Investment appraisal is fundamental area in accounting. The methods of investment appraisal are payback, accounting rate of return and the discounted cash flow methods of net present value (NPV) and internal rate of return (IRR).
The most important of these methods, both in the real world and in the Professional Diploma in Sustainability, is NPV.
The aim of this article is to briefly discuss the key areas to look out for in an NPV and then work a comprehensive example which builds them all in. Technically the example is likely harder than any examination question is likely to be. It does demonstrate as many of the issues that ProDipSust candidates might face as is possible, however it is important to note that examination questions will be in a scenario format and hence finding the information required may be slightly more challenging than in the example shown.
Key areas
Relevant/irrelevant cashflows
Candidates should remember the ‘Golden Rule’ which states that to be a relevant cash flow an item must be a future, incremental cash flow. Irrelevant items to look out for are sunk costs such as amounts already spent on research and apportioned or allocated fixed costs or notional costs such as depreciation. Equally all financing costs should be ignored as the cost of financing is accounted for in the discount rate used.
Inflation
Candidates must be aware of the two different methods of dealing with inflation and when they should be used. The money method is where inflation is included in both the cash flow forecast and the discount rate used while the real method is where inflation is ignored in both the cash flow forecast and the discount rate. The money method should be used as soon as a question has cash flows inflating at different rates or where a question involves both tax and inflation. Because of this the money method is commonly required.
Taxation
Building taxation into a discounted cash flow answer involves dealing with ‘the good, the bad and the ugly’! The good news with taxation is that tax relief is often granted on the investment in assets which leads to tax saving cash flows. The bad news is that where a project makes net revenue cash inflows the tax authorities will want to take a share of them. The ugly issue is the timing of these cash flows as this is an area which often causes confusion.
Working capital
The key issue that must be remembered here is that an increase in working capital is a cash outflow. If a company needs to buy more inventories, for example, there will be a cash cost. Equally a decrease in working capital is a cash inflow. Hence at the end of a project when the working capital invested in that project is no longer required a cash inflow will arise. Candidates must recognise that it is the incremental change in working capital that is the cash flow.
Having reminded you of the key areas let us now consider a comprehensive example:
A project requires an initial investment of $800,000 and then earns net
cash inflows as follows:
Year 1 2 3 4 5 6 7
Cash inflows ($000) 100 200 400 400 300 200 150
In addition, at the end of the seven-year project the assets initially
purchased will be sold for $100,000.
Determine the project’s ROCE using:
(a) initial capital costs
(b) average capital investment
Solution:
Annual cash flows are taken to be profit before depreciation.
Average annual depreciation = ($110,000 – $10,000) ÷ 5 = $20,000
Average annual profit = $24,400 – $20,000 = $4,400
Using initial cost:
ROCE =
Average annual profit
Initial capital cost × 100%
ROCE =
$4,400
$110,000 × 100% = 4%
Using average capital investment:
Average annual profits (as before) = $4,400
Average book value of assets =
Initial cost + Final scrap value
2
Average book value of assets =
$110,000 + $10,000
2 = $60,000
ROCE =
Average annual profit
Average book value of assets × 100%
ROCE =
$4,400
$60,000 × 100% = 7.33%
