ACF 361

Kwasi Poku

Mar 2015
 Chapter four
FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION
Introduction

 A wide range of individuals and organizations have financial and

other links with companies.

In our first lecture, we identified a number of stakeholder groups

such as employees, customers, suppliers and the community.

These stakeholder groups have their own specific interests which

may sometimes conflict.
However, in one way or another, they are all concerned with the performance of
the company, its continuing existence, and its ability to provide them with a
positive return in some form, most usually cash.

Ideally, each of these user groups would like information about the past
performance of the entity, about its current state of affairs and, perhaps most
importantly, about its future – with all this information being directed to their
specific concerns.
FINANCIAL RATIOS

• Financial ratios provide a quick and relatively simple means of

examining the financial condition of a business.

• A ratio simply expresses the relation of one figure appearing in

the financial statements to some other figure appearing there (for
example, net profit in relation to capital employed) or perhaps
some resource of the business (for example net profit per
employee).
Ratios can be very helpful when comparing the financial health of
different businesses.

Differences may exist between businesses in the scale of

operations, and so a direct comparison of say the profits
generated by each business may be misleading.

By expressing profit in relation to some other measure (for

example sales), the problem of scale is eliminated.
Example:

A business with a profit of, say, Ghc10,000 and a sales turnover of

Ghc100,000 can be compared with a much larger business with a
profit of say, Ghc80,000 and a sales turnover of Ghc1,000,000 by
the use of a simple ratio.

There is no generally accepted list of ratios which can be applied

to company financial statements, nor is there a standard method
of calculating many ratios.
The ratios discussed in this section are those that many consider
to be among the more important for decision making purposes.
FINANCIAL RATIO CLASSIFICATION

Ratios can be grouped into certain categories, each of which

reflect a particular aspect of financial performance or position.

The following broad categories provide a useful basis for

explaining the nature of the financial ratios to be dealt with.
(a) Profitability ratio: -

Business come into being with the primary purpose of creating

wealth for the owners.

Profitability ratios provide an insight into the degree of success of

the owners in achieving this purpose.

They express the profits made in relation to other key figures in

the financial statements or to some business resource.
(b) Efficiency:
 Ratios may be used to measure the efficiency with which
certain resources have been utilized within the business.
 These ratios are also referred to as activity ratios.

(c) Liquidity:

 This is very vital to the survival of a business in the sense that there
has to be sufficient liquid resources to meet maturing obligations.
Certain ratios may be calculated which examine the relationship
between liquid resources held and creditors due for payment in the
near future.

(d) Gearing:
Gearing is an important issue which managers must consider when
making financial decisions.

The relationship between the amount financed by the owners of the

business and the amount contributed by outsiders has an important
effect on the degree of risk associated with a business.
(e) Investment: -
Certain ratios are concerned with assessing the returns and performance of
shares held in a particular business.

THE NEED FOR COMPARISON

Calculating a ratio will not by itself tell you very much about the position or
performance of a business.
It is only when you compare this ratio with some bench mark that the information
can be interpreted and evaluated.
BASES FOR COMPARISON
(1) Past Periods – By comparing the ratio you have calculated with the ratio of a
previous period, it is possible to detect whether there has been an improvement or
deterioration in performance.

(2) Planned Performance – Ratios may be compared with the targets which
management developed before the commencement of the period under review.
The comparison of planned performance with actual performance may therefore
be a useful way of revealing the level of achievement attained.
(3) Similar Businesses – In a competitive environment, a business must
consider its performance in relation to those of other businesses
operating in the same industry.

Survival may depend on the ability to achieve comparable levels of

performance.

This is a useful basis for comparing a particular ratio achieved by

similar businesses during the same period.
 KEY STEPS IN FINANCIAL RATIO ANALYSIS

(1) The first step involves identifying the key indicators and relationships which
require examination. In order to carry out this step, the analyst must be clear
who the target users are and why they need the information.

(2) The next step is to calculate the appropriate ratios for the particular users and
the purpose for which they require the information.

