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technical capital investment appraisal relevant to CAT Scheme Papers 4 and 10 cash ﬂow This article, on the subject of capital investment appraisal using discounted cash depreciation has been included in the profit estimates above, which should be assumed to cumulative depreciation each year, or even the discounted investment from the flow (DCF), is particularly relevant to CAT arise at each year end. previous year. students preparing for intermediate level Marks were given for the conclusion and Paper 4. It may also provide useful revision Required: justification, in Part b(ii), if consistent with for those opting to sit Paper 10. i Calculate the net present value (NPV) of the NPV in Part b(i). Most candidates, on the Question 1 in Section B of the recent the investment at a discount rate of 10% basis of their own figures, knew whether and December 2005 Paper 4 examination per annum (the company’s required rate of why the investment was worthwhile. Some required candidates to calculate the net return). candidates, however, failed to justify their present value (NPV) of a capital investment conclusion or did not understand the criteria project. Apart from awareness of the Discount factors at 10% are: for determining investment viability. discounting process, the key aspects of Year 1 0.909 Overall, candidates demonstrated an capital investment appraisal that this Year 2 0.826 almost universal lack of awareness, or a question tested were: Year 3 0.751 serious misunderstanding, of the discounted understanding the distinction between Year 4 0.683 cash flow capital investment appraisal process. cash flow and profit Year 5 0.621 awareness that it is cash flow (not profit) CASH FLOW AND PROFIT that is discounted in the evaluation of ii State, on the basis of your calculations, Referring to the question above, addition of capital investment viability whether the investment is worthwhile. the annual incremental profits/(losses) will ability to adjust profit figures to establish Justify your statement. indicate whether, before taking account of cost cash flows. of capital, the investment in new machinery is Examiner’s comments expected to generate income in excess of the This article uses Part (b) of the question, In answers to Part b(i) of Question 1, very few initial cost of the investment. Therefore: and the examiner’s comments on candidate candidates made any attempt to calculate the £000 performance, to highlight and explain aspects annual depreciation, and even fewer to adjust Year 1 (11) of this topic. profit for the depreciation calculated. Year 2 3 Those candidates who did adjust the Year 3 34 QUESTION annual profit figures given in the question Year 4 47 A company is considering an investment frequently deducted the depreciation rather Year 5 8 in new machinery. The annual incremental than adding it back. Also, in the calculation 81 profits/(losses) relating to the investment are of NPV, candidates were often careless, or estimated to be: seemingly unclear, as to whether values were Total profit before cost of capital is £81,000, £000 positive or negative. For example, the year 1 ie income exceeds the investment cost by Year 1 (11) loss was taken as positive not negative, and £81,000. The charging of depreciation is Year 2 3 there were frequent errors of sign with the a means of spreading the cost of the new Year 3 34 initial investment and with the total NPV. machinery over the asset’s life to enable the Year 4 47 Several candidates took the profit figures to be calculation of profit over shorter periods (eg Year 5 8 in £ rather than £000. per annum). Over the life of the machinery, It was also not uncommon for the inflows incremental profit will equal incremental cash Investment at the start of the project would to be completely ignored, with candidates flow. This can be demonstrated by adding be £175,000. The investment sum, assuming discounting some variant of the initial back depreciation (a non-cash flow item) to nil disposal value after five years, would be investment in each of the years. This tended profit in each year to establish the net cash written off using the straight-line method. The to be £175,000 in each year, £175,000 less inflows from the machinery investment. 