Week 10 - Tutorial 9 Flashcards
Investment Appraisal - A Worked Example
Week 10b
Some Proposed Projects
Years Project A (£) Project B (£) Project C (£)
Initial cost -23,000 -23,000 -23,000
Projected net profits
1 6,000 1,000 1,000
2 2,500 1,800 1,000
3 1,000 2,200 2,000
4 500 3,000 6,000
5 1,000 1,000 8,000
Other Information
• The non-current asset purchased initially is the same for each project
• It is expected to have an economic life of five years
and a residual value of £3,000
• The cost of capital the organisation uses is 5%
Having calculated the PP, NPV and IRR of each project, state which project you would choose and why
PP
• First calculate the annual depreciation
(23,000-3,000)/5 = £4,000 per annum
• This is added on to the net profit as it does not represent cash leaving the business
Calculate the Actual Cash Flows
Years Project A (£) Project B (£) Project C (£)
0 -23,000 -23,000 -23,000
1 10,000 5,000 5,000
2 6,500 5,800 5,000
3 5,000 6,200 6,000
4 4,500 7,000 10,000
5 5,000 5,000 12,000
Calculate the Cumulative Cash Flows
Years Project A (£) Project B (£) Project C (£)
0 -23,000 -23,000 -23,000
1 -13,000 -18,000 -18,000
2 -6,500 -12,200 -13,000
3 -1,500 -6,000 -7,000
4 3,000 1,000 3,000
5 8,000 6,000 15,000
•The PP for Project A = 3 years + (1500/4500)12
= 3 years 4 months
•The PP for Project B = 3 years + (6,000/7,000)12
= 3 years and 10 months
•The PP for Project C = 3 years + (7,000/10,000)*12
= 3 years and 8 months
NPV
Project A
Year Net Cash(£) Discount Rate (5%) PV
0 -23,000 1 -23,000
1 10,000 0.952 9,520
2 6,500 0.907 5,896
3 5,000 0.864 4,320
4 4,500 0.823 3,704
5 5,000 0.784 3,920
NPV 4,360
Project B
Year Net Cash(£) Discount Rate (5%) PV
0 -23,000 1 -23,000
1 5,000 0.952 4,760
2 5,800 0.907 5,261
3 6,200 0.864 5,357
4 7,000 0.823 5,761
5 5,000 0.784 3,920
NPV 2,059
Project C
Year Net Cash(£) Discount Rate (5%) PV
0 -23,000 1 -23,000
1 5,000 0.952 4,760
2 5,000 0.907 4,535
3 6,000 0.864 5,184
4 10,000 0.823 8,230
5 12,000 0.784 9,408
NPV 9,117
IRR
• We now need to calculate the IRR
• Remember, the higher the NPV then the higher the
discount rate will need to be to get a negative NPV
• If 20% does not provide a negative NPV, then the
higher the resulting NPV the higher the IRR will be
Which Project is Best?
• Quickest PP = A
• Highest NPV = C
• Highest IRR =
Investment Appraisal Question
The marketing director of a small company is proposing an investment in a new project. The project would involve an initial investment in machinery at a cost of £45,000. Additional investment in working capital of £7,000 would also be required at the start of the project and this would be recovered in full at the end of the project. The project is expected to last five years, at the end of which the machinery is expected to have a scrap value of £5,000. The company policy is to depreciate all non-current assets using the straight line method. The following are the estimated sales and total costs of the project: Year Sales (£) Total costs (£) 1 55,000 50,000 2 57,000 53,000 3 67,000 61,000 4 52,000 49,000 5 42,000 37,000
The company usually expects a payback period of no more than three years and its estimated cost of capital is 6%.
Required:
Calculate the Payback Period, NPV and IRR for the proposed investment and advise the company on whether you consider the proposal is acceptable.
Investment Appraisal Solution
First calculate the depreciation
(£45,000-£5,000)/5 = £8,000 per year
We will add this figure back on to the profit each year
Actual cash flows Year £ 0 -52,000 1 13,000 2 12,000 3 14,000 4 11,000 5 25,000 Includes depreciation, residual value of the asset and the repayment of working capital
Cumulative cash flows Year £ 0 -52,000 1 -39,000 2 -27,000 3 -13,000 4 -2,000 5 23,000
Payback period = 4 years + (2,000/25,000)*12
= 4 years and 1 month
NPV
Year Net (£) Discount Rate (5%) PV (£)
0 -52,000 1 -52,000
1 13,000 0.943 12,259
2 12,000 0.89 10,680
3 14,000 0.84 11,760
4 11,000 0.792 8,712
5 25,000 0.747 18,675
NPV 10,086
IRR
Year Net (£) Discount Rate (20%) PV (£)
0 -52,000 1 -52,000
1 13,000 0.833 10,829
2 12,000 0.694 8,328
3 14,000 0.579 8,106
4 11,000 0.482 5,302
5 25,000 0.402 10,050
NPV -9,385
6+14 * (10,086/19,471) = 13.25%
Although the payback exceeds the normal requirement of the organisation, the project has a positive NPV and an IRR far higher than the organisation’s cost of capital. Therefore, the proposal is acceptable.
