technical capital investment appraisal relevant to CAT Scheme Papers 4 and 10 cash flow This article on the subject of capital by apr33488

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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

								
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