DCF FOR CAPITAL INVESTMENT - CRE Learning
DCF for Capital Investment
Analysis
R. G. A. Boland and R. M. Oxtoby
This programme was developed as part of a two day multi-media learning system (Autonomous Group Learning) which has been continually updated and used to train over 20000 managers in 30 countries since 1969.
ISBN 0 340 17467 6
Copyright © RGAB 2006/1 All rights reserved.
Contents
|How to use this programme |vii |
| |1 |
|Chapter 1 Introduction | |
| | |
|Chapter 2 Basics of Capital Investment Analysis |6 |
|set 2.1 CIA as part of Financial Management |9 |
|set 2.2 DCF Concepts and Investment |18 |
|set 2.3 Simple Measures of CIA |27 |
| | |
|Chapter 3 Measures of Investment |36 |
|set 3.1 Discount Rates and Relevant Cost Analysis |40 |
|set 3.2 Net Present Value, Profitability Index, and Yield |48 |
|set 3.3 ‘DICH’ |57 |
| | |
|Chapter 4 Tax Effects and Non-quantitative Factors |63 |
|set 4.1 Income Tax and Depreciation |68 |
|set 4.2 Tax Shields and Terminal Values |75 |
|set 4.3 Quantitative and Non-quantitative Factors |85 |
| | |
|Chapter 5 Capital Budgeting Systems |91 |
|set 5.1 Budgeting and Planning |94 |
|set 5.2 Risk and Uncertainty |100 |
|set 5.3 Assumptions and Manipulation |106 |
| | |
|Summary-A Final Look at CIA |115 |
|Quiz A test of knowledge acquired from the programme |121 |
|For the Instructor |133 |
|Answers to the Quiz |135 |
|Simplified Glossary |136 |
[v]
Progress Worksheet
|Chapter and |Times in minutes |Total of |Frame no. |
|set no | |frames* |of each |
| | |in error |error |
| |Estimated |Actual | | |
|1 |10 | | | |
|2·1 |20 | | | |
|2·2 |20 | | | |
|2·3 |20 | | | |
|3·1 |15 | | | |
|3·2 |20 | | | |
|3·3 |15 | | | |
|4·1 |15 | | | |
|4·2 |15 | | | |
|4·3 |20 | | | |
|5·1 |15 | | | |
|5·2 |15 | | | |
|5·3 |10 | | | |
|Summary lecture |30 | | | |
|Total time |240 | | | |
|Quiz |30 | | | |
note: The authors would be pleased to receive the information outlined above and other comments from any serious student who is interested in research into the effectiveness of programmed learning.
* Where more than one answer is required in a frame, a frame containing one error is treated as a frame in error.
[vi]
How to Use this Programme
INTRODUCTION
This is an experimental programme in applying a fairly new technique to the problem of learning capital investment analysis. The authors would appreciate comments from both teachers and others who use the programme, in order to improve the design of later editions.
PURPOSE OF THE, PROGRAMME
This programme is designed to enable you to teach yourself the language and basic concepts of DCF for capital investment analysis. It is not a textbook, but an aid to the understanding of existing textbooks.
The programme leads you from simple to complex ideas in a gradual fashion. The programme is like a ladder, and the parts of the programme are like the rungs in a ladder: you cannot reach the top rung of a ladder unless you have first used all the lower rungs. If there are several rungs missing in the ladder, it is not only very difficult to reach the top, but the ladder also becomes unstable. The same things apply in the use of this book: you will need to have mastered the earlier parts before you can understand the later ones.
CONTENTS
This book is divided into five chapters. Chapter 1 is a brief introduction. Chapters 2–5 comprise the main programme, which is a series of ‘sets’. In each set there is a summary, a set of ‘learning-patterns’ and twenty to forty ‘frames’ which systematically present new knowledge and also demand from you written answers.
The main programme is followed by a quiz designed to test the knowledge you have acquired. There is also a brief glossary of CIA language, together with a postscript in lecture form on some of the trickier material presented in the programme.
TECHNIQUE
The following technique is used in writing the programme.
1. The number of dotted lines gives some indication of the number of words needed for a correct response (...... …... ……).
2. An acceptable answer to a frame is the correct answer shown, or any reasonable synonym. You are the judge.
3. Answers that require an amount of money are indicated in the frame by ‘£.........’ and not by the normal ‘.........’.
[vii]
ROUTINE
The routine for the student to follow in using the programme is as follows.
1. Read the summary of the set. If you already understand all the words and concepts, pass directly on to the next set; if not, do the set.
2. Study the learning-patterns for two minutes, and then read each frame and refer to the appropriate exhibit each time. (You should not try to memorise anything; refer to the exhibit over and over again. It is quick and easy.)
3. Write down your response.
4. Check each response one at a time with the correct answer, which is one frame down. Do not wait until the end; check each answer separately.
5. If your answer is the same as the correct answer, or is any reasonable synonym, mark it with a tick and go on to the next frame.
6. If the answer is not correct, read the frame again, write the answer to the frame correctly, and then go on to the next frame.
7. At the end of the set, read the summary of the set and study the learning-patterns again. Count the number of correct answers you have made. If you have 80% correct, move to the next set. If you have less than 80% correct, do the set again.
WRITING THE ANSWERS
Writing the answers is absolutely essential to the learning process; the answer must be written before you look at the correct solution. If you do the programme without writing, or merely glance ahead, you will lose half of the value of the programme. (However, a little intelligent cheating can be educational!)
SEQUENCE
Each frame must be answered in turn. The sequence has been carefully designed to introduce new knowledge and to reinforce old knowledge. Do not skip frames; any apparent repetitions are there for a good reason. Avoid careless answers. If you begin to make mistakes because you are tired and have not read the text carefully, take a rest. If you continually miss one particular point, go back to the set in which it first appeared and do that set again. Use the glossary to help you where necessary.
And now read quickly through Chapter 1: ‘Introduction’.
[viii]
Important Note
In front of each set is a summary of technical terms and ideas to be learned from the set. Read the summary quickly.
If you already understand all of the summary, do not complete the set – pass on to the next one.
If you do not completely understand every technical term and idea in the summary, do the whole set. Do not attempt to do only part of a particular set.
Chapter 1 Introduction
Estimated time: 10 minutes
note: Look at the glossary at the back of this book, and use it regularly to find out the meaning of any words or abbreviations you don’t know.
FINANCIAL MANAGEMENT
Accounting and finance in business are concerned with transactions, records, accounting reports, costs, prices, margins, cash flows, etc.
However financial management seeks to increase the long-term value of the business, and concentrates upon four key areas of decision:
a) size of the business
b) rate of growth of the business
c) stability of the business in terms of sales and profits
d) kinds of assets to be acquired (CIA)
CAPITAL INVESTMENT ANALYSIS (CIA) AND DISCOUNTED CASH FLOW (DCF)
Capital Investment Analysis (CIA) is that part of financial management which deals with the acquisition of assets; it involves the risk of substantial investment now for benefits later.
In CIA we have to start with certain givens or assumptions:
a) size of the investment (how much to invest?)
b) horizon (how long will the project be working?)
c) annual savings (how much to save each year?)
d) terminal value (what to get back by selling the assets at the end of the horizon?)
e) tax and interest rates (what tax rates and interest rates are relevant?)
For a new investment to be acceptable (to achieve the required minimum rate of return on the new money invested) the present value of the cash inflows should equal or exceed the present value of the cash outflows, and to calculate these present values (at year 0) we need compound interest or ‘discounting’ techniques.
Discounted Cash Flow (DCF) is a compound interest technique to reduce cash flows at different time periods (say years 1 to 10) to a common standard PV (present value) at year 0, so that they may be comparable. Whereas compound interest is normally computed forward from years 0 to 10, DCF works backward from year 10 to year 0. Thus discounting is compound interest worked backwards.
DCF does not make CIA decisions, but merely improves the quality of decision-making by giving a realistic assessment of real costs and benefits from a capital investment.
1
Introduction
CAPITAL INVESTMENT DECISIONS AND ALTERNATIVES
We carefully identify the specific capital investment decision to be made as either:
a) buy A now or do not buy A now (investment project)
b) buy A or lease A (buy v lease)
c) buy A or buy B (mutually exclusive projects)
d) buy a limited selection of A, B, C, D, E, F, etc. with a limited amount of money available (capital rationing)
In capital investment analysis, we consider all alternatives for achieving the same objectives; we analyse not merely good projects, but all the best alternatives.
MEASURES OF INVESTMENT
Good capital investment decisions are partly intuitive, because assessment of both quantitative and non-quantitative factors requires sound business judgement.
However, to aid decision-making, we make use of certain measures of investment, such as Payback, Simple Return on Investment, Net Present Value, Profitability Index, and Yield.
We compute these measures of investment using several techniques, including Relevant Cost Analysis, DCF, AA (Alternative Analysis), and PFD (Provision for Disaster Analysis).
DICH
‘DICH’ is a way of thinking systematically about each capital investment problem in terms of Decision and criteria, Investment, Cash flow, Horizon and terminal values.
TAXES AND DEPRECIATION
Income tax affects CIA because tax ‘shields’ paid and received change the timing of the cash flows. Tax shields may arise from annual depreciation or equipment sold or scrapped at a loss. Tax shields on equipment losses are benefits received earlier rather than later.
DISCOUNT RATES
Management selects the interest or discount rate, or ‘hurdle rate’, as the minimum rate of return required from new investment opportunities. This rate accounts for capital and interest recovered, but does not necessarily account for inflation.
2
Introduction
Selection of the hurdle rate is a long-term strategic decision which involves the concept of ‘Cost of Capital’ to ensure that new investments do improve the long-term profitability and value of the business.
OVERALL APPROACH TO CIA
CIA for any individual project is only meaningful when it is part of a capital-budgeting system. This involves long-term planning, short-term capital budgets, analysis, forms and procedures, evaluation, decision, and finally audit.
All investment projects involve risk, because we invest definite cash now for indefinite future benefits. For effective analysis, good data and valid assumptions are vital. Forecasts and estimates by ‘experts’ may sometimes be distorted by human and organisational pressures to become more political than realistic.
Good capital investment ensures the long-term survival of the business. It requires many controls and a balanced approach to analysis of different types of projects, including replacement projects, expansion projects, product-line projects, and strategic projects. Such decision-making requires the highest level of management skills.
Sound business judgement and intuition are the keys to effective capital investment analysis. DCF is only a tool, not a scientific answer to capital investment decision-making, since DCF relies completely upon the validity of the underlying assumptions provided by the operating managers.
note: Now have a look at the CIA worksheet and discount tables following. Don’t try to understand them – all will be explained later – then start Chapter 2.
3
Introduction
CIA Worksheet for Project A
|Assumptions | | | | | |
| |30 | | | | |
| |20 | | | | |
| |– | | | |100 |
| |20 | | | |(100) |
| |10 | | | |ignored |
| |– | | | | |
| | | | | |100 |
| |10 | | | | |
| |20 | | | | |
| | | | | | |
| | | | | |100 |
| |30 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at 20 % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |100/30 |3·3 |3 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on |30/100 |30 |20 |
|Investment (SRI) |( 100% |% |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |126 – 100 |+26 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
4
Introduction
Discount Table A
Present value of 1·00 received once only in years 1–10
|Discount rate (or ‘hurdle’ rate) |
|Year |0% |10% |20% |30% |as below |
|0 |1·0 |1·0 |1·0 |1·0 | |
|1 |1·0 |0·9 |0·8 |0·8 | |
|2 |1·0 |0·8 |0·7 |0·6 | |
|3 |1·0 |0·8 |0·6 |0·4 | |
|4 |1·0 |0·7 |0·5 |0·4 | |
|5 |1·0 |0·6 |0·4 |0·3 | |
|Subtotal |
|6 |1·0 |0·6 |0·3 |0·2 |as below |
|7 |1·0 |0·5 |0·3 |0·2 | |
|8 |1·0 |0·5 |0·3 |0·1 | |
|9 |1·0 |0·4 |0·2 |0·1 | |
|10 |1·0 |0·3 |0·2 |0·1 | |
|Total |
Discount Table B
Cumulative totals of discounted values of 1·00 received every year for 1–10 years (i.e. PV of 1·00 received every year in years 1–00)
|Discount rate (or ‘hurdle’ rate) |
|Year |0% |10% |20% |30% | |
|0 |— |— |— |— | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | |as above* |
|1 |1·0 |0·9 |0·8 |0·8 | |
|2 |2·0 |1·7 |1·5 |1·4 | |
|3 |3·0 |2·5 |2·1 |1·8 | |
|4 |4·0 |3·2 |2·6 |2·2 | |
|5 |5·0 |3·8 |3·0 |2·4 | |
|6 |6·0 |4·4 |3·3 |2·6 |as above† |
|7 |7·0 |4·9 |3·6 |2·8 | |
|8 |8·0 |5·4 |3·8 |2·9 | |
|9 |9·0 |5·8 |4·0 |3·0 | |
|10 |10·0 |6·1 |4·2 |3·1 | |
note: These are a simplified form of part of the discount tables used in DCF calculations. Rather fuller tables are given on pages 66 and 67.
5
Chapter 2 Basics of Capital Investment Analysis
note: ‘Learning-patterns’ are included at the beginning of each chapter to help you to think more deeply about the concepts and reinforce the language that you learn from each part of the programme. Look at these patterns carefully before and after studying each set, to develop a continuous ‘feeling’ for the subject.
A Before investment, search for all alternatives
[pic]
B Calculations based on poor assumptions are valueless
[pic]
6
Basics of Capital Investment Analysis
C Cash profile-a picture of cash in v cash out
|a) |Year 0 |Year 1 |Year 2 |Year 3 |
| | |In |In |In |
| | |50 |50 |50 |
| |Cash | | | |
| |100 | | | |
| |Out | | | |
|b) |Year |Out |In |Net |
| |0 |100 |– |100 |
| |1-3 |– |50 p.a. |(150) |
| | |
NOTE: Old-machine book value is not a cash flow and
therefore not relevant!
7
Basics of Capital Investment Analysis
F Simple measures of investment–payback
[pic]
G Simple measures of investment–SRI
[pic]
H DCF measures of investment–NPV
Annual savings 30
PVF for discount 20% at 10 yr horizon = 4·2 (from Table B)
PV of savings = 30 X 4·2 = 126
PV of investment = 100
Net present value =+26
Decision ? YES – invest (all other things being equal)!
8
Set 2.1 CIA as part of Financial Management
Estimated time: 20 minutes
summary
Financial Management deals with four key business-problem areas:
a) size
b) growth
c) stability of sales and profits
d) assets acquired (capital investment)
Capital investment analysis (CIA) deals with the fourth of these problems: the acquisition of new assets. It involves a cash profile (see glossary and learning-pattern 2C) of cash paid out now for benefits to be received later (we hope). New assets may be justified by reasons of policy, legal requirement, or profitability (return on investment). CIA is concerned mainly with the profitability of projects as measured by return on investment.
CIA involves a process of search, analysis, decision-making, and audit. The creative search for all alternatives widens any investment decision from ‘Go’ or ‘No Go’ to a choice of alternatives by time, efficiency, quantity, source, etc.
In carrying out CIA, we start with six basic assumptions (outlined on the CIA worksheet) with regard to Investment, Annual Savings, Horizon, Tax Rate, Discount Rate, and Terminal Values.
key note: Read the summary above and look at the learning-patterns at the beginning of this chapter. If you understand all of the summary, proceed immediately to the next set; if not, then complete this set, and then study the summary and learning-patterns again.
9
|Set 2.1 Detailed Frames |Correct answers |
| | | |
|1. CIA stands for capital ......... analysis. The word ‘capital’ implies investments that are | | |
|......... (long/short)-term | |see answer below |
| | | |
|2. Capital investments involve investment now for benefit ......... (later/immediately). Any | | |
|investment in property, planning, equipment, research, and development, etc. which involves | | |
|investment now for benefits later is a ......... investment. | |investment |
| | |long |
| | | |
|3. The investment now is fairly definite, but the hoped-for later benefits are less definite, and | | |
|thus each capital investment ......... (does/does not) involve a measure of risk. | |later |
| | |capital |
| | | |
|4. CIA is that part of the financial management of a business which deals primarily with which of | | |
|the following (choose one only): | | |
|a) size of the business? | | |
|b) rate of growth? | | |
|c) stability of sales and profits? | | |
|d) capital assets to be acquired? | |does |
| | | |
|5. Capital budgeting, project analysis, capital appraisal, and return-on-investment analysis are | | |
|all names for capital ...... …... | |(d) |
| | | |
|6. The long-term survival of a business depends upon investment to achieve ......... | |investment |
| | |analysis |
| | | |
| | | |
|7. CIA leads to better decision-making for unproved ......... | |profits |
10
|Set 2.1 Detailed Frames | |Correct answers |
| | | |
|8. Cash paid out now for benefits (hopefully) later, is a capital investment ......... | | |
|(True/False). Even that nice dinner for the girl-friend? | | |
| | |profits |
| | | |
|9. Capital investments involve investment ......... for benefits ......... | |true |
| | |yes |
| | | |
|10. Some investments are directly for profit, but others are only indirectly profitable; yet such | | |
|investments may be necessary for reasons of general policy or compliance with the law (e.g. a legal| | |
|requirement to build lavatories). Must we compute the profitability of such projects which we are | | |
|going to do for policy reasons? | | |
| | |now |
| | |later |
| | | |
|11. Capital investment (CI) decisions involve ......... (large/ small) amounts over ......... | |no (if we have |
|(long/short) time-periods | |decided to invest |
| | |anyway, there is |
| | |no point in |
| | |working out |
| | |numbers) |
| | | |
|12. CI decisions must be justified in one of three ways: | | |
|a) policy, or | | |
|b) law, or | |large |
|c) return on ......... | |long |
| | | |
|13. Which of the following are CI decisions: | | |
|a) appraisal and selection of projects? | | |
|b) replacement v major overhaul? | | |
|c) evaluation of lease proposals? | | |
|d) maintenance of equipment? | | |
|e) method of raising capital? | |investment |
11
|Set 2.1 Detailed Frames | |Correct answers |
| | | |
|14. A CIA decision to buy or not to buy machine A is known as a ‘Go’ or ‘......... Go’ decision. | |(a), (b), (c) |
| | |(investment is a separate |
| | |problem from financing) |
| | | |
|15. However, perhaps there are better alternatives to machine A If we make a creative search for | | |
|another alternative investment, then the decision changes from ‘Go’ or ‘No Go’ to a choice of | | |
|Project A or….. | | |
| | |no |
| | | |
|16. Every CIA decision has many alternatives. ‘Green wood can be bent. When it is dry, it is | | |
|straightened only by the fire’, so be sure to seek all alternatives in a CIA decision ......... | | |
|(before/after) you choose to analyse any particular projects in detail. | | |
|note: some ‘old Eastern sayings’ are included in the programme to (a) encourage you to think more | | |
|deeply about some of the CIA concepts, (b) interest and amuse you, (c) relieve the monotony of the | |project b |
|programme technique. We hope you appreciate them. | | |
| | | |
|17. Now study the learning-pattern dealing with the creative search for all alternatives. Is CIA | | |
|simply a matter of do or do not invest? | | |
| | |beforE |
| | | |
|18. Name three ‘do’s’ that are alternatives: do ........., do ........., and do ......... | | |
| | |no |
| | | |
|19. Timing extends the alternatives available: invest now or….. | | |
| | |WITHOUT |
| | |NOTHING SOMETHING ELSE |
|20. Similarly, the amount of the investment makes alternatives: invest all or invest .........? And| | |
|again, the supplier – A, B, C, or ......... else – provides other ......... | | |
| | | |
| | |LATER |
12
|Set 2.1 Detailed Frames | |Correct answers |
| | | |
|21. And so, before making an investment, we search out all possible alternatives, and even then our| | |
|assumptions may be wrong and we ‘Provide for Disaster’ – consider all eventualities ......... | |some |
|(before/after) making an investment. | |someone |
| | |alternatives |
| | | |
|22. Now, every capital investment may be considered as cash outflow and cash inflow in a ......... | | |
|profile. | |before |
| | | |
|23. Cash received is called cash ........., and cash paid is cash ....… | | |
| | |cash |
| | | |
|24. All investments may be represented as cash flows in a ....... ........ | |in/inflow |
| | |out/outflow |
| | | |
|25. Cash ‘out’ is normally the ......... (Can your wife really ‘save’ by spending more?) | | |
| | |cash profile |
| | | |
|26. Cash ‘in’ is normally annual ......... (investments/savings/ costs). | |investment |
| | |She thinks so! |
| | | |
|27. Must an investment in a new machine be justified by: | |savings (e.g. |
|a) policy, and | |lower operating |
|b) law, and | |costs with the new |
|c) return on investment? | |investment) |
| | | |
|28. What questions does CIA seek to answer: | | |
|a) Go or No Go? | | |
|b) lease v buy? | |no-any one is enough |
|c) which alternative? | | |
| | | |
|29. Each CIA worksheet is set up for only one alternative: to indicate Go or ......... | | |
| | |all |
13
|Set 2.1 Detailed Frames | |Correct answers |
| | | |
|30. In this set we have discussed capital investments as cash ........., and have noted the need to| | |
|search for all ......... and to provide for......... | | |
| | |no go |
| | | |
|31. Which of the following is a cash flow that actually ‘rings the cash register’: | | |
|a) salvage (terminal) value? | | |
|b) new investment? | | |
|c) old-machine book value? | | |
|Book values are not cash flows, but terminal values are cash flows ......... (True/False). Cash | | |
|flows ‘ring the ......... register’. | |flows alternatives disaster |
| | | |
|32. Terminal values of old replaced machines are cash flows, whereas book values are ......... cash| |(a), (b) |
|flows. | |true |
| | |cash |
| | | |
|33. CIA ......... (is/is not) part of financial management. It involves investment for hoped-for | | |
|benefits in the ......... It involves ......... amounts for ......... periods. Is marriage a | | |
|capital investment? | | |
| | |not |
| | | |
|34. Remember that investments may be justified by policy or legal requirements, or we must justify | |is |
|them (by under taking CIA) by return on ......... | |future |
| | |large |
| | |long |
| | |yes |
| | | |
|35. Now complete part only of the CIA worksheet for Project A following, which provides a | | |
|systematic approach to computation of measures of investment. Write in the following (the | | |
|assumptions): Investment, 200; Annual Savings, 30; Horizon, 10 years; Terminal Value, nil; Tax | | |
|Rate, ignored; Discount Rate, 20%; Old-machine Book Value, nil; say Old-machine Horizon, nil years;| | |
|Old-machine Terminal Value now, 100. | | |
| | | |
| | | |
| | |investment |
14
CIA Worksheet for Project A-
fill in as instructed in set 2.1, frame 35
|Assumptions | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |years |
| |Net Investment/Annual Savings | | |
|Simple Return on |/ |% |% |
|Investment (SRI) |( 100% | | |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
15
|Set 2.1 Detailed Frames | |Correct answers |
| | | |
|36. Are you doing this programme alone? If so may we suggest a way to make it more interesting and | | |
|effective learning? Try to get one or two colleagues to work with you and do the programme in a | | |
|small group, so that you can discuss problems and make progress together. Our research indicates | | |
|that programmed instruction in a group setting provides higher quality and effectiveness in | | |
|learning. | | |
| | | |
|Check your completion of the worksheet with the solution on page 17, then read again the summary of| | |
|this set and review the learning-patterns at the beginning of this chapter, before proceeding to | | |
|set 2.2. | | |
16
CIA Worksheet for Project A–solution
|Assumptions | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |years |
| |Net Investment/Annual Savings | | |
|Simple Return on |/ |% |% |
|Investment (SRI) |( 100% | | |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
17
Set 2.2 DCF Concepts and Investment
Estimated time: 20 minutes
summary
In CIA we compare the cost of a new investment (cash outflow), with the savings (income or cash inflow) which result from making that new investment. We construct a cash profile of cash outflows and cash inflows for the life (Horizon) of the new investment (say years 0 to 10).