Question A:
You are given the following cash flow statements for Ink Reasing plc.
Cash flow statement of Ink Reasing plc for the year ended 31 December
Year 1 Year 2
£000 £000
Cash flows from Operating Activities
Profit before financing costs 1,800 2,500
Depreciation 1,500 1,900
Change in Working Capital
Increase in trade receivables (800) (1,200)
Increase in inventories (600) (1,300)
Increase in trade payables 100 200
Interest paid (600) (600)
Income taxes paid (400) (600)
= Net cash from Operating Activities 1,000 900
Cash flows from Investing activities
Proceeds from disposal of equipment - 100
Purchase of property and equipment (2,100) (4,000)
= Net cash from Investing activities (2,100) (3,900)
Cash flows from Financing Activities
Proceeds of issue of shares 2,000 -
(Repayment of) increase in borrowings (600) 2,200
Dividends paid (400) (500)
= Net cash from Financing activities 1,000 1,700
Net (decrease)/increase in cash (100) (1,300)
Opening cash 400 300
Closing cash 300 (1,000)
Question A continued
Write a report explaining what the above cash flow statement of Ink Reasing shows. Is the company successful? (Hint: Go through each of the 9 questions
discussed in lectures about the Interpretation of the Cash Flow Statement)
- Was there a positive amount generated from Profits after adjusting for Depreciation?
- Has working capital changed, and how did this affect Net Cash from Operating Activities?
- Have there been significant investing activities?
- Has there been a reduction in investments in non-current assets and other businesses? How much money was raised, and how was this used?
- Has the business been raising substantial long-term financing? Why do these funds seem to be needed?
- Are the cash flows from financing activities negative (i.e., has there been a reduction in long-term funding)?
- Has one form of long-term capital been used to redeem another (perhaps issuing shares to repay debentures)? Why might this have been done?
- Was the amount of dividend covered by cash flows from operating activities?
- Did the cash balance increase or decrease during the year? Why – what were the main contributors to this?
The company’s bankers stated that, in view of the £1m increase in the company’s overdraft (Closing Cash value of £ -1,000,000), and the additional borrowings of £2.2m, the increase in the amount of dividends paid is not justified. Do you agree? Hint: Look at the increase in dividends in comparison to the increase in profits and cash flows.
- Was there a positive amount generated from Profits after adjusting for Depreciation?
In Year 1 Ink Reasing plc’s cash flows from profit plus depreciation produced a positive cash flow of £3.3 million. In Year 2 cash flows from profit plus depreciation increased to £4.4 million. - Has working capital changed, and how did this affect Net Cash from Operating Activities?
In Year 1 Ink Reasing plc’s financed additional working capital of £1.3 million, reducing the net cash from operating activities. In Year 2, after financing a substantial increase in working capital, £2.3 million, the net cash from operating activities decreased. - Have there been significant investing activities?
In Year 1, the company spent £2.1 million on fixed assets and in Year 2, the company’s net expenditure
on additional non-current assets was much increased
to £3.9 million - Has there been a reduction in investments in non-current assets and other businesses? How much money was raised, and how was this used?
There has been an increase in net expenditure on
non-current assets from £2.1 million to £3.9 million - Has the business been raising substantial long-term financing? Why do these funds seem to be needed?
In Year 1, the company spent £2.1 million on fixed assets which meant that they needed to raise additional funding. They raised £2 million by issuing
shares, part of which (£0.6million) was used to reduce borrowings.
In Year 2, the company’s net expenditure on additional non-current assets was much increased (£3.9 million), which left a substantial shortfall. As a result they had to borrow £2.2 million. - Are the cash flows from financing activities negative (i.e., has there been a reduction in long-term funding)?
In Year 1, net cash from financing activities was £1 million. This positive cash flow from financing activities was mainly due to the issues of shares of £2 million.
