Investment Appraisal
ACCA Director 
Investment Appraisal
Investment Appraisal
The nature of investment decisions
An investment decision into setting up a factory may involve purchasing non-current assets such as factories and land as well as working capital such as inventories. These are included in the capital budget.
Stages of capital investment decision-making process:
- Identifying investment opportunities arising from strategic choices.
- Checking investment proposals which fit the strategy.
- Evaluating investment proposals using different appraisal techniques.
- Approving investment proposals by the management.
- Implementing and reviewing investments.
Exam rehearsal question: PV Co is evaluating an investment proposal to manufacture Product W33, which has performed well in test marketing rials conducted recently by the company’s research and development division. The following information relating to his investment proposal has now been prepared. Required: Identify and explain the key stages in the capital investment decision-making process, and the role of investment appraisal in this process. (7 marks) Comment: Identifying investment opportunities: Investment opportunities could arise from the analysis of strategic choices or legal requirements. The key requirement is that investment proposals should help achieve organisational objectives. Checking investment proposals: Different projects may require different investments with different returns, ie some are risky with fewer returns while some are less risky with higher returns. Therefore, it is vital for businesses to choose projects which fit the strategy with the most appropriate use of resources. Evaluating investment proposals: Potential investment opportunities need to be evaluated to determine which offer the most attractive opportunities to achieve organisational objectives, ie to maximise shareholder wealth. This is the stage where investment appraisal plays a key role, ie which investment proposals have the highest net present value. Approving investment proposals: The most suitable investment proposals are passed to the relevant level of authority for consideration and approval. Very large proposals may require approval by the board of directors, while smaller proposals may be approved at divisional level, and so on. Once approval has been given, implementation can begin. Implementing and reviewing investments: Time required to implement the investment proposal will depend on its size and complexity, and is likely to be several months. Following implementation, the investment project must be reviewed to ensure that the expected results are being achieved and for future improvements. Tutorial note: only 7 points are required. |
Non-discounted Techniques
Sketch:
Non-discounted techniques do not consider the time value of money effect when appraising projects. Techniques include ARR and payback period.
Accounting Rate of Return (ARR)
Calculation: ARR = AAP (Annual Average Profit) AI (Average Investment) Other names: Return on capital employed (ROCE) / Return on Investment (ROI) Where:
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Decision criteria:
- Project ARR > Target ARR: accept the project.
- Project ARR < Target ARR: reject the project.
Exam rehearsal question:
The research and development division has prepared the following demand forecast as a result of its test marketing rials.
No terminal value or machinery scrap value is expected at the end of four years. A target return on capital employed of 30% per year is set. Required: Calculate the return on capital employed (accounting rate of return) based on average investment and comment on whether the project should be accepted based on this criteria. (4 marks) Comment:
Calculation of income:
Calculation of operating costs:
Calculation of return on capital employed:
Conclusion: The project should not be undertaken as the ROCE of this project is less than the target one of 30%. |
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Disadvantages |
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Case study – ROCE of Shell
Over the years, the oil company Royal Dutch Shell plc (Shell) has over-invested in unconventional natural gas and oil projects leading to a fall in its group’s ROCE. Current liabilities account for 19% of its total assets, and this means an increase in short term liabilities such as paying suppliers late would not necessarily affect its ROCE that much. However, an impairment on some projects in the US would be very likely to improve ROCE in the future.
Payback Method
This method computes the length of time it takes for cash inflows from trading to pay back the initial investment.
Decision criteria:
- Project payback > Target payback: reject the project.
- Project payback < Target payback: accept the project.
Exam rehearsal question: The following information relates to an investment project which is being evaluated by the directors of Fence Co, a listed company. The initial investment, payable at the start of the first year of operation, is $3·9 million.
What is the payback period of the investment project?
Comment:
Payback period = 2 years + 1,200/1,600 = 2.75 years |
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Disadvantages |
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Case study - Next
Next is a UK high street retailers with 499 stores across the country. Due to the shift towards online shopping, Next has been planning to close some of its loss-making stores. However, landlords are under hard pressure and offer rent reduction on lease renewal (in 2019, around 28%). Next expects the payback period of its new store to be less than two years.
