MA2-Managing Costs & Finances

Investment Appraisal
Capital expenditure:
▪ Expenditure incurred in acquisition of non-current assets.
▪ It is not charged to income statement although a depreciation charge will usually be made to write off
the capital expenditure gradually overtime.
▪ Capital expenditure appears in statement of financial position.

Revenue expenditure:
▪ Expenditure incurred for the purpose of trade off the business or to maintain the existing earning
capacity of non-current assets.
▪ It is charged to income statement.

Capital income:
▪ Income from the sale of non-current assets.

Revenue income:
▪ Income from the sale of trading assets. It also includes interest and dividend received from
investment held by the business.

Capital expenditure budget:

▪ Capital expenditure budget is a long term plan and is considered very important for the business.
▪ Major expenses are required for it so most projects are considered individually and are fully
appraised.
▪ Suitable finance must be arranged for capital expenditure.
▪ Capital expenditure should have a positive value for the business.

Investment appraisal: Investment appraisal techniques are required to determine:

▪ whether a new project should be accepted
▪ which of two (or more) projects to accept
▪ whether to lease or buy a new asset
▪ How to raise finance for the purchase of an asset
Relevant and irrelevant costs: The cost which is useful for decision making is known as relevant
cost. Relevant costing is used in long term decision making and investment decisions. The relevant
costs are:
▪ Only cash items
▪ Future cash flows
▪ Incremental cash flows

Following are the examples of some important relevant and irrelevant costs
➢ Past or Sunk Cost or Historical cost: Costs that have been incurred to date are past costs or sunk
costs, irrecoverable costs. These are irrelevant for decision making because we cannot change the
past.
➢ Committed cost: Costs that are already committed to be incurred regardless of the decision made.
Committed costs are irrelevant to decision. Mostly fixed costs are committed cost.
➢ Apportioned cost: All costs or charges being allocated but without the responsible manager’s
control or not actual cost are irrelevant for decision making. For example absorbed overheads, fixed
overheads.

Compiled by: Muzzamil Malik Page 1

 MA2-Managing Costs & Finances

➢ Notional cost: A notional cost or imputed cost is a hypothetical accounting cost to reflect the use of a
benefit for which no actual cash expense is incurred. For example Notional rent, notional interest,
depreciation, provisions. These are non-cash items and irrelevant for decision making.
➢ Incremental Cost: Costs which are additional due to only one specific decision are incremental cost
and they are relevant.
➢ Controllable Cost: Costs that can be controlled because of one particular decision are controllable
costs and they are relevant for decision making.
➢ Uncontrollable Cost: Costs which cannot be controlled because of a specific decision are
uncontrollable cost and they are irrelevant for decision making.
➢ Avoidable Cost: Costs that can be avoided because of one specific decision are avoidable costs and
they are relevant.
➢ Unavoidable Cost: Costs that cannot be avoided because of one specific decision are unavoidable
costs and they are irrelevant for decision making.
➢ Fixed cost: Fixed costs are generally irrelevant to decision making because they do not change but
the incremental fixed costs are always relevant.
➢ Variable cost: Variable costs are normally relevant for decision making.
➢ Opportunity Cost: Opportunity cost is the benefit which has been given up, by choosing one option
instead of another. Opportunity costs only apply to the use of scarce resources. Where resources are
not scarce, no sacrifice exists from using these resources.
➢ Differential/ incremental cost: Differential cost is the difference in total costs between alternatives.
Incremental costs are similar in principle to the economist’s concept of marginal cost.

Relevant cost of using machines

Use of machinery will incur some incremental costs:
▪ Repair cost
▪ Hire charges
▪ Fall in resale value

Note: depreciation is irrelevant cost

Cost Behaviour
▪ Variable costs are usually relevant costs.
▪ Fixed costs which do not change when the activity level changes irrelevant cost. Fixed cost may only
be fixed in the short term.
▪ Incremental fixed cost is relevant cost.
❖ Additional fixed cost are incurred in a decision to increase an extra activity or
❖ Fixed cost will decrease if the scale of an operation is reduced.

INVESTMENT APPRAISAL METHODS

There are mainly two methods to appraise any prospective investment.
1. Non-discounted cash flow methods (traditional methods)
➢ Accounting rate of return
➢ Simple payback period
2. Discounted cash flow methods (DCF methods)
➢ Discounted payback period
➢ Net present value
➢ Internal rate of return

Compiled by: Muzzamil Malik Page 2

 MA2-Managing Costs & Finances

Various surveys have shown that the traditional methods are still more common than the discounted
cash flow methods, the theoretically inferior internal rate of return is more commonly used.