Cash outflows usually take place immediately the investment is made (year 0). The present value (year 0) is thus easily computed as the cash outflow (year 0) reduced by the salvage value of any old machine that the investment replaces.
On the other hand the cash inflows consist of annual savings/income over the horizon of the new investment (years 0-10), plus salvage or terminal value of the new investment when finally disposed of at end of the horizon (year 10). For an acceptable new investment (which achieves the required minimum return on investment of new money) the PV (at year 0) of the cash inflows should equal or exceed the PV of the cash outflows (years 1-10), at the required discount rate.
Discounted Cash Flow (DCF) is a compound interest technique for calculating the PV (at year 0) of future cash flows (years 1 to 10). Since the new investment is usually made in year 0, DCF concentrates on reducing the cash inflows (year 1 to 10) to PV at year 0. It discounts the cash flows to the value in year 0.
Discount tables are compound interest tables worked backwards to year 0. Discount Table A (page 5) gives the PV of any one amount of money at a given discount rate for a given time period, from say years 1 to 10. In practice some new investments produce the same cash inflows each year for several years. Table B gives the cumulative PV of any one amount of money at z given discount rate every year, from say years 1 to 10. Thus Table B is a summary of Table A and is used for quick calculations.
DCF accounts for interest, not inflation. In inflationary conditions, management must set higher discount rates as the minimum ‘hurdle’ rate. Cash outflow for new investment in year o is reduced by the cash inflow from the terminal (salvage) value of any old machine it replaces. It is the salvage value of the old machine which is important (the actual money received). The old-machine book value is irrelevant.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
18
|Set 2.2 Detailed Frames |Correct answers |
| | | |
|1. Discounted Cash Flow (DCF) is a tool of .................... | |see answer below |
| | | |
|2. DCF is a method of calculating the cost of ............. (interest/ inflation). | |capital |
| | |investment |
| | |analysis (cia) |
| | | |
|3. Discounting is the reverse of compounding; therefore, in DCF, the Present Value of a future | | |
|amount is the ............. (discounted/compounded) value today. | | |
| | |interest |
| | | |
|4. Another way of defining DCF is to say that the Present Value (PV) of a future cash flow is a | | |
|......... cash flow. | |discounted |
| | | |
|5. DCF allows for the cost of money by discounting the cash flows in and out each year to Present | | |
|Value (PV), to find the net ......... (present/future) value at year 0 | | |
| | |discounted |
| | | |
|6. Now study Simple Table A (on page 5) and try to relate it to Summary Table B. Remember that the | | |
|discount tables reduce all money received or paid hi the future to its PV at year ......... An | | |
|acceptable capital investment has future cash inflows that repay the initial ......... in year 0. | | |
| | | |
| | |present |
| | | |
|7. Notice the relationship between Discount Tables A and B. Except for the sub-totals, all the | | |
|figures for the PV of 1·00o after year 0 are less than 1. This is because they represent the | | |
|discounted value of a single amount of 1·00. In Table B, on the other hand, all the amounts after | | |
|year 1 are greater than 1, because they represent the cumulative totals of the discounted values of| | |
|several different amounts of 1·00 received ......... year. | | |
| | |o |
| | |investment |
19
|Set 2.2. Detailed Frames | |Correct answers |
| | | |
|8. Future cash inflows must also provide compound interest on the outstanding balance of the | | |
|......... | |every |
| | | |
|9. Initial investment is normally taken to be in year ......... | |investment |
| | | |
|10. The Present Value (PV) is the value at year 0, which ......... (is/is not) today. | | |
| | |o |
| | | |
|11. The PV Factor (PVF) is a number. It is the PV in year 0 of 1·00 unit of money received at some | | |
|time in the future. The value of the PVF for different discount rates is given in the discount | | |
|tables on page 5. The PVF for 1·00 received once at some time in the future is given in Table A. | | |
|The PVF for 1·00 received every year over a given period is given in Table B. Use Table A (page 5) | | |
|to find the following PVs: | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | |is |
| |Am|Discount Rate |
| |ou| |
| |nt| |
20
|Set 2.2 Detailed Frames | |Correct answers |
| | | |
|13. Net Present Value (NPV) is the excess of PV of annual savings (PVS) over the PV of the original| | |
|......... (PVI): NPV = PVS – PVI. | |discount |
| | |time |
| | | |
|14. To find the NPV of a project, we need to know cash ........., horizon, and discount ......... | | |
| | |investment |
| | | |
|15. Now for some practice in relating Table A to Table B. (Practice makes perfect you know!) | | |
|a) What is the present value of 1·00 at 10% in year 1? | | |
|b) What is the present value of 1·00 at 10% in each of years 1 and 2? | | |
|c) What is the present value of 1·00 at 10% in each of years 1-5? | | |
| | |flows |
| | |rate |
| | | |
|16. Can you trace a figure of 3·80 in Table A and then in Table B? Do you see that Table A is | |0·9 |
|related to Table B in that Table B is a ......... of Table A? | |1·7 |
| | |3·8 |
| | | |
|17. The PV of savings is equal to the PVF × annual savings. For example, PV of annual savings of 50| | |
|for 5 years (i.e. 50 received every year for 5 years) at a discount rate of 20% is equal to PVF for| | |
|5 years at 20% (from Table B, page 5) × 50 = ? × 50 = ? | | |
| | | |
| | |summary |
| | | |
|18. From the following cash flow, what is the Net Present Value for this project at a discount rate| | |
|(DR) of 10%? | | |
| | | |
| | | |
| | | |
| | | |
| | | |
|Year |Project |10% DR |PV|Answer |
| |Cash Flow |PVF | |(don’t cheat) |
| | | |
|Investment (1000) means cash ......... in year 0. | |150 |
21
|Set 2.2 Detailed Frames | |Correct answers |
| | | |
|19. In frame 18, the cash inflow of 500 refers to ......... cash savings in years 1 to ......... | |npv = — 1000+ |
| | |1250 = +250 |
| | |out |
| | | |
|20. The Horizon is the working life of the project. It means how long the project will: | | |
|a) work technically? | | |
|b) be economic? | |annual |
|In the above project, the horizon was ......... years. | |3 |
| | | |
| | | |
|21. The discount rate used is the minimum rate of return required. Is this the ‘hurdle’ rate? | |(b) |
|......... (Yes/No). | |3 |
| | | |
|22. Which of the following might be classified as terminal-value cash flow: | | |
|a) salvage value of new investment at end of horizon? | | |
|b) salvage value of old equipment replaced by new investment? | | |
| | | |
| | |yes |
| | | |
|23. What is the PV of 100 hi one year’s time at 20%? | | |
|What is the PV of 100 in two years’ time at 20%? | | |
|Note that the sooner money is received, the more it is worth. | | |
| | |both |
| | | |
|24. What is the PV of 100 each year for years 1 and 2 at 20%? | |80 |
| | |70 |
| | | |
|25. Discount tables are compound-interest tables worked ......... | | |
| | |80 + 70 = 150 |
| | | |
|26. Refer to the discount tables (on page 5). Simple Table A shows the PV of 1·00 received | | |
|......... only in years 1–10, and Summary Table B shows the PV of 1·00 received every ......... in | | |
|years 1–10. | | |
| | |backwards |
22
|Set 2.2 Detailed Frames | |Correct answers |
| | | |
|27. Using Simple Table A, what is the PV of 30 at 20% received once only in year 5? | |once |
| | |year |
| | | |
| | | |
| | | |
|28. What is the PV of 30 at 20% received every year for 5 years? | | |
|But don’t forget, ‘If a gem falls into mud, it is still valuable. If dust ascends to heaven, it | | |
|remains useless.’ A bad project is a bad project, so don’t expect DCF to ‘improve’ it! | |0·4 × 30 = 12 |
| | | |
| | | |
|29. In this set we have discussed aspects of discounted cash flow, including the PVI, which stands | | |
|for the ‘Present Value of .........’, and the PVS, which stands for the ‘Present Value of | | |
|.........’ | | |
|PVS – PVI = NPV, which stands for ‘......... Present Value’. Discount Table A is summarised in | | |
|Summary Table ......... | |3·0 × 30 = 90 |
| | | |
| | | |
|30. Now just one or two more frames to clarify the difference between gross investment and net | | |
|investment. | | |
|Gross investment in new machine, 1000 | | |
|Old machine replaced: | |investment |
|Book value, 800 | |savings |
|Terminal value, 400 | |net |
|Cash out in year 0 is a net investment of ......... | |b |
| | | |
| | | |
|31. Did you say 200? Wrong–the old book value is not a ......... flow. Try again: | | |
|New gross investment, 500 | | |
|to replace old equipment | | |
|Book value, 200 | | |
|Salvage value now, 50 | | |
|Cash out in year o is ......... | | |
| | |600 (1000 – 400) |
23
|Set 2.2 Detailed Frames | |Correct answers |
| | | |
|32. Now let’s continue with the CIA worksheet for Project A (on page 25). From the following | |cash |
|information, and that already provided on the worksheet, complete the ‘Cash Profile’ part of the | |450 (500—50) |
|worksheet. (Check your work against the solutions provided on page 26.) | | |
| | | |
|On first line | | |
|Year 0: gross investment of 200 (out) reduced by the terminal value of the replaced old machine of | | |
|100 (in), to show net investment of 100. | | |
|(note: This information has already been filled in for you on the part of the worksheet headed | | |
|‘Old-machine Effect on New Investment’. Under this section, the book value of the old machine is | | |
|given as zero, i.e. the value has been completely written off by depreciation. Selling the machine | | |
|for 100 now (its terminal value) thus leads to a book profit of 100. Book values are, however, | | |
|irrelevant to the cash profile. We are interested only in the terminal value of 100, which reduces | | |
|the cost of the investment (now in year 0) by 100.) Discount rate 20% and PV factor (for cash out) | | |
|of 1·0 for year 0, to show PVI of 100 (out). | | |
| | | |
|On second line | | |
|Years 1–10: annual savings (in) of 30. | | |
|(note: The ‘Annual Cash Flow’ section of the worksheet has already been filled in to show details | | |
|of the calculation of annual taxable income for tax purposes. However, for the present, tax paid is| | |
|shown as nil; we are ignoring this complication for the time being.) PV factor for 10 years at 20% | | |
|is 4·2 (see Discount Table B on page 5). This gives actual PV of savings to be 4·2 × 30 = 126. | | |
| | | |
|33. Now read again the summary of the set, and review the learning patterns at the front of the | | |
|chapter. | | |
24
CIA Worksheet for Project A-(continued)
fill in as instructed in set 2.2, frame 32
|Assumptions | | | | | |
| |1-10 | | | |
| |30 | | | | |
| | | | | | |
| | | | | |100 |
| |20 | | | | |
| |– | | | | |
| |20 | | | |(100) |
| |10 | | | |ignored |
| |– | | | | |
| | | | | |100 |
| |10 | | | | |
| |20 | | | | |
| | | | | | |
| | | | | |100 |
| |30 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |years |
| |Net Investment/Annual Savings | | |
|Simple Return on |/ |% |% |
|Investment (SRI) |( 100% | | |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
25
CIA Worksheet for Project A–solution (continued)
|Assumptions | | | | | |
| |1-10 | | | |
| |30 | | | | |
| | | | | | |
| | | | | |100 |
| |20 | | | | |
| |– | | | | |
| |20 | | | |(100) |
| |10 | | | |ignored |
| |– | | | | |
| | | | | |100 |
| |10 | | | | |
| |20 | | | | |
| | | | | | |
| | | | | |100 |
| |30 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |years |
| |Net Investment/Annual Savings | | |
|Simple Return on |/ |% |% |
|Investment (SRI) |( 100% | | |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
26
Set 2.3 Simple Measures of CIA
Estimated time: 20 minutes
SUMMARY
Capital investment not made for reasons of policy or law may be evaluated in CIA for profitability or return on investment. Several measures of profitability of investment are available:
a) Payback
This is computed by the formula
[pic]
(years)
The payback period is the number of years required to recover the investment. It measures cash recovery and the time needed to begin profit making, but it ignores the timing of the cash flows (i.e. how long it is before we receive the money), cash flows after the payback period, and tax effects. It is thus not a very good measure of the profitability of an investment. More complex ‘after tax’ formulae are sometimes used.
b) Simple Return on Investment
SRI (a poor measure) is computed by
[pic]
SRI ignores the time value of money (i.e. the sooner we get the money, the more it is worth to us) and the tax effects.
c) Net Present Value
NPV, a DCF measure, is computed by
PV of savings — PV of investment = NPV (cash)
A zero or positive NPV implies an adequate return above the minimum required. However, large investments tend to have larger NPV’s than smaller investments.
The overall approach to CIA is to determine the assumptions of the proposed investment and to examine the available alternatives, relevant annual savings,
27
Set 2.3 Simple Measures of CIA
cash profile, measures of investment, and also non-quantitative factors, before making a decision.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
28
|Set 2.3 Detailed Frames |Correct answers |
| | | |
|1. Many firms evaluate investment projects by using simple measures of investment such as Payback, | | |
|which is the number of years required to ‘recover’ the ........ (cost/ profit) of the investment. | | |
| | |see answer below |
| | | |
|2. For an investment of 200 with annual savings of 50 each year, the payback is ........ years. | | |
| | |cost |
| | | |
|3. Payback may be defined in various ways, but a simple definition is Net Investment divided by | | |
|Annual Savings (before depreciation and tax). Payback measures the ........ (cash/interest) | | |
|recovery. | |4 |
| | | |
|4. But what is ‘net’ investment? Well, if a new investment (200) replaces an old machine (terminal | | |
|value of 50), then the gross investment is 200 but the net Investment is only 200 – ........... = | | |
|.......... | | |
| | |cash |
| | | |
|5. For annual savings of 50 per annum and a net investment of 150, the payback period is now only | | |
|........ years. Is the terminal value of an old machine relevant to the new investment? | |50 |
| | |150 |
| | | |
|6. However, Payback has defects because it ignores (choose four): | | |
|a) timing of cash Sows (whether cash comes in now or in 3 years’ time)? | | |
|b) cash flows after Payback? | | |
|c) tax effects? | | |
|d) time needed for profit-making? | | |
|e) depreciation? | |3 |
|But it does help the manager to assess risk ........ (True/False). | |yes (but not the |
| | |book value) |
29
|Set 2.3 Detailed Frames | |Correct answers |
| | | |
|7. Another simple measure of investment is Simple Return on Investment (SRI), computed as Annual | | |
|Savings divided by Net Investment, times 100%. This measure is too simple, and it ignores the | | |
|........ (time/profit) value of money. | |(a), (b), (c), (e) |
| | |true |
| | | |
|8. SRI is Annual Savings (e.g. 30) divided by Net Investment (e.g. 100), times 100%. | | |
|[pic] | | |
|‘That building without a firm base, do not build it high. | | |
|Or if you do-be afraid’ (Sufi saying). | | |
| | | |
| | |time |
| | | |
|9. However, DCF measures of investment are more rigorous. Now we discuss Net Present Value (NPV), | | |
|which uses three factors to assess a project: | | |
|a) PV of the investment at the year ........, | | |
|b) PV of annual ........ for years 1–5, | | |
|c) specific horizon and discount rate. | |30 |
| | |30% |
| | | |
|10. The PV of savings (say 126) minus the PV of investment (say 100) for a specific discount rate | | |
|(say 10%) and a specific horizon (say 10 years) equals the ........ Present Value. | |o |
| | |savings |
| | | |
|11. Does a positive NPV imply a return above the minimum required? | |net |
| | | |
|12. This can be misleading, because big investments tend to have large NPV’s and small investments | | |
|smaller NPV’s ........ (True/False). | |yes |
| | | |
|13. Now study the learning-pattern referring to Payback, SRI, and NPV as simple CIA measures of | | |
|........ | |true |
30
|Set 2.3 Detailed Frames | |Correct answers |
| | | |
|14. For an investment of 100 with annual savings 20, the pay-back is ........ years, and the SRI | | |
|is ........ % | |investment |
| | | |
|15. However, for the DCF measure of NPV, it is not enough to work simply on savings of 20; we | | |
|must know a discount rate (say 10%) and a horizon period (say 10 years), so that we can assess | | |
|the present value of the savings. In this example, PVS = 20 ( 6·1 (the PVF) = ........ | | |
|The PVF of 6·1 comes from ........ PVI was 100, therefore NPV = 122 – 100 = ........ | | |
| | | |
| | |5 |
| | |20% |
| | | |
|16. If the horizon of the project were only 5 (not 10) years, then the PVS would be only 20 times| |122 |
|........., giving PVS of 76 and an NPV of ........ | |discount table |
| | |b (page 5) |
| | |+ 22 |
| | | |
|17. The Payback measure uses the formula Investment/ Annual Savings, and the result is shown in | |3·8 |
|........ | |–24 |
| | | |
|18. The SRI measure uses the formula Annual Savings/ Investment, and the result is shown as a | | |
|........ | |years |
| | | |
|19. In calculating NPV, we use the formula Present Value of Savings (PVS) minus Present Value of | | |
|Investment (PVI), and the result is shown in ........ | | |
| | |percentage |
| | | |
|20. Which of these three measures of investment uses DCF? | |money |
| | | |
|21. DCF measures cash flow sufficient to repay the original ........ and provide ........ on the | | |
|balance oustanding. | |npv |
31
|Set 2.3 Detailed Frames | |Correct answers |
| | | |
|22. Now to summarise what we have learnt about CIA and DCF. Firstly, Capital Investment Analysis | |investment |
|is a part of ........ ......... | |interest |
| | | |
|23. CIA deals with investment ........ for benefits ........ | |financial |
| | |management |
| | | |
|24. DCF ........ (is/is not) a tool of CIA. | |now |
| | |later |
| | | |
|25. For effective CIA, which of the following must we take into account: | | |
|a) assumptions? | | |
|b) alternatives? | | |
|c) cash profile? | | |
|d) measures of investment? | | |
|e) non-quantitative factors? | |is |
| | | |
|26. The different measures of investment are SRI, ........, and ........ | |all |
| | | |
|27. Capital investments may be justified by law, policy, or ........ on investment. | |payback |
| | |npv |
| | | |
|28. Does CIA always involve assumptions? | |return |
| | | |
|29. The key assumption in evaluating a CIA project is the ........ (horizon/profit). | |yes |
| | | |
|30. For effective CI decision-making, measures of investment must be compared against a standard.| | |
|Now list the key CIA assumptions. | |horizon |
32
|Set 2.3 Detailed Frames | |Correct answers |
| | | |
|31. Now we complete the CIA worksheet for Project A (following). Given the assumptions, annual | | |
|cash flow, old-machine effect on new investment, and cash profile, we compute: | | |
|a) Payback | | |
|[pic] | | |
|b) SRI | | |
|[pic] | | |
|c) NPV | | |
|PVS 126 | | |
|less PVI 100 | | |
|NPV (amount) | | |
|Is this an acceptable investment? | | |
| | |investment |
| | |annual savings |
| | |horizon |
| | |discount rate |
| | |terminal value |
| | | |
|32. ‘What may appear to you a group of bushes could well be a place wherein a leopard lurks’, so| | |
|be careful with DCF; it may seem harmless, but, if your assumptions are faulty, DCF is | |now check with the |
|positively dangerous. Beware! | |correct solution |
|Now that you have completed the set, read the summary and review the learning-patterns for this | |yes, npv = +26 |
|chapter once again, before going on to Chapter 3. You’re making progress. Keep it up! | | |
33
CIA Worksheet for Project A-(completed)
fill in as instructed in set 2.3, frame 31
|Assumptions | | | | | |
| |1-10 | | | |
| |30 | | | | |
| | | | | | |
| | | | | |100 |
| |20 | | | | |
| |– | | | | |
| |20 | | | |(100) |
| |10 | | | |ignored |
| |– | | | |100 |
| |10 | | | | |
| |20 | | | |100 |
| |30 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |3 |
| |Net Investment/Annual Savings | |years |
|Simple Return on |/ |% |20 |
|Investment (SRI) |( 100% | |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
34
CIA Worksheet for Project A-(completed)
|Assumptions | | | | | |
| |1-10 | | | |
| |30 | | | | |
| | | | | | |
| | | | | |100 |
| |20 | | | | |
| |– | | | | |
| |20 | | | |(100) |
| |10 | | | |ignored |
| |– | | | |100 |
| |10 | | | | |
| |20 | | | |100 |
| |30 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |100/30 |3.3 |3 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on | 30/100 ( 100% |30 |20 |
|Investment (SRI) |Annual Savings/Net Investment |% |% |
|Net Present Value (NPV) |126 — 100 |+26 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
35
Chapter 3 Measures of Investment
A Before investment, search for all alternatives
[pic]
B Relevant cash profile
OUT (costs) IN (contributions)
Investment costs Contribution after tax (defined as
Variable costs sales less variable costs and taxes)
relevant
Differential costs Annual savings (cost reductions)
Opportunity costs Salvage values
Sunk costs Net profit
Fixed costs non-relevant
Book costs
C AA-alternative analysis
Buy or don’t buy machine A ?
