Investment appraisal - Further aspects

PAYBACK PERIOD

 The time a project will take to pay back the money spent on it.

 Based on expected cash flows provides a measure of liquidity and risk

 Unlike discounting techniques, it assumes cash flows occur evenly during the year

1. IF PAY BACK PERIOD IS QUICKER THAN COMPANY’S MAXIMUM RETURN TIME,

PROJECT SHOULD BE ACCEPTED.

2. IF FACED BY MUTUALLY EXCLUSIVE PROJECTS, CHOOSE THE ONE WITH QUICKEST

PAY BACK PERIOD.

CALCULATION:

  1. Constant annual cashflows

Pay back period = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛t / 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

  1. Uneven annual cash flows: Add the inflows and deduct from investment until the sum equals or exceeds the investment

To convert the answer into years and months, multiply decimal point by 12.

If the sum of inflows exceeds the investment, find the number of years and months by pro-rata calculation

Advantages:-

  1. Simple to understand

  2. Selection on payback period basis reduces risk ofliquidity problems

  3. Uses cash flows and not accounting profits

  4. Emphasises cash flows in earlier years

Disadvantages:-

  1. Not a measure of absolute profitability

  2. Ignores TVM (Discounted payback period maybe used to consider TVM)

  3. Doesn’t take into account the cash flows beyond the payback period as an investment appraisal technique

ACCOUNTING RATE OF RETURN

ARR = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

 Annual average profit is after depreciation

 Average annual profit = net cash flow – depreciation

 Average value of investment = (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡+𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒) / 2

1. If ARR > targeted returns, accept project

2. Choose project with highest ARR

Advantages

  1. Simple to understand

  2. Widely used and accepted

  3. Considers the whole life of projects

Disadvantages

  1. Not a measure of absolute profitability

  2. Ignores TVM

  3. Doesn’t consider cash flows, uses subjective accounting profits including depreciation

  4. Not a measure of absolute profitability

  5. Not reliable

DISCOUNTED PAYBACK

 Cash flows are discounted to present value and then the same process is followed as that of calculating normal payback period.

 Thus overcomes the criticism of not considering TVM.

DEALING WITH TAXATION

Effects of tax on in investment appraisal

Assumption :

1. Taxable profits = Net cash flow - Tax depreciation

2. Half corporation tax is paid in current year and the other half in next year (Check question in exam)

3. Taxation is relevant cost

4. If there are tax losses, it is adjusted against some other project where there is surplus

Types:-

  1. Corporation tax

  2. Impact of tax

Impact:-

  1. Tax depreciation is a deductible alternative to depreciation. It reduces the tax payable > The tax depreciation is not a cash flow and to calculate the tax impact we have to multiply each year’s tax depreciation by the corporation tax rate. The effect of tax depreciation is on the amount of tax payable, which is the relevant cash flow.

  2. Project cash flows reduced by tax payable

TAX DEPRECIATION:-

 Tax depreciation is used to reduce taxable profits, and the consequent reduction in a tax payment should be treated as a cash saving arising from the acceptance of the project.

 In this examination tax depreciation is generally allowed on the cost of plant and machinery at the rate of 25% on a reducing balance basis

 It may also be possible to claim tax depreciation on the costs of installation

Balancing allowance / charge:-

 For example, if a business buys equipment for $100,000 in Year 0 and disposes of it in Year 5 for $20,000, it will receive tax relief on the net cost of $80,000. If the rate of corporation tax is 30%, the reduction in tax payments over the five years would be 30% × $80,000 = $24,000.

 Balancing allowances are given as a final deduction to ensure the full fall in value has been allowed. Balancing charges occur where the total tax depreciation claimed exceeds the fall in value of the asset. The excess claimed is treated as a taxable amount in the year of disposal.

Timings of tax savings associated with tax depreciation:-

 The benefit of tax saved because of tax depreciation is received when the corporation tax should have been paid.

 Assets are assumed to be bought at T0

 It should be assumed that asset is bought at the start of the accounting period and therefore the first tax depreciation is offset against the year 1 net cash flows

WORKING CAPITAL

 Treated as investment in the beginning of the project

 Change in WC treated as cash flow

 WC doesn’t qualify for tax relief

 At the end of the project, WC is released and it treated as inflow

INFLATION IN CASH FLOWS

 If there is inflation, it can either be adjusted in cash flows or in cost of capital

 Cash flows not adjusted for inflation are called current/ real cash flows

 Cash flows adjusted for inflation are called money/ nominal cash flows

 Cash flows given in exam are money cash flows unless states otherwise

 Read question carefully determine in what terms are the cash flows given. If they are given in current terms, they need to be increased with the inflation rate. Sometimes, they may be given in first year term and only the cash flows from 2nd year need to be inflated.

Methods of dealing with inflation:-

(Remain consistent in method)

  1. Real method: Do not inflate cash flows, leave them in real terms. Discount using real rate. Real/ real

  2. Money/ nominal method: Inflate cash flow using inflation rate, make

    them money flows. Discount using money rate. Money/ money

Nominal rate: Inflation not adjusted

Real rate: Inflation adjusted

Formula of real rate of return: (1+r) = (1+𝑚) / (1+𝑖)

r is real rate of return, m is money cost of capital, i is inflation

  1. It is easier to use one real rate in exam rather than inflating all cash flows to money terms

  2. In perpetuities, real rate method is the only method

  3. Inflation may not affect all the costs at the same time. If separate inflation rates for separate costs are given, real rate method cannot be used.

Types of inflation:-

  1. Specific inflation rate: Impacts each cash flow

  2. General rate of inflation: Impacts investor's overall required rate of return. Investors in the project need compensation for lost purchasing power which affects everything

When to use real/ money method:-

  1. When there is one rate of inflation: a) Real cashflows - real method b) Nominal cashflow - nominal method

  2. When there is more than one rate of inflation: Money / nominal method

Like inflation, there can also be deflation due to various economic or organisational reasons.

DEALING WITH BOTH INFLATION AND TAX IN THE SAME QUESTION:-

Questions with both tax and inflation are best tackled using the money method.

 Inflate costs and revenues, where necessary, before determining their tax implications.

 Ensure that the cost and disposal values have been inflated (if necessary) before calculating tax

depreciation.

 Always calculate working capital on these inflated figures, unless given.

 Use a post-tax money discount rate

CAPITAL ASSET REPLACEMENT DECISIONS - Decision to replace capital assets

Decisions to consider:-

  1. Mutually exclusive projects with unequal lives: In order to compare machines with different lives, their costs need to be annualized.

    a) Formula: Equivalent annual cost = 𝑃𝑉 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 / 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 𝑛

    b) LCM method: This is where we find the smallest number, which we can divide into by each of a set of numbers and evaluate the NPV cost over this period.

  2. Optimum replacement cycle: With increased age, machine's maintenance cost increases, residual value decreases. Hence, optimum time to replace them must be found.

Factors to consider under Optimum replacement cycle:-

1. Capital cost of new equipment

2. Operating costs

3. Resale value

4. Taxation and subsidies

5. Inflation

Steps to calculate Optimum replacement cycle:-

  1. Consider each possible replacement cycle - year 1, year 2, etc

  2. Calculate equivalent annual cost

  3. Select cycle with lowest cost