In Year 2, net cash from financing activities increased to £1.7 million. This was largely due to the increase in borrowings of £2.2 million. - Has one form of long-term capital been used to redeem another (perhaps issuing shares to repay debentures)? Why might this have been done?
In Year 1, they they raised £2 million by issuing shares, part of which (£0.6million) was used to reduce borrowings.
The additional funds raised from issuing shares were used appropriately to purchase fixed assets and to reduce long term borrowings.
Ink Reasling may have done this to lower their interest payments. - Was the amount of dividend covered by cash flows from operating activities?
In Year 1, the dividends were well covered by profits and by cash flows from operating activities.
In Year 2, the increase in dividends is justified by the increased profits, and the cash flows that they generated.
As the company raised an additional £2 million by issuing shares in Year 1 the increase in dividends of only £100,000 is modest. - Did the cash balance increase or decrease during the year? Why – what were the main contributors to this?
In Year 1, the closing cash was a positive £300,000
In Year 2, the closing cash decreased to an overdraft of £1 million, which was mainly due to the increase in non-current assets that forced the
company to increase borrowings by £2.2 million.
- The company appears to be successful, expanding, and generating profits.
- But they invested more in additional assets than could easily be afforded.
- The increase in dividends is justified by the increased profits, and the cash flows that they generated
- As the company raised an additional £2 million by issuing shares in Year 1 the increase in dividends of only £100,000 is modest.
- However, if the bank is concerned about the company’s overall level of borrowing the company should plan ways of reducing it, and attempt to expand and increase profitability within the means available to them
Question B:
Ballamauda Ltd. - summarised statements of financial position as at 31 December
Year 1 Year 2
Non-current assets £000 £000 £000 £000
Machinery at cost 80 70
Provision for depreciation (40) (44)
40 26
Current Assets
Inventories 50 35
Receivables 38 28
Cash 0 90
88 153
Total Assets 128 179
Current liabilities
Trade payables 32 39
Taxation 3 5
Overdraft 16 0
51 44
Non-current liabilities
Debentures 0 40
Equity
Share capital 35 35
Retained earnings 42 60
77 95
128 179
Notes: During the year ending 31 December year 2
a. A machine originally cost £10,000, and there was £6,000 depreciation which had been charged on it, thus it was valued at £4,000. It was sold for £3,400.
b. Interest of £2,400 and dividends of £6,000 were paid.
c. The tax charge for year 2 was £4,000. The retained earnings figure is after tax, interest and dividends.
You are required to produce a cash flow statement for Ballamauda Ltd for the year ended 31 December year 2. Complete the table below.
Question B continued
£000
Cash generated from operating activities
Operating profit
Depreciation
Other (sale of asset)
Tax charge
Change in working capital
Inventories
Receivables
Payables
Interest
Dividends
Tax paid
Cash generated from investing activities
Purchase of non-current assets
Disposal of non-current assets
Cash generated from financing activities
Issue of debentures
Dividends paid
Interest paid
Change in Cash
Opening Balance
Closing Balance
£000
Cash generated from operating activities
Operating profit 18,000
Depreciation 10,000
Loss on sale of machine 600
Decrease in inventories 15,000
Decrease in receivables 10,000
Increase in payables 7,000
Interest paid 2,400
Dividends paid 6,000
Tax charge for year 4,000
Less 73,000
Tax paid 2,000
Net cash inflow from Operating Activities 71,000
Cash generated from investing activities
Purchase of non-current assets 0
Disposal of non-current assets 3,400
Net cash inflow from investing activities 3,400
Cash generated from financing activities
Issue of debentures 40,000
Dividends paid 6,000
Interest paid 2,400
Net cash inflow from financing activities 31,600
Change in Cash 106,000
Opening Balance -16,000
Closing Balance 90,000
Operating profit = Retained earnings Year 2 minus Year 1
Depreciation = See explanation later
Loss on sale of machine = See explanation later
Decrease in inventories = Inventories Year 1 minus Year 2
Decrease in receivables = Receivables Year 1 minus Year2
Increase in payables = Payables Year 2 minus Year 1
Interest paid = Added back on as it is taken off later
Dividends paid = Added back on as it is taken off later
Tax charge for year = See explanation later
Tax paid = See explanation later
Purchase of non-current assets = None purchased this year
Disposal of non-current assets = Provided in question – actual cash received
Issue of debentures = Debentures Year 2 minus Year 1
Dividends paid = Provided in question
Provided in question = Provided in question
Change in cash = Sum of cash flows from operating, investing and financing activities (71,000+3,400+31,600)
Opening balance = (Year 1: Balance Sheet Zero Cash and £16,000 overdraft)
Closing balance = (Year 2: Balance Sheet £90,000 Cash and no overdraft)
• Depreciation
- At the beginning of the year the provision for depreciation was £40,000, whereas it ended the year as £44,000
- During the year there was also provision for depreciation of £6,000 in respect of a machine that was sold. In other words, this was written off. This means that the total change in depreciation must have been an increase of £10,000 (i.e. the difference between £44,000 and £34,000 [£40,000 - £6,000])
• Sale of the machine
- The machine originally cost £10,000, and there was £6,000 depreciation which had been charged on it. Thus, it was was valued at £4,000. As it was sold for £3,400, there was a loss of £600. However, whilst this loss would have been shown on the income statement there was no actual outflow of cash, therefore it is added back on to the operating profit in the cash flow statement
• Taxation
- Tax charged and tax paid are two different things. The first relates to how much tax a business will have to pay on that year’s profit, whereas the second refers to the actual tax they have paid during the year.