(3) The final step is the interpretation and evaluation of the ratios. Interpretation
involves examining the ratios with an appropriate basis for comparison and other
information which may be relevant.
THE RATIOS CALCULATED

PROFITABILITY
The following ratios may be used to evaluate the profitability of the
businesses.

(a) RETURN ON ORDINARY SHAREHOLDERS FUNDS

The ROSF compares the amount of profit for the period available to
the ordinary shareholders, with the ordinary shareholders stake in the
business.
The ratio which is normally expressed in percentage terms is as
follows:

ROSF = Net profit after tax & pref. dividend (if any) x 100
Ordinary share capital plus reserves

The net profit after taxation and after any preference dividend is
used in calculating the ratio as this residual figure represents the
amount of profit available to ordinary shareholders.
In the case of Alexis Plc, the ROSF ratio for the year ended 31 M arch 19 x 2
is:

R O SF = £15 9 . 2 x 100
£4 9 8.3
= 31.9 %
For the year ended, 31st M arch 19x3

R O SF = £1 6 4 . 2 X 100
£636.6 = 2 5 .8 %
RETURN ON CAPITAL E M PLO Y ED ( ROCE)
The R O CE is a fundamental measure of business performance.

This ratio expresses the relationship between the net profit

generated by the business and the long term capital invested in
the business.

The R O CE is expressed in percentage terms as follows:

ROCE = Net Profit before Interest and Taxation
Share capital + Reserves + Long term loans

N et profit before interest and taxation is used because the ratio

attempts to measure the returns to all suppliers of long term
finance before …

… any deduction for interest payable to lenders or payments of

dividends to share holders are made.
For the year ending 31 M arch 1 9 x 2, the R O CE for Alexis Plc
is:

R O CE = £ 2 4 3. 4 x 100
£ 6 9 8.3 = 34.9 0 %

For 31 M arch 1 9 x3 R O CE = £ 246.4 x 100

696.6
= 35.4 %
• ROCE is considered by many to be a primary measure of
profitability. It compares inputs (capital invested) with outputs
(profit).

• This comparison is of vital importance in assessing the

effectiveness with which funds have been deployed.
Although ROSF and ROCE measure returns on capital invested,
ROSF is concerned with measuring the returns achieved by
ordinary shareholders, …

.... whereas ROCE is concerned with measuring returns achieved

from all the long term capital invested.
Net Profit margin
The net profit margin relates the net profit for the period to the
sales during that period. The ratio is expressed as:

Net Profit = Net Profit before Interest

and Taxation x 100
Sales
The net profit before interest and taxation is used in this ratio as it represents the profits
from trading operations before any costs of servicing long term finance are taken into
account. This is often regarded as the most appropriate measure of operational
performance …..
… . for comparison purposes as differences arising from the way in
which a particular business is financed will not influence this
measure.

In practice the net profit after taxation is also used, on

occasions, as the numerator.

The purpose for which the ratio is required will determine which
form of calculation is appropriate.
The ratio compares one output of the business (profit) with
another output (sales).
The net Profit margin of Alexis Plc (based on the net profit before interest
and taxation) for the year ended 31 March 19x2 is:

Net Profit Margin = £243.4x 100

£2,240.8
= 10.9%

For the year ended 31 March 19x3

Net Profit Margin = £246.4x 100

£2,681.2
= 9.2%
GROSS PROFIT MARGIN
The gross profit relates the gross profit of the business to the sales
generated for the same period. Gross profit represents the
difference between sales and cost of sales.

The ratio is therefore a measure of profitability in buying (or

producing) and selling goods before any other expenses are taken into
account.

