Dada Adefolami

By Dada Adefolami

Investment appraisal is a collection of techniques used to identify the attractiveness of an investment. The purpose of investment appraisal is to assess the viability of project, programmed or portfolio decisions and the value they generate, therefore ,Capital budgeting, or investment appraisal, is the planning process used to determine whether an organization’s long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm’s capitalization structure (debt, equity or retained earnings).
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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 one must ensure that they can define it, make the necessary calculations to financial problems.
The most important of these methods, is NPV. which may include problems such as inflation, taxation, working capital and relevant/irrelevant cash flows.
Variance analysis is the quantitative investigation of the difference between actual and planned behaviour. This analysis is used to maintain control over a business. Hence budget variance is the difference between the budgeted or baseline amount of expense or revenue, and the actual amount. The budget variance is favourable when the actual revenue is higher than the budget or when the actual expense is less than the budget. How to calculate flexible-budget variance as follow:
1. Subtract the actual data from the static budget to calculate the variance. …
2. Divide the result from Step 1 by the budget to calculate the percentage variance from budget. …
3. Analyze the results from Step 1 and Step 2 to draw conclusions about the forecast.
problem areas
Inflation
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 an organization has cash flows inflating at different rates or where an organization involves both tax and inflation. Because of this the money method is commonly required. Ensure using the Fisher formula provided,to calculate a money cost of capital or indeed a real cost of capital for discounting purposes. 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.

Taxation
Building taxation into a discounted cash flow 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 misunderstanding.

Working capital
The key issue that must be understood 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 the project is no longer required a cash inflow will arise. Must recognize that it is the change in working capital that is the cash flow. often concern that the inventories purchased last year will have been sold hence must be replaced. However, to the extent the items have been sold their cost will be reflected elsewhere in the cash flow.

The Relevant/irrelevant cash flows
The problem is hardly a big issue ‘Golden Rule’ which states that to be included in a cash flow table an item must be a future, incremental cash flow. Irrelevant items to look out for are sunk costs such as amounts already spent on research and apportioned or allocated fixed costs. Equally all financing costs should be ignored as the cost of financing is accounted for in the discount rate used.
Fixed appraisal
Sometimes directors of a company will only appraise projects across a set time horizon, which will not be the full length of the project and so does not include all of the cash flows. If a four-year time horizon is used, then the tax effects of the fourth year must be taken into account, even if tax is paid in arrears and the cash flows arise in the fifth year.
The Investment Decision relates to the decision made by the investors or the top-level management with respect to the amount of funds to be deployed in the investment opportunities. Simply, selecting the type of assets in which the funds will be invested by the firm is termed as the investment decision.Further more,to evaluate an investment
A. add up all costs associated with the business investment decision you’ve made.
B. Identify the total income you’ve taken in as a direct result of making this investment based on sales reports.
C. Subtract your cost from the total sales, and then divide that figure by the total cost.
Capital Investment Decisions. Capital investments are funds invested in a firm or enterprise for the purposes of furthering its business objectives. Capital investment may also refer to a firm’s acquisition of capital assets or fixed assets such as manufacturing plants and machinery that are expected to be productive over many years.

Notes:Understand the difference between a ‘T’ and a Year. ‘T’ is a point in time and hence T0 is now and T1 is in one-years’ time. A Year is a period of time and hence Year 1 is the period between T0 and T1 and Year 2 is the period between T1 and T2. Please note T1 is both the end of Year 1 and the start of Year 2.

As the investment in working capital is based on the expected sales revenue this has to be calculated first, note how the price per unit was given in first-year terms and hence that figure has been used for Year 1. In the following years the forecast inflation has been included. You should note the cumulative nature of inflation.

The working capital need is simply calculated as stated % of sales revenue. When calculating the working capital cash flows it is the change in the working capital need which is the cash flow. For instance, Year 1 the need is 13.2 and as nothing has previously been invested the cash flow is an outflow of 13.2. In Year 2 the need has risen to 13.6 but as 13.2 has already been invested the cash flow is just an outflow of 0.4 the increase in the need. In Years 3 and 4 the need decreases and hence cash inflows arise.

