1. 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

2. 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

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

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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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.
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15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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.
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22. NPV & IRR 7
CIMA P1 Performance Operations SEPTEMBER 2014

23. 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

24. 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

25. NPV & IRR 10 IRR of a perpetuity IRR = perpetuity ÷ initial investment
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26. 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

27. 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.
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28. DCF: additional points 3
Costs to include in project appraisal
Relevant costs only.
Finance related cash flows normally excluded.
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29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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