Discounted cash flows (DCF) techniques
Time value of money concept
As time goes by, the value of money received decreases compared to money received now. There are three reasons for this.
- Opportunity cost – sacrificed gains from giving up the opportunity to receive money now.
- Default risk – there is an increased default risk from the counterparty if money is received later.
- Inflation –price to pay for the same goods or services may increase in the future due to the effects of monetary policies.
The fundamental reason that the interest is charged is because of the ‘opportunity cost’ reason.
Compounding and discounting
Calculation (Compound): Future value (FV) = Present value (PV) x (1 + r) n Example: Calculate terminal sum of $1,000 invested at 10% per annum over three years. Comment: FV = 1,000 x (1 + 0.1)3 =1,331 |
Calculation (Discount): PV = FV x 1/(1 + r)n or PV = FV x Discount Factor Example: Calculate present value of $1,331 invested at 10% per annum over three years. Comment: PV = $1,331 / (1 + 0.1)3 = $1,000 |
Calculation (Annuities): PV = Annuities x Annuity factor Example: Calculate present value of $1,000 received every year for 3 years if interest rate is 10%, starting in Year 1. Comment: PV = $1,000 x 2.487 = $2,487 |
Calculation (Advanced annuities): PV = Annuities x (1+Annuity Factor) Example: Calculate present value if the first cash flow takes place immediately and cash flow would last for 3 years. Comment: PV = $1,000 + $1,000 x AF (1-2 years) =$1,000 + $1,000 x 1.736 = $2,736 |
Calculation: Delayed annuities: for example, a 4-year project with the first cash flow starting in three years’ time: PV = Annuities x Annuity factor (4 years) x DF (year 2) Example: What is present value of $1,000 incurred each year for four years, starting in three years’ time, if discount rate is 5%? Comment: PV = $1,000 x AF (4 years at 5%) 3.546 x DF (2 years at 5%) 0.907 = $3,216 |
Calculation (Perpetuities): PV = Perpetuities x Perpetuity factor (1/r) Example: Calculate present value of $100,000 received in perpetuity if interest rate is 10%. Comment: PV = $100,000 x 1/10% = $1,000,000 |
Calculation: Growing perpetuities: PV = Perpetuities x Perpetuity factor (1/r-g) Example: Calculate present value of $100,000 received in perpetuity if interest rate is 10%, and cash flow grows by 2% per year. Comment: PV = Perpetuities x 1/(r-g) = $100,000 x 1/(0.1-0.02) = $1,250,000 |
Calculation: Advanced perpetuities: PV = Perpetuities x Perpetuity factor (1 + 1/r) Example: Calculate present value of $100,000 received in perpetuity if interest rate is 10%. Assume cash flows start immediately. Comment: PV = $100,000 x (1 + 1/10%) = $1,100,000 |
Calculation: Delayed perpetuities: for example, a project with the first cash flow starting in three years’ time: PV = Perpetuities x Perpetuity factor (1/r) x DF year 2 Example: Calculate present value of a perpetuity of $3,000 starting in 6 years’ time, growing at 3% per year and discount rate is 10%. Comment: PV = ($2,000 x 1/(0.1 – 0.03) ) x DF (year 5 at 10%) 0.621 =$17,741 |
Relevant cash flows
Relevant cash flows are future, incremental cash flows.
- Variable and fixed costs as a result of the investment decision are relevant cash outflows. Examples - extra variable costs, incremental fixed costs, and tax paid from balancing charge (tax gains when non-current assets are disposed of).
- Extra contribution and sales revenue as a result of the investment decision are relevant cash inflows. Examples - extra contribution, extra sales revenue, tax savings on depreciation, and tax savings from balancing allowance (tax losses when non-current assets are disposed of).
- Fixed costs incurred irrespective of the investment decision goes ahead are irrelevant cash outflows. Example - sunk costs.
- Interest expenses are not considered to be relevant cash flows as these are included in the discount factor calculation.