The working capital is required at the start of each year the cash flow for Year 1 will occur at T0 and the cash flow for Year 2 will occur at T1, etc. Finally, at the end of the project any remaining investment in working capital is no longer required and generates a further cash inflow at T4. The sum of the working capital cash flow column would total zero as anything invested is finally released and turns back into cash.

Finally
1. A cash flow table should always be started on a new page as it will then hopefully fit on the one page. This avoids the need to transfer data over a page break which inevitably leads to errors. As tax is paid one year in arrears the cash flow table is taken to T5 even though it is only a four-year project. A cash flow table should be split into a ‘Revenue’ section and a ‘Capital’ section. In the ‘Revenue’ section all the taxable revenues and tax allowable costs are shown. In the ‘Capital’ section all the cash flows relating to the asset purchase and other cash flows which have no impact on tax are shown. should ensure you put brackets around negative cash flows as otherwise negative items may be treated as if they are positive when the cash flows are totalled.

2. Note the normal assumption that the revenue for a year arises at the end of the year – hence the revenue for Year 1 is shown at T1. This assumption also applies to the variable and fixed costs.
3. The variable costs for each year are based on the sales units for the year, the price per unit and the inflation rate for costs. Note that as the cost was given in current terms, which is as at T0 and the first costs are recorded at T1, the inflation has to be accounted for immediately. You should contrast this with the inflation of the sales revenue.

4. The fixed costs are relevant as to be incremental. The cost per unit for the first year has been given and this is multiplied by the forecast sales in Year 1 to give the total incremental fixed costs. Like the variable costs the cost per unit was given in current terms and hence inflation must be accounted for immediately. From Year 1 onwards the fixed costs have continued to be inflated by the relevant inflation rate of X%. You must remember that fixed costs are fixed and does not change as the activity level changes. In this way you will avoid the common error which is to treat the fixed costs as though they were variable.
5. The tax is calculated at Y% of the net revenue cash flows. As tax is paid one year in arrears the tax for Year 1 which is calculated at the end of Year 1 will become a cash flow at T2. This pattern continues in the following years.

6. If residual value was given in money terms and hence already reflects the impact of inflation. Had the value been given in current terms and no specific inflation rate was indicated then the logical approach would be to inflate at the general inflation rate. The normal assumption is that the asset is disposed of on the last day of the last year of the project and hence the cash inflow is shown at T4.
7. Remember that these are the ‘good news of tax’ and so are cash inflows.

8. The working capital cash flows could be in the ‘Capital’ section as they do not have any tax impact. If they were put in the ‘Revenue’ section they would change the net revenue cash flows and this would impact on the tax calculated which would be incorrect.
9. The discount factors rate depend what is the suitable money cost of capital calculated

10. The present values are by multiplying the total net money cash flows by the discount factors.
11. The NPV is simply the sum of the present values calculated. You should always comment on what the NPV calculated is indicating about the viability of the project. Net Present Value Method is the best capital budgeting method. Reasons: NPV gives importance to the time value of money. It determines how much cash will flow in as a result of the investment, and compares that against the cash that will flow out in order to make the investment.
Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc.

The Capital budgeting consists of various techniques used by management include.
1. Payback Period.
2. Discounted Payback Period.
3. Net Present Value.
4. Accounting Rate of Return.
5. Internal Rate of Return.
6. Profitability Index.

The purpose of budget analysis is to understand how an organization’s money is being spent and managed, and whether the budget meets the group’s goals. The organization could be a business, a government, a charity or any other entity that draws up budgets. Capital budget preparation frame work.

1. Create a financial blueprint for your company’s objectives.
2. Examine existing cash flow statements to determine your company’s current costs vs. revenue.
3. Calculate the projected cost of capital expenditures.
4. Consider alternatives to purchasing.

The most important of these methods, is NPV. which may include problems such as inflation, taxation, working capital and relevant/irrelevant cash flows.
Dada Suraju Adefolami, Professor of Finance, School of Business Administration, UNEM University Costa Rica, is a Finance / Management Consultant and Certified Forensic Accountant. You can reach him via: [email protected]; 08052043855

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