- The tax charge of £4,000 is added back on to the operating profit as it was deducted from that to get the final figure on the statement of financial position, but does not equate to cash paid.
- To get the tax paid figure we add the amount owing at the end of year 1 (£3,000 – under current liabilities) to the tax charge (£4,000), which comes to £7,000. This is what the business should owe at the end of year 2; however, as they only owe £5,000 (current liabilities – year 2) they must have paid £2,000 during year 2.
Question C:
Soldriction plc- summarised statements of financial position as at 31 December
Year 3 Year 4
Non-current assets £m £m £m £m
Intangible assets 50 50
Machinery at cost 90 84
Provision for depreciation (30) (44)
60 40
110 90
Current assets
Inventories 36 40
Receivables 44 48
Cash 0 8
80 96
Total assets 190 186
Current liabilities
Trade payables 28 20
Taxation 6 4
Overdraft 13 0
47 24
Non-current liabilities
Debentures 0 13
Equity
Share capital 90 90
Retained earnings 53 59
143 149
190 186
During the year ending 31 December year 4
a. The company sold machinery, which had cost £12m, and on which £5m depreciation had been charged, for £3m.
b. Interest of £3m was paid.
c. The taxation charge for year 4 was £5m
Complete the cash flow statement for Soldriction plc for the year ended 31 December year 4.
Category Explanation £m
Cash generated from operating activities
Operating profit, See explanation later, 11
Plus
Depreciation, See explanation later, 19
Loss on sale of machine, See explanation later, 4
Interest paid, Added back on as it is taken off later, 3
Less
Increase in inventories, Year 3 minus Year 4, (4)
Increase in receivables, Year 3 minus Year 4, (4)
Decrease in payables, Year 4 minus Year 3, (8)
Taxation paid, See explanation later, (7)
Net cash cash inflow from Operating Activities 14
Cash used in investing activities
Purchase of non-current assets, Explanation later, (6)
Disposal of non-current assets, Provided in question – actual cash received, 3
Net cash outflow from Investing activities (3)
Cash used in financing activities
Issue of debentures, Year 4 minus Year 3, 13
Interest paid, Provided in question, (3)
Net cash inflow from Financing activities 10
Change in Cash, Sum of cash flows from operating, investing and financing activities (14-3+10), 21
Opening Balance, (Year 3: Balance Sheet: Zero Cash and £13m overdraft), (13)
Closing Balance, (Year 4: Balance Sheet: £8m Cash and no overdraft), 8
• Operating profit
- As there is no other information available it is necessary to use the retained earnings figures for years 3 and 4. This has increased by £6m.
- However, we must also add the taxation charge for the year to this, therefore this figure is £6m + £5m = £11m
• Depreciation
- At the beginning of the year the provision for depreciation was £30m and it ended the year as £44m.
- During the year the provision for depreciation was also reduced by £5m in respect of a machine that was sold. This means that the total change in depreciation must have been an increase of £19m.
• Taxation
- The amount owing at the end of year 3 was £6m and the charge for year 4 was £5m, therefore if £4m was owing at the end of year 4 the company has paid £7m in tax during the year
• Loss on the sale of the machine
- The machine was valued at £12m less £5m depreciation, that is £7m. As it only sold for £3m there was a loss of £4m; however this was not a cash outflow so is added back on to the operating profit figure
• Purchase of non current assets
- The figure for the machinery for year 4 should have been £90m less £12m for the sale of the machine, that is £78m. However, as it is £84m, machinery worth £6m must have been purchased
