Assdcf

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 Chapter 1 Introduction Chapter 2 Basics of Capital Investment Analysis SET 2.1 CIA as part of Financial Management SET 2.2 DCF Concepts and Investment SET 2.3 Simple Measures of CIA Chapter 3 Measures of Investment SET 3.1 Discount Rates and Relevant Cost Analysis SET 3.2 Net Present Value, Profitability Index, and Yield SET 3.3 DICH Chapter 4 Tax Effects and Non-quantitative Factors SET 4.1 Income Tax and Depreciation SET 4.2 Tax Shields and Terminal Values SET 4.3 Quantitative and Non-quantitative Factors Chapter 5 Capital Budgeting Systems SET 5.1 Budgeting and Planning SET 5.2 Risk and Uncertainty SET 5.3 Assumptions and Manipulation Summary-A Final Look at CIA Quiz A test of knowledge acquired from the programme For the Instructor Answers to the Quiz Simplified Glossary
vii 1 6 9 18 27 36 40 48 57 63 68 75 85 91 94 100 106 115 121 133 135 136
[v]
Progress Worksheet
Chapter and set no 1 21 22 23 31 32 33 41 42 43 51 52 53 Summary lecture Total time Quiz
NOTE:
Times in minutes Estimated 10 20 20 20 15 20 15 15 15 20 15 15 10 30 240 30 Actual
Total of frames* in error
Frame no. of each error
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 25 comprise the main programme, which is a series of sets. In each set there is a summary, a set of learningpatterns 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 dont 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. Dont try to understand them all will be explained later then start Chapter 2. 3
Introduction
CIA Worksheet for Project A

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 30 10 YEARS
IGONRED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss (PROFIT) Old-machine Tax Shield at % Old-machine Terminal Value Now Total Reduction of New Investment in Year 0
20% 100
Annual Cash Flow Years Annual Savings 30 less Depreciation: 20 New: 200/10 years Old: / years 20 Incremental 10 Taxable Income Tax at % 10 After-tax Income 20 add Depreciation Annual After-tax Cash Flow 30 Cash Profile Year 0 110 Cash Out 200 In 100 30
Years
100 (100)
IGNORED
100 100
PV Factor at 20% Discount 10 42 (TABLE B)
PV Cash Out 100 In 126 100 126
PV Factor at % Discount
PV Cash Out In
Measure of Investment Payback (PB) Simple Return on Investment (SRI) Net Present Value (NPV) Profitability Index (PI) Yield (Internal Rate of Return)
Formula 100/30 Net Investment/Annual Savings 30/100 100% Annual Savings/Net Investment 126 100 PV Savings PV Investment / PV Savings/PV Investment / = PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon years= 4
Result 33 years 30 % +26 amount index
Standard 3 years 20 % Zero or Plus 1.0 plus
Introduction
Discount Table A Present value of 100 received once only in years 110
Year 0% 0 10 1 10 2 10 3 10 4 10 5 10 Subtotal 50 (adding amounts for years 15) 6 10 7 10 8 10 9 10 10 10 Total 100 (adding amounts for years 1-10) Discount rate (or hurdle rate) 10% 20% 10 10 09 08 08 07 08 06 07 05 06 04 38 30 06 05 05 04 03 61 03 03 03 02 02 42 30% 10 08 06 04 04 03 24 02 02 01 01 01 31
as below
as below
Discount Table B Cumulative totals of discounted values of 100 received every year for 110 years (i.e. PV of 100 received every year in years 100)
Year 0 1 2 3 4 5 6 7 8 9 10
NOTE:
0% 10 20 30 40 50 60 70 80 90 100
Discount rate (or hurdle rate) 10% 20% 09 17 25 32 38 44 49 54 58 61 08 15 21 26 30 33 36 38 40 42
30% 08 14 18 22 24 26 28 29 30 31 as above as above*
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
B Calculations based on poor assumptions are valueless
Basics of Capital Investment Analysis C Cash profile-a picture of cash in v cash out a) Year 0 Year 1 In 50 Cash 100 Out b) Year 0 1-3 Out 100 100 In 50 p.a. 150 Net 100 (150) (50) Year 2 In 50 Year 3 In 50
NOTE: This is an oversimplified picture of cash inflows before using DCF methods. D Present values
NOTE: Cash flow in early years has higher PV. E Investmentgross and net Gross investment (200) Salvage value now of old machine 80 Net investment 120
NOTE: Old-machine book value is not a cash flow and therefore not relevant! 7
Basics of Capital Investment Analysis F Simple measures of investmentpayback
G Simple measures of investmentSRI
H DCF measures of investmentNPV Annual savings 30 PVF for discount 20% at 10 yr horizon = 42 (from Table B) PV of savings = 30 X 42 = 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) b) c) d) size growth stability of sales and profits 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 1. CIA stands for capital ......... analysis. The word capital implies investments that are ......... (long/short)-term
Correct answers
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-oninvestment 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 8. Cash paid out now for benefits (hopefully) later, is a capital investment ......... (True/False). Even that nice dinner for the girlfriend?
Correct answers
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 ......... (long/short) time-periods
NO
(if we have 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 c) return on ......... 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?
LARGE LONG
INVESTMENT
11
Set 2.1 Detailed Frames 14. A CIA decision to buy or not to buy machine A is known as a Go or ......... Go decision.
Correct answers (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 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?
PROJECT B
BEFORE
18. Name three dos that are alternatives: do ........., do ........., and do ......... 19. Timing extends the alternatives available: invest now or..
NO
WITHOUT NOTHING ELSE
SOMETHING
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 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 ......... (before/after) making an investment. 22. Now, every capital investment may be considered as cash outflow and cash inflow in a ......... profile. 23. Cash received is called cash ........., and cash paid is cash ....
Correct answers
SOME SOMEONE ALTERNATIVES
BEFORE
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?) 26. Cash in is normally annual ......... (investments/savings/ costs).
CASH PROFILE
INVESTMENT
She thinks so! 27. Must an investment in a new machine be justified by: a) policy, and b) law, and c) return on investment? 28. What questions does CIA seek to answer: a) Go or No Go? b) lease v buy? c) which alternative? 29. Each CIA worksheet is set up for only one alternative: to indicate Go or ......... (e.g. lower operating costs with the new investment)
SAVINGS
NO-any
one is enough
ALL
13
Set 2.1 Detailed Frames 30. In this set we have discussed capital investments as cash ........., and have noted the need to search for all ......... and to provide for.........
Correct answers
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. 32. Terminal values of old replaced machines are cash flows, whereas book values are ......... cash flows.
FLOWS DISASTER
ALTERNATIVES
(a), (b)
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 them (by under taking CIA) by return on .........
IS 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 Afill in as instructed in set 2.1, frame 35

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate Annual Cash Flow Years Annual Savings less Depreciation: New: / years Old: / years Incremental Taxable Income Tax at % After-tax Income add Depreciation Annual After-tax Cash Flow Cash Profile Year Cash Out In PV Factor at % Discount PV Cash Out In PV Factor at % Discount PV Cash Out In Years Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at % Old-machine Terminal Value Now Total Reduction of New Investment in Year 0
Formula / Net Investment/Annual Savings / 100% Annual Savings/Net Investment PV Savings PV Investment / PV Savings/PV Investment / = PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon years= 15
Result years % amount index
Standard years % Zero or Plus 1.0 plus
Set 2.1 Detailed Frames 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 learningpatterns at the beginning of this chapter, before proceeding to set 2.2.
Correct answers
16
CIA Worksheet for Project Asolution

IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at % Old-machine Terminal Value Now Total Reduction of New Investment in Year 0
20% 100
Annual Cash Flow Years Annual Savings less Depreciation: New: / years Old: / years Incremental Taxable Income Tax at % After-tax Income add Depreciation Annual After-tax Cash Flow Cash Profile Year Cash Out In
Years
PV Cash Out In
PV Cash Out In
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 1. Discounted Cash Flow (DCF) is a tool of ....................
Correct answers 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. 4. Another way of defining DCF is to say that the Present Value (PV) of a future cash flow is a ......... cash flow. 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 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. 7. Notice the relationship between Discount Tables A and B. Except for the sub-totals, all the figures for the PV of 100o after year 0 are less than 1. This is because they represent the discounted value of a single amount of 100. 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 100 received ......... year.
INTEREST
DISCOUNTED
DISCOUNTED
PRESENT
O INVESTMENT
19
Set 2.2. Detailed Frames 8. Future cash inflows must also provide compound interest on the outstanding balance of the ......... 9. Initial investment is normally taken to be in year ......... 10. The Present Value (PV) is the value at year 0, which ......... (is/is not) today. 11. The PV Factor (PVF) is a number. It is the PV in year 0 of 100 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 100 received once at some time in the future is given in Table A. The PVF for 100 received every year over a given period is given in Table B. Use Table A (page 5) to find the following PVs: Amount Discount Rate 100 0% 100 20% 100 20% 100 100 100 100 100 500 200 20% 20% 30% 20% 20% 10% 20% Year 0 0 1 5 10 10 10 5 3 4 Present Value ? ? ? ? ? ? ? ? ? ? Answer (dont cheat) 100 100 080 040 020 010 020 040 400 100
Correct answers
EVERY
INVESTMENT
a) b) c) d) e) f) g) h) i) j)
IS
12. The PV depends upon the ......... rate and the ......... -period (or horizon).
20
Set 2.2 Detailed Frames 13. Net Present Value (NPV) is the excess of PV of annual savings (PVS) over the PV of the original ......... (PVI): NPV = PVS PVI.
Correct answers
DISCOUNT TIME
14. To find the NPV of a project, we need to know cash ........., horizon, and discount ......... 15. Now for some practice in relating Table A to Table B. (Practice makes perfect you know!) a) What is the present value of 100 at 10% in year 1? b) What is the present value of 100 at 10% in each of years 1 and 2? c) What is the present value of 100 at 10% in each of years 1-5?
INVESTMENT
FLOWS RATE
16. Can you trace a figure of 380 in Table A and then in Table B? Do you see that Table A is related to Table B in that Table B is a ......... of Table A? 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 = ?
09 17 38
SUMMARY
18. From the following cash flow, what is the Net Present Value for this project at a discount rate (DR) of 10%? Year 0 1 2 3 Project 10% DR Cash Flow PVF l000(out) 10 500 (in) 09 500 (in) 08 500 (in) 08 Net Present Value PV 1000 +450 ? ? ? Answer (dont cheat) 1000 +450 +400 +400 +250
3 150
Investment (1000) means cash ......... in year 0.
21
Set 2.2 Detailed Frames 19. In frame 18, the cash inflow of 500 refers to ......... cash savings in years 1 to .........
Correct answers = 1000+ 1250 = +250

NPV OUT
20. The Horizon is the working life of the project. It means how long the project will: a) work technically? b) be economic? In the above project, the horizon was ......... years. 21. The discount rate used is the minimum rate of return required. Is this the hurdle rate? ......... (Yes/No). 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?
ANNUAL
(b) 3
YES
23. What is the PV of 100 hi one years 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 100 received ......... only in years 110, and Summary Table B shows the PV of 100 received every ......... in years 110.
BACKWARDS
22
Set 2.2 Detailed Frames 27. Using Simple Table A, what is the PV of 30 at 20% received once only in year 5?
Correct answers
ONCE YEAR
28. What is the PV of 30 at 20% received every year for 5 years? But dont 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 dont expect DCF to improve it!
04 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 .........
30 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: Book value, 800 Terminal value, 400 Cash out in year 0 is a net investment of .........
INVESTMENT SAVINGS NET B
31. Did you say 200? Wrongthe 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 32. Now lets continue with the CIA worksheet for Project A (on page 25). From the following information, and that already provided on the worksheet, complete the Cash Profile part of the 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 10 for year 0, to show PVI of 100 (out). On second line Years 110: 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 42 (see Discount Table B on page 5). This gives actual PV of savings to be 42 30 = 126.
Correct answers
CASH
450 (50050)
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
IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out In PV Factor at % Discount %
20% 100
Annual Cash Flow Years Years Annual Savings 1-10 less Depreciation: 30 New: 10/5 years 20 Old: / years Incremental 20 Taxable Income 10 Tax at % After-tax Income 10 add Depreciation 20 Annual After-tax Cash Flow 30 Cash Profile Year Cash Out In PV Factor at % Discount
100 (100)
IGNORED
100 100
PV Cash Out In
CIA Worksheet for Project Asolution (continued)

IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out 100 126 100 126 Result years % amount index In PV Factor at % Discount %
20% 100
Annual Cash Flow Years Years Annual Savings 1-10 less Depreciation: 30 New: 10/5 years 20 Old: / years Incremental 20 Taxable Income 10 Tax at % After-tax Income 10 add Depreciation 20 Annual After-tax Cash Flow 30 Cash Profile Year 0 110 Cash Out 200 In 100 30 PV Factor at % Discount 10 42
100 (100)
IGNORED
100 100
PV Cash Out In
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 net investment annual savings before depreciation and tax = payback period (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 annual savings net investment 100% = SRI (%)
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 NPVs 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:
Set 2.3 Detailed Frames 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. 2. For an investment of 200 with annual savings of 50 each year, the payback is ........ years. 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. 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 ........... = ..........
Correct answers
see answer below
COST
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? 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? But it does help the manager to assess risk ........ (True/False).
50 150
3 (but not the book value)

YES
29
Set 2.3 Detailed Frames 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.
Correct answers
(a), (b), (c), (e)

TRUE
8. SRI is Annual Savings (e.g. 30) divided by Net Investment (e.g. 100), times 100%. ? SRI = 100% = ........% 100 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 15, 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 NPVs and small investments smaller NPVs ........ (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 14. For an investment of 100 with annual savings 20, the pay-back is ........ years, and the SRI is ........ % 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 61 (the PVF) = ........ The PVF of 61 comes from ........ PVI was 100, therefore NPV = 122 100 = ........
Correct answers
INVESTMENT
5 20%
16. If the horizon of the project were only 5 (not 10) years, then the PVS would be only 20 times ........., giving PVS of 76 and an NPV of ........
122
DISCOUNT TABLE B
(page 5)
+ 22 17. The Payback measure uses the formula Investment/ Annual Savings, and the result is shown in ........ 38 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 ........ 20. Which of these three measures of investment uses DCF?
PERCENTAGE
MONEY
21. DCF measures cash flow sufficient to repay the original ........ and provide ........ on the balance oustanding.
NPV
31
Set 2.3 Detailed Frames 22. Now to summarise what we have learnt about CIA and DCF. Firstly, Capital Investment Analysis is a part of ........ .........
Correct answers
INVESTMENT 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 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 net investment, 200 100 = ........ years annual savings, 30 b) SRI annual savings 100% = ......... % net investment c) NPV PVS 126 less PVI 100 NPV (amount) Is this an acceptable investment?
Correct answers
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 now check with the harmless, but, if your assumptions are faulty, DCF is positively correct solution dangerous. Beware! YES, NPV = +26 Now that you have completed the set, read the summary and review the learning-patterns for this chapter once again, before going on to Chapter 3. Youre making progress. Keep it up!
33
CIA Worksheet for Project A-(completed) fill in as instructed in set 2.3, frame 31
Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 30 10 Years
IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at % Old-machine Terminal Value Now Total Reduction of New Investment in Year 0
20% 100
Annual Cash Flow Years Annual Savings 1-10 30 less Depreciation: New: 200/ 10 years 20 Old: / years 20 Incremental 10 Taxable Income Tax at % 10 After-tax Income 20 add Depreciation Annual After-tax Cash Flow 30 Cash Profile Year 0 1-10 Cash Out 200 In 100 30
Years
100 (100)
IGNORED
100
100
PV Factor at % Discount 1.0 4.2
PV Cash Out 100 In 126 100 126
PV Cash Out In
CIA Worksheet for Project A-(completed)