How many alternatives:
1,2,3.4,5,6,... ?
NOTE: Do it early, to avoid the dreaded emotional Investment !
36
Measures of Investment
D NPV-example 1
Investment 10
Annual savings 5
Horizon 5 years
PVF at DR 20% for 5 years = 30 (from Table B)
PVS – PVI = NPV
(15) (10) (?)
E NPV-example 2
Investment 10
Annual savings 2
Horizon 10 years
PVF at DR 20% for 10 years = 4·2 (from Table B)
PVS – PVI = NPV
(?) (10) (?)
F CIA assumptions
[pic]
37
Measures of Investment
G DCF measures of investment
| |PVS | |
|NPV = PVS – PVI | | PI = PVS / PVI |
| |PVI | |
| |
|Yield is the discount rate that would make PVS – PVI = 0. |
H PVS – PVI = NPV
[pic]
I Short-cut to yield
Investment 90; Annual savings 30:
PVF = 90 / 30 = 3·0 (same as Payback)
Look up Horizon in Table B and locate DR:
Horizon (years) DR (%)
3 0% (Payback)
4 12%
5 20%
10 30%
50 33%
NOTE: Do the savings in years 11–50 make much difference ?
38
Measures of Investment
J DCF measures related
If PVS-PVI, then what is:
NFV ?
PI ?
Yield ?
Answers: 0.1.DR.
K Capital investment decisions
[pic]
PS. DCF helps to quantify the assumptions; it does not decide !
L ‘DICH’ approach
[pic]
39
Set 3.1 Discount Rates and Relevant Cost Analysis
Estimated time: 15 minutes
summary
Good capital investment decisions are intuitive and depend upon both quantitative and non-quantitative data. DCF is only a tool of CIA to aid sound business judgement.
DCF involves a compound interest calculation which reduces future cash inflows to present value at year 0.
Management selects the discount rate (DR) as an Investment Opportunity Rate (or minimum rate of return required, or ‘hurdle’ rate).
Relevant Cost Analysis is a technique to select the relevant cash flows for a specific decision. Relevant cash flow is not the same as total cash flow, because sunk costs and fixed costs, etc. are not usually relevant. Variable costs are usually relevant.
To ensure that out of all the alternatives the best is chosen, every alternative must be detected and considered before making a specific investment decision.
Recheck the underlying assumptions and thus ‘provide for disaster’ (PFD) by forecasting possible losses and devising alternate courses of action.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
40
|Set 3.1 Detailed Frames | |Correct answers |
| | | |
|1. Good capital investment decisions are intuitive. They depend upon both quantitative and ........| |see answer below |
|data. | | |
| | | |
| | | |
|2. DCF is a ........ to aid business decisions. | |non-quantitative |
| | | |
| | | |
|3. DCF involves compound-interest calculations worked backwards. This means that all cash is | | |
|reduced to present ........ at year ........ | |tool |
| | | |
| | | |
|4. DCF uses the discount rate (DR) as a general term for a rate of ........ | |value |
| | |0 |
| | | |
| | | |
|5. The discount rate automatically provides for inflation as well as for interest ........ | | |
|(True/False). To provide for inflation, management would have to select a particularly ........ | | |
|(high/low) discount rate. | |interest |
| | | |
|6. The DR is selected by ........ (management/accountants). | |false |
| | |high |
| | | |
| | | |
|7. The selection of the DR or ‘hurdle’ rate ........ (is/is not) a key management decision. | | |
| | |management |
| | | |
|8. The discount or ‘hurdle’ rate selected by management is an investment opportunity rate, or | | |
|required ........ (minimum/maximum) rate of return. | | |
| | |is |
| | | |
|9. How is the DR set? It is usually the ‘Average Cost of Capital’ as a required ........ on | | |
|investment. | |minimum |
41
|Set 3.1 Detailed Frames | |Correct answers |
| | | |
|10. The ‘Average Cost of Capital’ is a complex concept involving both equity and debt finance. | | |
|Simply (perhaps too simply), if equity costs 20% and debt 10%, and there are equal quantities of | | |
|equity and debt finance, then the average cost of capital is ........ (10%/15%/20%). | | |
| | | |
| | |return |
| | | |
|11. If there is more equity than debt, this ........ (will/will not) increase the average cost of | | |
|capital. | |15% |
| | | |
|12. However, even with the ‘right’ hurdle rate, capital investment problems must be very carefully | | |
|defined, to ensure that the rate is applied to the relevant ........ flows. | | |
| | |will |
| | | |
|13. Cash flows relevant to a specific decision are known as the ........ cash flows. | | |
| | |cash |
| | | |
|14. Relevant cash flows are not necessarily the total receipts and payments for the company as a | | |
|whole. For example, variable costs (which change with different investment plans) are relevant cash| | |
|flows; but fixed costs (overheads), which do not change in this way, are not relevant ........ | | |
|........ | | |
| | | |
| | |relevant |
| | | |
|15. Which of the following are usually relevant to a specific capital investment decision: | | |
|a) variable costs? | | |
|b) all costs? | | |
|c) differential costs? | | |
|d) new-investment costs? | | |
|e) contribution (sales less variable cost)? | | |
|f) fixed costs? | | |
| | |cash flows |
| | | |
|16. Sunk costs, book costs, fixed costs, and exchanges of cash or inventory ........ (are/are not) | | |
|usually specifically related to an individual capital investment decision because they do not | | |
|........ with the alternative decisions. | | |
| | |(a), (c), (d), (e) |
42
|Set 3.1 Detailed Frames | |Correct answers |
| | |are not |
|17. Income from sales — variable costs = contribution. | |change |
|Contribution — tax = contribution after ........, which is a cash Sow. | | |
| | | |
|18. Income from sales is a relevant cash inflow, and variable costs are a relevant cash outflow; | | |
|hence contribution ........ (is/is not) a relevant cash flow. | | |
| | |tax |
| | | |
|19. Tax payments are also a relevant cash outflow, so contribution after tax is a ........ cash | | |
|flow. | |is |
| | | |
|20. Net profit is defined as Contribution after Tax minus Fixed Costs. Fixed costs (which do not | | |
|generally change with different investment plans) are not usually relevant cash flows. Will net | | |
|profit then be a relevant cash flow? | | |
| | |relevant |
| | | |
|21. Now refer to the learning-patterns, and list three cash outflows which are usually relevant. | | |
| | |no |
| | | |
|22. Now list two cash inflows which are usually relevant. | |investment |
| | |variable cost |
| | |differential |
| | |cost |
| | | |
|23. Before involvement in a particular investment, it is important that all possible ........ are | |contribution |
|determined. | |terminal values |
| | | |
|24. ‘A tree freshly rooted may be pulled up by one man alone, but let the tree take root and it | | |
|will not be moved.’ There fore it is very, very important that the search for alternatives should | | |
|be done in the ........ (early/midway) stage of CIA, before you get emotionaly involved (do you | | |
|ever?) in one particular possibility. | | |
| | |alternatives |
43
|Set 3.1 Detailed Frames | |Correct answers |
| | | |
|25. It is so easy to become emotionally attached to a particular investment or project that, unless| | |
|we do Alternative Analysis (AA) early, we may refuse to change our minds when confronted with new | | |
|facts. Consider ........ in the early stages of planning, to avoid an emotional commitment to one | | |
|plan which may blind you to the superior features of an ........ (So too with choosing a wife or | | |
|husband!) | | |
| | |early |
| | | |
|26. Let us therefore remember that CIA is always based on assumptions that could be wrong ........ | | |
|(True/False). Always check and recheck the ........ of so-called ‘experts’. | |alternatives |
| | |alternative |
| | | |
|27. False assumptions could lead to disaster in CIA, but we id not think about all possible | | |
|situations that might make our assumptions wrong until something actually goes wrong ........ | |true |
|(True/False). | |assumptions |
| | | |
|28. Now suggest two situations that might arise which could destroy the value of a new capital | | |
|investment, e.g. rings not achieved. | |false |
| | | |
|29. PFD is Provision for Disaster. Before actually making a CIA decision, search for all | | |
|alternatives and make provision for ........ | |horizon shorter |
|‘I fear you will not reach Mecca, for the road you follow leads to Turkistan’; thus be careful that| |than expected |
|in CIA you are analysing the ........ (good/best) projects. If you are on the wrong track, DCF may | |investment costs |
|not help ........ (True/False). | |more (beware |
| | |the Concorde!) |
| | | |
|30. Search for best alternatives, and avoid emotional ............ | |disaster |
| | |best |
| | |true |
44
|Set 3.1 Detailed Frames | |Correct answers |
| | | |
|31. Now complete the Cash Profile and the first three Measures of Investment on the CIA worksheet | | |
|for Project B (following). | |INVESTMENT |
| | | |
|32. Now that you have completed the set, read the summary and review the learning-patterns for this| |now check with the solution |
|chapter, before going on to the next set. | | |
45
CIA Worksheet for Project B–
fill in as instructed in set 3.1, frame 31
|Assumptions | | | | | |
| |1-5 | | | |
| |3.0 | | | | |
| |2.0 | | | | |
| |– | | | | |
| |2.0 | | | | |
| |1.0 | | | | |
| |– | | | | |
| |1.0 | | | | |
| |2.0 | | | | |
| |3.0 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |3 |
| |Net Investment/Annual Savings | |years |
|Simple Return on | / ( 100% |% |20 |
|Investment (SRI) |Annual Savings/Net Investment | |% |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
46
CIA Worksheet for Project B–solution
|Assumptions | | | | | |
| |1-5 | | | |
| |3.0 | | | | |
| |2.0 | | | | |
| |– | | | | |
| |2.0 | | | | |
| |1.0 | | | | |
| |– | | | | |
| |1.0 | | | | |
| |2.0 | | | | |
| |3.0 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |10/3 |3.3 |3 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on | 3/10 ( 100% |30 |20 |
|Investment (SRI) |Annual Savings/Net Investment |% |% |
|Net Present Value (NPV) |9 – 10 |–1 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |% |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
47
Set 3.2 Net Present Value, Profitability Index, and Yield
Estimated time: 20 minutes
summary
In this set we deal with three DCF measures of investment, all closely related to each other.
a) Net Present Value (NPV)
We have already encountered this in set 2.3. NPV measures the excess return on investment at present value (year 0). NPV is Present Value of Savings (PVS) minus the Present Value of Investment (PVI):
PVS – PVI = NPV (money)
300 – 200 = 100 (good)
b) Profitability Index (PI)
This measures the excess return on investment in the form of an index number. If this figure is greater than 1, this indicates that savings are greater than the minimum required at the selected hurdle rate; if it is less than 1, that they are less than the minimum required.
[pic]
c) Yield, or Internal Rate of Return
This measures the actual return on investment as a percentage of the investment. It is the discount rate that makes PVS – PVI = 0.
Given PVI = 200 and PVS at 10% = 300, yield is more than 10%, since PVS is greater than PVI.
Given PVI = 200 and PVS at 15% = 250, yield is more than 15%, since PVS is greater than PVI.
Given PVI = 200 and PVS at 20% = 200, yield is 20%, since PVS is exactly equal to PVI.
All DCF measures of investment are related. Thus, if the NPV is zero, then the PI = 1, and the yield = the discount rate used.
Given the assumptions on the CIA worksheet, all measures of investment are computed by simple arithmetic.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
48
|Set 3.2 Detailed Frames |Correct answers |
| | | |
|1. We now discuss DCF measures of investment, all of which are related to NPV (which measures the | | |
|excess return on investment at a specific discount rate for a specific horizon at year ........). | | |
| | |see answer below |
| | | |
| | | |
|2. Present Value of Investment (PVI) equals the PV of net cash outflows or ........ | | |
|(savings/investment). | |o |
| | | |
| | | |
|3. Present Value of Savings (PVS) equals the PV of net cash inflows or ........ | | |
|(investment/savings). | |investment |
| | | |
| | | |
|4. From PVI and PVS, can you derive a formula for finding the NPV? | |savings |
| | | |
| | | |
|5. NPV is a measure of the excess of savings over investment. If PVS is 13 and PVI is 20, then NPV | | |
|is ........ | |npv = pvs — pvi |
| | | |
| | | |
|6. The NPV measure is PVS – PVI, and the result is a: | | |
|a) percentage? | | |
|b) ratio? | | |
|c) money value? | |– 7 |
| | | |
| | | |
|7. If the NPV is greater than 0, then the investment returns ........ (more/less) than the ‘hurdle’| | |
|discount rate. Is NPV — 7 a good investment? | | |
| | |(c) |
| | | |
| | | |
|8. If the NPV is equal to zero, the decision to invest should be ........ (Yes/No). | |more |
| | |no |
49
|Set 3.2 Detailed Frames | |Correct answers |
| | | |
|9. Another measure of investment is the Profitability Index (PI). The PI measures the excess return| | |
|on investment in the form of an index number. | | |
|The formula for the PI is : | | |
|[pic] | | |
|and, if PVS is 14 and PVI 20, then PI is about ........ | | |
| | |yes (return is |
| | |just good enough) |
| | | |
|10. If PI = 1, this indicates that the PVS (the cash inflow from savings when discounted at the | | |
|selected hurdle rate) exactly equals the cost of the investment (PVI); in other words, the | | |
|investment is yielding a return at exactly the minimum required rate (the hurdle rate). Thus, when | | |
|PVS = PVI, PI = 1. But when PVS = PVI, NPV = 0. A PI of ........ is thus equivalent to a NPV of 0. | | |
| | | |
| | |0·7 |
| | | |
|11. If the profitability index is greater than 1, this indicates that the PVS (discounted value of | | |
|future cash savings) is greater than the PVI (the cost of the investment); i.e. the investment is | | |
|more profitable than the minimum required. A PI figure of 1·5 is thus a cause for ........ | | |
|(greater/ lesser) satisfaction than one of 1·2. | | |
| | |1 |
| | | |
|12. Conversely, if PI is less than 1, this indicates that the predicted return on the investment is| | |
|going to be ........ (less/more) than the minimum required. | | |
| | |greater |
| | | |
|13. Thus an investment is acceptable if PI is equal to or greater than ........ Therefore, if the | | |
|PI is 0·7, ........ (Go/No Go). | |less |
| | | |
|14. A PI of 1 is associated with an NPV of 0. PI’s greater than 1 are associated with NPV’s of more| | |
|than ........; and PI’s of ........ ........ 1 are associated with NPV’s of less than 0. | |1 |
| | |no go |
50
|Set 3.2 Detailed Frames | |Correct answers |
| | | |
|15. So much for the Profitability Index. Let’s now go on to consider our third measure of | | |
|investment: Yield, or Internal Rate of Return (IRR). Yield measures the actual percentage of return| | |
|on investment. A good Yield exceeds the required ........ rate. | |o |
| | |less than |
| | | |
|16. If the Yield (say 12%) exceeds the hurdle rate (say 10%), the investment decision is ........ | |hurdle |
|(Go/No Go). | |(discount) |
| | | |
|17. Yield is a percentage. It is in fact the discount rate that would cause PVS to be equal to PVI | | |
|(i.e. NPV to equal 0, and PI to equal 1) if we were to discount annual savings at the Yield rate. | | |
|When NPV = 0, Yield exactly equals the ........ rate. | | |
| | |go |
| | | |
|18. If the Yield is greater than the discount (hurdle) rate, this implies that NPV is greater than | |discount |
|........ | |(hurdle) |
| | | |
|19. If the Yield is ........ than the discount rate, this implies that NPV is less than ........ | | |
| | |o |
| | | |
|20. Now refer back to frame 17. The Yield of an investment is the discount rate which would make | | |
|NPV = 0. If the NPV is 20 at a discount rate of 10%, is the Yield more or less than 10%? | |less |
| | |o |
| | | |
|21. To calculate the Yield on an investment, we want to find the discount rate which will make PVS | | |
|= PVI. Refer back to frame 17 of set 2.2. PVS = PVF × Annual Savings, where the Present Value | | |
|Factor (PVF) is determined from the discount tables on page 5. If we have annual savings of 3 over | | |
|a horizon of 10 years at a discount rate of 20%, then PVF = 4·2 (from Discount Table B, page 5), | | |
|and PVS = 3 × 4·2 = 13 (approximately). Remember, PVS = PVF × ........ ........ | | |
| | | |
| | |more |
51
|Set 3.2 Detailed Frames | |Correct answers |
| | | |
|22. If PVI = 18, and (as in the previous frame) PVS = 13, how do we find the Yield? The answer is | | |
|that we must determine the discount rate that would make PVS = PVI, which in this particular case | | |
|means finding the discount rate which would make PVS = 18. We determine the discount rate from the | | |
|PVF. If we want PVS = 18, then PVF × 3 (the annual savings) must equal 18, i.e. PVF must equal 18/3| | |
|= ........ | |annual |
| | |savings |
| | | |
| | | |
|23. Now, looking at Discount Table B (page 5), we see that, over a horizon of 10 years, we have a | | |
|PVF of almost exactly 6 for a discount rate of ........ | | |
| | |6 |
| | | |
| | | |
|24. If we calculate PVS using this discount rate (10%) over a horizon of 10 years with annual | | |
|savings of 3, will NPV be zero? Will PI = 1? Will the Yield equal the discount rate? | | |
| | |10% |
| | | |
| | | |
|25. Well, now you know how we compute the three DCF measures of investment: Net Present Value | |yes |
|(NPV), Profitability Index (PI), and Yield, which are all ........ (related/independent). | |yes |
| | |yes |
| | | |
| | | |
|26. Was that tough going? Why not take a coffee break and then come back to the rest of this set? | | |
|Now, please turn to learning-pattern 3G, which gives a formula for each of the three DCF measures | | |
|of investment. Like all DCF measures, NPV takes account of the time value of money, but it has the | | |
|disadvantage that the NPV for large investments ........ (is/is not) larger than for small | | |
|investments. | | |
| | | |
| | |related |
| | | |
| | | |
|27. Now look at the Profitability Index in the learning-pattern. What is the PI formula? | | |
| | |is |
52
|Set 3.2 Detailed Frames | |Correct answers |
| | | |
|28. What measure gives the rate of return on investment? | |[pic] |
| | | |
|29. Yield measures the actual rate of return on investment in ........ (percentage/years). | | |
| | |yield |
| | | |
|30. Do you remember the two simple (non-DCF) measures of investment we studied in set 2.3? What | | |
|measure reflects the profitability of an investment as a number of years? | | |
| | |percentage |
| | | |
|31. Does the Payback measure take into account the fact that we must discount future cash flows in | | |
|order to calculate their true present value? | | |
| | |payback |
| | | |
|32. Does Simple Return on Investment (SRI) share this same fault with the Payback measure? | | |
| | |no |
| | | |
|33. All DCF returns are in some way related. If the annual savings increase, how are NPV, PI, and | | |
|Yield affected? | |yes |
| | | |
|34. When the NPV = 0, then the PVS = ........ | |all become |
| | |higher |
| | | |
|35. When the NPV = 0, then the PI = ........ | |pvi |
| | | |
|36. When the NPV = 0, then the Yield equals the required ........ rate. | |1 |
53
CIA Worksheet for Project C–
fill in as instructed in set 3.2, frame 37
|Assumptions | | | | | |
| |1-5 | | | |
| |60 | | | |210 |
| |40 | | | | |
| |15 | | | | |
| |25 | | | |210 |
| |35 | | | | |
| |– | | | |ignored |
| |35 | | | | |
| |25 | | | | |
| |60 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |5 |
| |Net Investment/Annual Savings | |years |
|Simple Return on |/ |% |20 |
|Investment (SRI) |( 100% | |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |– |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |20 |
|(Internal Rate of Return) |PV Investment/ | |% |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
54
|Set 3.2 Detailed Frames | |Correct answers |
| | | |
|37. Now refer to the CIA worksheet for Project C, and compute Payback, SRI, NPV, PI, and Yield. | |hurdle |
| | |(discount) |
| | | |
| | | |
|38. Now check your working with the solution on page 56, before taking one more look at the | | |
|summary for this set, and the learning-patterns for this chapter, and then on to set 3.3. | | |
55
CIA Worksheet for Project C–solution
|Assumptions | | | | | |
| |1-5 | | | |
| |60 | | | |210 |
| |40 | | | | |
| |15 | | | | |
| |25 | | | |210 |
| |35 | | | | |
| |– | | | |ignored |
| |35 | | | | |
| |25 | | | | |
| |60 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |200/60 |3·3 |5 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on |60/200 |30 |20 |
|Investment (SRI) |( 100% |% |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |180 – 200 |–20 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |180/200 |0·9 |1.0 plus |
| |PV Savings/PV Investment |index | |
|Yield | 200/60 =3·3 |± 15 |20 |
|(Internal Rate of Return) |PV Investment/ |(from table B | |
| |Annual After-tax Cash Flow=PVF |page 67) | |
| |Table B: PVF at Horizon 5 years=3·3 |% |% |
56
Set 3.3 ‘DICH’
Estimated time: 15 minutes
summary
‘DICH’ is a systematic way of considering capital investment analysis, involving:
D–Decision and criteria (Exactly what kind of investment decision? How justified-policy? law? profitability?)