As cost of sales represents a major expense for retailing and manufacturing
businesses, a change in this ratio can have a significant effect on the
‘bottom line’ (that is the net profit for the year).
Gross Profit Margin = Gross Profit x100
Sales

For the year to 31 March 19x2, the ratio for Alexis Plc is:
Gross Profit Margin = £495.4 x100
£2,240.8
= 22.1%
Gross Profit Margin for the year to 31 March 19x3 is:
Gross Profit Margin = £609.2 x 100
£2,681.2
= 22.7%
The profitability ratios for Alexis Plc can be set out as follows:

19x2 19x3
ROSF 31.9% 25.8%
ROCE 34.9% 35.3%
Net Profit Margin 10.9% 9.2. %
Gross Profit margin 22.1% 22.7%

COMPARISON OF THE RATIOS OF ALEXIS Plc

The gross profit margin shows a slight increase in 19x3 over the previous
year. This may be for a number of reasons such as an increase in selling
prices and a decrease in the cost of sales.
However, the net profit margin has shown a slight decline over the
period.
This means that operating expenses (wages, rate, insurance and so on)
are absorbing a greater proportion of sales income in 19x3 than in the
previous year.

EFFICIENCY RATIOS
Efficiency ratios examine the ways in which various resources of the
business are managed.

The following ratios consider some of the important aspects of resource

management.
Average Stock Turnover Period
Stocks represent a significant investment for a business. For some
types of businesses for example manufacturers), stocks may account
for a substantial proportion of the total assets held.

The average stock turnover period measures the average number of

days for which stocks are being held.

The average stock for the period can be calculated as a simple

average of the opening and closing stock levels for the year.
However, in the case of a highly seasonal business where stock levels may
vary considerably over the year, a monthly average may be more
appropriate.

In the case of Alexis Plc, the stock turnover period for the year ended 31
March 19x2 is:

Stock Turnover Period

= Average Stock Held x 365 days.
Cost of sales
= £ (241 + 300)/2 x 365 days
£1745.4
= 57 days (to nearest day),
This means that, on average the stock held is being ‘turned over’ every 57
days.

A business will normally prefer a low stock turnover period to a high period
as funds tied up in stocks cannot be used for other profitable purposes.

The average stock turnover period for Alexis Plc for the year to 31 March
19x3 is:

tock Turnover Period = £ (300 + 370.8)/2 x 360

£2,072
= 59 days
 Average Settlement Period for Debtors
(Debtor Days)

A business will usually be concerned with how long it takes for

customers to pay the amounts owing. The speed of payment can have
a significant effect on the cash flows for the business.

The average settlement period for debtors calculates how long, on

average, credit customers take to pay the amounts which they owe to
the business.
A business will normally prefer a shorter average settlement period
than a longer one as, once again funds are being tied up which may
be used for more profitable purposes.

The ratio is as follows:

Debtor Days = Trade Debtors x 365 days

Credit sales

We are told that all sales made by Alexis Plc are on credit and so the
average settlement period for debtors for the year ended 31
March 19x2 is:
Debtor Days = £240.8x365
£2240.8
= 39 Days

Average settlement period for debtors for the year to 19x3 is

Average settlement = £210.2x 365

£2681.2
= 29 Days
 AVERAGE SETTLEMENT PERIOD FOR CREDITORS (CREDITOR DAYS)
The average settlement Period for creditors tells us how long, on
average the business takes to pay its trade creditors.

As trade creditors provide a free source of finance for the business, it
is perhaps not surprising that some businesses attempt to increase
their average settlement period for trade creditors.

However such a policy can be taken too far and can result in a loss of
goodwill by suppliers.
The ratio is calculated as follows:

Trade Creditors x 365 days

Creditor Days = Credit Purchases

Trade Creditors for the year ended 31 March 19x2 is as follows:

Creditor Days = £221.5x 365 Days

£1804.4
= 45Days
For the year ended 31 March 19x3:

Creditor Days = £228.8 x 365 Days

£2142.8
= 39 Days

SALES TO CAPITAL EMPLOYED RATIO

The sales to capital employed Ratio examines how effective the long –
term capital employed of the business has been, in generating sales
revenue.

The long term capital employed here is shareholders funds plus long
term loans.
Generally speaking, a higher sales to capital employed ratio is preferred
to a lower one.

A higher ratio will normally suggest that the capital (as represented by
total assets less current liabilities) is being used more productively in the
generation of revenue.

