1. B392 Online Tutorial 4 The session will begin at 7
B392 Online Tutorial 4 The session will begin at 7.00pm Please have access to the tutorial 4 activities and a calculator

2. Online Tutorial 4 Agenda
Qu 1 Project appraisal activity min
Qu 2 Buy or lease Exam qu mins
TMA 02 Any questions 5 mins

3. Online Tutorial 4 learning objectives
Understand, explain and apply the principles of discounted cash flow in investment appraisal
Use a spreadsheet model to produce a solution suitable for ‘what if analysis’
Understand the difference between the investing and financing decision

4. Qu 1: Project appraisal activity: Discounted cash flow
Read case study
Identify and comment on any errors
Please post your ideas into text chat 4

5. Original calculation Sales: units per year 250,000 400,000 500,000
£ '000
Year 1 2 3 4 5
Contribution
1330
2128
2,660
1,330
Depreciation
(438)
Interest payments
(200)
Fixed costs
(530)
(562)
(596)
(631)
Taxable operating cash flows
162
928
1427 62
Tax on operating cash flows
(49)
(278)
(428)
(19)
Capital exp
( )
Scrap value
250
Net after tax cash flows
879
1,149
(116)
Discount formula
1.0000
0.909
0.826
0.751
0.683
0.621
Present value
147
726
863
(79)
(12)
Net present value
(355)

6. Errors Never include interest in a NPV calculation. Why not?
This is included in the discount factor

7. Errors
Only ever include relevant cash flows
Sunk costs are irrelevant

8. Errors The discount factor used should be the WACC
This because it is generally assumed that the company has a pool of funds available for investment. Do you think there are exceptions to this?

9. Errors
Accounting depreciation is not acceptable to tax authorities (and is not a relevant cash flow)
Need to calculate tax depreciation using reducing balance method (see note 7)

10. Errors Calculation of tax depreciation Tax written down value
Tax written
down value
Capital allowance
25%
Tax on allowance
30%
Year
2000 1
1500
500
150 2
1125
375
112.5 3
844
281
84.38 4
250
594
178.13
(Bal allce)
Scrap value

11. Errors Inflation has been calculated incorrectly For example
Year Year 2
Sales 250,000 x 12 x 1.05 = 3,150, ,000 x 12 x ,292,000
VC ,000 x 7 x 1.04 = 1,820, ,000 x 7 x ,028,480
Contribution ,330, ,263,520

12. Incorporating inflation into dcf analysis
Choice is
Either use nominal cash flows and a nominal discount rate OR
Use real cash flows and a real discount rate
Both will give the same answer (if calculated correctly!!)
Which approach has been used in this scenario?
Could the other approach have been used?
When is it appropriate to use the other method?

13. Finding the real discount rate
The money discount rate is 10%
Inflation is 5%
What is the real discount rate
Solution
Use Fisher formula 1+R = (1+r)(1+i) see pg 52 unit 4
= (1+r) (1+0.05)
So 1+r = 1.1/1.05 = 1.048
r = or 4.8%

14. Qu 1 Using a spreadsheet
Spreadsheets can be useful for ‘what if ‘ analysis
They can incorporate
- A data area
Use of formulae
Inbuilt security
There is a spreadsheet answer available for this qu which you can look at to see how such a model might work 14

15. Inputs Cap ex 2,000 Cap_ex £ Scrap value 250 Scrap_v lue
Sales inflation
0.05
Inflation_sales
Sales price 12
Sales
Fixed costs
300
Fixed_costs
Fix cost inflation
0.06
Fix_cost_ inflation
Var costs inflation
0.04
Inflation_var
Variable costs 7
Variable_costs
Cap allowance
0.25
Cap_allow
Tax
0.3
Discount rate
0.12
Discount_rate

16. Qu 2 Buy or lease
Read case study
What are the key points here? 16

17. Qu 2 Buy or lease. The investment decision
Provide a discussion and net present value analysis of whether or not Crantree should replace the eight diesel vehicles, on the basis that Crantree will purchase them. Show your workings in good form, including any assumptions you make and round to the nearest whole figure.
What are the relevant cash flows?

18. Crantree plc
000's
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Additional running costs
0.0
-15.0
Additional cash inflows
57.0
Reduced maintenance costs
25.0
operating cashflows from new vans
67.0
Tax on operating net cash outflows
-20.1
After tax cashflows
46.9
Discount factors at 15%
1.0000
0.8696
0.7561
0.6575
0.5718
0.4972
3.3522
NPV from extra cashflow
0.00
40.78
35.46
30.84
26.82
23.32
157
Initial investment in new vans
scrap value of old vans
40.00
Scrap value of new vans on disposal
15.00
Tax allowance- WDA
13.50
Overall net cash outflows
60.40
75.4
Discount factor at 15%
Overall Present Value buying new vans
52.52
45.67
39.71
34.54
37.49
Overall NPV buying new vans
9.93

19. Qu 2 Buy or lease
What other factors should be included in the discussion?

20. Qu 2 Buy or lease
Need somewhere to charge vans. Will this impact on scheduling?
Training. Safety issues?
Suppliers

21. Qu 2 Buy or lease The financing decision
Provide a discussion and financial analysis of whether or not Crantree should lease or buy the vehicles, independently of the outcome of part (a). Show your workings in good form, including any assumptions you make and round to the nearest whole figure.
What are the relevant cash flows?

22. Financial analysis
The relevant discount rate is the after tax cost of debt finance calculated as 20% ( ) = 14% (see pg 74 unit 4)
Cost to buy
Purchase of vans (240,000)
Writing down allowance* ,347
PV Maintenance cost covered by lease (opportunity cost of purchasing)
= £31,000 x (annuity for 5 years at 14%) (106,426)
Tax savings on maintenance costs (reduces the opportunity cost above) 31,928
Total cost of purchasing (268,151)
* a flat 20% of the net value per annum discounted over the five years
= (240,000 – 15,000) x 20% x 30% x (5 years at 14%)

23. Cost to lease
PV of operating lease payments (£87,000 x ) (298,680)
Tax shield of lease payments (298,680 x 30%) ,604
Total cost of leasing (209,076)

24. Recommendation
The financial analysis shows that leasing the vans is cheaper than buying them. Other factors that Crantree’s management may want to consider include:
• The lessor firm continues to own the vans so it is important that it is stable financially, otherwise the vehicles may be re-possessed by a creditor of the lessor company.
• Management should check the terms of the leasing agreement carefully to see if they have flexibility to withdraw from the lease agreement before seven years without a prohibitive penalty. If the vans prove unreliable or unsatisfactory in any way that is significantly negatively impacting the business the flexibility to change vans would be desirable.
• As a publicly listed company, the accountant may wish to confirm the accounting treatment of the lease expense and lack of a recorded asset in case its impact on the accounts is material enough to impact the share price.

25. TMA 02
Questions?
INSERT group discussion photo (Jane’s) 25

26. Online Tutorial 4 learning objectives
Understand, explain and apply the principles of discounted cash flow in investment appraisal
Use a spreadsheet model to produce a solution suitable for ‘what if analysis’
Understand the difference between the investing and financing decision

27. End of online tutorial 4