I–Investment (How much? When? Relevant cost?)
C–Cash flow (Annual savings before and after tax?)
H–Horizon and terminal values. (How long? What alternatives? How much? How important?)
Effective CIA also requires AA (Alternative Analysis–search for the best alternative) and PFD (Provision for Disaster–critical evaluation of the key assumptions).
The CIA work sheet is specially designed for the recording of computed measures of investment which are calculated from given data.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
57
|Set 3.3 Detailed Frames |Correct answers |
| | | |
|1. CIA problems should be thought about in terms of ‘DICH’, ‘D’ means ‘........ and criteria’. | | |
| | |see answer below |
| | | |
| | | |
|2. Decisions and criteria involve questions about the investment. Which of the following are | | |
|important: | | |
|a) what investment? | | |
|b) why invest? | | |
|c) law or policy or profitability? | | |
|d) measures of investment? | |decision |
| | | |
| | | |
|3. The ‘I’ in DICH represents ‘Investment’. We need to know what investment, why, and which costs | | |
|are ........ | |all of them |
| | | |
| | | |
|4. Should we consider sunk costs when evaluating the in vestment? ........ (Yes/No). Relevant costs| | |
|are those that ‘........ the cash register’. | |relevant |
| | | |
| | | |
|5. The ‘C’ represents ‘Cash flow’. This involves an annual saving before depreciation, and tax and | | |
|after- ........ figures. Have we dealt with the tax effects yet? | |no |
| | |ring |
| | | |
| | | |
|6. ‘H’ represents the ‘Horizon and terminal values’. The Horizon is the economic working ........ | |tax |
|of the project. | |no–wait for the |
| | |next chapter |
| | | |
| | | |
|7. Is the Horizon the same as the legal and technical life of an investment? | | |
| | |life |
| | | |
| | | |
|8. And with Horizon we think about Terminal Values, which are also called ‘........ values’. | | |
| | |no |
58
|Set 3.3 Detailed Frames | |Correct answers |
| | | |
|9. They are normally ...... (relevant/irrelevant). | |salvage |
| | | |
|10. ‘DICH’ stands for: | | |
|D- ........ | | |
|I- ........ | | |
|C- ........ | | |
|H- ........ | |relevant |
| | | |
|11. DICH may be systematically applied to ...... problems. | |decision and |
| | |criteria |
| | |investment |
| | |cash flow |
| | |horizon and |
| | |terminal values |
| | | |
|12. Once DICH has been used, it is followed by the ........ profile and measures of ........ | | |
| | |cia |
| | | |
|13. Capital investment analysis involves making assumptions about new investment, followed by | | |
|systematic analysis of the consequences of those assumptions ........ (True/ False). | |cash |
| | |investment |
| | | |
|14. A systematic analysis from given assumptions involves calculation of measures of ........ | | |
| | |true |
| | | |
|15. CIA assumptions are evaluated by the ........ approach. By the way, are you still writing down| | |
|your answers? If s important you know. | |investment |
| | | |
|16. DICH also involves a search for all ........ | |dich |
| | | |
|17. Therefore we do an Alternative Analysis before making a ........ decision. | | |
| | |alternatives |
59
|Set 3.3 Detailed Frames | |Correct answers |
| | | |
|18. What about disaster? Is it also necessary to do a PFD analysis? | |cia |
| | | |
| | | |
|19. Alternative and PFD analyses are necessary to avoid emotional investment whereby managers adopt| | |
|too rigid an outlook ........ (True/False). | | |
| | |yes |
| | | |
| | | |
|20. If a manager develops emotional involvement in a particular investment project, will he be | | |
|influenced by new facts and logical rational argument? | | |
|‘Tie two birds together. They will not be able to fly, even with four wings’ (Sufi). | | |
| | | |
| | |true |
| | | |
| | | |
|21. In this set, we have examined a systematic approach to CIA known as the ‘........’ approach. | | |
| | |no |
| | | |
| | | |
|22. Now complete the CIA worksheet for Project D by computing the five measures of investment. | | |
| | |dich |
| | | |
| | | |
|23. Well, that’s the end of Chapter 3. You’re half-way through the book now! Read the summary of | | |
|this set and review the learning-patterns for this chapter once again, before moving on to Chapter | |check with |
|4. | |solution |
60
CIA Worksheet for Project D–
fill in as instructed in set 3·3, frame 22
|Assumptions | | | | | |
| |1-15 | | | |
| |30 | | | |120 |
| | | | | | |
| | | | | |60 |
| |12 | | | | |
| |10 | | | | |
| | 2 | | | |60 |
| |28 | | | |– |
| |– | | | |60 |
| |28 | | | | |
| |2 | | | | |
| | | | | |60 |
| |30 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |3 |
| |Net Investment/Annual Savings | |years |
|Simple Return on |/ |% |20 |
|Investment (SRI) |( 100% | |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |15 |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | |% |
| |Table B: PVF at Horizon years= | | |
61
CIA Worksheet for Project D–solution
|Assumptions | | | | | |
| |1-15 | | | |
| |30 | | | |120 |
| | | | | | |
| | | | | |60 |
| |12 | | | | |
| |10 | | | | |
| | 2 | | | |60 |
| |28 | | | |– |
| |– | | | |60 |
| |28 | | | | |
| |2 | | | | |
| | | | | |60 |
| |30 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |120/30 |4 |3 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on |30/120 |25 |20 |
|Investment (SRI) |( 100% |% |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |174—120 |+54 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |174/120 |1·5 |1.0 plus |
| |PV Savings/PV Investment |index | |
|Yield | 120/30 = 4·0 |25 |15 |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF |% |% |
| |Table B: PVF at Horizon years= 4·0 | | |
62
Chapter 4 Tax Effects and Non-quantitative Factors
A Depredation
[pic]
B Annual after-tax cash flow
|Approach 1 | |Approach 2 |
|Saving (cash in) |100 | |Saving (cash in) |100 |
|Depreciation |20 | |Tax 40% |40 |
|Taxable income |80 | | |60 |
|tax 40% (cash out) |32 | | | |
| |48 | |Depreciation tax shield |
|Depreciation |20 | | 20 ( 40% |8 |
|Cash flow after tax |68 | |Cash flow after tax |68 |
C Terminal values and tax shields
| |Case1 |Case 2 |Cash 3 |
|Old-machine present net book value | 100 | 100 | 100 |
|Terminal value |80 |40 |0 |
|Book loss | 20 | 60 | 100 |
|Tax shield – 40% | 8 | 24 | 40 |
|Terminal value |80 |40 |0 |
|Reduction of new investment | 88 | 64 | 40 |
63
Tax Effects and Non-quantitative Factors
D Benefit from scrapping old machine now
[pic]
E Comparing different working lives
[pic]
F ‘DICH’ analysis
[pic]
G CIA decisions
[pic]
64
Tax Effects and Non-quantitative Factors
H NQ factors
[pic]
I CIA decision
[pic]
J Measures of investment
[pic]
65
Tax Effects and Non-quantitative Factors
Discount Tables-Stage 2
Table A: Present value of 1·0 received once only in any year 1–15
|Year |0% |1% |
| | | |
|1. If you are finding this programme a little tough, remember ‘I have never seen a man lost who | | |
|was on a straight path.’ So keep to the path of this programme and you cannot fail to learn CIA! | | |
|Now, most capital investment projects will, it is to be hoped, increase profitability. | | |
|Governments like to share in a company’s increased profits by way of increased income ........ on| | |
|those profits. Does the government also share losses? | | |
| | | |
| | |see answer below |
| | | |
|2. CIA involves a systematic analysis of cash flows in a cash profile, and to be realistic such | |tax |
|cash flows ........ (can/cannot) ignore tax. | |yes indeed! |
| | | |
|3. The effect on annual cash flow that we must now consider is the impact of ........ | | |
| | |cannot |
| | | |
|4. Therefore, valid CIA computations must include the effect of income tax on ........ flows. | | |
| | |income tax |
| | | |
|5. Are measures of investment ‘useful’ before tax? Why waste our time with before-tax CIA? | | |
| | |cash |
| | | |
|6. Income tax must be considered as a relevant cash ........ in the cash profile. | |no-we teach ‘before tax’ only as|
| | |a preliminary to help you |
| | |understand the more complex |
| | |after-tax computations |
| | | |
|7. Tax affects DCF because tax payable and receivable affects the ........ of the cash flow. | | |
| | |flow |
69
|Set 4.1 Detailed Frames | |Correct answers |
| | | |
|8. The key word in the effect of income tax on saving is ........ (timing/tax rate). | | |
| | |timing |
| | | |
|9. Savings are taxed at the tax ........ set by the ........ | |timtng |
| | | |
|10. If the tax rate is 40% and the gross savings 1000, then after-tax saving will be ........ | |rate |
| | |government |
| | | |
|11. However , when we have machinery and equipment, the government allows us depreciation each | | |
|year until it is scrapped. Depreciation ........ (reduces/increases) the amount of tax payable on| | |
|savings. | |600 |
| | | |
|12. Depreciation is the allocation of the cost of a fixed asset over its economic life or horizon| | |
|which is decided upon by the ........ (tax law/company) | | |
| | |reduces |
| | | |
|13. For CIA, depreciation expense is based on the life of the asset as specified by the tax law | |tax law (for tax purposes) |
|........ (True/False). | | |
| | | |
|14. For tax purposes, the cost of a fixed asset is not treated as an expense at purchase; the | | |
|cost is allocated as ........ expense. | |true |
| | | |
|15. Investment is a cash flow in year 0, but depreciation is not a cash flow after year 0; | | |
|however, it ........ (does/does not) reduce tax in years 1–5. | | |
| | |depreciation |
| | | |
|16. Depreciation is different from other costs because it ........ (is/is not) a cash flow. | | |
| | |does |
| | | |
|17. The determining factor in deciding the depreciation in CIA computations is the ........ law. | | |
| | |is not |
70
|Set 4.1 Detailed Frames | |Correct answers |
| | | |
|18. Note that tax law may allow many kinds of depreciation; we now discuss simple examples of | | |
|straight-line and declining-balance, or ‘accelerated’, depreciation over a 5-year horizon with an| | |
|investment of 100. | | |
|Straight-line depreciation reduces the original book value by the same 20 each year ........ | | |
|(True/False). | | |
| | |tax |
| | | |
|19. Compute the net book value left after depreciation: | | |
|Year 0 100 | | |
|Year 1 80 | | |
|Year 2 60 | | |
|Years 3 ? | | |
|Year 4 ? | | |
|Years 5 ? | |true |
| | | |
|20. Now study the declining-balance depreciation, in which we take 30% of the declining balance | | |
|each year. Complete the following: | | |
|Depreciation Book value | | |
|Year 0 — 100 | |40 |
|Year 1 30 70 | |20 |
|Year 2 21 ? | |0 |
| | | |
|21. Now complete the full table for declining-balance depreciation: | | |
|Depreciation Book value | | |
|Year 2 21 49 | | |
|Year 3 15 34 | | |
|Year 4 ? ? | | |
|Year 5 ? ? | |49 |
| | | |
|22. What happens to the final net book value? | |10, 24, 7, 17 |
| | | |
|23. Thus depreciation may be computed in several ways, and does affect the tax payable; but the | | |
|cash flow for CIA is affected by the income tax, not by the depreciation ........ (True/False). | | |
| | |scrapped |
71
|Set 4.1 Detailed Frames | |Correct answers |
| | | |
|24. Study learning-pattern 4B, dealing with savings after tax. Annual savings before tax of 100 | | |
|are reduced to annual cash flow after tax of ........ Tax was ........ | | |
| | |true |
| | | |
|25. To compute after-tax cash flow, we have ........ (one/two) | |68 |
|methods. | |32 |
| | | |
|26. One way is to deduct depreciation of 20 from the savings to leave taxable income of ........ | | |
|Tax of 40% on this = 32, which leaves an income of 48. Adding back depreciation of ........ gives| | |
|net after-tax cash flow of ........ | | |
| | |two |
| | | |
|27. Depreciation is deducted and then added back because it ........ (is/is not) a cash flow. | |80 |
| | |20 |
| | |68 |
| | | |
|28. The other method shown in the learning-pattern is to deduct tax on annual savings of 100 at | | |
|40% (= 40) to give 60, and add to this the tax shield for 40% of 20 (the depreciation) = 8. The | | |
|after-tax savings of 68 ........ (are/are not) the same as in frame 26. | | |
| | |is not |
| | | |
|29. In this set we have discussed tax and depreciation, which affect the ........ of the cash | | |
|flow. Cash flow before tax ........ (is/is not) the same as cash flow after tax. | | |
| | |are |
| | | |
|30. Right, now complete the CIA worksheet for Project E (following) with correct after-tax | |timing |
|computations. | |is not |
| | | |
|31. Now that you have completed the set, read the summary again, and review the learning-patterns| |check with the |
|at the beginning of this chapter. | |correct solution |
72
CIA Worksheet for Project E–
fill in as instructed in set 4.1, frame 30
|Assumptions | | | | | |
| |1-5 | | | |
| |60 | | | |210 |
| | | | | | |
| | | | | |– |
| |40 | | | | |
| |15 | | | | |
| |25 | | | |210 |
| |35 | | | |84 |
| |14 | | | |– |
| |21 | | | | |
| |25 | | | | |
| |46 | | | |84 |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at 10% | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |5 |
| |Net Investment/Annual Savings | |years |
|Simple Return on |/ |% |10 |
|Investment (SRI) |( 100% | |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |– |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |10 |
|(Internal Rate of Return) |PV Investment/ | |% |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon years= | | |
73
CIA Worksheet for Project E–solution
|Assumptions | | | | | |
| |1-5 | | | |
| |60 | | | |210 |
| | | | | | |
| | | | | |– |
| |40 | | | | |
| |15 | | | | |
| |25 | | | |210 |
| |35 | | | |84 |
| |14 | | | |– |
| |21 | | | | |
| |25 | | | | |
| |46 | | | |84 |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at 10% | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |200/60 |3·3 |5 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on |60/200 |30 |10 |
|Investment (SRI) |( 100% |% |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |174–116 |+58 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |174/116 |1·5 |1.0 plus |
| |PV Savings/PV Investment |index | |
|Yield | 116/46 = 2·5 |±30 |10 |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF |% |% |
| |Table B: PVF at Horizon 5 years= 2·5 | | |
74
Set 4.2 Tax Shields and Terminal Values
Estimated time: 15 minutes
summary
Tax is payable on profits and, therefore, tax is receivable (a tax shield) on losses.
The book loss and tax shield on a replaced machine is computed as follows:
Net book value, say 200
less Terminal value 50
Bookless 150
Tax shield (40% of 150 =
cash inflow in year 0) 60
If the replaced machine were not scrapped immediately, tax relief would be available as annual depreciation over its remaining life, but the tax shield in year 0 (60 above) is obviously a time advantage in present-value terms.
The effects of replacing an old machine are therefore:
a) advantage: terminal value and tax shield in year 0 reducing the cost of the new machine
b) disadvantage: only incremental (not full) depreciation in the computation of tax on annual savings on the new machine
Incremental depreciation is the excess of depreciation on new equipment over existing depreciation on old replaced equipment. It provides a differential effect on taxable income and cash flow.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the^ summary above again.
75
|Set 4.2 Detailed Frames | |Correct answers |
| | | |
|1. Now, in this set we discuss tax shields on the book loss for old fixed assets that are replaced | | |
|by the new capital investment. When we depreciate a fixed asset, we get tax relief for depreciation| | |
|each year; if we scrap it early, we get tax relief (shield) for the book loss immediately. The | | |
|government therefore kindly provides tax relief both on ........ depreciation and book ........ | | |
|(losses/gains). | | |
| | |see answer below |
| | | |
|2. Tax relief on a loss is called a ‘tax ........’ | |annual |
| | |losses |
| | | |
|3. A tax shield is a cash ........; whereas tax payable is a cash ......... | |shield |
| | | |
|4. If old machinery is sold or scrapped, the resulting book loss ........ (does/does not) provide a| |inflow |
|tax shield. | |outflow |
| | | |
|5. If equipment with a book value of 400 is sold for nothing, there is a book loss of ........ and | | |
|a tax shield of 40% ( 400 = ........ | |does |
| | | |
|6. The tax shield of 160 is a cash ........ in year ........ | |400 |
| | |160 |
| | | |
|7. However, a loss on disposal of equipment is ........ (reduced/increased) by any terminal value. | | |
|If book value was 400 and terminal value, 100, the book loss would be ........ and the tax shield | |inflow |
|at 40% would be ........ | |o |
76
|Set 4.2 Detailed Frames | |Correct answers |
| | | |
|8. The book value of equipment is the written-down value for tax purposes. Why is the book value | | |
|written down each year? ...... .….. …... If equipment with a book value of 500 is sold for 500, | |reduced |
|there ........ (is/is not) a book loss and a tax shield. | |300 |
| | |120 |
| | | |
|9. However, if equipment with a book value of 500 is scrapped for nothing, there is a book loss and| |because of |
|therefore a 40% ........ shield of ........ immediately. | |depreciation |
| | |is not |
| | | |
|10. Now study learning-pattern 4C, dealing with terminal values and tax. In case 1, the original | | |
|book value has been reduced by depreciation to a net book value of ........ | |tax |
| | |200 |
| | | |
|11. The net book value was reduced by a terminal value of ........, to provide a book loss of | | |
|........ and a 40% tax shield of ........ | |100 |
| | | |
|12. The total relief for the scrapping of the old machine is: | | |
|a) tax shield on the book loss = ........, plus | | |
|b) terminal value = ........ | |80 |
|which together ........ (reduce/increase) the cost of the new investment. | |20 |
| | |8 |
| | | |
|13. In case 3, where there is no terminal value, the tax shield is computed on the full book loss | |8 |
|of ........, to give a relief of ........ | |80 |
| | |reduce |
| | | |
|14. Now fill in the missing computations for case 2. | | |
|Book loss, ........ | | |
|Tax shield, ........ | | |
|Terminal value, 40 | |100 |
|Total reduction of cost of new investment, ........ | |40 |
77
|Set 4.2 Detailed Frames | |Correct answers |
| | | |
|15. Thus old book losses and terminal values do provide a reduction in the cost of the new | | |
|investment. The actual book value ........ (is/is not) a cash flow, but the tax shield and the | | |
|terminal values are ........ …... | |60 |
|Getting tired of the programme? Of course not-you’re making excellent progress! | |24 |
| | |64 |
| | | |
|16. Now let us relate the tax shield on book losses to annual tax shield for depreciation. The key | | |
|point is that if we hold on to an old machine, we would get an annual tax shield for depreciation | | |
|during its remaining life ........ (True/False). Are you sure? | |is not |
| | |cash flows |
| | | |
|17. Now refer to the learning-pattern on savings after tax (4B). We see that in method 1 the cash | | |
|flow after tax is computed by savings of 100 less ........ of 20, which gives the taxable income of| |true |
|........ | |yes! |
| | | |
|18. Taxable income 80, less tax 32, plus depreciation 20, equals cash flow after tax of ........ | |depreciation |
| | |80 |
| | | |
|19. In method 2, cash flow after tax is computed as : savings 100, less tax 40, to give after-tax | | |
|saving of ........, plus tax shield on depreciation (20 × 40% = ........). | | |
| | |68 |
| | | |
|20. Do both methods yield the same result? | |60 |
| | |8 |
| | | |
|21. What is this result? | |yes |
| | | |
|22. Now we always take the full annual-depreciation tax shield for new equipment. Should it replace| | |
|an old machine, then we ........ (do/do not) lose the old annual depreciation. | |cash flow after |
| | |tax = 68 |
78
|Set 4.2 Detailed Frames | |Correct answers |
| | | |
|23. The old machine used to provide an annual-depreciation tax shield each year ........ | | |
|(True/False). | |do |
| | | |
|24. A tax shield in year 0, instead of over the remaining life of the old equipment, gives an | | |
|advantage in terms of ........ (interest/time). | |true |
| | | |
|25. The incremental advantage of a new machine for annual depreciation, therefore, is not the total| | |
|new annual depreciation (say 20) but only the excess over the old-machine depreciation (say 5) | | |
|........ (True/False). | |time |
| | | |
|26. Excess depreciation (15) on a new machine (20) over existing depreciation on an old machine (5)| | |
|is called ........ (incremental/balancing) depreciation. | | |
| | |true |
| | | |
|27. This means that, if the new machine gives depreciation of 20 and the old machine would have | | |
|given 5, the incremental depreciation for cash flow is ........ Thus, in calculating tax on annual | | |
|savings, we deduct not the full depreciation but only the ........ depreciation. | | |
| | |incremental |
| | | |
|28. Overall, therefore, when a new machine replaces an old one, we take a tax shield on ........ | | |
|loss in year 0, but only ........ depreciation in the annual cash flow. | |15 |
| | |incremental |
| | | |
|29. To summarise the CIA effect when the new machine replaces an old one: | | |
|a) the new investment is reduced by ........ (what?), | | |
|b) the annual saving is affected ........ (how?). | |book |
| | |incremental |
79
|Set 4.2 Detailed Frames | |Correct answers |
| | | |
|30. Be nice to the government, because tax is payable on ...... but tax is receivable on | |a) terminal |
|........ | |value and tax |
| | |shield of old |
| | |machine |
| | |b) by incremental |
| | |(no full) |
| | |depreciation |
| | | |
|31. If a new machine (cost, 1000; horizon, 10 years) replaces an old one (book value, 500; | | |
|remaining life, 10 years), then the incremental depreciation is only ........ | |profits |
| | |losses |
| | | |
|32. And if the old machine (book value, 500) is scrapped for 100, then the total reduction of | | |
|the new investment is 100 + (40% of ........ ) = ........ | |100 – 50 = 50 |
| | | |
|33. Now do Projects F and G. | |400 |
| | |100 + 160 = 260 |
| | | |
|34. Now that you have completed the set and know all there is to know about tax shields (don’t | | |
|you believe it!), read the summary for this set again, and review the learning-patterns for this| |check with the |
|chapter. | |correct solution |
80
CIA Worksheet for Project F–
fill in as instructed in set 4.2, frame 33
|Assumptions | | | | | |
| |1–10 | | | |
| |30 | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |200 / 30 |7 |4 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on | 30 / 200 ( 100% |15 |10 |
|Investment (SRI) |Annual Savings/Net Investment |% |% |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | 200 / 26 = 8·0 |about |10 |
|(Internal Rate of Return) |PV Investment/ |4 |% |
| |Annual After-tax Cash Flow=PVF |% | |
| |Table B: PVF at Horizon 10 years= 6·1 | | |
81
CIA Worksheet for Project F–solution
|Assumptions | | | | | |
| |1–10 | | | |
| |30 | | | | |
| |20 | | | | |
| |– | | | | |
| |20 | | | | |
| |10 | | | | |
| |4 | | | | |
| |6 | | | | |
| |20 | | | | |
| |26 | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |200 / 30 |7 |4 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on | 30 / 200 ( 100% |15 |10 |
|Investment (SRI) |Annual Savings/Net Investment |% |% |
|Net Present Value (NPV) |159 — 200 |–41 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |159 / 200 |0·8 |1.0 plus |
| |PV Savings/PV Investment |index | |
|Yield | 200 / 26 = 8·0 |about |10 |
|(Internal Rate of Return) |PV Investment/ |4 |% |
| |Annual After-tax Cash Flow=PVF |% | |
| |Table B: PVF at Horizon 10 years= 8·0 | | |
82
CIA Worksheet for Project G–to be completed
|Assumptions | | | | | |
| | 1–10 6–10 | | | |
| |30 |30 | | |100 |
| |20 |20 | | | |
| |20 |– | | | |
| | | | | | |
| | | | | | |
| | | | | |50 |
| | | | | | |
| | | | | | |
| | | | | |70 |
| | |26 | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |150 / 30 |5 |4 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on | / ( 100% |% |10 |
|Investment (SRI) |Annual Savings/Net Investment | |% |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | uneven cash flow / difficult of compute = |% |10 |
|(Internal Rate of Return) |PV Investment/ | |% |
| |Annual After-tax Cash Flow=PVF | | |
| |Table B: PVF at Horizon 10 years= | | |
83
CIA Worksheet for Project G–solution
|Assumptions | | | | | |
| | 1–10 6–10 | | | |
| |30 |30 | | |100 |
| | | | | | |
| | | | | |50 |
| |20 |20 | | | |
| |20 |– | | | |
| |– |20 | | |50 |
| |30 |10 | | |20 |
| |12 |4 | | |50 |
| |18 |6 | | | |
| |– |20 | | | |
| | | | | |70 |
| |18 |26 | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |150 / 30 |5 |4 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on |30 / 150 |20 |10 |
|Investment (SRI) |( 100% |% |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |134 — 130 |+4 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |134 / 130 |1·0 |1.0 plus |
| |PV Savings/PV Investment |index | |
|Yield | uneven cash flow / difficult of compute = |±10 |10 |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF |% |% |
| |Table B: PVF at Horizon 10 years= | | |
84
Set 4.3 Quantitative and Non-quantitative Factors
Estimated time: 20 minutes
summary
Overall CIA decisions are entirely dependent upon sound business judgement. Management uses Q and NQ factors to reach good decisions. The validity of a good CIA decision is known only afterwards, and the manager is entirely responsible for his overall judgement. Thus post-completion audits are vital.
