Tutorial 5 SOLUTIONS - Capital Investment Decisions

Model Answers and Detailed Feedback

Question 1 – Solution:

Equipment A Equipment B
Total profit before depreciation £160,000 £280,000
Less Total Depreciation (£80,000) (£150,000)
Total profit after depreciation £80,000 £130,000

Average annual profit £16,000 £26,000

Average investment
£60,000 £100,000
(initial cost + disposal value) / 2

ARR 26.7% 26%

Both investments generate an accounting rate of return that is above the hurdle rate of
25%, but equipment A would be preferred as it has a higher ARR. Other factors such as
the efficiency and reliability of the equipment would also need to be considered prior to
making a final decision.

Detailed Solution and Feedback to Question 2:

The first part of this exercise asks us to “deduce the relevant annual cash flows
associated with buying the equipment”. The important words/phrases here are
“relevant” (i.e. cash flows that vary with the decision being made – you should know
what relevant costs/revenues are from Lecture 2 on relevant costing) and “cash flows”
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(i.e. transactions involving cash in and cash out of the business, as opposed to
accounting profit which includes non-cash items like depreciation).

So, the first thing we need to do for part (a) is to determine which of the figures
mentioned in the exercise are relevant to the decision of whether or not to buy the
equipment and on top of that which of those relevant figures are cash flows, since we
are asked to deduce the relevant cash flows.
Let us look at all the figures mentioned in the exercise:

Description of Amount Relevant or Cash flow or

revenue/cost Irrelevant? other figure?
Capital cost to purchase
£100,000 Relevant Cash flow
new equipment

Cost of research and Irrelevant (historical

£50,000 Cash flows
development work cost)

Sales price x
Revenues arising from
Sales volume
operation of new Relevant Cash flows
for each year
equipment
as per table
Variable cost
Variable costs arising x Sales
from operation of new volume for Relevant Cash flows
equipment each year as
per table

Relevant
Foregone contribution due
£15,000 each (it will only occur if
to lost sales of some Cash flows
year we buy the new
existing products
equipment)

Irrelevant Depreciation of
(these fixed costs will £20,000 is
be incurred NOT a cash
£30,000 per
Fixed costs irrespectively of flow. The
year
whether the new remaining
equipment is £10,000 is a
purchased or not) cash flow.

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 Relevant
(as they are additional
Additional overheads
overheads that will
arising from equipment £8,000 per
only be incurred if Cash flow
operation, excluding year
the business goes
overheads
ahead with the
investment)

Additional working capital £30,000 Relevant Cash flow

We are trying to identify figures that meet both criteria, i.e. are Relevant and are Cash
flows.

Once we have identified the relevant cash flows, we can present them in a table
across time and compute the net relevant cash flows for each year.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Purchase cost of (100,000
new equipment )
Additional
(30,000) 30,000
Working Capital
Revenues 80,000 120,000 144,000 100,000 64,000
Variable costs (40,000) (50,000) (48,000) (30,000) (32,000)
Additional
(8,000) (8,000) (8,000) (8,000) (8,000)
Overheads
Foregone
(15,000) (15,000) (15,000) (15,000) (15,000)
contribution
Totals
(130,000
(Net relevant 17,000 47,000 73,000 47,000 39,000
)
Cash Flows)

Part (b) of the requirements asks us to “deduce the payback period”.

This is fairly simple and easy to do. We just need to keep in mind two things related
to the payback period. The first thing is that in the payback period we work with
relevant cash flows and not profit figures. Secondly, with the payback period method
we do not discount any cash flows, i.e. we do not take into account the time value of
money. When working with the payback period method, we are interested in finding
out how quickly will the business recover its initial investment.

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 The payback period can be found in the table below:

Relevant Cash flows Cumulative

Time Calculations
(taken from part a) Cash Flows
Year 0 (130,000)
Year 1 17,000 (130,000) + 17,000 (113,000)
Year 2 47,000 (113,000) + 47,000 (66,000)
Year 3 73,000 (66,000) + 73,000 7,000
Year 4 47,000
Year 5 39,000

The payback period is the period by which we recover the initial investment of
130,000. The initial investment is recovered by the end of Year 3. Thus, the payback
period is 3 years.