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate Annual Cash Flow Annual Savings less Depreciation: New: 200/ 10 years Old: / years Incremental Taxable Income Tax at % After-tax Income add Depreciation Cash Profile Year 0 1-10 Cash Out 200 In 100 30 PV Factor at % Discount 1.0 4.2 PV Cash Out 100 126 100 Measure of Investment Payback (PB) Simple Return on Investment (SRI) Net Present Value (NPV) Profitability Index (PI) Yield (Internal Rate of Return) 126 Result 3.3 years 30 % +26 amount index Standard 3 years 20 % Zero or Plus 1.0 plus In PV Factor at % Discount PV Cash Out In 200 30 10 Years
IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss (PROFIT) Old-machine Tax Shield at % Old-machine Terminal Value Now Total Reduction of New Investment in Year 0
20% 100
Years 1-10 30 20 20 10 10 20 30 Annual After-tax Cash Flow
Years
100 (100)
IGNORED
100
100
Chapter 3
Measures of Investment
A Before investment, search for all alternatives
B Relevant cash profile OUT (costs) Investment costs Variable costs relevant Differential costs Opportunity costs Sunk costs Fixed costs Book costs non-relevant
IN (contributions) Contribution after tax (defined as sales less variable costs and taxes) Annual savings (cost reductions) Salvage values Net profit
C AA-alternative analysis Buy or dont 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 = 42 (from Table B) PVS PVI = NPV (?) (10) (?)
CIA assumptions
37
Measures of Investment G DCF measures of investment PVS NPV = PVS PVI PVI Yield is the discount rate that would make PVS PVI = 0. PI = PVS / PVI
H PVS PVI = NPV
Short-cut to yield Investment 90; Annual savings 30: PVF = 90 / 30 = 30 (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 1150 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
PS. DCF helps to quantify the assumptions; it does not decide ! L DICH approach
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 nonquantitative 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:
Set 3.1 Detailed Frames 1. Good capital investment decisions are intuitive. They depend upon both quantitative and ........ data.
Correct answers
see answer below
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
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 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%).
Correct answers
RETURN
11. If there is more equity than debt, this ........ (will/will not) increase the average cost of capital. 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. 13. Cash flows relevant to a specific decision are known as the ........ cash flows.
15%
WILL
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? 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.
CASH FLOWS
(a), (c), (d), (e)
42
Set 3.1 Detailed Frames 17. Income from sales variable costs = contribution. Contribution tax = contribution after ........, which is a cash Sow.
Correct answers
ARE NOT CHANGE
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. 19. Tax payments are also a relevant cash outflow, so contribution after tax is a ........ cash flow.
TAX
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 determined.
CONTRIBUTION 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 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!)
Correct answers
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/False).
TRUE 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 ........ I fear you will not reach Mecca, for the road you follow leads to Turkistan; thus be careful that in CIA you are analysing the ........ (good/best) projects. If you are on the wrong track, DCF may not help ........ (True/False).
HORIZON SHORTER THAN EXPECTED INVESTMENT COSTS
(beware the Concorde!)

MORE
30. Search for best alternatives, and avoid emotional ............
DISASTER BEST TRUE
44
Set 3.1 Detailed Frames 31. Now complete the Cash Profile and the first three Measures of Investment on the CIA worksheet for Project B (following).
Correct answers
INVESTMENT
32. Now that you have completed the set, read the summary and review the learning-patterns for this chapter, before going on to the next set.
now check with the solution
45
CIA Worksheet for Project B fill in as instructed in set 3.1, frame 31

IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 %
20%
Annual Cash Flow Years Annual Savings 1-5 less Depreciation: 3.0 New: 10/5 years 2.0 Old: / years Incremental 2.0 Taxable Income 1.0 Tax at % After-tax Income 1.0 add Depreciation 2.0 Annual After-tax Cash Flow 3.0 Cash Profile Year Cash Out In
Years
PV Cash Out In
PV Cash Out In
CIA Worksheet for Project Bsolution

IGNORED
20%
Annual Cash Flow Years Annual Savings 1-5 less Depreciation: 3.0 New: 10/5 years 2.0 Old: / years Incremental 2.0 Taxable Income 1.0 Tax at % After-tax Income 1.0 add Depreciation 2.0 Annual After-tax Cash Flow 3.0 Cash Profile Year 0 15 Cash Out 10 3 In
Years
PV Cash Out 10 9 In
PV Cash Out In
Result 3.3 years 30 % 1 amount index
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 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. PVS 300 = PI = 1.5 (good!) PVI 200 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:
is
Set 3.2 Detailed Frames 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 ........).
Correct answers
see answer below
2. Present Value of Investment (PVI) equals the PV of net cash outflows or ........ (savings/investment).
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. 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 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 : PVS = PI PVI and, if PVS is 14 and PVI 20, then PI is about ........ 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. 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 15 is thus a cause for ........ (greater/ lesser) satisfaction than one of 12. 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. 13. Thus an investment is acceptable if PI is equal to or greater than ........ Therefore, if the PI is 07, ........ (Go/No Go). 14. A PI of 1 is associated with an NPV of 0. PIs greater than 1 are associated with NPVs of more than ........; and PIs of ........ ........ 1 are associated with NPVs of less than 0.
Correct answers
(return is just good enough)

YES
07
GREATER
LESS
1
NO GO
50
Set 3.2 Detailed Frames 15. So much for the Profitability Index. Lets 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. 16. If the Yield (say 12%) exceeds the hurdle rate (say 10%), the investment decision is ........ (Go/No Go). 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. 18. If the Yield is greater than the discount (hurdle) rate, this implies that NPV is greater than ........ 19. If the Yield is ........ than the discount rate, this implies that NPV is less than ........ 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%? 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 = 42 (from Discount Table B, page 5), and PVS = 3 42 = 13 (approximately). Remember, PVS = PVF ........ ........
Correct answers
O LESS THAN
HURDLE
(discount)
GO
DISCOUNT
(hurdle)
LESS O
MORE
51
Set 3.2 Detailed Frames 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 = ........
Correct answers
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 ........
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 (NPV), Profitability Index (PI), and Yield, which are all ........ (related/independent).
YES 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 28. What measure gives the rate of return on investment?
Correct answers PVS PVI = PI
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.
53
CIA Worksheet for Project C fill in as instructed in set 3.2, frame 37

IGNORED
20% 210 14 YEARS
Annual Cash Flow Years Annual Savings 1-5 less Depreciation: 60 New: 200/5 years 40 Old: 210/14 years 15 Incremental 25 Taxable Income 35 Tax at % After-tax Income 35 add Depreciation 25 Annual After-tax Cash Flow 60 Cash Profile Year 0 15 Cash Out 200 60 In
Years
210 210
IGNORED
PV Cash Out 200 180 In
PVI
PVS
Standard 5 years 20 % Zero or Plus 1.0 plus 20 %
Set 3.2 Detailed Frames 37. Now refer to the CIA worksheet for Project C, and compute Payback, SRI, NPV, PI, and Yield.
Correct answers
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 Csolution

IGNORED
20% 210 14 YEARS
Annual Cash Flow Years Annual Savings 1-5 less Depreciation: 60 New: 200/5 years 40 Old: 210/14 years 15 Incremental 25 Taxable Income 35 Tax at % After-tax Income 35 add Depreciation 25 Annual After-tax Cash Flow 60 Cash Profile Year 0 15 Cash Out 200 60 In
Years
210 210
IGNORED
PVI
PVS
Formula 200/60 Net Investment/Annual Savings 60/200 100% Annual Savings/Net Investment 180 200 PV Savings PV Investment 180/200 PV Savings/PV Investment 200/60 =33 PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon 5 years=33 56
Result 33 years 30 % 20 amount 09 index 15 (from table B page 67) %
Set 3.3
DICH
SUMMARY
DICH is a systematic way of considering capital investment analysis, involving: DDecision and criteria (Exactly what kind of investment decision? How justified-policy? law? profitability?) IInvestment (How much? When? Relevant cost?) CCash flow (Annual savings before and after tax?) HHorizon and terminal values. (How long? What alternatives? How much? How important?) Effective CIA also requires AA (Alternative Analysissearch for the best alternative) and PFD (Provision for Disastercritical 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:
Set 3.3 Detailed Frames 1. CIA problems should be thought about in terms of DICH, D means ........ and criteria.
Correct answers
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 ........ of the project.
TAX NOwait
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 9. They are normally ...... (relevant/irrelevant). 10. DICH stands for: D- ........ I- ........ C- ........ H- ........ 11. DICH may be systematically applied to ...... problems.
Correct answers
SALVAGE
RELEVANT
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 ........ 13. Capital investment analysis involves making assumptions about new investment, followed by systematic analysis of the consequences of those assumptions ........ (True/ False). 14. A systematic analysis from given assumptions involves calculation of measures of ........ 15. CIA assumptions are evaluated by the ........ approach. By the way, are you still writing down your answers? If s important you know.
CIA
CASH INVESTMENT
TRUE
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 18. What about disaster? Is it also necessary to do a PFD analysis?
Correct answers
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, thats the end of Chapter 3. Youre 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 4.
check with solution
60
CIA Worksheet for Project D fill in as instructed in set 33, frame 22

IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out 120 174 120 174 Result years % amount index In PV Factor at % Discount %
15% 120 12 YEARS 60
Annual Cash Flow Years Years Annual Savings 1-15 less Depreciation: 30 New: 180/15 years 12 Old: / years 10 Incremental 2 Taxable Income 28 Tax at % After-tax Income 28 add Depreciation 2 Annual After-tax Cash Flow 30 Cash Profile Year 0 1-15 Cash Out 180 In 60 30 PV Factor at % Discount 10 58
120 60 60 60 60
PV Cash Out In
Standard 3 years 20 % Zero or Plus 1.0 plus 15
CIA Worksheet for Project Dsolution

IGNORED
Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out 120 174 In PV Factor at % Discount %
15% 120 12 YEARS 60
Annual Cash Flow Years Years Annual Savings 1-15 less Depreciation: 30 New: 180/15 years 12 Old: / years 10 Incremental 2 Taxable Income 28 Tax at % After-tax Income 28 add Depreciation 2 Annual After-tax Cash Flow 30 Cash Profile Year 0 1-15 Cash Out 180 In 60 30 PV Factor at % Discount 1.0 5.8
120 60 60 60 60
PV Cash Out In
PVI
PVS
Formula 120/30 Net Investment/Annual Savings 30/120 100% Annual Savings/Net Investment 174120 PV Savings PV Investment 174/120 PV Savings/PV Investment 120/30 = 40 PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon years= 40 62
Result 4 years 25 % +54 amount 15 index 25 %
Chapter 4 Tax Effects and Non-quantitative Factors

A Depredation
B Annual after-tax cash flow Approach 1 Saving (cash in) Depreciation Taxable income tax 40% (cash out) Depreciation Cash flow after tax C Terminal values and tax shields Case1 100 80 20 8 80 88 63 Case 2 100 40 60 24 40 64 Cash 3 100 0 100 40 0 40 10 0 20 80 32 48 20 68 Approach 2 Saving (cash in) Tax 40% 100 40 60 8 68
Depreciation tax shield 20 40% Cash flow after tax
Old-machine present net book value Terminal value Book loss Tax shield 40% Terminal value Reduction of new investment
Tax Effects and Non-quantitative Factors D Benefit from scrapping old machine now
E Comparing different working lives
DICH analysis
G CIA decisions
64
Tax Effects and Non-quantitative Factors H NQ factors
CIA decision
Measures of investment
65
Tax Effects and Non-quantitative Factors
Discount Tables-Stage 2 Table A: Present value of 10 received once only in any year 115
Yea r 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 0% 10 1% 10 5 % 10 09 09 08 08 07 42 07 07 06 06 06 74 05 05 05 04 04 97 8 % 10 09 09 08 07 07 40 06 06 05 05 05 67 04 04 04 03 03 86 10 % 10 09 08 07 07 06 38 06 05 05 04 04 61 04 03 03 03 02 76 12 % 10 09 08 07 06 06 36 05 05 04 04 03 57 04 03 03 03 02 68 15 % 10 09 08 07 06 05 34 04 04 03 03 02 50 03 03 02 02 02 58 18 % 10 09 08 07 05 04 31 04 03 03 02 02 45 02 02 02 01 01 50 20 % 10 08 07 06 05 04 30 03 03 02 02 02 42 02 01 01 01 01 47 25 % 10 08 07 06 05 04 27 03 02 02 01 01 36 01 01 01 01 01 38 30 % 10 08 06 05 04 03 24 02 02 01 01 01 31 01 00 00 00 00 33 35 % 10 07 05 04 03 02 22 02 01 01 01 01 27 00 00 00 00 00 28 40 % 10 07 05 04 03 02 20 01 01 01 00 00 24 00 00 00 00 00 25 50 % 10 07 04 03 02 01 17 01 01 00 00 00 20 00 00 00 00 00 20
10 10 10 10 10 10 10 10 10 10 50 49 10 09 10 09 10 09 10 09 10 09 100 95 10 09 10 09 10 09 10 09 10 09 150 139
66
Tax Effects and Non-quantitative Factors
Table B: Present value of 10 received annually (every year) for year 115
Yea r 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
NOTE:
0% 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
1% 10 19 29 39 49 58 67 77 86 95 104 113 121 130 139
5% 8% 10% 12% 15% 18% 20% 25% 30% 35% 40% 50% 09 18 27 35 42 50 56 62 68 74 79 84 89 93 97 09 18 26 33 38 47 52 58 62 67 71 75 79 82 86 09 17 25 32 38 44 49 53 58 61 65 68 71 74 76 09 17 24 30 36 41 46 50 53 57 60 62 64 66 68 09 16 23 29 34 38 42 45 48 50 52 54 56 57 58 08 16 22 27 31 35 38 41 43 45 47 48 49 50 51 08 15 21 26 30 33 36 38 40 42 43 44 45 46 47 08 14 19 22 24 29 32 33 35 36 36 37 38 38 39 08 14 19 22 24 26 28 29 31 31 31 32 32 32 33 07 13 17 20 22 24 25 26 27 27 28 28 28 28 28 07 12 16 29 20 22 23 23 24 24 24 25 25 25 25 07 11 14 16 17 18 19 19 19 20 20 20 20 20 20
These tables are deliberately simplified to one decimal place which is usually not significant in CIA computation. 67
Set 4.1 Income Tax and Depreciation Estimated time: 15 minutes SUMMARY Capital investment analysis before tax is not useful, because tax payable and receivable (tax shields) affect the timing of the cash flows in the cash profile. Savings are taxed at the tax rate, thus gross annual savings of 1000 are reduced by 40% (or whatever percentage the prevailing rate of company tax may be) to net annual savings of 600 after tax. The cost of a fixed asset is allocated as a depreciation expense over its working life (horizon) for CIA. Depreciation rates depend upon the tax law. Depreciation of fixed assets is not a cash flow, but does affect the tax payable on annual savings.
KEY NOTE:
Set 4.1 Detailed Frames 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 companys increased profits by way of increased income ........ on those profits. Does the government also share losses? 2. CIA involves a systematic analysis of cash flows in a cash profile, and to be realistic such cash flows ........ (can/cannot) ignore tax.
Correct answers
see answer below
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 8. The key word in the effect of income tax on saving is ........ (timing/tax rate). 9. Savings are taxed at the tax ........ set by the ........ 10. If the tax rate is 40% and the gross savings 1000, then after-tax saving will be ........ 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. 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) 13. For CIA, depreciation expense is based on the life of the asset as specified by the tax law ........ (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.
Correct answers
TIMING
TIMTNG
RATE GOVERNMENT
600
REDUCES
TAX
LAW
(for
tax
purposes)
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 15. 16. Depreciation is different from other costs because it ........ (is/is not) a cash flow.
DEPRECIATION
DOES
17. The determining factor in deciding the depreciation in CIA computations is the ........ law.
IS NOT
70
Set 4.1 Detailed Frames 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). 19. Compute the net book value left after depreciation: Year 0 100 Year 1 80 Year 2 60 Years 3 ? Year 4 ? Years 5 ? 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 Year 1 30 70 Year 2 21 ?
Correct answers
TAX
TRUE
40 20 0
21. Now complete the full table for declining-balance depreciation: Year 2 Year 3 Year 4 Year 5 Depreciation 21 15 ? ? Book value 49 34 ? ?
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 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 ........ 25. To compute after-tax cash flow, we have ........ (one/two) methods.
Correct answers
TRUE
68 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 computations.
TIMING IS NOT
31. Now that you have completed the set, read the summary again, and review the learning-patterns at the beginning of this chapter.
check with the correct solution
72
CIA Worksheet for Project E fill in as instructed in set 4.1, frame 30

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 80 5 YEARS 40% Years Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at 40% Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 10% 210 14 YEARS
Annual Cash Flow Years Annual Savings 1-5 less Depreciation: 60 New: 200/5 years 40 Old: 210/14 years 15 Incremental 25 Taxable Income 35 Tax at 40% 14 After-tax Income 21 add Depreciation 25 Annual After-tax Cash Flow 46 Cash Profile Year 0 15 Cash Out 200 In 84 46
210 210 84 84
PV Factor at 10% Discount 10 38
PV Cash Out 116 174 PVI PVS In
PV Cash Out In
CIA Worksheet for Project Esolution