Quantitative and non-quantitative factors are important for decision-making. Quantitative data in numerical form depends entirely upon the basic assumptions. Non-quantitative factors are all other relevant non-quantifiable data.
Q + NQ = D, but we must realise that the figures used in our assumptions are only rough estimates. Where assumptions are doubtful, use different assumptions to produce a range of quantitative results, and test the sensitivity of the results, i.e. different discount rates, horizons, terminal values, and levels of annual savings, etc.
Where the CIA problem is a choice between alternative projects with different horizons, a simple solution is to compare projects for the shorter horizon and estimate a terminal value as a cash inflow for the longer project. Alternatively, compare the projects by yield.
Inflation naturally affects every capital investment project, and CIA may deal with inflation by either (a) increasing the estimated cash flows in future years, or (b) increasing the discount rate so that projects must have a higher yield to be acceptable.
However, the normal discount rate relates merely to the compound interest effects, not to inflation.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
85
|Set 4.3 Detailed Frames |Correct answers |
| | | |
|1. ‘When a man is a beggar, he thinks that small change is a fortune. It is not. To rise above | | |
|beggarhood, he must rise above small change, even though he uses it as a means to an end. Used as| | |
|an end, it will become an end.’ | | |
|Therefore, in CIA, concentrate on large amounts, not the small change. Don’t do CIA for | | |
|investment of less than 1000! Don’t try to be too accurate with crude figures and crude | | |
|assumptions! Good CIA depends upon sound business judgement of Q and NQ factors. Management’s | | |
|role in CIA is to provide the assumptions and take full responsibility for the results ..........| | |
|(True/False). | | |
| | | |
| | |see answer below |
| | | |
|2. The key assumption in evaluating a CIA project is normally the .......... | | |
|(horizon/profit/investment). | |true |
| | | |
|3. Alternative projects may have horizons of, say, 5 years or 10 years. It is difficult to | | |
|compare alternative projects that have different ......... | |horizon |
| | | |
|4. One method of comparing investments with different horizons is to choose the .......... | | |
|(shorter/longer) horizon. | |horizons |
| | | |
|5. Choose the shorter horizon, and estimate the terminal value of the longer project as a cash | | |
|inflow at the end, to give a basis for .......... | |shorter |
| | | |
|6. Alternatively, use the Yield method, and see which investment produces the best .......... | | |
|(NPV/return/PI). | |comparison |
| | | |
|7. Remember, the Yield is the discount rate when the NPV equals .......... and the PI equals | | |
|.......... | |return |
86
|Set 4·3 Detailed Frames | |Correct answers |
| | | |
|8. An investment with a life of 4 years and an investment with a life of 10 years could be | | |
|compared by: | | |
|a) Yield? | | |
|b) SRI? | |0 |
|c) Horizon 4 years? | |1 |
| | | |
|9. But management uses both quantitative and non-quantitative factors for CIA decision-making. | | |
|Quantitative data is data that can be put into .......... form. | |(a), (c) |
| | | |
|10. Let’s not pretend that numbers based upon vague assumptions are too accurate. But to aid | | |
|decision-making, we need to compute a wide range of .......... (quantitative/non-quantitative) | |numerical |
|data. | | |
| | | |
|11. However, the key factor is the .......... (Q/NQ) one, since overall CIA decisions depend upon| | |
|the judgement of ............. (management/accountants). | | |
| | |quantitative |
| | | |
|12. Non-quantitative factors are those that .......... (can/cannot) be put into numbers. | |nq |
| | |management |
| | | |
|13. Which of the following could be classified as NQ factors: | | |
|a) legal? | | |
|b) policy? | | |
|c) human? | | |
|d) profitability? | |cannot |
|e) social? | | |
| | | |
|14. The important point to remember is that Q + NQ = D. ‘D’ represents .......... | | |
| | |(a), (b), (c), (d) |
| | | |
|15. If the quantitative result is poor, we might still decide to invest? .......... (True/False).| | |
| | |decision |
87
|Set 4·3 Detailed Frames | |Correct answers |
| | | |
|16. Why? Because of .......... factors. | |true |
| | | |
|17. However, with good quantitative results we must always invest .......... (True/False). | | |
| | |nq |
| | | |
|18. If CIA assumptions are doubtful, and the accountant insists that he has produced an | | |
|‘accurate’ NPV of 24327426·26, what should the manager do? | | |
| | |false |
| | | |
|19. CIA techniques and tools are used to quantify decisions with .......... | |fire him-he’s |
|(absolute/reasonable/useful) accuracy. | |too pseudo-accurate |
| | | |
|20. Which of the following help us to quantify CIA decisions: | | |
|a) discount rates? | | |
|b) horizons? | | |
|c) terminal values? | | |
|d) levels of cash flow? | |useful! |
| | | |
|21. An overall CIA decision uses | | |
|Q + .......... = .......... | |all |
| | | |
|22. However, CIA must be systematic and thus we use ‘DICH’. ‘DICH’ is D – ..........; I – | |nq |
|..........; C – .......... ; H – .......... | |d |
| | | |
|23. DICH is followed by .......... Analysis and Provision-for-.......... Analysis. | |decision |
| | |investment |
| | |cashflow |
| | |horizon and |
| | |terminal |
| | |values |
88
|Set 4·3 Detailed Frames | |Correct answers |
| | | |
|24. The next step in CIA is the cash profile, in which the actual cash flow is reduced to | |alternative |
|.......... (present/future) value. | |disaster |
| | | |
|25. From the cash profile we compute measures of .......... List four measures! | | |
| | |present |
| | | |
|26. Measures of investment are .......... factors, to be judged against a standard set by | |investment |
|.......... | |npv |
| | |pi |
| | |yield |
| | |payback (or sri) |
| | | |
|27. Other factors to be considered are .......... ones. | |quantitative |
| | |management |
| | | |
|28. DICH, Alternative Analysis, PFD Analysis, cash profiles, measures of investment, and NQ | | |
|factors are all designed to lead to .......... CIA decisions. | | |
| | |non-quantitative |
| | | |
|29. CIA decisions are key decisions of .......... amounts for .......... time-periods. Should we | | |
|complete CIA on a possible capital investment of 500·00? | | |
| | |effective |
| | | |
|30. CIA techniques aid good business .........., but don’t bother | |large |
|to make sophisticated analysis of peanuts, unless it .......... | |long |
|you! | |no!-too small |
| | | |
|31. And be sure you find good projects-don’t analyse a poor alternative. CIA projects should be | | |
|chosen after a creative search for opportunities and all .......... | |decisions |
| | |helps |
| | | |
|32. Are CIA projects affected by inflation? | |alternatives |
89
|Set 4·3 Detailed Frames | |Correct answers |
| | | |
|33. Does the discount rate: | | |
|a) automatically take into account inflation? | | |
|b) merely relate to compound-interest effects? | |yes |
| | | |
|34. Therefore, to take account of inflation in CIA, we could .......... (increase/decrease) the | | |
|amounts of the estimated future cash flows. | |(b) |
| | | |
|35. By using higher cash flows for future years, we .......... (do/do not) forecast some | | |
|inflationary effects. | |increase |
| | | |
|36. Alternatively, to take account of inflation we could .......... (increase/decrease) the | | |
|discount rate. | |do |
| | | |
|37. If the required’ discount rate is 10%, is a CIA project which produces a 12% yield an | | |
|acceptable one? | | |
|If we require not merely 10% but 13% for inflation, is the project acceptable? For high inflation, | | |
|we need .......... discount rates. | |increase |
| | | |
|38. Does CIA automatically take inflation into account? Should we consider it? | |yes |
| | |no |
| | |high |
| | | |
|39. Now, if you still want to: | | |
|a) push the numbers, | | |
|b) number crunch, | | |
|c) massage the digits, | |no |
|do all the CIA worksheet computations for Projects A-G again. | |yes |
| | | |
|40. Well, that completes the set and the chapter. Read the summary for this set again, take another| | |
|look at the learning-patterns for this chapter, and then race on to Chapter 5 and the last three | | |
|sets in this book. Enjoy yourself! | |check with the |
| | |correct solutions |
90
Chapter 5 Capital Budgeting Systems
A Capital budgeting system
[pic]
B Providing for risk
Horizon (
Estimates ( Graphs?
Hurdle rates (
Probabilities (( Sensitivity analysis?
C Approach to lease v buy
[pic]
D Assumptions
[pic]
91
Capital Budgeting Systems
E DICH
[pic]
F CIA manipulation
Can we turn an estimated yield of 8% into
the required hurdle rate of 15% ?
YES!
Manipulate the investment ?/ savings?/ horizon?/ volumes?/
terminal values?/ tax rates?/ combination with a
“good” project?
Alternatively – justify the investment by law or policy... or
quietly charge it to expense.
G Setting the hurdle rate
|E |
|D |
The average cost of capital (equity and debt) is the
minimum ‘hurdle’ rate = key management decision!
note: Should change over time!
H Investment
[pic]
92
Capital Budgeting Systems
I Jargon
[pic]
What to they mean? See glossary.
J Balanced approach
[pic]
93
Set 5.1 Budgeting and Planning
Estimated time: 15 minutes
summary
In CIA we must avoid the continuing possibility that our sophisticated analysis is applied to the wrong projects! We therefore need a Capital Budgeting System.
A systematic approach to capital budgeting involves a search for all possible projects and alternatives, long-range planning, short-range capital budgeting, research and analysis, criteria and decision, audit, disinvestment policy, and a system of forms and procedures.
CIA should be done as part of long-range planning, with attention paid to general economic activity and projections of sales volumes, facilities, and personnel.
Short-range capital budgets should tie in with long-range budgets, focusing on and forecasting cash flows. Such capital budgets force managers to plan their use of resources and to determine whether proposed projects meet company objectives.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
94
|Set 5.1 Detailed Frames |Correct answers |
| | | |
|1. A budget is a plan in financial terms. A capital budget involves both the long-term planning of | | |
|a series of major investment projects and the short-term development of each project. Whether | | |
|short-term or long-term, however, capital budgeting always refers to investment in .......... | | |
|projects. | | |
| | |see answer below |
| | | |
| | | |
|2. Capital budgeting is a systematic approach to key investment, including, firstly, a search for | | |
|all possible projects and .......... | |major |
| | | |
|3. But remember that capital budgeting is only part of long-range ..........; we want good projects| | |
|not merely ‘for this year’ but for the long-term running of the business. We plan for the | | |
|.......... | |alternatives |
| | | |
|4. Short-range capital budgets are necessary, but are only really useful if they are a part of a | |planning |
|..........-term plan. | |future |
| | | |
|5. When we have developed a list of possible projects, we research relevant data to compute CIA | | |
|measures of .......... | |long |
| | | |
|6. But, even after computing CIA measures of investment we cannot automatically decide whether to | | |
|invest or not Managers must decide the criteria in terms of which .......... decisions are to be | | |
|made. | |investment |
| | | |
|7. An investment decision is always Go or No Go .......... (True/False). | |investment |
95
|Set 5.1 Detailed Frames | |Correct answers |
| | | |
|8. ‘Kings rule men; wise men rule kings’, therefore, be wise in CIA and – after search, long- and | | |
|short-range planning, research and analysis, criteria and decision – introduce a completion audit | | |
|system which checks up on how wise a decision was made. Audit is a subsequent analysis and review | | |
|of capital investment projects to determine the ...... (validity/assumptions) of the previous | | |
|capital investment analysis. | |false-may be a |
| | |choice of A or B |
| | | |
|9. Audit provides a basis for reviewing past decisions and making ...... ones. Management is fully| | |
|responsible if a project goes sour ...... (True/False). | | |
| | |validity |
| | | |
|10. Another important part of a capital budgeting system is the ‘disinvestment policy’. | |new |
|‘Disinvestment’ means possible disposal of assets that fail to produce the required rate of ......| |true (judgement |
| | |was wrong!) |
| | | |
|11. The same CIA analysis made on new investments should be made on ..... (existing/past) | | |
|investments. | |return |
| | | |
|12. For example, if for an existing investment the PV of a possible tax loss now exceeds the PV of| | |
|future benefits, then the best alternative would be to ...... (carry on/terminate). | | |
| | |existing |
| | | |
|13. In other words, existing investments, if sold, could produce better ......... In practice, | | |
|disinvestment has all sorts of human and organisational implications, and it may be very difficult| | |
|to come to a decision to carry out this policy .......... (True/False). | | |
| | |terminate |
| | | |
|14. And finally, capital ...... needs forms and procedures to ensure that it operates | |earnings |
|systematically. | |true |
96
|Set 5.1 Detailed Frames | |Correct answers |
| | | |
|15. Controls for CIA can be devised for written project evaluations, approvals, and authorisations.| | |
|Such ...... controls are implemented by forms and procedures. | | |
| | |budgeting |
| | | |
|16. Good capital management requires many kinds of control. Forms and procedures can be designed | | |
|not only for technical problems, but also for ............ (accounting/human) problems in CIA. | | |
| | |cia |
| | | |
|17. However, CIA must be carried out in the framework of .......... (short/long)-term planning. | | |
| | |human |
| | | |
|18. Long-range planning involves forecasting, projection, and ranking of major ...... | | |
| | |long |
| | | |
|19. Which of the following forecasts are important for long-range planning: | | |
|a) general economic activity? | | |
|b) cash flows? | | |
|c) price and wage levels? | | |
| | |projects |
| | | |
|20. It is also important to forecast sales volume, facilities, and personnel needed in years to | | |
|come ...... (True/False). | |all |
| | | |
|21. However, be careful not to optimise CI on too short a horizon. Replacement decisions are | | |
|sometimes difficult because of uncertain ...... Any one investment may not optimise the service | | |
|required over a series of years – this sometimes is best analysed by operational-research | | |
|techniques. | | |
| | |true |
| | | |
|22. Technological obsolescence of replacement equipment is difficult to forecast, because the | | |
|working life of the installed machine depends on the economics of the ......... (previous/next) | | |
|machine. | |horizons |
97
|Set 5.1 Detailed Frames | |Correct answers |
| | | |
|23. The only certain thing about the future is that it will bring changes. Long-range planning | | |
|ranks major projects and includes plans to deal with ...... in the economy or within the company. | | |
| | |next |
| | | |
|24. Short-range capital budgets force ...... (managers/accountants) to look ahead. | | |
| | |changes |
| | | |
|25. A short-range budget should tie in with a ...... -range plan. | |managers |
| | | |
|26. For example, a one-year capital budget covers specific projects; but capital investments | | |
|involve large amounts for long periods. Thus a short-term capital budget ...... (is/is not) really| | |
|valid without a long-range plan. | | |
| | |long |
| | | |
|27. Forecasting cash flows for each investment is ...... -range capital budgeting. | | |
|‘The wise man is he who does today what fools will do three days hence’, so don’t take too long to| | |
|do the CIA. All CIA decisions must be timely made-a good decision today may be poor if too long | | |
|delayed ...... (True/False). | | |
| | | |
| | |is not |
| | | |
|28. A capital budgeting system involving long-range planning and short-range budgets enables a | | |
|company to coordinate budgets, to determine whether the projects meet the ...... set by managers. | |short |
| | |true |
| | | |
|29. Tests and yardsticks measure performances against standards, and the system ensures overall | | |
|consistency with company ...... | |standards |
98
|Set 5.1 Detailed Frames | |Correct answers |
| | | |
|30. We must continually check that we are not making a sophisticated CIA of the ........ | | |
|alternative. Therefore we need a system for capital budgeting. | | |
| | |objectives |
| | | |
|31. Now that you have completed the set, read the summary again and review the learning-patterns | | |
|for this chapter, before going on to the next set. | | |
| | |wrong |
99
Set 5.2 Risk and Uncertainty
Estimated time: 15 minutes
summary
There is an element of risk in all capital investment, since it involves definite investment now for only hoped-for benefits in the future.
For effective CIA we need good data and valid assumptions. To minimise risk, we may use conservative estimates, higher discount rates, probability techniques, shorter horizons, and graphical methods to show the sensitivity of the measures of investment to different assumptions.
Where the horizon of the project is doubtful, we may consider leasing rather than buying equipment or property. The final lease-or-buy decision, however, depends mainly on NQ factors. If no cash – lease; for ‘convenience’ – lease; for low cost – buy!!
If the assumptions are very dubious, complete only rough CIA measures, because they cannot be more accurate than the assumptions on which they are based. In computing measures of investment, remember that Payback and SRI ignore the time value of money and cash flows after the payback period. Yield does not indicate the size of the project. All measures involve assumptions about reinvestment of proceeds during the horizon. Managers should use several measures!
