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LEARNING OBJECTIVES

LEARNING OBJECTIVES. • Identify and apply relevant and incremental cash flows in NPV calculations Recognise and deal with sunk costs, incidental costs and allocated overheads The replacement decision/the replacement cycle The calculation of annual equivalent annuities

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LEARNING OBJECTIVES

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  1. LEARNING OBJECTIVES • • Identify and apply relevant and incremental • cash flows in NPV calculations • Recognise and deal with sunk costs, incidental • costs and allocated overheads • The replacement decision/the replacement • cycle • The calculation of annual equivalent annuities • • The make or buy decision • • Optimal timing of investment • • Fluctuating output situations

  2. QUALITY OF INFORMATION • Relevance • Completeness • Consistency • Accuracy • Reliability • Timeliness • Low cost of collection compared with benefit

  3. ARE PROFIT CALCULATIONS USEFUL FOR ESTIMATING PROJECT VIABILITY? • Working capital • Cash floats • Stock (inventories) • Debtors • Creditors incr ease in cash f loa ts incr ease in stoc ks incr ease in de btor s less the incr ease in cr editor s Net Pr ofit P eriodic oper a ting bef or e in v estment in net = – cash f lo w de pr ecia tion w or king ca pital

  4. DEPRECIATION Mac hine cost £20,000, a t time 0. Productive life of four years. Accountant’ s figur es Y ear 1 2 3 4 £ £ £ £ Pr ofit bef or e de pr ecia tion 12,000 12,000 12,000 12,000 Depreciation 5,000 5,000 5,000 5,000 Pr ofit after de pr ecia tion 7,000 7,000 7,000 7,000 Cash f lo w Year 0 1 2 3 4 £ £ £ £ £ Cash outf lo w –20,000 Cash inf lo w 12,000 12,000 12,000 12,000 Exhibit 3.2 Quarpro plc: An example of adjustment to profit and loss account

  5. Machinery cost £20,000 at time 0, life of four years, zero scrap value • Extra cash floats required: £5,000, at time 0. • Additional work in progress: £2,000 at time 0, £3,000 at time 2. • Increase in creditors: £1,000. ABC plc Accounting y ear Point in time (yearly interval) 1 2 3 4 £ £ £ £ £ Accounting pr ofit 7,000 7,000 7,000 7,000 Ad d bac k de pr ecia tion 5,000 5,000 5,000 5,000 12,000 12,000 12,000 12,000 Initial mac hine cost –20,000 Cash f loa t –5,000 5,000 Stoc k Closing stoc k 2,000 2,000 3,000 3,000 0 Opening stoc k 2,000 2,000 3,000 3,000 Net stoc k –2,000 0 –1,000 0 +3,000 adjustment (Outflow –tive, Inflow +tive) Cr editor s End of y ear 1,000 1,000 1,000 1,000 0 Star t of y ear 1,000 1,000 1,000 –1,000 Cash f lo w +1,000 0 0 0 –1,000 ef f ect of cr editor s (Outf lo w –ti v e , Inf lo w +ti v e) Net oper a ting –26,000 12,000 11,000 12,000 19,000 cash f lo w Point in time 0 1 2 3 4 Cash f lo w –26,000 12,000 11,000 12,000 19,000 Cost of ca pital 12% 12,000 11,000 12,000 NPV = –26,000 + + + (1 + 0.12) (1 + 0.12) (1 + 0.12) 2 3 19,000 + = + £14,099 (1 + 0.12) 4 T his pr oject pr oduces a positi v e NPV , i.e . it g ener a tes a r etur n w hic h is mor e than the r equir ed r a te of 12%, and ther ef or e should be acce pted. ABC plc: An example of profit to cash flow conversion

  6. INCREMENTAL CASH FLOWS Incr emental Cash f lo w for firm Cash f lo w for firm = – cash f lo w with the pr oject without the pr oject • Include all opportunity costs • Include all incidental effects • Ignore sunk costs • Be careful with overheads • Dealing with interest

  7. REPLACEMENT CYCLES • The cars cost £10,000 each • Four alternative projects: • Project 1 – sell cars after 1 year for £7,000 • Project 2 – sell cars after 2 years for £5,000 • Project 3 – sell cars after 3 years for £3,000 • Project 4 – sell cars after 4 years for £1,000 • Maintenance costs: • in the first year: £500 • in the second year: £900 • in the third year: £1,200 • in the fourth year: £2,500