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 80 5 YEARS 40% Years Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at 40% Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 10% 210 14 YEARS
Annual Cash Flow Years Annual Savings 1-5 less Depreciation: 60 New: 200/5 years 40 Old: 210/14 years 15 Incremental 25 Taxable Income 35 Tax at 40% 14 After-tax Income 21 add Depreciation 25 Annual After-tax Cash Flow 46 Cash Profile Year 0 15 Cash Out 200 In 84 46
210 210 84 84
PV Factor at 10% Discount 1.0 3.8
PV Cash Out 116 174 PVI PVS In
PV Cash Out In
Formula 200/60 Net Investment/Annual Savings 60/200 100% Annual Savings/Net Investment 174116 PV Savings PV Investment 174/116 PV Savings/PV Investment 116/46 = 25 PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon 5 years= 25 74
Result 33 years 30 % +58 amount 15 index 30 %
Set 4.2 Tax Shields and Terminal Values

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 Tax shield (40% of 150 = cash inflow in year 0) 150 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 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).
Correct answers
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 tax shield.
INFLOW 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 at 40% would be ........
INFLOW O
76
Set 4.2 Detailed Frames 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, there ........ (is/is not) a book loss and a tax shield.
Correct answers
REDUCED
300 120
9. However, if equipment with a book value of 500 is scrapped for nothing, there is a book loss and therefore a 40% ........ shield of ........ immediately. 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 ........
BECAUSE OF DEPRECIATION IS NOT
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 = ........ which together ........ (reduce/increase) the cost of the new investment.
80 20 8
13. In case 3, where there is no terminal value, the tax shield is computed on the full book loss of ........, to give a relief of ........
8 80
REDUCE
14. Now fill in the missing computations for case 2. Book loss, ........ Tax shield, ........ Terminal value, 40 Total reduction of cost of new investment, ........
100 40
77
Set 4.2 Detailed Frames 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 ........ ... Getting tired of the programme? Of course not-youre making excellent progress!
Correct answers
60 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 ........ 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% = ........).
DEPRECIATION
80
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 23. The old machine used to provide an annual-depreciation tax shield each year ........ (True/False). 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).
Correct answers
DO
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 30. Be nice to the government, because tax is payable on ...... but tax is receivable on ........
Correct answers 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 ........ ) = ........ 33. Now do Projects F and G.
100 50 = 50
400 100 + 160 = 260
34. Now that you have completed the set and know all there is to know about tax shields (dont you believe it!), read the summary for this set again, and review the learning-patterns for this chapter.
check with the correct solution
80
CIA Worksheet for Project F fill in as instructed in set 4.2, frame 33

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 30 10 YEARS 40% Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out In PV Factor at % Discount PV Cash Out In % 10%
Annual Cash Flow Years Years Annual Savings 110 less Depreciation: 30 New: 200 / 10 years Old: / years Incremental Taxable Income Tax at 40% After-tax Income add Depreciation Annual After-tax Cash Flow Cash Profile Year 0 110 Cash Out 200 In PV Factor at % Discount 10 61
Formula 200 / 30 Net Investment/Annual Savings 30 / 200 100% Annual Savings/Net Investment PV Savings PV Investment / PV Savings/PV Investment 200 / 26 = 80 PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon 10 years= 61 81
Result 7 years 15 % amount index about 4 %
CIA Worksheet for Project Fsolution

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 30 10 YEARS 40% Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out In PV Factor at % Discount PV Cash Out In % 10%
Annual Cash Flow Years Years Annual Savings 110 less Depreciation: 30 New: 200 / 10 years 20 Old: / years Incremental 20 Taxable Income 10 Tax at 40% 4 After-tax Income 6 add Depreciation 20 Annual After-tax Cash Flow 26 Cash Profile Year 0 110 Cash Out 200 In PV Factor at % Discount 10 61
Formula 200 / 30 Net Investment/Annual Savings 30 / 200 100% Annual Savings/Net Investment 159 200 PV Savings PV Investment 159 / 200 PV Savings/PV Investment 200 / 26 = 80 PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon 10 years= 80 82
Result 7 years 15 % 41 amount 08 index about 4 %
CIA Worksheet for Project Gto be completed

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 30 10 YEARS 20 40% Years 610 30 20 Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out In PV Factor at % Discount % 10% 100 5 YEARS 50
Annual Cash Flow Years Annual Savings 110 less Depreciation: 30 New: 200 / 10 years 20 Old: 100 / 5 years 20 Incremental Taxable Income Tax at % After-tax Income add Depreciation Annual After-tax Cash Flow Cash Profile Year 0 110 610 10 (Terminal value after tax) Cash Out 200 12 In
100
50 70
26
PV Factor at % Discount 10 61 23 ( = 6138) 04
PV Cash Out In
Formula 150 / 30 Net Investment/Annual Savings / 100% Annual Savings/Net Investment PV Savings PV Investment / PV Savings/PV Investment uneven cash flow / difficult of compute = PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon 10 years= 83
Result 5 years % amount index
CIA Worksheet for Project Gsolution

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 30 10 YEARS 20 40% Years 610 30 20 20 10 4 6 20 26 Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at 40% Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 PV Cash Out 130 69 60 5 130 Measure of Investment Payback (PB) Simple Return on Investment (SRI) Net Present Value (NPV) Profitability Index (PI) Yield (Internal Rate of Return) 134 Result 5 years 20 % +4 amount 10 index 10 % Standard 4 years 10 % Zero or Plus 1.0 plus 10 % In PV Factor at % Discount 10% 100 5 YEARS 50
Annual Cash Flow Years Annual Savings 110 less Depreciation: 30 New: 200 / 10 years 20 Old: / years 20 Incremental Taxable Income 30 Tax at 40% 12 After-tax Income 18 add Depreciation Annual After-tax Cash Flow 18 Cash Profile Year 0 110 610 10 (Terminal value after tax) Cash Out 200 In 70 18 26 12
100 50 50 20 50 70
PV Factor at % Discount 10 61 23 ( = 6138) 04
PV Cash Out In
Formula 150 / 30 Net Investment/Annual Savings 30 / 150 100% Annual Savings/Net Investment 134 130 PV Savings PV Investment 134 / 130 PV Savings/PV Investment uneven cash flow / difficult of compute = PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon 10 years= 84
Set 4.3 Quantitative and Non-quantitative Factors

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:
Set 4.3 Detailed Frames 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. Dont do CIA for investment of less than 1000! Dont try to be too accurate with crude figures and crude assumptions! Good CIA depends upon sound business judgement of Q and NQ factors. Managements role in CIA is to provide the assumptions and take full responsibility for the results .......... (True/False).
Correct answers
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 43 Detailed Frames 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? c) Horizon 4 years?
Correct answers
0 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. 10. Lets 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) data.
(a), (c)
NUMERICAL
11. However, the key factor is the .......... (Q/NQ) one, since overall CIA decisions depend upon the judgement of ............. (management/accountants). 12. Non-quantitative factors are those that .......... (can/cannot) be put into numbers.
QUANTITATIVE
NQ MANAGEMENT
13. Which of the following could be classified as NQ factors: a) legal? b) policy? c) human? d) profitability? e) social?
CANNOT
14. The important point to remember is that Q + NQ = D. D represents .......... 15. If the quantitative result is poor, we might still decide to invest? .......... (True/False).
(a), (b), (c), (d)
DECISION
87
Set 43 Detailed Frames 16. Why? Because of .......... factors.
Correct answers
TRUE
17. However, with good quantitative results we must invest .......... (True/False).
always
NQ
18. If CIA assumptions are doubtful, and the accountant insists that he has produced an accurate NPV of 2432742626, what should the manager do?
FALSE
19. CIA techniques and tools are used to quantify decisions with .......... (absolute/reasonable/useful) accuracy.
FIRE HIM-hes
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 ..........; C .......... ; H ..........
NQ D
23. DICH is followed by .......... Analysis and Provision-for-.......... Analysis.
DECISION INVESTMENT CASHFLOW HORIZON AND TERMINAL VALUES
88
Set 43 Detailed Frames 24. The next step in CIA is the cash profile, in which the actual cash flow is reduced to .......... (present/future) value.
Correct answers
ALTERNATIVE DISASTER
25. From the cash profile we compute measures of .......... List four measures! 26. Measures of investment are .......... factors, to be judged against a standard set by ..........
PRESENT
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 .......... timeperiods. Should we complete CIA on a possible capital investment of 50000?
EFFECTIVE
30. CIA techniques aid good business .........., but dont bother to make sophisticated analysis of peanuts, unless it .......... you! 31. And be sure you find good projects-dont analyse a poor alternative. CIA projects should be chosen after a creative search for opportunities and all ..........
LARGE LONG NO!-too
small
DECISIONS HELPS
32. Are CIA projects affected by inflation?
ALTERNATIVES
89
Set 43 Detailed Frames 33. Does the discount rate: a) automatically take into account inflation? b) merely relate to compound-interest effects?
Correct answers
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, do all the CIA worksheet computations for Projects A-G again.
NO 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
Providing for risk Horizon Estimates Hurdle rates Probabilities
Graphs? Sensitivity analysis?
Approach to lease v buy
Assumptions
91
Capital Budgeting Systems E DICH
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.
Setting the hurdle rate E D