Note on Lease-or-buy Analysis
Valid analysis is complex and difficult. However, DCF techniques may provide a helpful assessment of Q factors. NPV of the cost to buy is the original investment less the present value of the tax shield. NPV of the cost to lease is the present value of the after-tax lease payments. A range of computations should be made using different discount rates, horizons, and terminal values. Graphical methods may be used to indicate how the yield varies as assumptions are changed. More sophisticated lease-v-buy analysis is justified only with very reliable data.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
100
|Set 5.2 Detailed Frames |Correct answers |
| | | |
|1. If all elements of a capital investment could be reduced to valid quantifiable assumptions, | | |
|decision-making would be reduced to mathematical computation. This is not possible, but CIA | | |
|projects must still be based on good data and valid ...... | | |
| | |see answer below |
| | | |
|2. ‘Deep in the sea are riches beyond compare. But if you seek safety, it is on the shore.’ And so | | |
|recognise that all CIA projects involve risk, and risk means ...... So many good projects never get| | |
|analysed and result in an opportunity loss, which is a loss of the benefits of an ......! | | |
| | |assumptions |
| | | |
|3. We must search for ....... projects and assess the ...... The possibility of more than one | | |
|eventuality requires techniques that can ...... (quantify/qualify) the probable outcome. | |uncertainty |
| | |opportunity |
| | | |
|4. There are various approaches to risk in CIA. We could simply use conservative estimates, but | |new |
|this might detract from the realism of ...... (analysis/research). | |risk |
| | |quantify |
| | | |
|5. Again, we could set very high discount rates for projects, but the use of higher discount rates | | |
|would not allow for different years having different ...... (profits/risks). | | |
| | |analysis |
| | | |
|6. Again, we could use probability techniques to find the ‘expected value’ and ‘dispersion’ of cash| | |
|flows which are not constant from year to year. This is known as ...... (probability/possibility) | | |
|technique. | |risks |
| | | |
|7. And again, we could make three alternative cash flows using high, low, and ...... estimates of | | |
|the discount rate. | |probability |
101
|Set 5.2 Detailed Frames |Correct answers |
| | | |
|8. However, since the key CIA assumption is the ......, a practical method of providing for risk is| | |
|to shorten the ...... | |expected |
| | | |
|9. And finally, for all approaches to risk, we could use graphical methods to show the sensitivity | | |
|of the measures of investment to the different ..... Patterns and graphs ...... (do/do not) | |horizon |
|communicate well. | |horizon |
| | | |
|10. To sum up, risk in CIA can be approached by various methods: | | |
|a) using ...... assumptions, | | |
|b) computing all the ...... of investment, | | |
|c) the graphical ......, | | |
|d) the mathematical ......, | | |
|e) setting higher ...... rates, | |assumptions |
|f) assuming shorter .......... | |do |
| | | |
|11. In those cases where technological change makes equipment horizons extremely doubtful, we often| |conservative |
|consider not buying equipment but ...... it. | |measures |
| | |methods |
| | |techniques |
| | |discount |
| | |horizons |
| | | |
|12. In considering lease v buy, let’s first of all compare NPV measures. | | |
|Buy | | |
|NPV of the cost to buy = the original investment less | | |
|the PV of the tax ...... | | |
|Lease | | |
|NPV of the cost to lease = the PV of the after-tax lease | | |
|...... | |leasing |
102
|Set 5.2 Detailed Frames |Correct answers |
| | | |
|13. However, the trouble with DCF computations for lease v buy is that the assumptions of: | | |
|a) discount rate, | | |
|b) horizon, | | |
|c) terminal values, | | |
|are extremely dubious and could change the results completely! ....... (True/Not generally | | |
|true/False). | |shield |
| | |payments |
| | | |
|14. Often lease-v-buy decisions are confused by the legal implications, and are qualified by: | | |
|a) quantitative factors? | | |
|b) non-quantitative factors? | | |
| | |true |
| | | |
|15. And this raises the general problem of how CIA decisions are really made by managers. This | |(b) (Q is made |
|depends upon the ...... managers. | |to fit!) |
| | | |
|16. If the chief executive really wants to go into a project, he often seeks CIA, and of course | | |
|DCF measures, to ...... it. | |top |
| | | |
|17. If the initial CIA DCF measures do not justify what he wants to do, then the chief executive | | |
|may well ask for better figures. What does he mean? | | |
| | |justify |
| | | |
|18. So, although we talk about rational CIA, we must continually recognise its limitations. | |figures that |
|Experts under severe pressure ........ (will/will not) change their estimates. | |justify his |
| | |decision |
| | | |
|19. Now let us criticise the measures of investment. Remember that all involve ........, and all | | |
|of them have some disadvantages. | |will! |
| | | |
|20. Payback and SRI both ignore the time value of ......... | |assumptions |
103
|Set 5.2 Detailed Frames |Correct answers |
| | | |
|21. Payback also ignores all cash after the payback ...... | |cash/money |
| | | |
|22. All measures involve assumptions about reinvesting annual proceeds. Net Present Value and | | |
|Profitability Index assume that reinvestment of receipts is made at the ...... (hurdle/yield) rate;| | |
|whereas Yield assumes we can reinvest at the ...... (hurdle/yield) rate. | | |
| | |period |
| | | |
|23. The size of projects can be indicated by the ...... (yield/ NPV) and also by PI, but this can | | |
|be a disadvantage when comparing the profitability of a large investment with that of a small one. | | |
|PI has the additional drawback that it does not communicate well. | |hurdle |
| | |yield |
| | | |
|24. But remember that all DCF measures depend on valid assumptions, and management may not always | | |
|really want them ...... (True/False). | |npv |
| | | |
|25. Yield is better understood by businessmen than NPV or PI; thus the technical drawback of Yield | | |
|(that it assumes reinvestment of proceeds at the yield rate, which may be too high) is overcome by | | |
|its communication ...... (value/ barrier). | | |
| | |true |
| | | |
|26. In this set, we have discussed ways of ...... for risk and the problem of ....... v buy, have | | |
|outlined the measures of investment, and finally have questioned management’s motives in really | | |
|providing valid underlying ....... | | |
| | |value |
| | | |
|27. The trouble with CIA projects that involve risk is that even experts’ true estimates of future | |providing |
|costs and benefits are often distorted into tools of company politics ...... (True/Seldom true). | |lease |
| | |assumptions |
104
|Set 5.2 Detailed Frames |Correct answers |
| | | |
|28. A business fails when it ceases to react to its environment. Effective search for new capital | | |
|investment projects ...... (is/is not) part of CIA. | | |
|‘Oh you who fear the difficulties of the road to annihilation – do not fear. It is so easy, this | | |
|road, that it may be travelled sleeping.’ Thus in CIA we must continually search for new CI projects| | |
|to ensure the long-term survival of the business, although it may seem to be much easier to do | | |
|nothing. | | |
| | |true |
| | | |
|29. Now that you have completed this set, read the summary once again and review the | | |
|learning-patterns at the beginning of the chapter, before going on to set 5·3. | | |
| | |is |
105
Set 5.3 Assumptions and Manipulation
Estimated time: 10 minutes
summary
All CIA depends upon assumptions of investment, horizon, cash flows, terminal value, and discount rates. Reliable assumptions are vital to good analysis, and we may use a range of high, low, and expected estimates.
‘DICH’ sets the assumptions. Alternative Analysis, PFD, cash profiles, measures of investment, NQ factors, decision, and audit must follow.
CIA data can be manipulated like any other accounting data. To ‘improve’ the DCF return, we may:
a) reduce investment
b) increase savings
c) shorten time of savings
d) increase horizon
e) reduce tax rate
f) increase terminal values
g) deduct irrelevant salvage values
h) combine projects to cover a bad one with a good one
CIA assumptions should be clearly stated and justified in relation to the environment and all possible alternatives–not some alternatives only.
Management must insist that assumptions be fully justified.
key note: Read the summary above, look at the learning-patterns at the beginning of this chapter, complete the set, and then study the summary above again.
106
|Set 5.3 Detailed Frames |Correct answers |
| | | |
|1. In all discussions of CIA, one point recurs: that all CIA depends upon definite ...... | | |
| | |see answer below |
| | | |
|2. Can you list the assumptions? | | |
|I – ...... | | |
|H – ...... | | |
|Cash ...... | | |
|Terminal ...... | | |
|Discount ...... | |assumptions |
| | | |
|3. The key assumption is that all managers would like to be rational and honest; but they have to | |investment |
|survive tool! In CIA, the key assumption is the ........ | |horizon |
| | |flow |
| | |value |
| | |rates |
| | | |
|4. Because of the difficulty of reliable assumptions, estimates should be prepared which are high, | | |
|......, and ...... | |horizon |
| | | |
|5. Warning By changing the underlying assumptions, CIA computations may be manipulated to show any | | |
|required results ........ (True/Seldom true). | |low |
| | |expected |
| | | |
|6. The DICH’ approach sets the ...... | |true |
| | | |
|7. The DICH approach is: | | |
|D – ...... and criteria | | |
|I – ...... | | |
|C – ...... | | |
|H – ...... | |assumptions |
107
|Set 5.3 Detailed Frames |Correct answers |
| | | |
|8. After assumptions are set, the following steps should be taken: | | |
|a) alternative ......, | |decision |
|b) provision for ......, | |investment |
|c) cash ......, | |cashflow |
|d) measures of ......, | |horizon and |
|e) non - ...... factors. | |terminal values |
| | | |
|9. All these steps lead to a ...... | |analysis |
| | |disaster |
| | |profiles |
| | |investment |
| | |quantitative |
| | | |
|10. To discipline managers, and to aid better judgement in the future, the final procedure is ......| | |
| | |decision |
| | | |
|11. CIA data may be manipulated to show any result. In order to improve the DCF return, we may do | | |
|which of the following: | | |
|a) reduce the investment? | | |
|b) increase savings? | | |
|c) shorten time of savings? | | |
|d) reduce tax rate? | | |
|e) increase horizon? | | |
|f) increase terminal value? | | |
|g) deduct irrelevant salvage values? | | |
|h) combine projects to cover bad with good? | |audit |
| | | |
|12. CIA assumptions must be stated and ...... | |all! |
| | | |
|13. CIA decisions rest on assumptions that must be ...... | |justified |
| | |valid |
|14. CIA techniques aid good business ...... | | |
108
|Set 5.3 Detailed Frames |Correct answers |
| | | |
|15. DCF is a tool of ...... | |judgement |
| | |(intuition) |
| | | |
|16. CIA is a systematic analysis which explores the sensitivity of projects to different ...... | | |
| | |cia |
| | | |
|17. CIA should seek out all ...... Should the analyst press .hard for an alternative that his | | |
|superior really does not want to deal with? | |assumptions |
| | | |
|18. Promoting of CIA projects depends on quantitative and ...... factors. | |alternatives |
| | |(opportunities) |
| | |not if he wants |
| | |to keep his job! |
| | | |
|19. CIA decisions are key decisions for ...... amounts for ...... time-periods. | |non-quantitative |
| | | |
|20. In writing this programme, we too have made certain assumptions which are useful but not | | |
|necessarily always valid: projects may be for: | | |
|a) plant and equipment, | | |
|b) R & D, | | |
|c) advertising, | | |
|d) training, | |large |
|e) new business ventures. | |long |
| | | |
|To which of the above types of project might each of the following statements refer: | |answer (don’t cheat!): |
|New investment is not normally all in year 0. | | |
|All new investment is allowed immediately for tax (i.e. not depreciated), | |(b), (c), (d), (e) |
|Working capital is part of the new investment. | | |
|Underlying assumptions are always extremely unreliable or not valid, | |(b), (c), (d) |
|Terminal values may be substantial amounts, not merely small salvage items, | |(e) |
|Management may well get cost estimates that are wrong by a factor of 10 times. | | |
|vii) Benefits are impossible to forecast. | |(b), (c), (d) |
| | | |
| | |(b), (e) |
| | | |
| | |(b) |
| | |(d) |
109
|Set 5.3 Detailed Frames |Correct answers |
| | | |
|21. Thus DCF is still only a tool, not an answer to all the problems of CIA. When management tries to | | |
|make a rule that no CIA project is ever approved unless it involves a yield of 20% or over, then all | | |
|projects submitted are ...... | | |
| | | |
|22. However, the results of efficient CIA are shown in the running of the business, and the management| | |
|must take the credit because, whether the experts are found to be right or wrong, the final | | |
|responsibility is with the ...... | | |
| | |manipulated |
| | | |
|23. The end is at hand ! Now that you have completed the set, all that remains for you to do is: | | |
|a) read the summary for this set and review the learning-patterns for this chapter for the last time; | | |
|b) have one last attempt at a CIA worksheet-Project H (page 113); | | |
|c) read the summary lecture on ‘A Final Look at CIA’ which follows; | | |
|d) go for a short, brisk walk; and then | | |
|e) test what you’ve learnt from this book by completing the quiz that follows. | | |
| | | |
| | | |
| | |managers |
110
Instructions for Completing the CIA Worksheet
for Project H
assumptions
Write Investment 200; Annual Savings 50; Horizon 5 years; Terminal Value—; Tax Rate 50%; Discount Rate 20%; Old-machine Net Book Value Now 144; Old-machine Horizon Now 4 years; Old-machine Terminal Value Now 84.
cashflow
Write in the Annual Savings 50; New Depreciation 40 (computed as Investment 200 divided by Horizon 5 years); and deduct the Old-machine Depreciation 36 (Old-machine Net Book Value Now 144 divided by the Old-machine Horizon Now 4 years) to compute the Incremental Depreciation of the New Investment 4. Compute the Taxable Income 46; deduct Tax at 50 % = 23; and add back Incremental Depreciation 4 to compute the Annual After-tax Cash Flow 27.
old-machine effect on new investment
Write Old-machine Net Book Value Now 144 and deduct Old-machine Terminal Value Now 84 to compute Taxable Loss 60. Multiply by the Tax Rate 50% to compute the Old-machine Tax Shield 30. Add the Old-machine Terminal Value Now 84 to compute the Total Reduction of New Investment in Year 0 (cash inflow) 114.
cash profile
Write PV Factor at 20% Discount to remind you of the rate to use in the Discount Tables. Write in the Year column the item 0, and write the Investment of 200 under Cash Out.
Then write in Total Reduction of New Investment 114 (computed above) under Cash In for Year 0. This reduces the Gross Investment of 200 to a Net Investment of 86. Then write in Present Value Factor 1·0 (it is always 1·0 for year 0) and compute the Net Investment as PV Cash Out 86 (same amount). This is the PV of Investment (PVI).
Write under the Year column the Horizon period 1–5 years. Then under Cash In write the Annual After-tax Cash Flow 27 (above).
Look up in the Discount Tables the PV Factor (PVF) for Discount
111
Instructions for Completing the CIA Worksheet for Project H
Rate 20% at Horizon period of 5 years to get PVF of 3·0. Write this in the PV Factor column. Then compute the PV Cash In as the Cash In 27 (above) times the PVF 3·0 equals 81. This is the PV of Savings (PVS).
MEASURES OF INVESTMENT
payback: Write the Net Investment 116 and divide it by the Annual Savings before Tax 50 to compute the number of years to pay back the cash outflow: 2-3 years.
simple return on investment: Write the Annual Savings before Tax 50; divide by the Net Investment 116; and multiply by 100% to compute the SRI of 43%.
net present value: Write the PV of Savings 81 (above) and deduct the PV of Investment 86 to compute the Net Present Value —5.
profitability index: Write the PV of Savings 81 (above) and divide by the PV of Investment 86 to compute the Profitability Index 0·9.
yield: a) Quick method - for an even cash flow divide the PV of Investment 86 by the Annual After-tax Cash Flow 27 to compute a PV Factor 3·2. This will bring the PV of Savings 86 exactly equal to the PV of Investment 86. Look up the PV Factor in Discount Table B for a Horizon period of 5 years to find the appropriate Discount Rate Yield ±16%.
b) Trial and error - for uneven cash flows, try different Discount Rates, say 10 to 20%, until the NPV equals 0. Then the Discount Rate used is the Yield: ±16%.
112
CIA Worksheet for Project H–
to be completed as instructed on pages 111 and 112
|Assumptions | | | | | |
| | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
| | | | | | |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |/ |years |3 |
| |Net Investment/Annual Savings | |years |
|Simple Return on |/ |% |20 |
|Investment (SRI) |( 100% | |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |— |amount |Zero |
| |PV Savings — PV Investment | |or |
| | | |Plus |
|Profitability Index (PI) |/ |index |1.0 plus |
| |PV Savings/PV Investment | | |
|Yield | / = |% |20 |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF | |% |
| |Table B: PVF at Horizon years= | | |
113
CIA Worksheet for Project H-solution
|Assumptions | | | | | |
| |1-5 | | | |
| |50 | | | |144 |
| | | | | | |
| | | | | |84 |
| |40 | | | | |
| |36 | | | | |
| |4 | | | |60 |
| |46 | | | |30 |
| |23 | | | | |
| | | | | |84 |
| |23 | | | | |
| |4 | | | | |
| |27 | | | |114 |
Cash Profile
|Year |Cash |PV Factor |PV Cash |PV Factor |PV Cash |
| | |at % | |at % | |
| | |Discount | |Discount | |
| |Out |In | |
|Payback (PB) |116/50 |2·3 |3 |
| |Net Investment/Annual Savings |years |years |
|Simple Return on |50/116 |43 |20 |
|Investment (SRI) |( 100% |% |% |
| |Annual Savings/Net Investment | | |
|Net Present Value (NPV) |81 — 86 |–5 |Zero |
| |PV Savings — PV Investment |amount |or |
| | | |Plus |
|Profitability Index (PI) |81/86 |0·9 |1.0 plus |
| |PV Savings/PV Investment |index | |
|Yield | 86/27 =3·2 |±16 |20 |
|(Internal Rate of Return) |PV Investment/ | | |
| |Annual After-tax Cash Flow=PVF |% |% |
| |Table B: PVF at Horizon 5 years=3·2 | | |
114
Summary–A Final Look at CIA
introduction
The capital investment problem is primarily that of ascertaining whether the expected earnings from a proposed project justify the investment of funds for that project. Investment problems require that estimates of conditions in the future be made. Obviously, commitments of large amounts now for benefit later are of vital importance to the future of the company.
Any investment – be it stocks, bonds, land, equipment, or inventory – involves the same basic problem: that of a commitment made now in the expectation of earning a sufficient return in the future.
Specific capital budgeting problems arise in relation to decisions about building new facilities, replacement of equipment with better equipment or automating a manual operation, which type of equipment, lease v buy, etc.
These problems can be dealt with in two stages. The first step is to screen off the satisfactory investment proposals (those which will most likely earn a reasonable return) from those that probably will not. The second problem is to arrange the satisfactory proposals in order of preference, i.e. deciding which of the proposals is the best, which is second best, etc.
In every investment decision there are non-quantitative factors that must be taken into account. However, for our purpose, we will be discussing techniques of financial analysis which are applicable to problems for which quantitative data is available.
return-on-investment concept
Any investment involves risk, and a risk will not ordinarily be taken unless the investment can be shown to give a satisfactory return in the future. The problem to be resolved in an investment decision is whether the proposed investment is justified by the earnings it will produce over its life.
Some investments involve interest payments with the full amount of the investment being repaid at its termination date. Other investment repayments combine principal and interest. Many investment decisions relate to depreciable assets which have little or no resale value at the end of their economic life. Earnings on any investment must be large enough to repay both the investment itself and to earn a sufficient return on the amount not yet recovered.
115
Summary-A Final Look at CIA
present value
We will not invest 1 unit of money now unless we expect to get more than 1 unit of money later on. Similarly, if a proposal will produce earnings of 1 at the end of one year, we will be willing to invest only somewhat less than 1 in it now. Therefore the prospect of receiving 1 in one year’s time has a present value, a value now, of somewhat less than 1. How much less depends on how much we expect our investment to earn.
The present value for a payment of 1 to be received x years hence at any rate of return (r) can be found from the formula:
[pic]
Tables are available which give the computations of present values for various time-periods (see pages 66, 67 and the simplified table on page 5):
Table A–a single amount to be received N years from now;
Table B–amounts to be received for each of the next N years.
These present-value tables enable us to reduce aspects of a proposal to money amounts.
The present-value method for doing this uses this rule: an investment should be accepted if the present value of its earnings is equal to or exceeds the amount of investment required. The earnings are cash flows relevant to the problem and, in order to find the present value of these earnings, they are discounted at a specific rate of return, using the tables. The specified rate of return is referred to as the ‘hurdle’ rate.
Table A shows the present value of 1 received once after N years. Table B shows the present value of 1 received annually for each of the next N years. Table B can be used to find the present value of payments received annually for any given number of years.
Tables A and B show present values of earnings flows received once a year at the end of the year. Tables are also available which show the present values of earnings flows on a quarterly, monthly, or continuous basis. These are not commonly used, however.
unadjusted return on investment
The simple return-on-investment concept has one major weakness, in that it makes no allowances for differences in present values of the earnings of the various years, i.e. each year’s earnings are treated as if they were as valuable as those of every other year. For example, 300 earned next year is more attractive than the prospect of earning 300 three years from now, and that 300 is more attractive than the prospect of earning 300 four years from now.
116
Summary–A Final Look at CIA
In order to make calculations of the profitability of an investment which are more accurate than the simple unadjusted return, four factors must be taken into account: (a) the hurdle rate, (b) the amount of earnings each year, (c) the horizon, and (d) the amount of the investment.
hurdle rate
The hurdle rate (required rate of return) is selected by top management, and any investment proposals which do not indicate that they will earn that rate are not accepted. The choice of the earnings rate is largely subjective.
The hurdle rate can be based on various factors. Cost of capital is one approach, i.e. the hurdle rate should be equal to the company’s weighted average cost of capital (after-tax cost of debt capital and cost of equity capital).
Another approach is to formulate a balance sheet and an income statement for a satisfactory future situation. The balance sheet will show the real value of the assets and the proportion of fixed debt to equity capital which the management feels is satisfactory. The income statement will show what management feels to be an acceptable level of earnings.
Thus the hurdle rate is calculated as:
a) the after-tax interest cost (actual interest cost of long-term debt, multiplied by 1 minus income-tax rate);
b) add to this the net income after taxes;
c) divide this amount by the sum of long-term debt plus owner’s equity.
Many firms arrive at the hurdle rate by intuitive processes. If a particular rate results in rejection of a project that is felt to be satisfactory, the rate can be lowered.
The hurdle rate includes interest, but is certainly higher than any interest rate for borrowing money.
The hurdle rate required on any investment should reflect the relative risk of the investment compared to the average.
The calculations of costs, savings, and horizon are estimates, and often a higher earnings rate is required when these uncertainties are thought to be large. In addition, different earning rates may or may not be used in different profit-centres of the firm.
Methods of financing are usually considered as a separate problem. Whether or not the proposed investment project is desirable is an operating problem; how to finance the project is a financial one.