1. NON-DISCOUNTED CASH FLOW METHODS (TRADITIONAL METHODS)

➢ Accounting rate of return or Return on capital employed (ARR or ROCE)
This method of appraising the viability of a project over its several years life is similar to the
method of assessing the financial performance of a business over a single year.
It is sometimes called an accounting rate of return.
Return on capital employed = Average accounting profit per annum x 100
Capital Employed

The profit used is usually after depreciation but before interest and tax
Average accounting profit = Total profit of all years
Number of years

Average investment = Initial investment + scrap value

2
Decision rules
If accounting rate of return > Target=> Accept the project
If accounting rate of return < Target=> Reject the project

Advantages of Accounting rate of return

▪ Quick to calculate
▪ Simple to use and understand
▪ Familiar concept for managers
▪ Commonly used by external analysts

Disadvantages of Accounting rate of return

▪ Accounting profits might not be objectives of the organization
▪ Different methods of calculation are possible
▪ It ignores the time value of money
▪ It considers accounting profits rather than cash flows

➢ Simple payback period

This is the time taken to recover the initial cash flows from the cash inflows of the project. Payback
period is the amount of time that is expected to take for the cash inflows from a capital investment
project to equal the cash outflows. It is particularly useful if there are liquidity problems or if distant
forecasts are very uncertain.

Simple payback period = Initial investment ÷ annual cash inflows (in case of annuity)
Decision rules
If Simple payback period < Target => Accept the project
If Simple payback period > Target => Reject the project

Advantages of simple payback period

▪ It is easy to calculate and understand.
▪ It is widely used in practice as a first screening method.

Compiled by: Muzzamil Malik Page 3

 MA2-Managing Costs & Finances

▪ Its use will tend to minimize the effects of risk and help liquidity, because greater weight is given
to earlier cash flows which can probably be predicted more accurately than distant cash flows.
▪ It is based on cash flows rather than profits.

Disadvantages of simple payback period

▪ Total profitability is ignored.
▪ The time value of money is ignored.
▪ It ignores any cash flows that occur after the project has paid for itself. A project that takes time to
get off the ground but earns substantial profits once established might be rejected if the payback
method is used, where as a smaller project, paying back more quickly, may be accepted.

INTEREST
Money earned or paid for the use of money is called interest. Interest cost is always on outstanding
balance. The two types of interest are.

➢ Simple interest: Interest calculated on principal amount is Simple interest

Simple Interest = Principal amount x r x n
➢ Compound interest: Compound interest is calculated on principle amount as well as any
previous outstanding interest.
Compound Interest = Principal amount (I + r)n
Where,
r = Interest rate
n = Number of years

FUTURE VALUE
Future value is defined as the value or sum of money at a future date at a particular interest rate.
Future value is calculated by multiplying present value with a compound factor
F.V = P.V (1 + r)n
Where, PV = Present value
F.V = Future value
r = interest rate / discount rate
n = number of time periods

The method of converting present value into future value is called as compounding.

PRESENT VALUE
Present value is the value which refers to the value of money at today which is to be received in
future. The present value of a future sum tells us what a future sum is worth today.
P.V = F.V (1 + r)-n
Where, PV = Present value
F.V = Future value
r = interest rate / discount rate
n = number of time periods
The method of converting future value into present value is called as discounting.

TIME VALUE OF MONEY CONCEPT

There is a time preference for receiving the same sum or money sooner rather than later. Conversely,
there is a time preference for paying the same sum of money later rather than sooner.

Compiled by: Muzzamil Malik Page 4

 MA2-Managing Costs & Finances

Reasons for Time Preference for Money

There are three very important reasons why money has a time preference.
▪ Consumption Preference – money received now can be spent on consumption
▪ Risk preference – risk disappears once money is received.
▪ Investment preference – money received can be invested in the business, or invested
externally.