NOTE:
The average cost of capital (equity and debt) is the minimum hurdle rate = key management decision!
Should change over time!
Investment
92
Capital Budgeting Systems

I Jargon
What to they mean? See glossary.
Balanced approach
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:
Set 5.1 Detailed Frames 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 longterm, however, capital budgeting always refers to investment in .......... projects. 2. Capital budgeting is a systematic approach to key investment, including, firstly, a search for all possible projects and ..........
Correct answers
see answer below
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 ..........-term plan.
PLANNING 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 FALSE-may be a the ...... (validity/assumptions) of the previous capital investment choice of A or B analysis. 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 NEW disinvestment policy. Disinvestment means possible disposal of TRUE (judgement assets that fail to produce the required rate of ...... was wrong!)
11. The same CIA analysis made on new investments should be made on ..... (existing/past) investments. 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). 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). 14. And finally, capital ...... needs forms and procedures to ensure that it operates systematically.
RETURN
EXISTING
TERMINATE
EARNINGS TRUE
96
Set 5.1 Detailed Frames 15. Controls for CIA can be devised for written project evaluations, approvals, and authorisations. Such ...... controls are implemented by forms and procedures. 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. 17. However, CIA must be carried out in the framework of .......... (short/long)-term planning.
Correct answers
BUDGETING
CIA
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 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.
Correct answers
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 longrange 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 dont 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). 28. A capital budgeting system involving long-range planning and shortrange budgets enables a company to coordinate budgets, to determine whether the projects meet the ...... set by managers.
IS NOT
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 30. We must continually check that we are not making a sophisticated CIA of the ........ alternative. Therefore we need a system for capital budgeting.
Correct answers
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. 99
WRONG
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:
Set 5.2 Detailed Frames 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 ......
Correct answers
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 ......! 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.
ASSUMPTIONS
UNCERTAINTY OPPORTUNITY
4. There are various approaches to risk in CIA. We could simply use conservative estimates, but this might detract from the realism of ...... (analysis/research). 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).
NEW RISK QUANTIFY
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 8. However, since the key CIA assumption is the ......, a practical method of providing for risk is to shorten the ...... 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) communicate well. 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, f) assuming shorter .......... 11. In those cases where technological change makes equipment horizons extremely doubtful, we often consider not buying equipment but ...... it.
Correct answers
EXPECTED
HORIZON HORIZON
ASSUMPTIONS DO
CONSERVATIVE MEASURES METHODS TECHNIQUES DISCOUNT HORIZONS
12. In considering lease v buy, lets 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 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).
Correct answers
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 (b) (Q is made made by managers. This 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. 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? 18. So, although we talk about rational CIA, we must continually recognise its limitations. Experts under severe pressure ........ (will/will not) change their estimates.
TOP
JUSTIFY
FIGURES THAT 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 21. Payback also ignores all cash after the payback ......
Correct answers
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. 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. 24. But remember that all DCF measures depend on valid assumptions, and management may not always really want them ...... (True/False).
PERIOD
HURDLE YIELD
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 managements motives in really providing valid underlying .......
VALUE
27. The trouble with CIA projects that involve risk is that even experts true estimates of future costs and benefits are often distorted into tools of company politics ...... (True/Seldom true).
PROVIDING LEASE ASSUMPTIONS
104
Set 5.2 Detailed Frames 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.
Correct answers
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 53.
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) b) c) d) e) f) g) h) reduce investment increase savings shorten time of savings increase horizon reduce tax rate increase terminal values deduct irrelevant salvage values 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 alternativesnot some alternatives only. Management must insist that assumptions be fully justified.
KEY NOTE:
Set 5.3 Detailed Frames 1. In all discussions of CIA, one point recurs: that all CIA depends upon definite ......
Correct answers
see answer below
2. Can you list the assumptions? I ...... H ...... Cash ...... Terminal ...... Discount ...... 3. The key assumption is that all managers would like to be rational and honest; but they have to survive tool! In CIA, the key assumption is the ........
ASSUMPTIONS
INVESTMENT 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 8. After assumptions are set, the following steps should be taken: a) alternative ......, b) provision for ......, c) cash ......, d) measures of ......, e) non - ...... factors.
Correct answers
DECISION INVESTMENT CASHFLOW HORIZON AND 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 ...... 14. CIA techniques aid good business ......
JUSTIFIED
VALID
108
Set 5.3 Detailed Frames 15. DCF is a tool of ......
Correct answers
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? 18. Promoting of CIA projects depends on quantitative and ...... factors.
ASSUMPTIONS
ALTERNATIVES
(OPPORTUNITIES)
NOT IF HE WANTS TO KEEP HIS JOB!
19. CIA decisions are key decisions for ...... amounts for ...... time-periods. 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, e) new business ventures. To which of the above types of project might each of the following statements refer: New investment is not normally all in year 0. All new investment is allowed immediately for tax (i.e. not depreciated), iii) Working capital is part of the new investment. iv) Underlying assumptions are always extremely unreliable or not valid, v) Terminal values may be substantial amounts, not merely small salvage items, vi) Management may well get cost estimates that are wrong by a factor of 10 times. vii) Benefits are impossible to forecast.
i)
NON-QUANTITATIVE
LARGE LONG
answer (dont cheat!): (b), (c), (d), (e) (b), (c), (d) (e) (b), (c), (d) (b), (e) (b) (d)
ii)
109
Set 5.3 Detailed Frames 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 ......
Correct answers
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 youve 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; Oldmachine 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 10 (it is always 10 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 15 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 30. Write this in the PV Factor column. Then compute the PV Cash In as the Cash In 27 (above) times the PVF 30 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 09.
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 32. 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%. 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
b)
CIA Worksheet for Project H to be completed as instructed on pages 111 and 112
Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate Annual Cash Flow Years Annual Savings less Depreciation: New: / years Old: / years Incremental Taxable Income Tax at % After-tax Income add Depreciation Annual After-tax Cash Flow Cash Profile Year Cash Out In PV Factor at % Discount PV Cash Out In PV Factor at % Discount PV Cash Out In Years Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 %
Standard 3 years 20 % Zero or Plus 1.0 plus 20
CIA Worksheet for Project H-solution