117
Summary–A Final Look at CIA
earnings
The earnings of an investment are the additional monies that a firm predicts it will make, as opposed to what earnings would be if the investment were not made. Thus there is a differential to be considered.
When a new piece of equipment increases the company’s productive output, the incremental profit on this increase is the earnings anticipated on the investment in the equipment.
income taxes
Savings or income resulting from an investment are obviously subject to income tax. Owner’s equity will be increased only by the amount remaining after these taxes have been deducted.
In estimated earnings, depreciation is often omitted from calculations. Since depreciation is an allowable expense for tax purposes, and provides a tax shield, it screens earnings from the full impact of income taxes.
Depreciation can be calculated on a straight-line basis or on a declining-balance (‘accelerated’) basis.
Tables which show the present value of the depreciation tax shield can be easily computed, and this amount added to the present value of the after-tax cash earnings gives the total present value of the earnings.
Accelerated depreciation is often used for tax purposes, because a larger fraction of the depreciation tax shield occurs in the early years, where present values are high.
Income-tax calculations can be omitted entirely, since any project which produces the most profit before taxes will produce the most profit after taxes.
Interest paid is often not included in tax calculations, because we usually look for the overall rate of return on the investment, regardless of whether the monies required for investment are borrowed or come from the shareholders.
economic life – horizon
A cash-flow analysis is carried out for the life of the proposed project, the life being the time during which it is estimated that benefits can be expected. The three ways of defining the ‘life’ of equipment are (a) its physical life, (b) its technological life, (c) its product-market life. The economic life of equipment is the shortest of these three types of life, and can rarely be exactly predicted. The physical life of a machine is considered to be the number of years during which it will be of use. The technological life refers
118
Summary-A Final Look at CIA
to the time before obsolescence occurs. The product-market life refers to the time when the particular operation or product the equipment produces is no longer called for.
investment
The amount of investment is the sum that the company risks if it accepts the proposal. The relevant investment costs are the costs that will be incurred if the company undertakes the project and that would not be incurred if it were not undertaken.
Other factors are (a) investment credit, when a company receives a percentage of the cost of new equipment as a reduction in its income taxes. (b) Existing equipment may be sold and therefore reduce the amount of incremental investment. (c) Disposal of an existing machine may involve a write-off which gives special tax considerations. No tax gain or loss arises if new equipment replaces one of ‘like lend’. When existing assets are disposed of, the relevant amount by which the net investment is reduced is the proceeds of the sale, adjusted for taxes. (d) Equipment may have a salvage value, but this is usually insignificant and offset by other costs. When the salvage or terminal value is significant, the net residual value is a cash inflow in the year of disposal, and is part of the other cash inflows, (e) Sunk costs are not relevant. (f) An investment is the commitment of funds in any type of asset. We have been referring to the purchasing of equipment as an investment, but any commitment of funds is an investment. Often, additional funds may be tied up (e.g. in inventories and accounts receivable), and increased cash will be necessary. Part of this increased working capital will come from increased accounts payable and accrued expenses. It is reasonable to assume that the residual value of investments in working capital is about the same as the amount of the investment and that, at the end of the project, they can be liquidated. In this case, the amount of working capital is treated as a cash inflow in the last year of the project, and its present value is found by discounting at the required earnings rate.
Projects often involve alternative choices. A useful approach to such problems is to start with the alternative that requires the smallest investment and to analyse the difference in additional earnings that is expected from investment in a second alternative. In other words, is additional investment justified by additional earnings that might be expected?
Some projects involve a single commitment of funds, whereas others require funds spread out over a period of time. In order to make return-on-investment calculations, these investments must be brought to a common point in time. This is usually done by the application of discount rates to the amounts involved. The lower the uncertainty, the lower the rate.
119
Summary-A Final Look at CIA
dcf measures of investment
We finally assess the potential profitability of an investment, using any or all of the three DCF measures: Net Present Value, Profitability Index, and Yield.
a) Net Present Value
NPV = PVS — PVI, which is a measure of how much the present value of future savings exceeds the present cost of the investment.
b) Profitability Index
[pic]must be greater than 1 for a satisfactory investment.
c) Yield
This measure reflects the discount rate that would make the present value of earnings equal to the present value of the investment. If this figure equals or exceeds the required earnings rate, the proposal is satisfactory. Yield is the measure of investment that is best understood by business men.
final note: ‘The aim of a book may be to instruct, yet you can also use it as a pillow, although its objective is to give knowledge, direction, profit.’
and so
‘Aim for knowledge. If you become poor, it will become wealth for you; if you become rich it will adorn you.’
We hope you enjoyed the programme and will remember CIA, DCF, and the sayings. Good luck in applying what you learn to practical business problems.
120
Quiz–A Test of Knowledge Acquired from the
Programme
Estimated time: 30 minutes
(Choose the most correct answer.)
1 The main objective of capital investment analysis (CIA) is to:
a) avoid risky projects by scientific analysis?
b) increase funds for investment?
c) improve decision-making for increased profitability?
d) achieve a return exceeding the cost of borrowing?
2 CIA is most effectively used:
a) as part of long-term planning?
b) in a one-year capital budget?
c) by project?
d) as part of financial control?
3 After capital investment has been completed, an audit is:
a) wasted, because costs are sunk?
b) only going to cause trouble?
c) useless in most cases?
f) useful for many reasons?
4 The profitability index of an investment is:
a) PV of Savings/PV of Investment?
b) NPV/PV of Savings?
c) PV of Investment/PV of Savings?
d) PV of Savings/NPV?
5 When we invest 1000 in a machine to save 500 labour p.a. for five years, this investment is to:
a) improve product quality?
b) cut costs to a minimum?
c) improve profitability?
d) develop new operations?
6 A new machine costs 1000 and saves 600 of materials p.a. The DCF return on this investment is:
a) not calculable?
b) definitely good?
c) calculable with existing data?
d) calculable with additional assumptions?
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Quiz-A Test of Knowledge Acquired from the Programme
7 When a manager considers possible replacement of an existing machine by a new machine, how many alternative courses of action are normally available to him:
a) one?
b) several?
c) none?
d) two?
8 A company needs a system to evaluate capital expenditure for:
a) selection of most profitable investments?
b) internal control reasons?
c) assessment of cash needs?
d) tax reasons?
9 The PV in year 0 of 100000 received in year 3 at 20% is about:
a) 75000?
b) 380000?
c) 3·80?
d) 130000?
10 Capital investment is expenditure:
a) which always requires head-office approval?
b) in stocks and shares?
c) in plant and machinery?
d) with a life of more than 1 year?
11 Ignoring taxes, which of the following is not relevant to the decision to buy a new machine:
a) additional men needed to operate the machine?
b) salvage value of previous machine?
c) installation charges?
d) book loss on disposal of previous machine?
12 In deciding whether to research and manufacture a new product, R & D costs already paid in cash should be:
a) ignored?
b) allocated over the economic life of the product?
c) included in the initial investment?
d) deducted from the savings?
13 In capital investment analysis (CIA):
a) fixed costs are relevant if paid in cash?
b) only incremental costs are relevant?
c) fixed costs are always relevant?
d) all costs are relevant?
122
Quiz-A Test of Knowledge Acquired from the Programme
14 If machine B replaces machine A, then:
a) the book value of machine B is a cash flow?
b) the book value of machine A is not relevant for tax purposes?
c) the terminal value of machine A is relevant?
d) the salvage value of machine A is not relevant?
15 Research and development is a sunk cost:
a) before you have spent it?
b) after you are firmly committed to spend it?
c) unless it concerns yellow submarines?
d) if not yet paid in cash?
16 In capital investment analysis:
a) all costs are variable in the long run, and therefore relevant?
b) depreciation is a relevant cash flow?
c) only incremental cash flows are relevant?
d) only cash flows that do not change are relevant?
17 In deciding to lease or buy, actual depreciation is:
a) dependent on the management?
b) never relevant?
c) sometimes relevant?
d) relevant for tax purposes only?
18 For capital investment which increases sales volume, the relevant saving (cash inflow) is the incremental:
a) sales?
b) contribution after tax?
c) net profit?
d) cash balance?
19 An investment of 500 with a horizon of 2 years and savings in year 1 of 300 and in year 2 of 500 has (ignoring tax) a net present value (at a discount rate of 30%) of about:
a) less than 100?
b) 350?
c) 100?
d) 600?
20 The PV of a cash flow of 25000 p.a. for 5 years is:
a) the PV of year 1 × 5?
b) not calculable without further data?
c) the PV of 125000?
d) 125000?
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Quiz-A Test of Knowledge Acquired from the Programme
21 The PV of 200000 in year 2 plus 300000 in year 5 at 20% is about:
a) 261000?
b) 383000?
c) 100000?
d) 500000?
22 For CIA, a post-completion audit is:
a) an audit of a new project?
b) an audit of a post-office project?
c) an audit of a failed project?
d) something else?
23 The key factor in the quantitative (only) analysis of capital expenditure is:
a) the strategic value of investment to the company?
b) the return on investment?
c) the payback?
d) the prevention of friction between managers?
24 The PV of 200 p.a. for 2 years at 30% is about:
a) 140?
b) 60?
c) 280?
d) 80?
25 The PV of cash flow in year 5 normally brings it to a value at:
a) year 0?
b) the end of year 1?
c) the beginning of year 2?
d) year 5, which accounts for inflation and time delay?
26 Which of the following investments has the highest profitability index?
a) PVI, 10000; PVS, 18000?
b) PVI, 10000; PVS, 8000?
c) PVI, 1000; PVS, 800?
d) PVI, 20000; PVS, 30000?
27 The minimum required earning rate for CIA is normally:
a) the borrowing rate?
b) the lending rate?
c) the cost of capital?
d) the return on the least profitable investment?
124
Quiz-A Test of Knowledge Acquired from the Programme
28 100 today at 5% is worth one year from now:
a) 100?
b) 102·50?
c) 105?
d) something else?
29 For an investment of 1000 with savings of 500 p.a. for 5 years, the internal rate of return (ignoring tax) is about:
a) 250%?
b) 40%?
c) 100%?
d) 6%?
30 The determining factor in deciding the depreciation in CIA computations is:
a) the tax law?
b) the cash position of the company?
c) the actual life of the asset?
d) the profit position of the company?
31 CIA should normally compute:
a) only as accurately as is useful to management?
b) to the nearest pound/franc/dollar?
c) as accurately as possible?
d) to the nearest hundred pounds/francs/dollars?
32 For CIA, the figures in the full four-figure discount tables are normally:
a) not accurate enough for precise results?
b) not useful after three figures?
c) scientifically valid?
d) absolutely vital for really useful analysis?
33 Depreciation is different from other costs, because it is:
a) not allowed as a deduction for tax?
b) based on the accountant’s judgement?
c) a non-cash expense?
d) reducing every year?
34 Depreciation of a machine in CIA computation is normally based on:
a) anticipated replacement cost of fixed asset?
b) market value of fixed asset?
c) cost of fixed asset for tax purposes?
d) something else?
125
Quiz-A Test of Knowledge Acquired from the Programme
35 If a machine with a 10 year life is to be replaced after 3 years, then:
a) the new machine cannot be a good investment?
b) the horizon of the old machine was incorrect?
c) the old machine must not be sold?
d) the old-machine calculation was completely wrong?
36 In CIA for a new machine, the salvage value of an old (replaced) machine should be:
a) disregarded?
b) deducted from the original cost of the new investment?
c) considered a cash saving at the end of the project life?
d) allocated over the life of the investment?
37 The horizon of a CIA project is normally:
a) the economic life of the project?
b) the technical life of the project?
c) simply a matter of management judgement?
d) the tax life of the major asset?
38 To appreciate sensitivity of our capital investment analysis to horizon, we use:
a) the most likely working life only?
b) a range of working lives?
c) the minimum working life only?
d) the technical life?
39 A firm plans to introduce product A on the market and sell it for 5 years. A machine with a physical life of 15 years is needed to manufacture A, but it cannot be adapted to any other use. What is the horizon of the investment for CIA?
a) 20 years?
b) 10 years?
c) 15 years?
d) 5 years?
40 To develop a product X, very considerable R & D has been spent for the past 10 years. Now we make a CIA to decide whether to actually manufacture the resulting product or not. For a successful product X, the CIA will probably show:
a) a high IRR, because the R & D is not sunk?
b) a very high IRR, because the R & D is sunk?
c) an average IRR, because the R & D is not sunk?
d) a low IRR, because the R & D is sunk?
126
Quiz-A Test of Knowledge Acquired from the Programme
41 Capital investment for CIA purposes is:
a) plant or machinery?
b) any cash outflow in year 0?
c) any outflow in year 0 or later that produces measurable benefits in future years?
d) only R & D, advertising, or plant?
42 Under no capital rationing, a company accepts CIA projects:
a) without limit?
b) if the net present value is negative?
c) if the payback exceeds five years?
d) if the PI exceeds 1?
43 If government grants and investment allowances are available against a new investment, then they should be:
a) offset in year 0 against initial expenditure on investment?
b) taken into cash flow as expected to be received?
c) best ignored?
d) allocated over the life of the project?
44 In determining the investment of a capital project, we include:
a) the fixed capital cost plus working capital assets less offsetting items?
b) the fixed capital costs plus working capital assets?
c) only the fixed capital cost?
d) only initial expenditure in year 1?
45 Investment in a new machine for 1000 replaces an old machine (original cost, 500; present salvage value, 100). Ignoring income tax, the net investment is:
a) 100?
b) 1500?
c) 900?
d) 1400?
46 For effective CIA, all cash flows must be analysed:
a) yearly?
b) monthly?
c) quarterly?
d) as appropriate and useful?
47 The major problem in CIA is:
a) horizon?
b) terminal value?
c) tax rate?
d) savings?
127
Quiz-A Test of Knowledge Acquired from the Programme
48 A company could use probability and expected-value techniques in CIA to:
a) check the net present value?
b) indicate a good payback?
c) improve the yield?
d) rank projects for acceptability?
49 If annual saving on a project before income tax is 600000, depreciation 200000, and income tax 40%, then the annual after-tax cash flow is:
a) 600000?
b) 660000?
c) 340000?
d) 440000?
50 For a CIA project, cash flow is the same as net profit if there is:
a) no tax?
b) no depreciation?
c) some fixed cost and depreciation?
d) no fixed cost or depreciation?
51 We can increase the NPV (net present value) of a CIA project by:
a) reducing the discount rate?
b) reducing the savings?
c) increasing the discount rate?
d) shortening the horizon?
52 Managers making capital investment decisions should rely on:
a) natural flair?
b) financial analysis plus business judgement?
c) business experience only?
d) market research?
53 Working capital in CIA projections should normally be:
a) included in appropriate years out and in?
b) included in year 0 and depreciated?
c) ignored?
d) reduced to a minimum?
54 In calculating CIA cash flow, income tax is:
a) taken into account when paid?
b) ignored?
c) not usually important?
d) the only important assumption?
128
Quiz-A Test of Knowledge Acquired from the Programme
55 In CIA, we use cash flow, not net profit, because:
a) only cash flow is relevant?
b) it is difficult to estimate profit accurately?
c) of the importance of liquidity to a company?
d) of the high cost of borrowing cash?
56 CIA projects submitted for approval should be those:
a) immediately required by individual managers?
b) resulting from creative search for opportunities?
c) approved by budgets?
d) exceeding 25% yield?
57 If we invest 10000 for a saving of 4000 per annum, the payback is:
a) not known?
b) 2½ years?
c) 40 years?
d) 4 years?
58 Which of the following is true:
a) projects with no cash inflows in early years must be avoided as they cannot be worthwhile?
b) in analysing a project, it is sufficient to calculate expected benefits on a global basis, and not annually?
c) none of these statements?
d) it is usual to estimate the cash flows in detail for the first three years and then include a total figure for the estimated balance?
59 If the purchase of one machine requires the purchase of another, the machines are most likely:
a) dependent investment projects?
b) independent investment projects?
c) mutually exclusive investment projects?
d) none of the above?
60 To compare and rank two cost-saving CIA projects which have different horizons, we:
a) use net present value, and choose the project with the smaller NPV?
b) use yield, and choose the higher percentage?
c) use payback, and choose the larger number?
d) use profitability index, and choose the smallest number?
129
Quiz-A Test of Knowledge Acquired from the Programme
61 To account for risk in CIA we:
a) must use probability?
b) only apply probability and expected value if there are scientific assumptions?
c) could use various methods?
d) ignore all terminal values?
62 CIA seeks to:
a) eliminate risk?
b) ignore risk?
c) increase risk?
d) quantify risk?
63 If we raise the discount rate to account for risk, then we:
a) ignore the cost of capital?
b) ignore the variations of risks in different years?
c) use more sophisticated tools?
d) are always justified?
64 For CIA, simple return on investment is:
a) a poor measure?
b) a useful tool?
c) the best approach?
d) good for accountants?
65 If two investment projects are independent:
a) either both must be undertaken or neither can be?
b) they must be justified separately?
c) undertaking one precludes undertaking the other?
d) neither will work alone?
66 If two investments are ‘mutually exclusive’ alternatives:
a) CIA is not appropriate?
b) if funds are available, both should be undertaken?
c) if one is undertaken, the other should not be?
d) neither should be undertaken unless the payback is good?
67 Risk can be reduced in CIA computation by:
a) shortening the horizon?
b) lengthening the horizon?
c) ignoring the horizon?
d) brightening the horizon?
130
Quiz-A Test of Knowledge Acquired from the Programme
68 In reality, the accountant’s most helpful role in capital expenditure evaluation is to:
a) accept or reject projects?
b) be extremely accurate?
c) check the computation and be pessimistic about the assumptions?
d) avoid interfering?
69 In CIA, the NQ (non-quantitative) factors are:
a) never as important as the Q (quantitative) factors?
b) the same as the Q factors?
c) sometimes as important as the Q factors?
d) a minor part of the analysis, subject to acceptable Q factors?
70 Simple return on investment is not a good measure of investment, because it does not:
a) consider the timing of the cash flows?
b) consider the risk?
c) show payback?
d) consider the real investment?
71 The attractiveness of a CIA project is best measured by:
a) the increase of annual profits?
b) the increase of market share?
c) the increase in cash resources?
d) the return on investment and increase in value of the company?
72 An investment with a life of 4 years and an investment with a life of 10 years are:
a) comparable with no assumptions needed?
b) comparable with an assumption regarding terminal values at the end of year 4?
c) not comparable?
d) comparable if the costs of the projects are the same?
73 The ‘DICH’ approach to CIA stands for:
a) Data, Income, Capital, Horizon?
b) a four-letter word?
c) Decision, Income, Cash flow, Horizon?
d) Decision, Investment, Cash flow, Horizon?
74 A CIA project analysis is:
a) definite and always useful to management?
b) sometimes deceptive without a long-term plan?
c) financially more reliable?
d) not as important as a long-term project?
131
Quiz-A Test of Knowledge Acquired from the Programme
75 The ‘yield’ of a project is:
a) the discount rate when the profitability index equals 1?
b) the present value factor when net present value equals 0?
c) the discount rate when net present value is positive?
d) the borrowing rate when net present value is negative?
76 In CIA:
a) each new project must be analysed with a new approach?
b) every project must be analysed in the same way?
c) no basic approach is feasible?
d) a basic approach may be used for most projects?
77 If the NPV (net present value) is greater than zero, then a decrease in the discount rate will:
a) reduce net present value?
b) increase net present value?
c) not affect the yield?
d) reduce the yield?
78 Payback:
a) is all the practical manager really needs to know?
b) is too inaccurate to ever be useful?
c) fails to consider cash flow after the payback period?
d) is the best criterion for investment from a shareholder’s viewpoint?
79 Management’s role in CIA is to:
a) make the broad computations?
b) check the broad computations?
c) understand the techniques?
d) provide the assumptions, and evaluate the result?
80 The key assumption in evaluating a CIA project is normally:
a) the proper discount rate?
b) the payback period?
c) the horizon?
d) the profit?
132
For the Instructor
Programmed learning is designed to simulate an individual tutor. In designing this programme, we have analysed in detail what knowledge and skills we are trying to teach, and what behaviour we expect of the student when he has completed the programme.
The advantages of the programme are:
1. Each student can learn at the pace most suitable for him.
2. The student studies advanced material only when he has mastered the elementary material.
3. The programme is designed to prompt a correct answer from the student. The aim is to reward the student as much as possible; if he is rewarded, he will be motivated to continue paying attention.
4. The student cannot daydream. He is continuously active, and receives immediate and continuous confirmation of his success in learning the material.
5. Frames are designed to bring the critical point to the attention of the student, and to establish his understanding of each critical point.
6. Learning-patterns seek to reinforce the programme symbolically.
The record of responses made by the student highlights areas where the programme might well be reconsidered. No programme is perfect, and consistent errors in any one frame by many students may indicate that the frame should be redesigned.
important note
In the light of the authors’ practical experience in using this programme with several hundred students, the following advice is offered to teachers who plan to use this book.
1. The programme does not eliminate the teacher, it changes his role. He does not transfer information but (a) creates the environment which motivates the student to enjoy learning, and (b) discusses problem areas with the student.
133
For the Instructor
2. For effective use of the programme with student groups, the teacher should:
a) integrate the programme into the course design,
b) require students to write the programme (for review),
c) set a definite test for students on the programme content,
d) discuss the programme in relation to the rest of the course.
3. The programme is not usually as effective if used (a) casually, without writing or test, and (b) without environmental motivation.
Please contact the authors (via the publishers) for further information, if required.
