ACCA F9 Lecture 2

7/27/2019 ACCA F9 Lecture 2

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ACCA PAPER F9FINANCIAL MANAGEMENT

LECTURE 2


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INVESTMENTAPPRAISAL

ROCE

Payback

Net present value

Internal rate of return


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CHAPTER 7


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CAPITAL BUDGETING PROCESS

Capital expenditure is often expensive and requirescareful analysis. The main stages in the capitalbudgeting process are:


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ROCE


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LECTURE EXAMPLE 1


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RELEVANT CASH FLOWS

Only the cash flows affected by the decision to investshould be taken into account when appraisinginvestments, these are called relevant costs.

Only consider future, incremental cash flows

Ignore:

sunk costs

Committed costs

Depreciation

Interest & dividend payments

Include opportunity costs


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RELEVANTCASHFLOWS


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LECTURE EXAMPLE 2


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PAYBACK

This is a measure of how many years it takes for the cashflows affected by the decision to invest to repay the cost ofthe original investment. A long payback period isconsidered risky because it relies on cash flows that are inthe distant future.


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PAYBACK


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LECTURE EXAMPLE 3


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CAPTURE SUMMARY

Capital Expenditure is often expensive and requirescareful analysis.

Neither ROCE nor payback are adequate methods ofappraising capital investments by themselves; the mainproblem with both methods is that they ignore the timevalue of money. Both methods are useful complements tothe more sophisticated methods that are looked at in thenext chapter.


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CHAPTER 8


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THETIMEVALUEOFMONEY

Money received today is worth more than the same sumreceived in the future because of:

The potential for earning interest

The impact of inflation

The effect of risk Many projects involve investing money now and receiving

returns on the investment in the future; so the timing of aprojects cash flows need to be analysed to see if theyoffer a better return than the return an investor could get

if they invested their money in other ways. The process of adjusting a projects cash flows to reflect

the return that investors could get elsewhere is calleddiscounting.


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LECTURE EXAMPLE 1


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COMPOUNDING

Compounding calculates the future value of a givensum of money

FV = PV (1 + r)n

where FV = future value after n periods

PV = present or initial value

r = rate of interest per period

n = number of periods


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DISCOUNTING

Discounting is the conversion of future cash flows totheir present value


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ANNUITIESANDPERPETUITIES

An annuity is a constant annual cash flow for anumber of years


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LECTURE EXAMPLE 2

1. What is the present value of $1,000 incontribution earned each year from years 1-10,when the required return on investment is 11%?

2. What is the present value of $2,000 costsincurred each year from years 3-6 when the costof capital is 5%?


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An perpetuity is an annual cash flow that occurs forever


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LECTURE EXAMPLE 3

An organisation with a cost of capital of 14% isconsidering investing in a project costing $500,000.The project would yield nothing in Year 1, but fromYear 2 would yield cash inflows of $100,000 per

annum in perpetuity.

Required

Assess whether the project should be undertaken.


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NETPRESENTVALUE

All future cash flowsare discounted to theirpresent value and thenadded

A positive resultindicates the projectshould be accepted

A negative result and

the project should berejected


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LECTURE EXAMPLE 4

A machine will cost $80,000

It has an expected life of 4 years with an anticipated scrapvalue of $10,000.

Expected net operating cash inflows each year are as follows:

1.20,000

2.30,0003.40,000

4.10,000

The cost of capital is 10% p.a.

Calculate the Net Present Value of the investment anddetermine whether or not it should be accepted. whatreservations might you have about your investmentdecision?


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LECTURE EXAMPLE 5

LCH manufactures product X which it sells for $5 per unit.Variable costs of production are currently $3 per unit, fixed costs50c per unit. A new machine is available which would cost$90,000 but which could be used to make product X for a variablecost of only $2.50 per unit. Fixed costs, however, would increase

by $7,500 per annum as a direct result of purchasing themachine. The machine would have an expected life of 4 yearsand a resale value after that time of $10,000. Sales of product Xare estimated to be 75,000 units per annum. LCH expects to earnat least 12% p.a. from its investments. Ignore taxation.

You are required to decide whether LCH should purchase themachine.


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INTERNAL RATE OF RETURN

One problem in practice with using a Discounted CashFlow approach to investment appraisal is that it isvirtually impossible to calculate accurately the Cost ofCapital for a company.

Because of the uncertainty regarding the Cost of Capital

it would be useful to know the breakeven rate of interesti.e. the rate of interest at which the project would have anNPV of zero.

he rate of interest at which the NPV of the project is zerois known as the Internal Rate of Return (IRR).

In order to estimate the IRR, we calculate the NPV of theproject at two different rates of interest and estimate arate giving an NPV of zero assuming linearity.


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INTERNAL RATE OF RETURN

3 Step Approach

Step 1 calculate the NPV of the project at 5%If for example the NPV is +, we know that the project gives>5% return

Step 2 calculate the project at 10%

If for example the project is negative we know that theproject gives


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INTERNALRATEOFRETURN

The rate of interest (discount) at which the NPV = 0


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LECTURE EXAMPLE 6

A company is trying to decide whether to buy amachine for $80,000 which will save costs of $20,000per annum for 5 years and which will have a resalevalue of $10,000 at the end of year 5. If it is the

companys policy to undertake projects only if theyare expected to yield a DCF return of 10% or more,ascertain whether this project should be undertaken.


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NPV OR IRR?

Both NPV and IRR are superior methods forappraising investments compared to thetechniques covered in the previous chapterbecause:

they account for the time value of money (unlike ROCE andpayback)

they focus on relevant cash flows (unlike ROCE)

they look at the cash flows over the whole life of the project(unlike payback)

By examining the advantages and disadvantagesof IRR (NPV has the opposite pros and cons) asa DCF technique, it can be shown that NPV isthe superior technique.


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INTERNALRATEOFRETURN


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DISADVANTAGES OF IRR


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NPV A BETTER TECHNIQUE

NPV does not have any of the problems of IRR. The roleof IRR is to act as a tool for explaining the benefits of aninvestment to non-financial managers; it should not beused as the financial analysis used to justify the

investment decision.

This is not to say that NPV is perfect; like any financialtechnique, there is the danger that the non-financial

benefits of an investment are ignored.


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SUMMARY

Capital expenditure is often expensive and requires

careful analysis .

Payback is a useful device for screening risky projects,

but NPV is the best method for the financial analysis of aproject. IRR is useful for explaining the benefits of aproject to non- financial managers. ROCE is only usefulfor picturing how an investment might impact on a firmsfinancial statements.


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TUTORIAL

1. A machine will cost $45,000 and is expected to generate

$8,000 for each of the following 8 years. he cost ofcapital is 15% p.a. Calculate the NPV of the investment.

2. The cost of capital is 12% p.a. What is the present valueof $20,000 first receivable in 4 years time and thereafter

each year for a total of 10 years?3. A machine costs $100,000 and is expected to generate

$12,000 p.a. in perpetuity. The cost of capital is 10% p.a.What is the NPV of the project?

4. The rate of interest is 5%. p.a. What is the present value

of $18,000 first receivable in 5 years time and thereafterannually in perpetuity?


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TUTORIAL

For the project in Lecture Example 4:a) Calculate the NPV of the project at an interest rate of 15%

b) Estimate the IRR of the project using your results from part(a) and from Example 4.

c) Interpret the result of (b).

Exam Bank Question 11 - Mazen

ACCA F9 Lecture 2

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