Exam rehearsal question Tao Co is considering investment in plant that would cost $600,000 and would be scrapped after six years for $15,000. Depreciation will be charged on a straight-line basis. Fixed costs will increase from $30,000 to $37,000 per year as a result of this investment. The additional contribution generated by the plant will be $225,000 each year after subtracting depreciation. All cash flows occur at the end of the year with the exception of the initial investment which occurs immediately. What is the relevant net cash flow for project appraisal at the end of the first year? Comment: $315,500 Additional fixed costs – cash outflows: $(7,000) Additional contribution + Depreciation (non-cash): $225,000 + ($600,000-$15,000)/6 years = $322,500 |
Net Present Value (NPV)
Sketch:
NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
- Step 1: Add up all the present values
- Step 2: Deduct initial investment
Decision rule:
- NPV > 0 - Accept the proposed project
- NPV < 0 - Reject the proposed project
- NPV = 0 – The proposed project is breakeven
Tutorial note: In every NPV exam question, decision rule must be stated at the end of the question.
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Disadvantages |
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Exam rehearsal question The directors of Pelta Co are considering a planned investment project costing $25m, payable at the start of the first year of operation. The following information relates to the investment project. This information needs adjusting to take account of selling price inflation of 4% per year and variable cost inflation of 3% per year. The fixed costs, which are incremental and related to the investment project, are in nominal terms. The year 4 sales volume is expected to continue for the foreseeable future. Pelta Co pays corporation tax of 30% one year in arrears. The company can claim tax-allowable depreciation on a 25% reducing balance basis. The views of the directors of Pelta Co are that all investment projects must be evaluated over four years of operations, with an assumed terminal value at the end of the fourth year of 5% of the initial investment cost. The NPV analysis of the project is as follows:
Required: Critically discuss the views of the directors on Pelta Co’s investment appraisal. (4 marks) Comment: Evaluation period: Sales are expected to continue beyond year 4 and so the view of the directors that all investment projects must be evaluated over four years of operations does not seem sensible. The investment appraisal would be more accurate if the cash flows from further years of operation were considered. Assumed terminal value: The view of the directors that a terminal value of 5% of the initial investment should be assumed has no factual or analytical basis to it. Terminal values for individual projects could be higher or lower than 5% of the initial investment and in fact may have no relationship to the initial investment at all. A more accurate approach would be to calculate a year 4 terminal value based on the expected value of future sales. |
Taxation effects of relevant cash flows
Timing of tax:
- Tax is paid in the current year – include tax payment in the current year
- Tax is paid one year in arrears – include tax payment in the next year
Exam approach:
Tutorial note: Cash flows are ‘depreciation x tax rate’ not ‘depreciation’ itself because depreciation reduces profits before tax, and there is where tax could be saved. |
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Incremental cash flows to be included in the NPV analysis:
- Tax paid on cash profits - outflows
- Tax savings on tax depreciation* on non-current assets - inflows
- Tax savings on tax depreciation (balancing allowance) when non-current assets are sold – inflows
- Tax paid on tax depreciation (balancing charge) when non-current assets are sold – outflows
* Tax depreciation is commonly known as capital allowance in tax terms.
* Balancing charge or allowance – to compare sale proceeds of the non-current assets with their carrying value (known as tax written down value)
Calculation of depreciation:
Depreciation expense = (Cost – Residual value) / number of years
Depreciation expense = % x Carrying value Carrying value = Cost – Accumulated depreciation |
Calculation:
In the exam, it is assumed the value of non-current assets at the end of their useful lives is zero and therefore, the whole remaining capital allowance would be treated as balancing allowance. |
Exam rehearsal question: An extract of the NPV analysis is done on a three year project.
Required: Complete the above NPV analysis extract if –
Comment: 1. Tax rate is 30% payable one year in arrears:
2. Tax rate is 30% paid in the current period:
3. Tax depreciation on the non-current assets is on a straight line basis for 5 years. Assuming tax is paid one year in arrears.
4. Tax depreciation on the non-current assets is at a reducing balance rate of 20%. Assuming tax is paid one year in arrears.
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Calculation:
Example: The discount rate is 5%. Required: Calculate the adjusted discount rate if the tax rate is 30% and 0%. Comment: 5% x 70% = 3.5% or 5%. Dive deeper, conquer those exams, and truly make your mark by grabbing your spot in our ACCA online course today at www.globalapc.com – let’s crush this together! |
Categories: : Financial Management (FM)