However a very high ratio may suggest that the business is

undercapitalized, that is, it has insufficient long term capital to support
the level of sales achieved.
The ratio is calculated as follows:
Sales to capital = sales
Employed ratio long term capital employed
(that is, shareholders’ funds + long term loans)

The ratio for Alexis Plc in 19x2 is:

Sales to capital employed

= £2,240.8
£ (498.3+200.0) = 3.2 times
For 19x3, the ratio is:

Sales to capital = £2,681.2

Employed £ (636.6+60.0)
= 3.8 times
SALES PER EMPLOYEE
The sales per employee ratio relate sales generated to a particular business
resource. It provides a measure of the productivity of the workforce.
The ratio is calculated as follows:

Sales Per employee = Sales

Number of employees

The ratio for Alexis Plc in 19x2 is:

Sales Per Employee = 2,240,800
14
= £160057
For the year ended 31 March 19x3, the ratio is:

Sales Per Employee = £2,681,200

18
= £148,956

The efficiency ratios for Alexis Plc may be

SUMMARIZED AS FOLLOWS:
 19x2 19x3
• Stock turnover Period 57 days 59 days
• Average settlement 39 days 29 days
for Debtors
• Average settlement 45 days 39 days
Period for Creditors
• Sales to capital employed 3.2 times 3.8 times
• Sales Per employees £160 057 140,956

COMPARISON OF EFFICIENCY RATIOS FOR ALEXIS Plc

 A comparison of the efficiency ratios between years provide a mixed
picture. The average settlement period between debtors and creditors has
reduced.
The reduction may have been the result of deliberate policy decisions, for
example tighter credit control for debtors, paying creditors promptly in
order to maintain good will or to take advantage of discounts.

The stock turnover period has shown a slight decrease over the period but
this may not be significant.

Overall, there has been an increase in the sales to capital employed ratio
which means that the sales have increased by a greater proportion than the
capital employed of the business.

Sales per employee, however, has declined and the reasons for this should
be investigated.
LIQUIDITY RATIOS:
CURRENT RATIO
The current ratio compares the liquid assets (cash and those assets held
which will soon be turned into cash) of the business with current liabilities
(creditors due within one year).
The ratio is calculated as follows:

Current ratio = Current Assets

Current Liabilities.
For the year ended 31 March 19x3 the ratio is:
Current ratio = £574.3= 1.8 times
£321.8
For 19x3 the ratio is:
Current ratio = £622.0
£364.8
= 1.7 times
The ratio reveals that the current assets cover the current liabilities
by 1.8 times.

In some texts, the notion of an ideal current ratio (usually 2 times) is
suggested for businesses.

However this fails to take into account the fact that different types
of businesses require different current ratios.
The higher the ratio, the more liquid the business is considered to be. As
liquidity is vital to the survival of the business, a higher current ratio is
normally preferred to a lower one.

ACID TEST RATIO

The acid test ratio represents a more stringent test of liquidity. It can be
argued that, for many businesses, the stock in hand cannot be converted to
cash quickly.

Note that in the case of Alexis Plc, the stock turnover period was more than 50 days
in both years. As a result, it may be better to exclude this particular asset from any
measure of liquidity.
The acid test ratio is based on this idea and is calculated as follows:
Acid test ratio = Current Assets (excluding stock)
Current liabilities

The Acid test ratio for Alexis Plc for the year ended 19x2 is as
follows:
Acid test ratio = £(574.3-300)
£321.8
= 0.9 times
For 19x3, the Acid test ratio is;

Acid test ratio = £(622.0-370.8)

£364.8
= 0.7 times
We can see that the ‘liquid’ current assets do not quite cover the current
liabilities and so the business may be experiencing some liquidity problems.

 In some types of businesses, however, where a pattern of strong positive

cash flow exists, it is not unusual for the acid test ratio to be below 1.0
without causing liquidity problems.

The liquidity ratios for Alexis Plc over the two year period may be
summarized as follows:

19x2 19x3
Current ratio 1.8 1.7
Acid text ratio 0.9 0.7
COMPARISON OF LIQUIDITY RATIOS
A comparison of the two years reveals a decrease in both the current
ratio and acid test ratio. These changes suggest a worsening liquidity
position for the business.

