Studying Paper F9? Performance objectives 15 and 16 are relevant to this exam
ADVANCED INVESTMENT APPRAISAL
Investment appraisal is one of the eight core topics within Paper F9, Financial Management and it is a topic which has been well represented in the F9 exam. The methods of investment appraisal are payback, accounting rate of return and the discounted cash flow methods of net present value (NPV) and internal rate of return (IRR). For each of these methods students must ensure that they can define it, make the necessary calculations and discuss both the advantages and disadvantages. The most important of these methods, both in the real world and in the exam, is NPV. A key issue in the Paper F9 syllabus is that students start their studies with no knowledge of discounting but are very rapidly having to deal with relatively advanced NPV calculations which may include problems such as inflation, taxation, working capital and relevant/irrelevant cash flows. These advanced NPV or indeed IRR calculations have formed the basis for very many past exam questions. The aim of this article is to briefly discuss these potential problem areas and then work a comprehensive example which builds them all in. Technically the example is probably harder than any exam question is likely to be. However, it demonstrates as many of the issues that students might face as is possible. Exam questions, on the other hand, will be in a scenario format and hence finding the information required may be more difficult than in the example shown. The problem areas Inflation Students must be aware of the two different methods of dealing with inflation and when they should be used. The money method is where inflation is included in both the cash flow forecast and the discount rate used while the real method is where inflation is ignored in both the cash flow forecast and the discount rate. The money method should be used as soon as a question has cash flows inflating at different rates or where a question involves both tax and inflation. Because of this the money method is commonly required. Students must ensure that they can use the Fisher formula provided to calculate a money cost of capital or indeed a real cost of capital for discounting purposes. They must also be able to distinguish between a general inflation rate which will impact on the money cost of capital and potentially some cash flows and a specific inflation rate which only applies to particular cash flows.
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2 ADVANCED INVESTMENT APPRAISAL OCTOBER 2010 Taxation Building taxation into a discounted cash flow answer involves dealing with ‘the good the bad and the ugly’! The good news with taxation is that tax relief is often granted on the investment in assets which leads to tax saving cash flows. The bad news is that where a project makes net revenue cash inflows the tax authorities will want to take a share of them. The ugly issue is the timing of these cash flows as this is an area which often causes confusion. Working capital The key issue that must be remembered here is that an increase in working capital is a cash outflow. If a company needs to buy more inventories, for example, there will be a cash cost. Equally a decrease in working capital is a cash inflow. Hence at the end of a project when the working capital invested in that project is no longer required a cash inflow will arise. Students must recognise that it is the change in working capital that is the cash flow. There is often concern amongst students that the inventories purchased last year will have been sold and hence must be replaced. However, to the extent the items have been sold their cost will be reflected elsewhere in the cash flow table. Relevant/irrelevant cash flows This problem is rarely a big issue in Paper F9 as students have been examined on this topic previously. However students should remember the ‘Golden Rule’ which states that to be included in...