Paper F2 Management Accounting 2019/4/4

Chapter 19 Methods of project appraisal 2019/4/4

Methods of project appraisal Chapter Preview Methods of project appraisal Key methods Time value of money (Discounted) payback period Present value VS Future value NPV Discounting VS Compound interest IRR Relevant cost 2019/4/4 Ji Weili, JXUFE

Why? How? Project appraisal -- to decide which are worthwhile, whether or not to make an investment. How? --Identify and calculate relevant cash flows for investment projects. -- Apply an investment appraisal method. 2019/4/4 Ji Weili, JXUFE

Appraisal methods Non-discounted cash flow techniques-- payback period Discounted cash flow (DCF) techniques-- discounted payback period, net present value(NPV), internal rate of return(IRR) 2019/4/4 Ji Weili, JXUFE

Payback period --the time taken for the initial investment to be recovered in the cash from the project. Example: p.418 question used in the situation if there are liquidity problem, or if distant forecasts are very uncertain. 2019/4/4 Ji Weili, JXUFE

The time value of money Futuer value (FV) & Compound interest终值和复利 FV=PV(1+r)n r--利率 n--计息期数 Present value (PV) & Discounting 现值和贴现（折现） PV=FV/(1+r)n r--贴现率 n--贴现期数 2019/4/4 Ji Weili, JXUFE

The time value of money Discount rate 贴现率--经常使用资金（本）成本率(cost of capital) Discount factor/Present value factor 现值系数 Present Value Table 现值系数表 Annuities 年金 --an annual cash payment or receipt which is the same amount every year for a number of years. Annuity-- the sum of the present value factor Annuity Table 年金现值系数表 2019/4/4 Ji Weili, JXUFE

Discounted cash flow techniques Discounted payback period 贴现的投资回收期 Net present value(NPV) 净现值 Internal rate of return(IRR) 内含报酬率 2019/4/4 Ji Weili, JXUFE

Calculation--PV of future benifits minus PV of future costs. Decison rule: NPV>0, accept NPV<0, reject Calculation--PV of future benifits minus PV of future costs. Example: P424-5.1.1 2019/4/4 Ji Weili, JXUFE

IRR>cost of capital, accept IRR<cost of capital, reject Decison rule: IRR>cost of capital, accept IRR<cost of capital, reject Calculation--the discount rate which produces the NPV of zero. Example: P429-5.8.1 2019/4/4 Ji Weili, JXUFE

Identify relevant and non-relevant costs Relevant costs should be used for decision making, arising as a direct consequence of a decision. Non-relevant costs are irrelevant for decision making, should not be taken account of in decision making . 2019/4/4 Ji Weili, JXUFE

Relevant Costs FUTURE FUTURE FUTURE INCREMENTAL INCREMENTAL What is a relevant cost? FUTURE FUTURE FUTURE INCREMENTAL INCREMENTAL INCREMENTAL CASHFLOW Only future costs are affected by our decision Only future costs are affected by our decision Only future costs are affected by our decision i.e. incurred as a direct result of our decision i.e. incurred as a direct result of our decision i.e. incurred as a direct result of our decision Only cash Only cash Also use this slide to run through the things which are NOT relevant costs eg sunk, historic, book values, committed costs, contracted costs etc. 2019/4/4 Ji Weili, JXUFE

Example e.g. need 500kg of material for new project have 300kg in stock (cost $3/kg) current purchase price = $5/kg scrap value = $1/kg what’s the relevant cost of the 500kg? IRRELEVANT Not in notes so go through slowly 2019/4/4 Ji Weili, JXUFE

Important concept: Opportunity Costs The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year is $20,000. 2019/4/4 Ji Weili, JXUFE

Differental or incremental costs 'Differental costs' is used to compare the differences in cost between two options. 'Incremental costs' is used to state the relevant costs when two or more options are compared. 2019/4/4 Ji Weili, JXUFE

Non-relevant costs: Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. 2019/4/4 Ji Weili, JXUFE

Non-relevant costs: Committed Costs --A future cash outflow that will be incurred anyway. --Committed costs may exist because of contracts already enter into by the organization. 2019/4/4 Ji Weili, JXUFE

Non-relevant costs: Notional Costs --A hypothetical accounting cost to reflect the use of a benefit. --no cash expense is incurred. 2019/4/4 Ji Weili, JXUFE

Avoidable VS Unavoidable costs Other Concepts Avoidable VS Unavoidable costs Attributable Fixed Costs VS General Fixed Costs 1 2 2019/4/4 Ji Weili, JXUFE

We’ve Conquered Time Value of Money! 2019/4/4 Ji Weili, JXUFE