The business must monitor its liquidity carefully and be alert to any
further deterioration in these ratios.

GEARING
Gearing occurs when a business is financed, at least in part, by
contributions from outside parties.
The level of gearing (that is the extent to which a business is
financed by outside the parties) associated with a business is often an
important factor in assessing risk.

Where a business borrows heavily, it takes on a commitment to pay

interest charges and make capital repayments.

This can be a real financial burden and can increase the risk of a
business becoming insolvent.
Nevertheless, it is the case that most businesses are geared to a
greater or lesser extent.
GEARING RATIO
 The gearing ratio, measures the contribution of long-term lenders to the long term
capital structure of a business. It is calculated as follows:

Gearing = Long term liabilities share

capital + reserves + Long term liabilities

 The gearing ratio for Alexis Plc for the year ended 31 March 19x2 is;

 Gearing ratio = £200 x 100

£ (498.3+200)
= 28.6%
 Gearing Ratio for 19x3:

= £60 x100
£(636.6+60) = 8.6%

o This ratio reveals a substantive fall in the level of gearing over the year.
The gearing ratio for 19x2 reveals a level of gearing which would not
normally be considered to be very high.

o However, in deciding on what an acceptable level of gearing might be, we

should consider the likely future pattern and growth of profit and cash
flows.
INTEREST COVER RATIO

 The interest cover ratio measures the amount of profit available to cover interest
payable.
The ratio may be calculated ass follows;

 Interest Cover ratio = Profit before interest & taxation

Interest Payable

 The ratio for Alexis Plc for the year ended 31 March 19x2 is:

Interest Cover ratio = £(219.0+24)

£24
= 10.1 times
The ratio shows that the level of profit is considerably higher than the level
of interest payable.

Thus, a significant fall in profits could occur before profit levels failed to
cover interest payable.

The Interest cover ratio for 19x3 is;

Interest Cover ratio
= £ (240.2+6.2)
£6.2

= 39.7 times
COMPARISON OF GEARING RATIOS

19x2 19x3
Gearing Ratio 28.6% 8.6%
Interest Cover Ratio 10.1 times 39.7 times

Both the gearing ratio and interest cover ratio have changed
significantly in 19x3. This is owing mainly to the fact that a
substantial part of the long – term loan was repaid during 19x3.
 This repayment had the effect of reducing the relative contribution of long-term
lenders to the financing of the business and reducing the amount of interest
payable.
INVESTMENT RATIOS
There are a number of ratios which are designed to help investors who hold
shares in a company to assess the returns on their investment.

DIVIDEND PER SHARE

The dividend per share ratio relates the dividend announced during a period to
the number of shares in issue during that period. The ratio is calculated as
follows:

Dividend = Dividends announced during

Per share the Period
No. of shares in Issue
In essence, the ratio provides an indication of cash return which an investor
receives from holding shares in a company.
Although it is a useful measure, it must always be remembered that the
dividends received will usually only represent a partial measure of return to
investors.

The ploughed back profits also belong to the shareholders and should, in
principle, increase the value of the shares held.

The ratio can be calculated for each class of share issued by a company.
Alexis Plc has only ordinary shares in issue and therefore only one dividend
per share ratio can be calculated.
Dividend per share for Alexis Plc for the year-ended 19x2 is:

Dividend Per share = £40.2

£600
(i.e. £0.50 shares and £300 share capital)

= 0.067 = 6.7p

The dividend per share for 19x3 is;

Dividend per share = £60.0

668.2
0.089 = 9.0p
Comparing dividend per share between companies is not always useful as
there may be differences between the nominal value of shares issued.

However, it is often useful to monitor the trend of dividends per share for a
particular company over a period of time.

DIVIDEND PAYOUT RATIO

The dividend payout ratio measures the proportion of earnings which a
company pays out to share holders in the form of dividends.

The ratio is calculated as follows;

Dividend = Dividends Announced for the year
Payout Ratio Earnings for the year available for Dividends x 100

In the case of ordinary (equity) shares, the earnings available for dividend will
normally be the net profit after taxation and after any preference dividends
announced during the period.
The ratio is normally expressed as a percentage.