Part (c) calculating the NPV

Now, to compute the net present value we simply need to discount these cash flows
to their present value and then sum them up, in order to obtain the Net Present
Value of this investment.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net relevant
Cash Flows (130,000) 17,000 47,000 73,000 47,000 39,000
(I)
Discount rate -
8% 1/(1.08)^0 1/(1.08)^1 1/(1.08)^2 1/(1.08)^3 1/(1.08)^4 1/(1.08)^5
(II)
PV of relevant
cash flows
(130,000) 15,741 40,295 57,950 34,546 26,543
(III) =
(I) x (II)
Net Present
Value £45,075
(Sum of III)

So, we conclude based on our analysis above that this investment has a positive NPV
of £45,075, so the business should accept this project, subject to the project also
meeting other qualitative requirements (i.e. good strategic fit to the company’s overall
strategic goals etc.).

Detailed Solution & Feedback to Question 4 (self-study question)

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In Part (a) we are asked to determine the relevant annual cash flows arising from
the hospital’s decision about whether or not to purchase the new X-ray machine.

It is very important to stress that whenever we are faced with a similar exercise, we
need to be able to understand the various options/alternatives that the
business/organisation faces. In our example, if the hospital does not purchase the new
X-ray machine it will continue operating the existing X-ray machine. It is understood
that if the hospital goes ahead with the purchase of the new X-ray machine that it will
dispose of the existing X-ray machine. So the two choices faced by the hospital are: i)
purchase the new X-ray machine and sell the existing X-ray machine or ii) don’t
purchase the new X-ray machine and continue operating with the existing X-ray
machine. These two choices need to be carefully considered when determining which
cash flows are RELEVANT.
Just as we discussed in Question 2 of last week’s tutorial, we need to look at all the
figures provided in the exercise in order to determine the relevant cash flows.

Relevant or Cash flow or

Description Amount
Irrelevant? other figure?
Cash flow
Revenue of the X-ray £200,000 (we assume that the
Irrelevant
department (per year) revenues are cash
revenues)
£40,000 per
Saving on labour costs year Relevant Cash flow
(years 1 to 4)

£25,000 per
Saving on operating costs year Relevant Cash flow
(years 1 to 4)

Disposal value of existing £45,000 in

Relevant Cash flow
X-ray machine today year 0

Purchase price of
£300,000 in
SUPREME X-ray Relevant Cash Flow
year 0
machine

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 Relevant
Disposal value of
£60,000 (NB: what is
SUPREME X-ray
minus £5,000 relevant here is
machine in year 4 vs. Cash flow
= £55,000 in the difference
Disposal value of existing
year 4 between the two
X-ray machine in year 4
disposal values)

£15000 in
Additional investment in year 0
Relevant Cash Flow
working capital (we recover
this in year 4)

Once we have determined the relevant cash flows, we present them in a table format
across the various years and calculate the net relevant cash flows for each
year/period.

Year 0 Year 1 Year 2 Year 3 Year 4

Investment in new X-ray
-300,000
machine
Additional working capital -15,000
Disposal value of existing
45,000
machine
Labour cost savings 40,000 40,000 40,000 40,000
Operating cost savings 25,000 25,000 25,000 25,000

Recovery of additional
15,000
working capital
Difference between disposal
value of new vs. old X-ray 55,000
machine

Net Relevant Cash flows -270,000 65,000 65,000 65,000 135,000

Part (b) of the question asks us to “calculate the Net Present Value of purchasing the
SUPREME, as opposed to staying with the existing machine”.

To do that we simply need to take the net relevant cash flows from part (a) and
discount them to the present by using the 10% cost of capital rate that we are
provided with in the exercise.

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Instead of manually calculating the discount factor for each of the four years you can
save time by obtaining the discount factors from the Present Value discount factor
Table, which you can find at the end of your textbook (pp. 551-552).

Once we have discounted all future cash flows to the present we can them sum them
up to obtain the Net Present Value of the option to purchase the new X-ray machine,
as opposed to sticking with the existing X-ray machine.

