INVESTMENT APPRAISALS – FURTHER ASPECTS
P2 – Chapter 6
PAYBACK PERIOD
The time a project will take to pay back the money spent on it.
Based on expected cash flows provides a measure of liquidity and risk
Unlike discounting techniques, it assumes cash flows occur evenly during the year
1. IF PAY BACK PERIOD IS QUICKER THAN COMPANY’S MAXIMUM RETURN TIME,
PROJECT SHOULD BE ACCEPTED.
2. IF FACED BY MUTUALLY EXCLUSIVE PROJECTS, CHOOSE THE ONE WITH QUICKEST
PAY BACK PERIOD.
CALCULATION
constant annual Uneven annual
cashflows cash flows
Pay back period = Add the inflows and deduct from
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 investment until the sum equals or
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 exceeds the investment
If the sum of inflows exceeds the
To convert the answer into years and
investnment, find the number of years and
months, multiply decimal point by 12.
months by pro-rata calculation
Payback period as an investment appraisal technique
Advantages Disadvantages
Simple to understand Not a measure of absolute profitability
Selection on payback period basis reduces risk of Ignores TVM (Discounted payback period maybe
liquidity problems used to consider TVM)
Uses cash flows and not accounting profits Doesn’t take into account the cash flows beyond
the payback period
Emphasises cash flows in earlier years
ACCOUNTING RATE OF RETURN
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
ARR =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Annual average profit is after depreciation
Average annual profit = net cash flow – depreciation
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡+𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
Average value of investment =
2
1. If ARR > targeted returns, accept project
2. Choose project with highest ARR
ARR as an investment appraisal technique
Advantages Disadvantages
Simple to understand Not a measure of absolute profitability
Widely used and accepted Ignores TVM
Considers the whole life of projects Doesn’t consider cash flows, uses subjective
accounting profits including depreciation
Not a measure of absolute profitability
Not reliable
DISCOUNTED PAYBACK
Cash flows are discounted to present value and then the same process is followed as that of
calculating normal payback period.
Thus overcomes the criticism of not considering TVM.
DEALING WITH TAXATION
Effects of tax on in investment apppraisal
Assumption :
1. taxable profits = net cash flow - tax depreciation
2. Half corporation tax is paid in current year and the other half in next year (Check question in exam)
3. Taxation is revelavnt cost
4. If there are tax losses, it is adjusted against some other project where there is surplus
Types Impact
Tax depreciation is a
Impact of tax
Project cash flows deductible alternative
depreciation
Corporation tax reduced by tax to depreciation. It
(capital
payable reduces the tax
allowance)
payable
the tax depreciation is not a cash flow and to
calculate the tax impact we have to multiply each
year’s tax depreciation by the corporation tax rate.
The effect of tax depreciation is on the amount of
tax payable, which is the relevant cash flow.
TAX DEPRECIATION
Tax depreciation is used to reduce taxable profits, and the consequent reduction in a tax payment
should be treated as a cash saving arising from the acceptance of the project.
In this examination tax depreciation is generally allowed on the cost of plant and machinery at the
rate of 25% on a reducing balance basis
It may also be possible to claim tax depreciation on the costs of installation
Balancing allowance/ charge
For example, if a business buys equipment for $100,000 in Year 0 and disposes of it in Year 5 for
$20,000, it will receive tax relief on the net cost of $80,000. If the rate of corporation tax is 30%, the
reduction in tax payments over the five years would be 30% × $80,000 = $24,000.
Balancing allowances are given as a final deduction to ensure the full fall in value has been allowed.
Balancing charges occur where the total tax depreciation claimed exceeds the fall in value of the
asset. The excess claimed is treated as a taxable amount in the year of disposal.
Timings of tax savings associated with tax depreciation
The benefit of tax saved because of tax depreciation is received when the corporation tax should
have been paid.
Assets are assumed to be bought at T0
It should be assumed that asset is bought at the start of the accounting period and therefore the
first tax depreciation is offset against the year 1 net cash flows
NPV with tax – Example pro forma
WORKING CAPITAL
Treated as investment in the beginning of the project
Change in WC treated as cash flow
WC doesn’t qualify for tax relief
At the end of the project, WC is released and it treated as inflow
INFLATION IN CASH FLOWS
If there is inflation, it can either be adjusted in cash flows or in cost of capital
Cash flows not adjusted for inflation are called current/ real cash flows
Cash flows adjusted for inflation are called money/ nominal cash flows
Cash flows given in exam are money cash flows unless states otherwise
Read question carefully determine in what terms are the cash flows given. If they are given in
current terms, they need to be increased with the inflation rate. Sometimes, they may be given in
first year term and only the cash flows from 2nd year need to be inflated.
Methods of dealing with
inflation
(Remain consistent in method)
Money/
Real method nominal
method
Do not inflate cash flows, leave them in Inflate cash flow using inflation rate, make
real terms them money flows
Discount using Discount using
real rate money rate
Real/ real Money/ money
Rates can be adjusted for inflation effects
Nominal rate Real rate
Inflation not adjusted Inflation adjusted
Formula: Real rate of return –
(1+𝑚)
(1+r) =
(1+𝑖)
r is real rate of return, m is money cost of capital, i is inflation
It is easier to use one real rate in exam rather than inflating all cash flows to money terms
In perpetuities, real rate method is the only method
Inflation may not affect all the costs at the same time. If separate inflation rates for
separate costs are given, real rate method cannot be used.
Types of inflation
Specific inflation General rate of
rate inflation
Impacts investor's overall required rate of
impacts each cash flow
return
Investors in the project need
compensation for lost purchasing
power which affects everything
When to use real/ money method
Is there one rate
of inflation (and no
tax) in the
question?
Yes No
Nominal cash
Real cash flows - Money/ nominal
flows - nominal
real method method
method
Like inflation, there can also be deflation due to various economic or organisational reasons.
DEALING WITH BOTH INFLATION AND TAX IN THE SAME QUESTION
Questions with both tax and inflation are best tackled using the money method.
Inflate costs and revenues, where necessary, before determining their tax implications.
Ensure that the cost and disposal values have been inflated (if necessary) before calculating tax
depreciation.
Always calculate working capital on these inflated figures, unless given.
Use a post-tax money discount rate
CAPITAL ASSET REPLACEMENT DECISIONS - Decision to replace capital assets
Decisions to consider
Mutually exclusive
Optimum
projects with unequal
replacement cycle
lives
With increased age, machine's
In order to compare machines with
maintenance cost increases, residual
different lives, their costs need to be
value decreases. Hence, optimum time
annualised
to replace them must be found.
Formula: Factors to consider:
1. Capital cost of new equipment
Equivalent annual cost = 2. operating costs
𝑃𝑉 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 3. Resale value
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 𝑛 4. taxation and subsidies
5. Inflation
LCM method
This is where we find the smallest number, which we can
divide into by each of a set of numbers and evaluate the
NPV cost over this period. Steps to calculate:
Consider each possible
replacement cycle - year
1, year 2, etc
Calculate equivalent
annual cost
Select cycle with lowest
cost