The dividend payout ratio for Alexis Plc in 19x2 is;

Dividend Payout ratio = £40.2 x 100

£159.2
= 25.3%
The ratio for 19x3 is

Dividend Payout ratio =£60 x 100

£164.2
= 36.5%

EARNINGS PER SHARE

The earnings per share of a company, relates the earnings generated by the
company during a period and available to shareholders to the number of
shares in issue.
For ordinary shareholders, the amount available will be represented by net
profit after tax (less any preference dividend where applicable).
The ratio for ordinary shareholders is calculated as follows:

Earnings Per = Earnings Available to Ordinary

Share Shareholders
No. of ordinary shares in issue
The EPS for Alexis P/c in 19x2 is:

EPS = £159.2
600
= 26.5P
The EPS for Alexis P/c in 19x3 is:
EPS = £164.2
668.2
= 24.6P

The ratio is regarded by many investment analysts as a fundamental

measure of share performance. The trend in earnings per share
overtime is used to help assess the investment potential of a company’s
shares.

It is not usually very helpful to compare the earnings per share of one
company with another.
Difference in capital structures can render any such comparison
measure meaningless.

However, like dividend per share, it can be very useful to monitor the
changes which occur in this ratio for a particular company over time.

OPERATING CASH FLOW PER SHARE

It cans be argued that, in the short run at least, operating cash flow
per share provides a better guide to the ability of a company to pay
dividends and to undertake planned expenditures than the earnings
per share figure.
o The operating cash flow (OCF) per ordinary share is calculated as
follows:

OCF per ordinary = Operating Cash flows – Preference dividends (if any)
No. of ordinary shares in Issue

The OCF for Alexis Plc in 19x2 is:

OCF per share = £231.0

600.0 = 38.5p
OCF per share in 19x3 is;

OCF per share = £251.4

668.2
= 37.6p
There has been a slight decline in the ratio over the two-year period. Note
that, for both years, the operating cash flow per share for Alexis Plc is
higher than the earnings per share. This is not unusual.

The effect of adding back depreciation in order to derive operating cash

flows will often ensure a higher figure is derived.
PRICE/EARNINGS RATIO
The price/earnings ratio relates the market value of a share to the earnings per share.
This ratio can be calculated as follows:

P/E ratio = Market Value per Share

Earnings per share
The Ratio = £ 2.50
26.5p = 9.4 times
The P/E ratio for Alexis Plc in 19x3 is

P/E ratio = £3.50

24.6
= 14.2 times
o The ratio reveals that the capital value of the share in 19x2 is 9.4 times
higher than its current level of earnings. The ratio is in essence, a measure
of market confidence concerning the future of a company.

o The higher the P/E ratio, the greater the confidence in the future earning
power of the company and, consequently, the more investors are prepared
to pay in relation to the earnings stream of the company.
THE INVESTMENT RATIOS FOR ALEXIS Plc
19x2 19x3
Dividend Per share 6.7p 9.0p
Dividend Payout ratio 25.3% 36.5%
Earnings Per share 26.5p 24.6p
OCF per share 38.5p 37.6p
Price/Earnings ratio 9.4 times 14.2 times

COMPARISON OF INVESTMENT RATIOS

 There has been a significant increase in the dividend per share in 19x3 when compared to
the previous year.
 The dividend payout ratio reveals that this can be attributed at least in part to, an
increase in the proportion of earnings distributed to ordinary shareholders.
Earnings per share show a slight fall in 19x3 when compared with the
previous year. A slight fall also occurs in the operating cash flows per share.

 However, the price/earnings ratio shows a significant improvement. The

market is clearly much more confident about the future prospects of the
business at the end of the year to 31 March 19x3.
 LIMITATIONS OF RATIO ANALYSIS

Although ratios offer a quick and useful method of analyzing the position
and performance of a business they are not without their limitations.

(1) Quality of Financial statements: - It must always be remembered that

ratios are based on financial statements….
…. and the results of ratio analysis are dependent on the quality of these
underlying statements.

