CIMA P2 Advanced Management Accounting First Intro slide – change details to your own For exams in 2016 江西财经大学会计学院 吉伟莉 499159596@qq.com

Chapter 8 Project appraisal Investment decision-making process Post audit Payback method ARR method NPV & IRR DCF: Additional points First Intro slide – change details to your own

Investment decision-making process 1 1. Creation phase Identifying objectives. Searching for investment opportunities. Assessing the business environment. CIMA P1 Performance Operations SEPTEMBER 2014

Investment decision-making process 2 2. Decision phase Listing possible alternatives. Carrying out financial analysis. Making a decision. CIMA P1 Performance Operations SEPTEMBER 2014

Investment decision-making process 3 3. Implementation phase Approving capital investment proposals. Reviewing capital investment decisions usually using a post completion audit. CIMA P1 Performance Operations SEPTEMBER 2014

Post audit 1 Post-completion audit (PCA) Measures success of project on completion. Used as feedback for future projects (lessons learned). Can help to motivate managers. Costs may outweigh benefits on small projects. Applied punitively, PCA may cause managers to become risk averse. CIMA P1 Performance Operations SEPTEMBER 2014

Post audit 2 Alternatives to PCA Teams could manage a project from beginning to end. More time could be spent choosing projects. CIMA P1 Performance Operations SEPTEMBER 2014

Payback method 1 Payback Time it takes cash inflows for investment to equal cash outflows. Usually expressed in years and months. Assume even cash flows in payback year. Cash flows, not accounting profits. Provides a general screening tool before more sophisticated technique is used. CIMA P1 Performance Operations SEPTEMBER 2014

Payback method 2 Payback decision rules Between two or more projects, accept one with shortest payback. Long payback is considered risky. Reject project if payback is greater than a target payback. CIMA P1 Performance Operations SEPTEMBER 2014

Payback method 3 Payback advantages Long payback means capital is tied up. A focus on early payback can enhance liquidity. Investment risk is increased if payback is longer. Shorter-term forecasts are likely to be more reliable. Calculation is quick and simple. Easily understood concept. CIMA P1 Performance Operations SEPTEMBER 2014

Payback method 4 Payback disadvantages Ignores timing of cash flows within payback period. Ignores time value of money. No distinction between projects with same payback period. Choice of cut-off payback is arbitrary. Can lead to excessive investment in short-term projects. CIMA P1 Performance Operations SEPTEMBER 2014

ARR method 1 Accounting rate of return (ARR) Recommend definition: Annual profits are after depreciation. Average investment = ½ (initial cost + residual value). Use net cash flow less depreciation if no profit figure given. CIMA P1 Performance Operations SEPTEMBER 2014

ARR method 2 ARR decision rules One project If ARR > target return then accept. If ARR < target return then reject. Two or more mutually exclusive projects Choose project with highest ARR (and above target). CIMA P1 Performance Operations SEPTEMBER 2014

ARR method 3 ARR advantages Quick and simple. Looks at entire life of project. Easily calculated from financial statements. Uses profit so may be more easily understood. CIMA P1 Performance Operations SEPTEMBER 2014

ARR method 4 ARR disadvantages Takes no account of timing of cash flows. Accounting profits are subject to a number of different accounting treatments. Takes no account of size of investment. Takes no account of length of project. Ignores the time value of money. CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 1 Present value (PV) A £ today is worth more than a £ tomorrow. PV = Cash equivalent now (X) of a sum of money (V) receivable or payable at the end of n time periods. Discounting converts a future value into a present value. Discounting formula: X = V/(1+r)n CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 2 Net present value (NPV) Sum of discounted cash inflows and outflows of a project. Based on cash flows, not accounting profits. Discount tables are provided in the exam. If NPV > 0 then accept project. If NPV < 0 then reject project. For two or more projects, choose highest NPV project. CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 3 Timing of cash flows Cash outlay at start of project (‘now’) occurs in time 0. Cash flow occurring during time period assumed to occur all at once at end of time period (end of year). Cash flow occurring at start of a time period is assumed to occur at end of previous time period. CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 4 Perpetuity An annual constant cash flow forever. PV of £1 pa in perpetuity at r% = £1/r (r = decimal). Annuity An annual constant cash flow for a number of years. Use discount factors from cumulative present value tables. CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 5 Net terminal value (NTV) Cash surplus remaining at end of a project after taking account of interest and capital repayments. NTV discounted at the cost of capital = NPV. CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 6 IRR Rate of interest at which the NPV of an investment is zero. If IRR > target rate of return then accept. Can find IRR using graphical approach or interpolation. CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 7 CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 8 IRR IRR interpolation formula: A = lower rate of return B = higher rate of return P is NPV at A N is NPV at B CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 9 IRR of an annuity Can be calculated directly from cumulative PV tables. Cumulative PV factor for years 1 to n at rate r = initial investment ÷ annuity = X. Look in cumulative PV tables at year n to find a discount factor corresponding to X. Corresponding rate = IRR. CIMA P1 Performance Operations SEPTEMBER 2014

NPV & IRR 10 IRR of a perpetuity IRR = perpetuity ÷ initial investment CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 1 NPV versus IRR When cash flow patterns are conventional, both give same accept/reject decision. IRR is more easily understood. IRR and ROCE/ROI can be confused. IRR ignores relative sizes of investments. Non-conventional cash flow patterns can give multiple IRRs. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 2 NPV versus IRR NPV is superior for ranking mutually exclusive projects. Variable discount rates can be incorporated into NPV but not IRR calculations. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 3 Costs to include in project appraisal Relevant costs only. Finance related cash flows normally excluded. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 4 Discounted payback Time taken before a project’s cumulative NPV turns from being –ve to +ve. Has same advantages of payback plus takes account of time value of money. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 5 Discounted payback index (DPBI) Measure of number of times a project recovers initial funds invested. = PV of net cash inflows ÷ initial cash outlay. Final point DCF techniques are superior to those that do not take into account the time value of money. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 6 Inflation Inflation can affect all of the cash flows and the cost of capital. Real cash flows exclude inflation – use real discount rate. Money cash flows include inflation – use money discount rate. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 7 Formula to learn (1 + money rate) = (1 + real rate) × (1 + inflation rate) Rules to learn If one rate of inflation, ignore inflation and use real cash flows and real cost of capital. If more than one rate of inflation, include inflation and use money cash flows and money cost of capital. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 8 UK corporation tax Payable by large companies quarterly. Payable in 7th and 10th months of the year in which profit is earned. Payable in the 1st and 4th months of the following year. Therefore half the tax is payable in year profit earned and half in following year. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 9 Writing down allowances (WDA) WDAs reduce taxable profits and hence tax payable. WDA rate is provided in question (usually 25% reducing balance). Reduction in tax payable = WDA × tax rate. Benefit of WDAs felt half in year they relate to and half the following year. CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 10 Balancing allowances When plant is sold there is a difference between sales price and reducing balance amount. Sales price > reducing balance = taxable profit (charge). Sales price < reducing balance = tax allowable loss (allowance). CIMA P1 Performance Operations SEPTEMBER 2014

DCF: additional points 11 Taxation and DCF appraisal Calculate WDAs and any balancing allowance or charge. Work out tax saving (rate × WDA or allowance) and tax increase (rate × charge). These will affect two years. Determine NPV. CIMA P1 Performance Operations SEPTEMBER 2014