134
Answers to the Quiz
1–c 21–a 41–c 61–c
2–a 22–d 42–d 62–d
3–d 23–b 43–b 63–b
4–a 24–c 44–a 64–a
5–c 25–a 45–c 65–b
6–d 26–a 46–d 66–c
7–b 27–c 47–a 67–a
8–a 28–c 48–d 68–c
9–a 29–b 49–d 69–c
10–d 30–a 50–d 70–a
11–d 31–a 51–a 71–d
12–a 32–b 52–b 72–b
13–b 33–c 53–a 73–d
14–c 34–c 54–a 74–b
15–b 35–b 55–a 75–a
16–c 36–b 56–b 76–d
17–d 37–a 57–b 77–b
18–b 38–b 58–c 78–c
l9–a 39–d 59–a 79–d
20–b 40–b 60–b 80–c
grading 70–80 Excellent
60–70 Good
Under 60 Fair–repeat the programme at
a later date.
135
Simplified Glossary
aa Alternative analysis.
accelerated depreciation Method of depreciation in which more depreciation is taken in earlier years than in later. Also called ‘declining-balance depreciation’. See depreciation.
accounting return on investment Measure of investment, computed:
[pic]
A poor measure, because it fails to consider DCF, horizon, risk, cash flow, etc.
alternative analysis A creative search for all opportunities and alternatives to each capital investment project, i.e. do it, don’t do it, delay doing it, do something else, do it partly, etc. Do this analysis early before developing ‘emotional investment’ in any one alternative.
ann Annualisation.
annualisation–ann Measure of CI. Converts net present value at year 0 to equivalent stream of cash over the horizon; e.g. NPV 90 at investment opportunity rate 20% (PVF for the full horizon period of 5 years 3·0) gives annualisation 30 p.a. Useful measure for replacement problems. Large investments have large ann’s. Useful to compare alternative replacement projects which seek to minimise annual costs at different horizons. See measures of investment.
as Annual savings.
at After income tax.
audit Subsequent analysis and review of CI projects to determine the validity of the previous CIA. Opportunity to examine underlying assumptions and estimates. Improves forecasting skills. Disciplines managers making new estimates. Difficult to audit projects that change substantially in installation.
book loss Net book value of machine scrapped, e.g. for loss of machine 100, accumulated depreciation 40, the net book value is 60. The book loss is the same 60 if there is no salvage value. Sunk cost only relevant to CIA because of tax effects. See tax shield and terminal value.
136
Simplified Glossary
bor Borrowing opportunity rate.
borrowing opportunity rate–bor Interest rate for borrowing money. Not used as discount rate for most CIA computations, except for fixed-period lease financing, which is similar to a long–term loan. It is not a ‘risk’ rate. Lower than investment opportunity rate (IOR). See lease v buy.
bt Before income tax.
budget A plan in financial terms. May be:
a) operating budget – sales, costs, expenses, and profits;
b) cash budget – cash in and out, with balance and peaks;
c) capital budget – long-term and short-term for CI projects.
One–year budgets are useful only if part of a long-term plan.
capital A complex concept. Distinguish capital (long-term) from revenue (short-term). Several meanings:
a) traditional sense – real goods of all kinds;
b) literal traditional sense – productive assets (capital not labour);
c) CIA meaning – any expenditure now for benefit in future years.
capital budgeting Capital investment analysis (CIA).
capital expenditure Capital investment.
capital investment Capital expenditure. Cash outflow (expenditure) now for benefit later, e.g. plant, property, equipment, advertising, R & D, etc. Need not be tangible property. The CIA meaning is wider than the technical accounting meaning. See capital.
capital investment analysis–cia Capital budgeting, which should involve DCF analysis. Analysis of capital investment projects involving expenditure now (year 0) for benefits later. Valid analysis only as part of long-term planning. Be careful not to sub-optimise over too short a horizon. See DICH approach to CIA and measures of investment.
capital investment decision Decision to invest now (year 0) for benefit later (years 1–5 etc.) May relate to cost reduction, expansion, product-line, or strategic objectives. Main types:
a) project – Go or No Go;
b) choice – project A or project B;
c) selection – limited number of projects from A, B, C, D, E, etc.;
d) replacement – A replaces B.
See capital investment analysis.
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Simplified Glossary
capital rationing CI decision to select a portfolio of projects out of those available. Not a ‘Go or No Go’ decision. See capital investment decision.
cash flow Cash payments and receipts that ‘ring the cash register’. Savings on a CI project computed before and after tax. Depreciation is not a cash flow but is adjusted in the cash flow to compute the tax payable. See present value of savings.
cash profile The cash outflows and inflows of a CI project. Investments and savings. Computed before and after income tax over the horizon of the project.
|e.g. |Year |Out |In |Net |
| |0 |–100 |+ (50) |–100 |
| |1 | |+ (50) |+ (50) |
| |2 | |+ (50) |+ (50) |
| |3 | |+ (50) |+ (50) |
| |Total |–100 |+ (150) |+ (50) |
Follows DICH analysis and provides basis for measures of investment.
cf Cash flow.
ci Capital investment.
cia Capital investment analysis.
cia worksheet Designed to set out the assumptions, cash flow, cash profile, and measures of investment. See examples in the programme.
conservatism Pessimistic attitude. CIA needs not merely a conservative but a realistic approach. See risk.
contribution Contribution to fixed costs and profits. Computed: Sales less Variable Costs less Income Tax = Contribution after tax. Excludes fixed costs. A relevant cash flow. Not usually the same as net profit (q.v.).
cost of capital Complex concept. Average cost of equity and debt financing of a company. Enables investment opportunity rate to be set so that acceptable capital investments lead to improvement in the value and profitability of a company.
cp Cash profile.
creative search Need to insure that CIA is applied to the appropriate projects. CIA system provides for creative search for investment opportunities available to the company–not a limited conservative selection. See alternative analysis.
138
Simplified Glossary
d Decision and criteria.
dcf Discounted cash flow.
decision and crtteria–d Define the precise investment decision before beginning CIA. Set criteria for acceptance. Consider all alternatives. See DICH approach to CIA.
declining–balance depreciation See accelerated depreciation.
depreciation Allocation of the cost of a fixed asset to expense over its working life. Not a cash flow. Adjusted in the cash flow for tax calculation. Not relevant to CIA except to provide tax shield based on the tax law and tax working life. See straight-line depreciation and accelerated depreciation. See savings after tax. See present value of savings. See differential depreciation tax shield.
dich approach to cia Basic analysis of a capital investment project in terms of:
a) Decision and criteria,
b) Investment,
c) Cash flow (before and after tax),
d) Horizon and terminal value.
followed by a cash profile and a computation of measures of investment. Don’t forget AA and PFD.
differential costs Difference in costs between two investment plans.
differential depreciation tax shield Difference between the tax shield for depreciation on a new machine and that for the old (replaced) machine. Used to compute savings after tax. Computed:
depreciation on new machine 1000/5 years 200
depreciation on old machine 500/5 years 100
differential (incremental) depreciation 100
discount Interest rate used in present-value computations.
discounted cash flow-dcf Cash flow discounted at an interest rate to give present value at year 0. Used to compute NPV, IRR, PI, and ANN.
discount rate–dr Rate of discount used for PV calculations. General term which could be applied to any rate. See return on investment, internal rate of return, investment opportunity rate, borrowing opportunity rate, etc.
139
Simplified Glossary
discount tables Tables indicating:
a) PV of 1·00 received in one year at a specified discount rate;
b) PV of 1·00 received every year at a specified discount rate.
See the simplified Discount Tables in the text. Used to obtain PVF, given a discount rate (%) and horizon (years).
disinvestment policy The need to review continually the possible disposal (disinvestment) of capital assets that fail to produce the required return. Sometimes the PV of a tax loss exceeds the PV of future benefits; thus disinvestment is the best alternative. Holding assets means a loss of opportunity cost (value).
downside risk Risk of failure of a CIA project. Extent of losses which could be sustained if the project fails. Consider possible salvage values. Should be part of PFD before a CIA decision is made.
dr Discount rate.
economic life Horizon. Working life. Period over which an investment provides benefits. Not physical life, not technical life, not market life. Economic life or horizon of CI project. Tax-law life may differ from CIA horizon.
ei Emotional investment.
equity A complex concept–normally refers to financing of assets by owners rather than by creditors (debt). See cost of capital.
expected value A complex concept. Most probable outcome. Average of possible outcomes weighted by their probabilities. A sophisticated technique for CIA. See risk.
financial management A complex concept concerned mainly with four major problems:
a) How large should a firm seek to be?
b) What rate of growth is required–sales, assets, equipment, etc.?
c) To what extent should instability in sales and profits be avoided?
d) What kind of assets should the firm acquire, and at what rate?
note: CIA applies to this problem.
financing decisions–Method of financing a CI project. Distinguish ‘investment’ from ‘financing’ problems. CIA deals with investment problems only. The yield of a project may be improved by ‘leverage’–using borrowed money to reduce the amount invested. However, CIA is most effective if investment is first evaluated before leverage. See also cost of capital and CIA.
140
Simplified Glossary
fixed asset An asset acquired for long–term use in the business. Normally with a working life greater than one year.
fixed cost A cost that does not change with a decision. Normally overhead cost. Not normally a relevant cost for CIA.
gross investment Total cash out for the investment. See also net investment,
h Horizon.
horizon–h Economic or working life of a CI project; not merely the technological or legal life. Horizon chosen as the time period for CIA. Key assumption for CIA. Reduce risk by shortening the horizon. See DICH approach to CIA. CIA is often applied to several different horizons. Tax life may differ from CIA horizon. See tax shield.
hurdle rate See IOR and cost of capital.
I Investment.
income tax Tax on taxable profits and losses. Reduces savings cash flow. See tax shield.
incremental Additional. Above. Excess of one alternative over another. Differential.
incremental depreciation Excess of depreciation on new machine over that on existing machine. The differential effect on taxable income affects tax and, therefore, the cash flow from a CIA project.
inflation Decreasing value of money. Not part of DCF except by requiring even higher IOR’s.
internal rate of return–irr Yield. Measure of capital investment. Computed as the discount rate when NPV equals 0 and PI equals one. IRR percentage should exceed the hurdle rate for the project to be acceptable. Implies a reinvestment of proceeds at the same interest rate over the full horizon. The yield concept is easily grasped by managers. See also NPV, ANN, PI, and PB.
Computed as follows:
Investment 120
Cash flow 40
Horizon 5 years
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Simplified Glossary
Discount factor needed to make PVS of 120 will be 120/40 = 3·0.
PVI = 120
PVS = 40 × 3·0 = 120
Yield = discount rate of 3·0 at 5 years = 20%
investment–i Investment or commitment of funds with expectation of earning a return over a future period of time. Not merely stock, shares or securities. Net investment is the gross investment less any salvage value of machine etc. replaced. See capital investment and DICH approach to CIA.
investment analysis See capital investment analysis.
investment opportunity rate–ior Risk rate. Hurdle rate. Standard percentage return required for acceptance of new CI project. Required earnings rate. Required rate for CIA. Based upon the cost of capital. Used to compute PVS and PVI. See also borrowing opportunity rate.
ior Investment opportunity rate.
irr Internal rate of return.
lease Rent of assets. Investment and financing decisions combined. See lease v buy.
lease v buy Rent of an asset compared with purchase–a complex analytical problem.
Cost of leasing = PV of after-tax lease payments
Cost of buying = PV of investment less PV of depreciation tax
shield
and therefore a simplified approach is:
a) prepare cash profiles after tax;
b) discount at BOR (financial, non-cancellable lease);
c) discount at IOR (operating, cancellable lease).
Repeat computations using different horizons. Decide mainly on NQ factors!
manipulation Any CIA may be manipulated by changing the assumptions.
To improve the yield we may:
a) reduce investment;
b) increase savings;
c) shorten time of saving;
d) increase horizon;
e) reduce tax rate;
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Simplified Glossary
f) increase terminal values;
g) deduct irrelevant salvage values!;
h) combine a bad project with a very good one to make one average project.
note: Insist that all assumptions be justified!
measures of investment–moi Computations which follow the DICH approach to CIA. Measure attractiveness of CIA projects:
a) Payback (PB)
b) Net Present Value (NPV),
c) Profitability Index (PI),
d) Annualisation (ANN),
e) Yield (IRR).
Each measure must be judged against a standard. Different measures rank projects in various orders of acceptability. See payback, net present value, profitability index, annualisation, internal rate of return, and ranking of investments.
moi Measures of investment.
mutually exclusive investment CI decision between project A or project B. Not a ‘Go or No Go’ decision. See capital investment decision.
nbv Net book value.
net book value–nbv Cost of fixed asset less accumulated depreciation. Basis for the computation of the tax shield on scrapping of equipment. Terminal (salvage) value reduces book value and tax shield. See terminal value.
net investment Gross investment less deduction for the terminal value and tax shield of any old investment that the new one replaces. Note, however, that for simple crude payback of the net investment, all tax effects are ignored. See payback.
net present value–mtv Measure of capital investment. PV of benefits from an investment less PV of all relevant costs incurred. PVS — PVI = NPV. Indicates a money measure of CIA at IOR. Aids selection of CI projects. Assumes reinvestment of annual proceeds at IOR during horizon period. Theoretically attractive. See also payback, profitability index, annualisation, and internal rate of return.
Difficulty: large investments tend to have larger NPV’s and therefore appear more attractive than small investments.
net profit After-tax contribution less fixed costs.
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Simplified Glossary
non–quantitative factors–nq Factors in a CI decision that cannot be put into numbers. Consideration of legal, policy, human, social, political, economic, and strategic factors related to a CI. Must be considered in a CI decision. The big risk is political. Q + NQ = D. See quantitative data and capital investment decision.
npv Net present value.
nq Non–quantitative factors.
operational research Management-science approach to practical problems. May be applied to CIA. Particularly useful for replacement problems due to the difficulty of estimating the effective horizon of equipment.
opportunity cost A complex concept. May be cost or benefit. Refers to alternative cost or benefit from another course of action. Often the market or salvage value or alternative value of an asset, e.g. net book value 100 not relevant. Salvage (terminal) value 300 is the opportunity cost of the asset (benefit foregone). Relevant to CIA. See relevant cost.
p Probability.
payback–pb May be defined in many different ways. Number of years for cash proceeds from CI to repay the original cash outlay. Years to pay back the investment, e.g. investment of 100 with gross savings of 20 p. a. is paid back in 5 years. Simple measure of cash availability. Useful to management. Fails to consider savings after the payback period or DCF. Definition of payback could vary to use net rather than gross investment; generally ignores taxes. See measures of investment.
note: In this work, payback is always defined before all tax effects as a simple crude measure. Alternative definitions are also used. See net investment.
pb Payback.
pfd Provision for disaster.
physical life Number of years equipment will perform technically. Not the horizon. One of the factors in setting the horizon. Not the same as the economic life. Relates to, but is not the same as, the tax life for depreciation tax shield.
pi Profitability index.
144
Simplified Glossary
present value–pv Value today of money to be received (or paid out) in the future, e.g. 100 to be received one year from now at 5% interest has a PV today of about 95. Thus 95 invested today at 5% will grow to about 100 after one year. Depends upon discount rate used. At zero discount rate, all present and future values are identical. See present value factor and investment opportunity rate.
present value factor–pvf Factor in the discount tables. Indicates the PV in year 0 of 1·00 received in years 1–50, or the PV of a series of cash flows of 1·00 in each year 1–50. Depends upon DR used. ANN is computed NPV/PVF. See present value and discount tables.
present value of investment–pvi PV of investment at year 0, computed:
a) investment in year 0
b) less salvage value of old machine,
c) less tax shield on the old machine.
PVS – PVI = NPV. PVS/PVI = PI. When PVI = PVS, the DR is the IRR.
present value of savings–pvs Present value at year 0 of the flow of savings in future years at a specified IOR and horizon. Computed:
Savings before tax 100
less: Depreciation 20
Taxable savings 80
less: Income tax at 40% 32
48
add: Depreciation
(not a cash flow) 20
Cash flow after taxes 68
PV at 20% for 5 years is PVF × PV of savings = 3·0 × 68 = 204.
probability Complex concept. Relative chance that a certain outcome will occur. Sophisticated approach to CIA. See provision for risk and expected value.
profitability index–pi A measure of investment. PVS/PVI = PI, Measures relative input to output of projects. Indicates profitability, but does not reveal materiality of the project. See measures of investment.
product market life Number of years a product made on a machine will be marketed.
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Simplified Glossary
provision for disaster Need to provide alternative plans of action where any assumptions underlying a CIA project may prove to be invalid. Consider the extent and significance of possible losses as part of CIA before the decision to invest. See downside risk.
provision for risk In CIA we provide for risk by:
a) shortening the horizon,
b) setting high discount rates,
c) making conservative estimates of cash flows,
d) probability and expected-value techniques.
pv Present value.
pvf Present value factor.
pvi Present value of investment.
pvs Present value of savings.
q Quantitative data.
quantitative data–q Data for CI that can be put into numbers. Data that influences a CI decision. Q + NQ = D. Need to compute a range of Q before considering NQ factors. Overall decision depends more upon management judgement of NQ factors than on Q alone. Sophisticated CIA techniques using probability and utility theory tend to quantify data formerly thought to be purely NQ.
ranking of investments Listing alternative CI in terms of acceptability. Uses measures of investment. Criteria for selection depends upon specific problems confronting the firm. See measures of investment and non–quantitative factors.
rate of return Vague term meaning percentage gain on an investment. See return on investment, internal rate of return, and yield.
relevant cost Cost relevant to a specific decision. Decision must be well defined to determine relevant cost and benefit. Usually cash flows that change with a decision. Often opportunity cost. Not sunk cost! Normally not book values or fixed costs.
return on investment–roi A vague yet complex concept. General term for rate (percentage) return on a capital investment. May be computed:
a) simple return–savings/investment × 100% (poor measure),
b) DCF return–see yield,
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Simplified Glossary
c) financial return–net profit/owners equity × 100% (depends on book values),
d) accounting return–average annual savings/average investment.
required earnings rate Minimum rate of return required to accept a CI. ‘Hurdle’ rate. See investment opportunity rate.
residual value Terminal value. Value of a capital investment at the end of the horizon. Affects tax shield. See terminal value.
revenue expense Expenditure for something used up in the period of one year.
risk A complex concept. Probability of more than one outcome. May be quantified using probability techniques. See provision for risk and uncertainty.
roi Return on investment.
salvage value See terminal value.
simple return Return on investment computed:
annual savings/investment × 100%
Poor measure, since it fails to consider DCF, horizon, risk, etc.
See measures of investment and return on investment.
standards of investment Standards set by management to measure the acceptability of CI projects:
Measure Standard
a) Payback years
b) NPV zero or positive money value
c) Profitability index 1 or more
d) Annualisation positive money value p.a.
e) Yield (IRR) exceeding hurdle rate (IOR)
See measures of investment.
strategy A complex concept. Refers to overall approach to achieve company objectives. Results from top management’s evaluation of environment, critical resources, and objectives. Enables development of key policies and long–term plans. CIA relates to strategy, since some key projects are adopted for strategic reasons. Projects may not easily be quantifiable with CIA techniques, but estimates should be made. See capital investment decision.
147
Simplified Glossary
sunk cost Cost arising from a past action not affected by a subsequent decision. Normally irrelevant to CIA, e.g. R & D of past years is not relevant to future decisions except for tax shields. Sunk costs are not relevant in the CIA computations; however, they may have a psychological effect upon CI decisions. May affect current earnings of a company and therefore management’s decision to undertake CI projects now rather than later. See terminal value.
tax shield Cash inflow due to tax relief on a taxable loss.
a) Depreciation tax shield, computed:
depreciation × tax rate
e.g. depreciation 100, tax rate 40% provides tax shield 40 (cash inflow).
b) Book–loss tax shield, computed:
book loss × tax rate
e.g. book loss 100, tax rate 40% provides tax shield 40 (cash inflow).
Tax shields tend to reduce the cost of a new CI.
technological life Machine life. Number of years for a CI to become obsolete. Not necessarily the horizon.
terminal value–tv Salvage value. Scrap value. Value at end of horizon period. TV of replaced machine reduces the investment cost of the new machine. TV of new machine reduces investment when present–valued to year 0. Affects tax shield. Both TV and tax shields affect the new CI. Computations of reduction of investment due to replaced old machine could be:
| |Case 1 |Case 2 |Case 3 |
|Old-machine book value |100 |100 |100 |
|Terminal value |— |50 |100 |
| |100 | 50 |— |
|Tax shield at 40% | 40 | 20 |— |
|Terminal value |— |50 |100 |
|Reduction in cost of new CI | 40 | 70 |100 |
uncertainty A complex concept. Outcomes that cannot be foreseen or quantified with probabilities. See utility theory.
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Simplified Glossary
utility theory A complex concept. A sophisticated CIA technique which tends to quantify CI factors formerly thought to be purely NQ. Measures the risk preference of the investor in quantitative terms. Appropriate for CIA under uncertainty.
working life–wl Economic life. Horizon of CI project.
yield Rate of interest. Several meanings:
a) internal rate of return (mainly means this!);
b) any rate of return on an investment–IRR or ROI;
c) simple return on an investment.
See internal rate of return.
149
Discounted cash flow–‘DCF’ is an important technique in the appraisal of the relative financial advantages of alternative investment projects, and one which is often thought of as being particularly ‘difficult’ for non-specialists.
This book provides an easily comprehensible introduction to the techniques and uses of DCF, either as an introduction to more advanced texts for accounting students, or for managers who are as yet unfamiliar with DCF and require an introduction to the subject to enable them to communicate with specialists in the field.
The book is divided into five chapters. Chapter 1 provides a brief introduction to the subject, and Chapters 2–5 comprise a series of programmed ‘sets’ containing the main text and worked examples. ‘Learning-patterns’ at the beginning of the chapters provide an easily remembered visual summary of the main points, and each set consists of a verbal summary followed by fifteen to forty programmed ‘frames’ which systematically present new knowledge, leading from simple to more complex ideas in a gradual fashion, and which require written responses.
The main text, with a summary lecture, can be worked through in 4 hours, and is followed by a quiz, to test the knowledge acquired from the programme, and an extensive glossary of DCF terminology.
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