Ratios will inherit the limitations of the financial statements on which

they are based.
In recent years, for example, conventional accounts have been distorted as
a result of changing price levels.

Traditional accounting assumes unfortunately, that, the monetary unit will

remain stable over time even though there have been high levels of inflation
during the past few decades.
One effect of inflation is that values of assets held for any length of time,
may bear little relation to current values.

Generally speaking, the value of assets held will be understated in current

terms during a period of inflation as they are recorded at their original costs
(less an amount written off for depreciation).
(2) The basis for comparison:-

When comparing businesses, it is important to note that no two businesses

will be identical and the greater the differences between businesses being
compared, the greater the limitations of ratio analysis.

(3) Balance Sheet ratios-

Because the balance sheet is only a ‘snapshot’ of the business at a particular

moment in time, any ratios based on balance sheet figures, such as the
liquidity ratios calculated, may not be representative of the financial
position of the business for the year as whole.
END OF CHAPTER
 Chapter six

MANAGEMENT OF WORKING CAPITAL

Introduction:
Working capital is usually defined as: ‘Current assets less Current liabilities
(that is, creditors due within one year)’.
The major elements of current assets are;
• Stocks
• Trade Debtors
• Cash (in hand and at bank)

The major elements of current liabilities are:

• Trade Creditors and
• Bank Overdrafts
• The size and composition of working capital can vary between industries.

• For some types of business, the investment in working capital can be

substantial, for example, a manufacturing company will invest heavily in
raw materials, work – in – progress and finished goods and will often sell
goods on credit thereby incurring trade debtors.

 A retailer, on the other hand, will hold only one form of stock (finished
goods), and will usually sell goods for cash.
Working capital represents a net investment in short-term assets.
These assets are continually flowing into and out of the business
and are essential for day to day operations.

The various elements of working capital are interrelated and can be

seen as part of a short-term cycle. The management of working
capital is an essential part of the short term planning process.

It is necessary for management to decide how much of each

element should be held.
Managers must try to identify changes occurring so as to ensure the level of
investment in working capital is appropriate.
• What kind of changes in the business environment might lead to a decision
to change the level of investment in working capital? Try and identify four
possible changes

In answering this activity, you may have thought of the following;
• Changes in interest rates
• Changes in market demand
• Changes in seasons
• Changes in the state of the economy
In the sections, which follow, we will consider each element of working
capital separately, examining the factors, which must be considered to
ensure their proper management.

MANAGEMENT OF STOCK
A business may hold stocks for various reasons. The most common reason
is, of course, to meet the immediate day – to -day requirements of
customers and production.
However, a business may hold more than is necessary for this purpose, if it is
believed that future supplies may be interrupted or scarce.
Similarly, if the business believes that cost of stocks will rise in the future, it may
decide to stockpile.
Where a business holds stock simply to meet the day-to-day requirements
of its customers and production, it will normally seek to minimize the
amount of stock held.

This is because, there are significant costs associated with holding stocks.

These include storage and handling costs, financing costs, the risk of
pilferage and obsolescence, and the opportunities foregone in tying up
funds in this form of asset.
COSTS ASSOCIATED WITH TOO LOW STOCK

• Loss of sales, from being unable to provide the goods required immediately.
• Loss of goodwill from customers, through inability to satisfy customer
demand
• High transportation cost incurred to ensure stocks are replenished quickly.
• Lost production owing to shortage of raw materials
• Inefficient production scheduling due to shortages.
• Purchasing stocks at a higher price than may otherwise have been necessary
in order to replenish stock quickly.
PROCEDURES AND TECHNIQUES FOR MANAGING STOCKS

(a) FORECASTS OF FUTURE DEMAND;

In order for there to be stock available to meet future sales, a business
must produce appropriate forecasts. The forecast should deal with each
product line.

 It is important that every attempt is made to ensure the accuracy of these

forecasts, as they will determine future ordering and production levels.

