CIMA Paper P2 Advanced Management Accounting Ian Kusano and Nathi - - PowerPoint PPT Presentation

CIMA Paper P2 Advanced Management Accounting

Ian Kusano and Nathi Thela

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Chapter Further Aspects of Investment Appraisal

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Chapter Content

Advanced Areas Relevant Cash Flows Risk Sensitivity Analysis Capital Rationing Inflation Taxation Replacement Decisions

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Uncertainty and Risk

• Add premium for risk
• Payback period
• Sensitivity charts
• Probability distribution

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Sensitivity Analysis

Sensitivity Margin = NPV PV of Flow Under Consideration

Sensitivity analysis in NPV questions typically involves posing ‘what if’ questions. The NPV is recalculated under different conditions, e.g. what would happen if demand fell by 10%, how would the result be affected if variable costs are 5% higher, etc. Alternatively, we may wish to discover the maximum possible change in one of the parameters before the opportunity becomes non-viable. This maximum possible change is often expressed as a percentage:

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March 2013 Exam

A company is considering investing in manufacturing equipment that has a three year life. The purchase price of the equipment is $70,000 and at the end of the three year period it will be sold for cash of $10,000. The equipment will be used to produce 6,000 units each year of a product which earns a contribution per unit of $7. Incremental fixed costs are expected to be $12,000 per annum. The company has a cost of capital of 8% per annum. Ignore tax and inflation. Required: Calculate the sensitivity of the investment decision to a change in the cost of capital to 20%.

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Example 1

BJS Ltd is considering investing $120,000 in equipment that has a life of 15 years. Its final scrap value is $25,000. The equipment will be used to produce 15,000 deluxe pairs of rugby boots per annum, generating a contribution of $2.75 per pair. Specific fixed costs are estimated at $18,000 per annum. The firm has a 15 % cost of capital. Required 1. Calculate the NPV of the project. 2. Calculate the sensitivity of your NPV to the: i. initial investment; annual contribution; annual fixed costs. 3. Identify the minimum annual sales required to ensure that the project at least breaks even.

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Considerations in NPV Questions

Taxation Inflation Working Capital Relevant Cash Flows

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Relevant Cash Flow

Investment decisions, like all other decisions, should be analysed in terms of cash flows that can be directly attributable to them. This has many implications:

• Sunk Costs - A sunk cost has already been incurred and therefore will not

be relevant to the investment decision.

• Opportunity cost - As in all decision making, opportunity costs are relevant,

and should be included in investment decisions.

• Fixed costs - Should be treated as a whole, and only where relevant. This

means that fixed overheads that are "absorbed"/ "charged"/ "allocated"/ "apportioned" to a project should be ignored. Only extra/incremental changes in fixed overheads should be included in discounted cash flow calculations.

• Depreciation - Depreciation is not a cash flow, and so should never be

included in a discounted cash-flow calculation. The only investment appraisal technique that will include depreciation is ARR

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Example 2 & 3

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Taxation

Two Workings

Tax depreciation Corporation Tax

• Net cashflows

are taxable

• Timings given
• CT rate given
• 25% reducing

balance p.a.

• Balancing allowance /

charge on disposal

• Use separate working

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Working Capital

The treatment of working capital is as follows:

• It is treated as an investment at the start of the project, like any other

investment.

• Working capital does not qualify for tax relief – so is ignored in the

taxation and tax depreciation calculations.

• At the end of the project the working capital is 'released'. This is

treated as a cash inflow at the end of the project, equal to the total investment in working capital (unless told otherwise).

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NPV Proforma

X X X Tax dep’n X Scrap value (X) Investment (X) (X) (X) Tax on net cash flow X X Net cash flow (X) (X) Costs X X Revenue Time 3 $ Time 2 $ Time 1 $ Time 0 $ X (X) Working capital

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NPV Proforma (cont.)

PV PV PV PV Present value x x x 1.00 Discount factor X X X (X) Net cash flows Time 3 $ Time 2 $ Time 1 $ Time 0 $

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Inflation

• Real cashflows; without

inflation

• Money, or actual,

cashflows; including inflation

• Use real rate
• Use money, or

nominal, rate

(1 + r)(1 + i) = (1 + m)   Must be Consistent !

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Other NPV Based Questions

Capital Rationing Asset Replacement

• Mutually exclusive
• ptions with unequal

lives

• EAC
• Optimum replacement

cycle – Eg 10

• Single period
• Divisible or not
• Multiple period
• Example 11