Assumptions Investment Annual Savings Horizon Terminal Value Tax Rate 200 30 5 YEARS 50% Years Discount Rate Old-machine Net Book Value Now Old-machine Horizon Now Old-machine Terminal Value Now Old-machine Effect on New Investment Old-machine Net Book Value Now less: Old-machine Terminal Value Now Taxable Loss Old-machine Tax Shield at Old-machine Terminal Value Now Total Reduction of New Investment in Year 0 % 20% 144 4 YEARS 84
Annual Cash Flow Years Annual Savings 1-5 less Depreciation: 50 New: 200/5 years 40 Old: 144/4 years 36 Incremental 4 Taxable Income 46 Tax at % 23 After-tax Income add Depreciation 23 Annual After-tax Cash Flow 4 27 Cash Profile Year 0 15 Cash Out 200 In 114 27
144 84 60 30 84 114 PV Cash Out In
PV Factor at % Discount 10 30
Formula 116/50 Net Investment/Annual Savings 50/116 100% Annual Savings/Net Investment 81 86 PV Savings PV Investment 81/86 PV Savings/PV Investment 86/27 =32 PV Investment/ Annual After-tax Cash Flow=PVF Table B: PVF at Horizon 5 years=32 114
Result 23 years 43 % 5 amount 09 index 16 %
SummaryA 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 years 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: PV = (1 + r) x 1
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 Aa single amount to be received N years from now; Table Bamounts 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 years 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
SummaryA 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 companys 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 owners 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
SummaryA 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 companys 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. Owners 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. HORIZON
ECONOMIC LIFE
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) b) 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. Profitability Index PVS PI = must be greater than 1 for a satisfactory investment. PVI 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.
c)
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
QuizA 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? 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? 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? 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? 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? 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? 121
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? 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? The PV in year 0 of 100000 received in year 3 at 20% is about: a) 75000? b) 380000? c) 380? d) 130000? 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? 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? 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? 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
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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? 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? 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? 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? 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? 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? 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? 123
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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? 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? 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? The PV of 200 p.a. for 2 years at 30% is about: a) 140? b) 60? c) 280? d) 80? 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? 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? 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
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Quiz-A Test of Knowledge Acquired from the Programme 28 100 today at 5% is worth one year from now: a) 100? b) 10250? c) 105? d) something else? 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%? 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? 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? 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? Depreciation is different from other costs, because it is: a) not allowed as a deduction for tax? b) based on the accountants judgement? c) a non-cash expense? d) reducing every year? 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
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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? 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? 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? 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? 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 What is the horizon of the investment for CIA? a) 20 years? b) 10 years? c) 15 years? d) 5 years? 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
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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? 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? 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? 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? 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? For effective CIA, all cash flows must be analysed: a) yearly? b) monthly? c) quarterly? d) as appropriate and useful? The major problem in CIA is: a) horizon? b) terminal value? c) tax rate? d) savings? 127
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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? 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? 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? 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? Managers making capital investment decisions should rely on: a) natural flair? b) financial analysis plus business judgement? c) business experience only? d) market research? 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? 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
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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? 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? If we invest 10000 for a saving of 4000 per annum, the payback is: a) not known? b) 2 years? c) 40 years? d) 4 years? 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? 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? 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
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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? CIA seeks to: a) eliminate risk? b) ignore risk? c) increase risk? d) quantify risk? 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? For CIA, simple return on investment is: a) a poor measure? b) a useful tool? c) the best approach? d) good for accountants? 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? 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? 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
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Quiz-A Test of Knowledge Acquired from the Programme 68 In reality, the accountants 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? 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? 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? 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? 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? 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? 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
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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? 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? 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? 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 shareholders viewpoint? Managements 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? 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
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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. 2. 3. Each student can learn at the pace most suitable for him. The student studies advanced material only when he has mastered the elementary material. 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. The student cannot daydream. He is continuously active, and receives immediate and continuous confirmation of his success in learning the material. Frames are designed to bring the critical point to the attention of the student, and to establish his understanding of each critical point. Learning-patterns seek to reinforce the programme symbolically.
4. 5. 6.
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. The programme is not usually as effective if used (a) casually, without writing or test, and (b) without environmental motivation.
3.
Please contact the authors (via the publishers) for further information, if required. 134
Answers to the Quiz

1c 2a 3d 4a 5c 6d 7b 8a 9a 10d 11d 12a 13b 14c 15b 16c 17d 18b l9a 20b 21a 22d 23b 24c 25a 26a 27c 28c 29b 30a 31a 32b 33c 34c 35b 36b 37a 38b 39d 40b 7080 6070 Under 60 41c 42d 43b 44a 45c 46d 47a 48d 49d 50d 51a 52b 53a 54a 55a 56b 57b 58c 59a 60b 61c 62d 63b 64a 65b 66c 67a 68c 69c 70a 71d 72b 73d 74b 75a 76d 77b 78c 79d 80c
GRADING
Excellent Good Fairrepeat the programme at a later date. 135
Simplified Glossary
AA
Alternative analysis. Method of depreciation in which more depreciation is taken in earlier years than in later. Also called declining-balance depreciation. See depreciation. Measure of investment, computed: average annual savings
ACCELERATED DEPRECIATION
ACCOUNTING RETURN ON INVESTMENT
100% average investment 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, dont 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. 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 30) gives annualisation 30 p.a. Useful measure for replacement problems. Large investments have large ANNs. Useful to compare alternative replacement projects which seek to minimise annual costs at different horizons. See measures of investment.
ANNUALISATIONANN
AS AT
Annual savings. After income tax. 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. 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
AUDIT
BOOK LOSS
Simplified Glossary
BOR
Borrowing opportunity rate. 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.
BORROWING OPPORTUNITY RATEBOR
BT
Before income tax. 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. Oneyear budgets are useful only if part of a long-term plan. 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 investment analysis (CIA). Capital investment.
BUDGET
CAPITAL
CAPITAL BUDGETING CAPITAL EXPENDITURE 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 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. Decision to invest now (year 0) for benefit later (years 15 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. 137
CAPITAL INVESTMENT ANALYSISCIA
CAPITAL INVESTMENT DECISION
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 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. 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 0 1 2 3 Total Out 100 In + (50) + (50) + (50) + (50) + (150) Net 100 + (50) + (50) + (50) + (50)
CASH FLOW
CASH PROFILE
100
Follows DICH analysis and provides basis for measures of investment.

CF CI CIA
Cash flow. Capital investment. Capital investment analysis. Designed to set out the assumptions, cash flow, cash profile, and measures of investment. See examples in the programme. Pessimistic attitude. CIA needs not merely a conservative but a realistic approach. See risk.
CIA WORKSHEET
CONSERVATISM
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.). 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.
COST OF CAPITAL
CP
Cash profile. Need to insure that CIA is applied to the appropriate projects. CIA system provides for creative search for investment opportunities available to the companynot a limited conservative selection. See alternative analysis. 138
CREATIVE SEARCH
Simplified Glossary
D
Decision and criteria. Discounted cash flow. Define the precise investment decision before beginning CIA. Set criteria for acceptance. Consider all alternatives. See DICH approach to CIA. See accelerated depreciation.
DCF
DECISION AND CRTTERIAD
DECLININGBALANCE 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. Dont forget AA and PFD. Difference in costs between two investment plans.
DIFFERENTIAL COSTS
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. 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
DISCOUNT RATEDR
Simplified Glossary
DISCOUNT TABLES
Tables indicating: a) PV of 100 received in one year at a specified discount rate; b) PV of 100 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). 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). 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.
DISINVESTMENT POLICY
DOWNSIDE RISK
DR
Discount rate. 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. Taxlaw life may differ from CIA horizon.
ECONOMIC LIFE
EI
Emotional investment. A complex conceptnormally refers to financing of assets by owners rather than by creditors (debt). See cost of capital. A complex concept. Most probable outcome. Average of possible outcomes weighted by their probabilities. A sophisticated technique for CIA. See risk. A complex concept concerned mainly with four major problems: How large should a firm seek to be? What rate of growth is requiredsales, assets, equipment, etc.? To what extent should instability in sales and profits be avoided? What kind of assets should the firm acquire, and at what rate? NOTE: CIA applies to this problem. a) b) c) d) 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 leverageusing 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
EQUITY
EXPECTED VALUE
FINANCIAL MANAGEMENT
FINANCING DECISIONSMethod
Simplified Glossary
FIXED ASSET
An asset acquired for longterm use in the business. Normally with a working life greater than one year. A cost that does not change with a decision. Normally overhead cost. Not normally a relevant cost for CIA. Total cash out for the investment. See also net investment,
FIXED COST
GROSS INVESTMENT H
Horizon. 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. See IOR and cost of capital.
HORIZONH
HURDLE RATE
I Investment.
INCOME TAX INCREMENTAL
Tax on taxable profits and losses. Reduces savings cash flow. See tax shield. 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. Decreasing value of money. Not part of DCF except by requiring even higher IORs.
INFLATION
INTERNAL RATE OF RETURNIRR
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 Cash flow Horizon 120 40 5 years 141
Simplified Glossary Discount factor needed to make PVS of 120 will be 120/40 = 30. PVI = 120 PVS = 40 30 = 120 Yield = discount rate of 30 at 5 years = 20%
INVESTMENTI
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. See capital investment analysis.
INVESTMENT ANALYSIS
INVESTMENT OPPORTUNITY RATEIOR
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 IRR
Investment opportunity rate. Internal rate of return. Rent of assets. Investment and financing decisions combined. See lease v buy. v BUY Rent of an asset compared with purchasea 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! 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; 142
LEASE LEASE
MANIPULATION
Simplified Glossary f) g) h) increase terminal values; deduct irrelevant salvage values!; combine a bad project with a very good one to make one average project. NOTE: Insist that all assumptions be justified!
MEASURES OF INVESTMENTMOI
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. CI decision between project A or project B. Not a Go or No Go decision. See capital investment decision.
MUTUALLY EXCLUSIVE INVESTMENT
NBV
Net book value. 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. 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. 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 NPVs and therefore appear more attractive than small investments. After-tax contribution less fixed costs. 143
NET BOOK VALUENBV
NET INVESTMENT
NET PRESENT VALUEMTV
NET PROFIT
Simplified Glossary
NONQUANTITATIVE FACTORSNQ
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 NQ
Net present value. Nonquantitative factors. 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. 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.
OPERATIONAL RESEARCH
OPPORTUNITY COST
Probability. 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:
PAYBACKPB
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 PFD
Payback. Provision for disaster. 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.
PHYSICAL LIFE
PI
Profitability index. 144
Simplified Glossary
PRESENT VALUEPV
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. Factor in the discount tables. Indicates the PV in year 0 of 100 received in years 150, or the PV of a series of cash flows of 100 in each year 150. Depends upon DR used. ANN is computed NPV/PVF. See present value and discount tables.
PRESENT VALUE FACTORPVF
PRESENT VALUE OF INVESTMENTPVI
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 at year 0 of the flow of savings in future years at a specified IOR and horizon. Computed: Savings before tax less: Depreciation Taxable savings less: Income tax at 40% add: Depreciation (not a cash flow) Cash flow after taxes 100 20 80 32 48 20 68
PRESENT VALUE OF SAVINGSPVS
PV at 20% for 5 years is PVF PV of savings = 30 68 = 204.