2. DISCOUNTED CASH FLOW METHODS (DCF METHODS)

Principles behind DCF methods
▪ It recognize the “time value of money” (having the use of money has a cost for example interest)
▪ People would prefer to receive money sooner rather than later
▪ Investors don’t attach equal values to equal sums of money receivable at different times
▪ In investment appraisal calculations, reduce (discount) later cash flows
▪ The discounting process is sometimes thought of as compound interest in reverse

➢ Discounted payback period

Discounted payback period is same as simple payback period with the difference that cash flows
are discounted cash flows. Simple payback period is always shorter than discounted payback
period.

➢ Net present value (NPV)

Net present value is the net of present values of cash flows.
Net present value = Present value of cash inflows – Present value of cash outflows.

Decision rules
If Net present value = Positive accept the project
If Net present value = Negative reject the project

Advantages of Net present value

▪ Shareholder wealth is maximized.
▪ It considers time value of money.
▪ It takes into account the time value of money.
▪ It is based on cash flows which are less subjective than profit.
▪ Shareholders will get benefits if a project with a positive net present value is accepted.
▪ It considers cash flows after payback period

Disadvantages of Net present value

▪ It can be difficult to identify an appropriate discount rate.
▪ For simplicity, cash flows are sometimes all assumed to occur at year ends: this assumption
may be unrealistic.
▪ Some managers are unfamiliar with the concept of net present value.

➢ Internal rate of return

Internal rate of return is the point where the present value of cash inflows is exactly equal to the
present value of cash outflows. It refers to the discount rate where net present value is zero. It is
calculated as
IRR = A + NPV A x ( B– A)
NPV A - NPV B

Compiled by: Muzzamil Malik Page 5

 MA2-Managing Costs & Finances

Where: A = Lower discount rate

B = Higher discount rate
NPV A = NPV A at A
NPV B = NPV B at B

IRR is more accurate if:

A = Lower discount rate at which NPV is positive &
B = Higher discount rate at which NPV is negative
But these two should be closest

Decision rules
If internal rate of return > cost of capital => Accept the project (in this NPV would be positive)
If internal rate of return < cost of capital => Reject the project (in this NPV would be negative)
If internal rate of return = cost of capital => Project is gearing no return

Advantages of Internal rate of return

▪ It takes into account the time value of money, unlike other approaches such as simple
payback period.
▪ Results are expressed as a simple percentage, and are more easily understood than some
other methods.
▪ It indicates how sensitive calculations are to changes in interest rates.

Disadvantages of Internal rate of return

▪ Projects with unconventional cash flows can produce negative or multiple internal rates of
return.
▪ Internal rate of return may be confused with accounting rate of return or return on capital
employed (ROCE), since both give answers in percentage terms.
▪ It may give conflicting recommendations with mutually exclusive projects, because the result
is given in the relative terms (percentages), and not in absolute terms ($) as with net present
value.
▪ Some managers are unfamiliar with the internal rate of return method.
▪ It cannot accommodate the changing interest rates.
▪ It assumes that funds can be re-invested at a rate equivalent to the internal rate of return,
which may be too high.

✓ ANNUITY
Whenever a project is expected to earn equal amount of cash flows in equal interval of time for a
defined time period, then the cash flows are said to be an Annuity. Constant cash inflows or outflows
for a defined time period is called annuity.
Present value of annuity = annuity x annuity factor
Annuity Factor = 1 - (1 + r)-n
r
✓ PERPETUITIES
Perpetuity is, in which equal cash flows are generated for unlimited time period. When a project has
expected to earn equal amount of cash flows in equal interval of time but for unlimited time period is
called perpetuity. If the perpetuity situation arises, the present value of perpetuity will be calculated
as:
Present value of perpetuity = constant yearly cash flow
Discount rate

Compiled by: Muzzamil Malik Page 6

 MA2-Managing Costs & Finances

✓ NOMINAL RATE AND EFFECTIVE RATE

Nominal rate is the interest rate which is quoted by the financial institutions and effective rate is the
actual rate of interest earned that a company charge. Nominal rate is used when interest is
compounded only once in a period. Effective rate is use when interest is compounded more than
once in a period. Interest may be compounded daily, weekly, monthly or quarterly. Effective rate is
greater than nominal rate when compounding is done for less than one year. Effective rate is equals
to the nominal rate if compounding is done at the end of year. Effective rate is calculated as:

n
Effective Rate = [(1 + r) – 1] x 100
Where
r = nominal rate of interest per compounding
n = number of times compounding is done in a period.

Effective rate is also called Annual Percentage Rate (APR) or compound annual rate (CAR).

Page 7 of 147