ACCA paper f9 financial management study materials F9FM session03 d08

Ü To assess an investment using the payback period and the ARR methods... 2.1 Definition The time it takes for the operating cash flows from a project to pay back the initial investment

OVERVIEW

Objective

Ü To understand the type of investment decisions that will be made by organisations

Ü To assess an investment using the payback period and the ARR methods

TYPES OF

EXPENDITURE

PAYBACK

INVESTMENTS

Ü Capital

Ü Revenue

Ü Investment decisions

Ü Definition

Ü Possible Improvements

Ü Advantages

Ü Disadvantages

EVALUATION

Ü Definition

Ü Calculation

Ü Advantages

Ü Disadvantages

1 TYPES OF EXPENDITURE

1.1 Capital

Ü Capital expenditure (CAPEX) refers to the purchase of non-current (fixed) assets or their improvement;

1.2 Revenue

Ü Revenue expenditure is incurred to maintain non-current assets e.g repairs

1.3 Investment decisions

Ü Decisions about which non-current assets should be acquired

Ü Also referred to as project appraisal, investment appraisal or CAPEX analysis

2.1 Definition

The time it takes for the operating cash flows from a project to pay back the

initial investment

Decision rule

If payback period < target ACCEPT

If payback period > target REJECT

Illustration 1

Annual cash flows (before depreciation but after tax) $0.3m

Solution

Payback period =

0.3 1.4 = 4.7 years (or five years if cash flows are assumed to arise at year ends.)

2.2 Possible Improvements

2.2.1 Discounted payback period

Ü First discount the cash flows to present value and then calculate the payback period

Ü This takes into account the time value of money

2.2.2 Bail-out factor

Ü This takes into account the estimated scrap/disposal value of the asset if the project is

abandoned early

2.3 Advantages of payback

X Simple to calculate

X Easy to understand

X Concentrates on earlier flows:

̌ more certain;

̌ more important if firm has liquidity concerns

2.4 Disadvantages of payback

W Ignores cash flows after payback period;

W Target period is subjective;

W Gives little information about change in shareholder wealth

W Unless flows are discounted, time value of money is ignored

3.1 Definition

The earnings of a project expressed as a percentage of the capital outlay or

average investment

Ü Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI)

3.2 Calculation

Ü This is a financial accounting measure based on the income statement and statement of financial position

Ü It includes:

Ü Calculated as

investment Initial

profit operating annual

Average

× 100

OR

investment Average

profit operating annual

Decision rule

If ARR > target ACCEPT

If ARR < target REJECT

Example 1

Operating cash flows:

Required:

Calculate ARR on

(i) Initial investment

(ii) Average investment

3.3 Advantages

X Uses readily available accounting information;

X Simple to calculate and understand;

X Often used by financial analysts to appraise performance

3.4 Disadvantages

W Different methods of calculation may cause confusion;

W Based on profits rather than cash Profits are easily manipulated by accounting policy

W Ignores time value of money;

W Target rate is subjective;

W A relative measure (%) – gives little information about the absolute change in

shareholders’ wealth

Example 2

A project being considered would require a machine costing $80,000 Market

research of $8,000 has already been carried out and has been capitalised The

result is that the project is expected to last for six years and produce net cash

earnings of $20,000 for each of the first three years and then $15,000 for each of

the last three years The anticipated scrap proceeds of the machine at various

stages in its life are as follows:

After year 1 $40,000

After year 2 $30,000

After year 3 $20,000

After year 4 $13,000

After year 5 $10,000

After year 6 $4,000

Required:

Evaluate the project using

(a) ARR

(b) ARR using the average investment approach

(c) payback period

(d) payback period incorporating the bail-out factor

You may assume that cash flows arise evenly during the year

Solution

(a)

(b)

(c)/ (d)

Time Flow Cumulative

flow Scrap Net cumulative flow

0

1

2

3

4

5

6

(88,000) 20,000 20,000 20,000 15,000 15,000 15,000

40,000 30,000 20,000 13,000 10,000 4,000

Payback period with bail-out =

Key points

Ð Payback and ARR are commonly used in practice However neither

method informs management of the absolute change in shareholders’

wealth due to a particular project

ÐAs well as being able to calculate payback and ARR it is therefore vital that

you can also explain why they are not acceptable methods of project

appraisal

FOCUS

You should now be able to:

Ü define and distinguish between capital and revenue expenditure;

Ü calculate payback and assess its usefulness as a measure of investment worth;

Ü calculate ARR and assess its usefulness as a measure of investment worth

EXAMPLE SOLUTIONS

Solution 1

Average annual profit

5 17 4

180 250 years

project of

No

on depreciati Total

flows

cash

Average investment

110 2

20 200 2

value Scrap + investment

=

ARR on initial investment 100 8.75%

200

5

5 17

Solution 2 — ARR and Payback

(a) ARR

Average annual earnings =

6

15,000) 3

20,000

= $17,500

Average annual depreciation =

6

000 , 4 8,000 +

= $14,000

000 , 88

000 , 14 17,500 − = 4%

(b) Average investment =

2

000 , 4 88,000 + = $46,000

000 , 46

000 , 14 17,500 − = 7.6%

(c)/ (d)

Time Flow Cumulative

flow Scrap Net cumulative flow

0

1

2

3

4

5

6

(88,000) 20,000 20,000 20,000 15,000 15,000 15,000

(88,000) (68,000) (48,000) (28,000) (13,000) 2,000 17,000

40,000 30,000 20,000 13,000 10,000 4,000

(88,000) (28,000) (18,000) (8,000)

− 12,000 21,000

Payback period = 41513 years

Payback period with bail-out = 4 years