PROBABILITY
Complex concept. Relative chance that a certain outcome will occur. Sophisticated approach to CIA. See provision for risk and expected value. 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. Number of years a product made on a machine will be marketed. 145
PROFITABILITY INDEXPI
PRODUCT MARKET LIFE
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. In CIA we provide for risk by: shortening the horizon, setting high discount rates, making conservative estimates of cash flows, probability and expected-value techniques.
PROVISION FOR RISK
a) b) c) d)
PV PVF PVI PVS Q
Present value. Present value factor. Present value of investment. Present value of savings. Quantitative data. 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. 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 nonquantitative factors. Vague term meaning percentage gain on an investment. See return on investment, internal rate of return, and yield. 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.
QUANTITATIVE DATAQ
RANKING OF INVESTMENTS
RATE OF RETURN
RELEVANT COST
RETURN ON INVESTMENTROI
A vague yet complex concept. General term for rate (percentage) return on a capital investment. May be computed: a) simple returnsavings/investment 100% (poor measure), b) DCF returnsee yield, 146
Simplified Glossary c) d) financial returnnet profit/owners equity 100% (depends on book values), accounting returnaverage annual savings/average investment.
REQUIRED EARNINGS RATE
Minimum rate of return required to accept a CI. Hurdle rate. See investment opportunity rate. Terminal value. Value of a capital investment at the end of the horizon. Affects tax shield. See terminal value. Expenditure for something used up in the period of one year.
RESIDUAL VALUE
REVENUE EXPENSE RISK
A complex concept. Probability of more than one outcome. May be quantified using probability techniques. See provision for risk and uncertainty. Return on investment. See terminal value.
ROI
SALVAGE 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 set by management to measure the acceptability of CI projects: Standard years zero or positive money value 1 or more positive money value p.a. exceeding hurdle rate (IOR)
STANDARDS OF INVESTMENT
Measure a) Payback b) NPV c) Profitability index d) Annualisation e) Yield (IRR) See measures of investment.
STRATEGY
A complex concept. Refers to overall approach to achieve company objectives. Results from top managements evaluation of environment, critical resources, and objectives. Enables development of key policies and longterm 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 managements decision to undertake CI projects now rather than later. See terminal value. 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) Bookloss 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. Machine life. Number of years for a CI to become obsolete. Not necessarily the horizon.
TAX SHIELD
TECHNOLOGICAL LIFE
TERMINAL VALUETV
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 presentvalued 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 1 100 100 40 40 Case 2 100 50 50 20 50 70 Case 3 100 100 100 100
Old-machine book value Terminal value Tax shield at 40% Terminal value Reduction in cost of new CI
uncertainty A complex concept. Outcomes that cannot be foreseen or quantified with probabilities. See utility theory. 148
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. Economic life. Horizon of CI project.
WORKING LIFEWL YIELD
Rate of interest. Several meanings: a) internal rate of return (mainly means this!); b) any rate of return on an investmentIRR or ROI; c) simple return on an investment. See internal rate of return. 149
Discounted cash flowDCF 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 25 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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DCF for Capital Investment Analysis

R. G. A. Boland and R. M. Oxtoby

ISBN 0 340 17467 6

Copyright RGAB 2006/1 All rights reserved.

vii 1 6 9 18 27 36 40 48 57 63 68 75 85 91 94 100 106 115 121 133 135 136

Times in minutes Estimated 10 20 20 20 15 20 15 15 15 20 15 15 10 30 240 30 Actual

Total of frames* in error

Frame no. of each error

How to Use this Programme

CIA Worksheet for Project A

PV Factor at 20% Discount 10 42 (TABLE B)

PV Cash Out 100 In 126 100 126

Result 33 years 30 % +26 amount index

Standard 3 years 20 % Zero or Plus 1.0 plus

Discount rate (or hurdle rate) 10% 20% 09 17 25 32 38 44 49 54 58 61 08 15 21 26 30 33 36 38 40 42

30% 08 14 18 22 24 26 28 29 30 31 as above as above*

Chapter 2 Basics of Capital Investment Analysis

B Calculations based on poor assumptions are valueless

Basics of Capital Investment Analysis F Simple measures of investmentpayback

G Simple measures of investmentSRI

Set 2.1 CIA as part of Financial Management Estimated time: 20 minutes

see answer below

6. The long-term survival of a business depends upon investment to achieve .........

7. CIA leads to better decision-making for unproved .........

9. Capital investments involve investment ......... for benefits .........

WITHOUT NOTHING ELSE

SOME SOMEONE ALTERNATIVES

24. All investments may be represented as cash flows in a ....... ........

IS FUTURE LARGE LONG YES

CIA Worksheet for Project Afill in as instructed in set 2.1, frame 35

Result years % amount index

Standard years % Zero or Plus 1.0 plus

CIA Worksheet for Project Asolution

Result years % amount index

Standard years % Zero or Plus 1.0 plus

Set 2.2 DCF Concepts and Investment Estimated time: 20 minutes

Correct answers see answer below

2. DCF is a method of calculating the cost of ............. (interest/ inflation).

CAPITAL INVESTMENT ANALYSIS (CIA)

Investment (1000) means cash ......... in year 0.

Correct answers = 1000+ 1250 = +250

INVESTMENT SAVINGS NET B

600 (1000 400)

Result years % amount index

Standard years % Zero or Plus 1.0 plus

CIA Worksheet for Project Asolution (continued)

Standard years % Zero or Plus 1.0 plus

see answer below

3 (but not the book value)

(a), (b), (c), (e)

23. CIA deals with investment ........ for benefits ........

24. DCF ........ (is/is not) a tool of CIA.

27. Capital investments may be justified by law, policy, or ........ on investment.

28. Does CIA always involve assumptions?

INVESTMENT ANNUAL SAVINGS HORIZON DISCOUNT RATE TERMINAL VALUE

PV Factor at % Discount 1.0 4.2

PV Cash Out 100 In 126 100 126

Result years % amount index

Standard 3 years 20 % Zero or Plus 1.0 plus

CIA Worksheet for Project A-(completed)

Years 1-10 30 20 20 10 10 20 30 Annual After-tax Cash Flow

A Before investment, search for all alternatives

H PVS PVI = NPV