  8. Point in time (years) 0 1 2 3 4 Pr oject 1 £ r e place after Pur c hase cost –10,000 one y ear Maintenance –500 Sale pr oceeds +7,000 Net cash f lo w –10,000 +6,500 Pr oject 2 r e placeafter Pur c hase cost –10,000 tw oy ear s Maintenance –500 –900 Sale proceeds +5,000 Net cash flow –10,000 –500 +4,100 Pr oject3 r e placeafter Pur c hase cost –10,000 thr eey ear s Maintenance –500 –900 –1,200 Sale pr oceeds +3,000 Net cash flow –10,000 –500 –900 +1,800 Pr oject4 r e place after Pur c hase cost –10,000 f our y ear s Maintenance –500 –900 –1,200 –2,500 Sale pr oceeds +1,000 Net cash flow –10,000 –500 –900 –1,200 –1,500 Assuming a discount rate of 10 per cent the Present Values (PVs) of costs of one cycle of the projects are: 6,500 PV –10,000 + = –4,090.90 1 1.1 500 4,100 PV –10,000 – + = –7,066.12 2 2 1.1 (1.1) 900 500 1,800 PV –10,000 – – + = –9,845.98 3 2 3 1.1 (1.1) (1.1) 500 900 1,200 1,500 PV –10,000 – – – – = –13,124.44 4 2 3 4 1.1 (1.1) (1.1) (1.1)

  9. Time (years) 0 1 2 3 4 5 6 7 . . . Cash flows (£) 1st generation –10,000 –500 –900 +1,800 2nd generation –10,000 –500 –900 +1,800 3rd generation –10,000 –500. . . Cash flows for Project 3 Cash outflows and cash inflow in one cycle Using the AEA Time 0 1 2 3 Cash flows (£) 10,000 –500 –900 +1,800 Time 0 1 2 3 Present value Actual cash flows (£) –10,000 –500 –900 +1,800 –9,845.98 Annual equivalent annuity (£) ? ? ? –9,845.98 (Recall that the first cash flow under an ‘immediate’ annuity arises after one year) PV = A  af PV or A = af In the case of the three-year replacement: –£9,845.98 A = = –£3,959.14 2.4868

  10. Time (y ear s) 0 1 2 3 £ Cash f lo w 1 –10,000 –500 –900 +1,800 Cash f lo w 2 –3,959.14 –3,959.14 –3,959.14 Present Value, calculated by Cash flow 1 and Cash flow 2 Time (y ear s) 0 1 2 3 4 5 6 7 . . . Cash f lo ws (£) Fir st g ener a tion –10,000 –500 –900 +1,800 Second g ener a tion –10,000 –500 –900 +1,800 T hir d g ener a tion –10,000 –500. . . Annual equivalent ann uity –3,959.14 –3,959.14 –3,959.14 –3,959.14 –3,959.14 –3,959.14 –3,959.14 0 Replacing the car every three years Cy c le Pr esent v alue of one c y c le (PV) Ann uity f actor (af) Ann ual equi v alent ann uity (PV/af) 1 y ear –4,090.90 0.9091 –4,500.00 2 y ear s –7,066.12 1.7355 –4,071.52 3 y ear s –9,845.98 2.4868 –3,959.14 4 y ear s –13,124.44 3.1699 –4,140.33 Using AEAs for all projects Lowest common multiple method

  11. TIMING OF PROJECTS Y ear of bottling Time 0 1 2 3 4 5 6 Net cash f lo w £000s per v a t 60 75 90 103 116 129 139 P er centa g e c hang e on pr e vious y ear 25% 20% 14.4% 12.6% 11.2% 7.8% Lochglen distillery’s choices NPVs for Lochglen distillery’s choices Y ear of bottling Time 0 1 2 3 4 5 6 £000s per v a t 75 90 103 116 129 139 2 3 4 5 6 1.09 (1.09) (1.09) (1.09) (1.09) (1.09) Net pr esent v alue 60 68.8 75.8 79.5 82.2 83.8 82.9

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