48 student accountant April 2006 technical Depreciation is £35,000 per annum (initial ANSWER Those candidates who discounted each of the investment £175,000 ÷ five years) so cash The annual cash flows identified above need annual profit figures as above, and then simply flows relating to the machinery investment to be discounted, using the factors at 10% added them to get a total NPV of £55,100 are: provided in the question, in order to determine failed to correctly take account of the timing the NPV: of the investment (effectively assumed to be £000 £35,000 in each of years 1 to 5 rather than Year 0 (175) Year Cash Discount NPV £175,000 up front). Year 1 24 ((11) + 35) flow factor As a consequence, the value of the Year 2 38 (3 + 35) £000 10% £000 £000 investment project was overstated – less Year 3 69 (34 + 35) 0 (175) 1.000 (175.0) than the undiscounted total of £81,000 but Year 4 82 (47 + 35) 1 24 0.909 21.8 much higher than the true present value of Year 5 43 (8 + 35) 2 38 0.826 31.4 £12,700. 81 3 69 0.751 51.8 Other candidates discounted each of 4 82 0.683 56.0 the annual profit figures and added them Thus, total cash flow is also £81,000 but with 5 43 0.621 26.7 187.7 as above, but then deducted this total a different pattern compared with the annual 81 12.7 of £55,100 from the initial investment profits/(losses). of £175,000 to get a negative NPV of Discounted at a rate of 10% per annum, £119,900. These candidates effectively DISCOUNTED CASH FLOWS the present value of the expected cash double-counted the investment and thus It is the timing of the cash (not the profit) that inflows from the investment, at £187,700, significantly understated the value of the is important in capital investment appraisal. exceeds the £175,000 original investment. investment project. Cash outflows are outflows of money which The net cash flow of £12,700 (£187,700 Those candidates who did adjust for have been provided to a business by investors, minus £175,000) is significantly less depreciation, but did this incorrectly by and on which a return on investment is than the undiscounted net cash flow of deducting it from (rather than adding it to) required while it remains invested. The sooner £81,000 due to the time value of money. the profit figures, effectively charged again for the cash is recovered the greater will be its The investment in new machinery is the cost of the investment. equivalent present value, and the better the nevertheless worthwhile, given that 10% As stated previously, many candidates return on the investment will be. is the company’s required rate of annual confused positive and negative values, either DCF involves the application of return, because the NPV is positive when in the discounting process with the year 1 discounting arithmetic to the estimated future the incremental cash flows are discounted at loss, or with the final NPV. cash flows from a capital investment project, this rate. For example, many candidates who in order to decide whether the project is double-counted the investment showed expected to earn a satisfactory rate of return. EXAMINATION ERRORS the NPV of £119,900 to be positive and Using the NPV method of DCF, the cost Most candidates in the December 2005 concluded (correctly on the basis of ‘own of capital which represents the minimum Paper 4, Accounting for Costs examination figures’) that the investment in machinery acceptable rate of return on investment is used seemed to know how to use discount factors was worthwhile. Some candidates were as the discount rate, in order to calculate the to arrive at present values. However, as less clear on the meaning of the resulting NPV of the cash inflows and outflows. The NPV already previously noted in the examiner’s present value, especially where there was method provides an absolute measure of the comments earlier in this article, the vast confusion as to whether values were positive cash surplus or deficit in present value terms majority of candidates discounted the wrong or negative. (as opposed to the internal rate of return (IRR) figures (ie profit rather than cash flow). method – not covered in this article – which Therefore: CONCLUSION provides a relative measure of project worth). Candidates need to appreciate the The profitability of a capital investment Year Cash flow Discount factor NPV significance of cash flow in capital investment project using NPV is determined by the £000 10% £000 appraisal and the distinction between profit relationship between the total present value of 1 (11) 0.909 (10.0) and cash flow. They also need to give more the net cash inflows and the present value of 2 3 0.826 2.5 thought to the discounting process and to the cash invested in the project, ie whether the 3 34 0.751 25.5 the meaning and significance of the resulting NPV is positive or negative. The decision rule, 4 47 0.683 32.1 calculations. using the NPV method of appraisal, is to invest 5 8 0.621 5.0 if NPV > 0 (ie positive). 81 55.1 Nigel Coulthurst is examiner for CAT Paper 4 50 student accountant April 2006