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 Year 0 Year 1 Year 2 Year 3 Year 4
135,00
Net Relevant Cash flows -270,000 65,000 65,000 65,000
0
Discount factor at 10% 1 0.9091 0.8264 0.7513 0.6830

PV of relevant cash flows -270000 59091 53719 48835 92207

Net Present Value -16148

The Net Present Value of investing in the new X-ray machine, as opposed to staying
with the existing X-ray machine is negative (i.e. -£16,148). Thus, based on purely
financial considerations this investment is not advisable, as it will reduce the wealth
of the hospital rather than increase it. However, prior to making a final decision the
hospital will also need to consider other factors that cannot necessarily by quantified
and reflected through the NPV calculation. These factors will be discussed in part (c)
of the question.

In part (c) of the question we need to use our creative skills (and some common
sense!) and think about the question presented to us not as a mere accounting
exercise, but rather as a potential real-life business situation.

In part (c) we are asked to name other factors (i.e. apart from the purely numerical
estimations) that the hospital management will also consider prior to making its final
decision on whether or not to purchase the new X-ray machine.

Some of those factors may include the following:

- Improved diagnoses and better patient treatment stemming from higher-
quality X-rays, if the new X-ray machine is purchased
- The new X-ray machine is faster and thus more efficient --> you can X-ray
more patients within a given time period
- Patient satisfaction may improve if the new X-ray machine is in operation
- If the new X-ray machine is purchased there will be fewer X-rays taken per
patient and also the new X-ray machine uses newer technology; hence staff
and technicians may be less exposed to the harmful effects of X-rays

Note, that the above considered factors are just some of the multiple factors that
the hospital will need to take into account prior to its investment decision. You may
think of some additional factors to complement the ones mentioned above.

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 Answers to common questions about this exercise

1. What if the exercise didn’t ask you in Step 1 to determine the relevant cash flows
but it directly asked you to calculate the NPV of purchasing the SUPREME as
opposed to staying with the existing machine. How would you solve the exercise in
this case?

Answer: You would still need to determine the relevant cash flows across time,
before you can calculate the NPV.

2. The first figure relating to the Revenue of the X-ray machine: is that a cash flow
or not?

Answer: We cannot say with certainty whether the revenue figure is a cash flow or
not (revenues can be generated in the form of cash or on credit). However, this isn’t
important in this case, as the revenue figure is IRRELEVANT to the investment
decision being made, so it will excluded anyway from the analysis.

3. How do we know whether the various figures that we find to be RELEVANT and
CASH FLOWS are cash inflows or cash outflows? For example, how do I know
whether I should put a plus or a minus sign in front of the savings on labour costs
in my table?

Answer: Cash inflows are flows of cash coming into the business, whereas cash
outflows are cash flows going out of the business. In the case of the saving on labour
costs and operating costs, they are considered cash inflows as they represent a
reduction in the cash outflows (which indirectly can be considered as a cash inflow).

4. Why is the difference between the two machine disposal values the relevant figure
in this case? Why isn’t the relevant figure simply the disposal value of the
SUPREME in year 4?

Answer: The relevant figures are the ones that vary with the investment decision.
The hospital has two options in this example. Continue as before with the existing
machine for the next four years, at which time the hospital can get rid of the existing
machine and receive £5,000 in return (the disposal value of the existing machine in
four years’ time). Alternatively, the hospital can purchase the new X-ray machine and

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operate it for the next four years, at which time it can sell it for £60,000. The relevant
figure, here, is the additional cash that the hospital will receive if it goes ahead
with buying the new X-ray machine, which is equal to £60,000 minus £5,000 =
£55,000.

5. Why is the word “additional” so important when discussing about whether the
working capital figure is RELEVANT or not?

Answer: In the exercise, we are provided with the additional working capital
investment. That is the relevant figure, as it represents the difference between the
working capital figure that the company currently has to invest for the existing X-ray
machine and the working capital figure it will have to invest if it goes ahead with its
decision to purchase the new X-ray machine.

If you have any further questions regarding this exercise, please post your
queries on the discussion forum on Moodle.

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