Twice what she paid
for it.
The payment will continue until the specified fixed period comes to an end or other
additional conditions stipulated within the policy occur, e.g. death of the owner.
Example
Emily advises her friend Jemima to take out an annuity – but Jemima is not quite as
good at maths as Emily and so is left feeling a little confused. There are two annuities
available to her:
• Annuity A will pay out £4,000 each year for 12 years
• Annuity B pays out £3,200 each year for 20 years
27
Both will involve the same initial purchase price. The first payout will be at the end of
the first year and it will continue regardless of whether she dies! If this unfortunate
event occurs, the payout from the annuity will move on to her next of kin.
If the rate of interest is 7% which one should she choose?
Jemima has come up against the problem of trying to figure out which one is best for
her. So, how do we compare them? We have another formula!
This is the cumulative discount factor formula:
1 1
( )
1
r - (1+r) n
Where:
r = interest rate
n = number of years the annuity will last for
Using this formula, we can help Jemima to compare both annuity options available to
her.
Annuity A:
Adding the interest rate of 7% into the formula we get:
1 1
0.07 ( 1-
(1 + 0.07)12 )
1
= 14.29 ( 1-
(2.252) )
= 14.29 x 0.556
= 7.945
28
Next we multiply this cumulative discount rate by the amount paid to calculate the
NPV:
£4,000 x 7.945 = £31,780
So the NPV is of Annuity A is £31,780.
Annuity B:
Now we need to repeat the process to calculate the NPV of annuity B. Returning to
the formula:
1 1 1
r ( - (1+r) n )
1 1
0.07 ( 1-
(1 + 0.07) 20 )
1
= 14.29 ( 1-
(3.87) )
= 14.29 x 0.741
= 10.594
£3,200 x 10.594 = £33,901
Therefore, based on the NPVs, Annuity B is the better option as it generates

more of a return overall. However, Jemima could still choose Annuity A if she
would prefer to have a larger annual payout for fewer years. She would receive
less money overall selecting this option though.
29

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CHAPTER 1

• Equity - Investment from owners/shareholders

• Debt – Money from lenders such as banks or bonds

• Retained earnings – Unspent/accumulated profits from prior periods

Strategic options are generated as part of the business strategy-setting process. As

• Internal rate of return (IRR) – This looks at an investment in terms of the

• Return on capital employed (ROCE) – This compares a company's capital

2. Net present value (NPV)

Therefore, NPV calculates an organisation’s change in wealth if it undertakes a

A project with a negative NPV shouldn’t be ruled out either. Sometimes, if

In summary, a project shouldn’t be automatically accepted just because it has a

Discounting and the time value of money

The timing of cash flows

Year 0 Year 1 Year 2 Year 3 Year 4

Again this is an understood assumption that ensures consistent treatment of inflows/

Example – basic NPV

Year 0 Year 1 Year 2 Year 3 Year 4

Cost of capital is 12%, so we can now calculate the NPV.

Year 0 Year 1 Year 2 Year 3 Year 4

Year 0 Year 1 Year 2 Year 3 Year 4

To find the present value for Year 1:

2,340 x 0.893 = 2,089.62

Year 0 Year 1 Year 2 Year 3 Year 4

(5,135) + 2,090 + 2,590 + 2,592 + 2,480 = 4,617

Example – NPV including relevant costs and scrap

Year 0 Year 1 Year 2 Year 3 Year 4

Year 0 Year 1 Year 2 Year 3 Year 4

Year 0 Year 1 Year 2 Year 3 Year 4

3. NPV and working capital

Year 0 working capital requirements

Year 0 Year 1 Year 2 Year 3 Year 4

Year 0 Year 1 Year 2 Year 3 Year 4

Mid-project working capital requirements

Final year working capital requirements

4. Tax in an NPV calculation

Example – NPV with working capital and tax

Year 0 Year 1 Year 2 Year 3 Year 4

• Working capital requirements are forecast to be 10% of revenue at the start of

• BB is charged corporation tax at 30%, It is collected one year in arrears

Year 0 Year 1 Year 2 Year 3 Year 4

Year 0 Year 1 Year 2 Year 3 Year 4

Year 0 Year 1 Year 2 Year 3 Year 4

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

We can now add this to our calculations:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Let's take a look at a slightly more complex example:

We start by calculating the year 1 capital allowance:

Year 1 capital allowance: £1,000,000 x 25% = £250,000

New balance = £1,000,000 - £250,000 = £750,000

Year 2 capital allowance: £750,000 x 25% = £187,500

New balance = £750,000 - £187,500 = £562,500

Year 3 capital allowance: £562,500 x 25% = £140,625

New balance = £562,500 - £140,625 = £421,875

Year 4 balancing allowance: Current balance - scrap value

£421,875 - £100,000 = £321,875

Year Capital allowances Tax savings (allowance x 30%)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5