These forecasts may be derived in various ways. They may be developed

using statistical techniques, or they may be based on the judgment of the
sales and marketing staff.
(b) FINANCIAL RATIOS:
A financial ratio, which can be used to help monitor stock levels, is the
average stock turnover period which we have already examined. The ratio,
as you may recall, is calculated as follows:

Average stock = Average Stock held x 365 days

Turnover period cost of sales

The ratio will provide a picture of the average period for which stocks are
held and can be useful as a basis for comparison.
(c) RECORDING AND REORDERING SYSTEMS:
The management of stocks in a business of any size requires a sound system
of recording stock movements. There must be proper procedures for
recording stock purchases and sales.

 Periodic stock checks will usually be required to ensure that the amount of
physical stocks held is consistent with the stock records.

To determine the point at which stock should be ordered, information

concerning the lead time (the time between the placing of an order and the
receipt of the goods) and the likely level of demand will be required.
In most businesses, there will be some uncertainty surrounding the above
factors, and so a buffer or safety stock level may be maintained in case
problems occur.

The effect of holding safety stock will be to raise the reorder point for
goods.

(D) LEVELS OF CONTROL

Management must make a commitment to the management of stocks.
However, the cost of controlling stocks must be weighed against the
potential benefits.

It may be possible to have different levels of control.

o A business may find that it is possible to divide its stock into three broad
categories: A, B and C. Each category will be based on the value of stock
held. Category A stocks will represent the high – value items.

o For example, 10 per cent of the physical stocks held may account for 65 per
cent of total value.

o For these stocks, management may decide to implement sophisticated

recording procedures, exert tight control over stock movements and have a
high level of security at the stock location.
 Category B stocks will represent less valuable items held, perhaps 30
percent of the total volume of stocks may account for 25 percent of the
total value of stocks held.

 Categorizing stock in this way can help ensure that management’s effort is
directed to the most important areas and that the cost of controlling stocks
are commensurate with their value.

(E) STOCK MANAGEMENT MODELS

It is possible to use decision models to help manage stocks, the economic
order quantity (EOQ) Model is concerned with the question: how much
stock should be ordered?
In its simplest form, the EOQ model assumes that demand is
constant, so that stocks will be depleted evenly ever time and that
stocks will be replenished just at the point the stock runs out.

EOQ also assumes that the key costs associated with stocks are the
cost of holding them and ordering them.
• It also assumes that companies do not require any safety stock and that
stock can be purchased in single units that correspond exactly to the EOQ,
for example, 158 units and not in multiples of 50 or 100 units.

 Finally the EOQ assumes that no discounts are available for bulk purchases.
The above assumptions do not mean we should dismiss the model as being of
little value.

 The model can be refined to accommodate the problems of uncertainty and

uneven demand as has been done by many businesses.
MATERIALS REQUIREMENTS PLANNING (MRP)
A material requirement planning (MRP) system takes as its starting point
forecasts of sales demand.

It then uses computer technology to help schedule the timing of deliveries
of bought in parts and materials to coincide with production requirements
to meet the demand.

MRP is a coordinated approach, which links material and parts deliveries to

their scheduled input to the production process.
 JUST – IN – TIME (JIT) STOCK MANAGEMENT

o Some manufacturing businesses have tried to eliminate the need to hold

stocks by adopting a just – in – time (JIT) stock management.

o This method was first used in the US defence industry during World War II
but in more recent times has been widely used by Japanese businesses.

o The essence of this approach is, as the name suggests, to

have supplies delivered to a business just in time for them to be used in the
production process.
By adopting this approach the stock holding problem rests with the suppliers
rather than the business. A close relationship between the business and
its suppliers is required to make the approach effective.

In JIT, as the suppliers will be required to hold stocks for the business, they
may try to recoup this additional cost through increased prices.

Finally the close relationship necessary between the business and its
suppliers may prevent the business from taking advantage of cheaper
sources of supply when they become available.
 MANAGEMENT OF DEBTORS

Selling goods on credit is very widespread and appears to be the norm

outside the retail trade.

When a business offers to sell its goods or services on credit, it must have
clears policies concerning:
• Which Customers should receive credit(five Cs of credit )
• How much credit should be offered
• What length of credit it is prepared to offer
• Whether discounts will be offered for prompt payment
• What collection policies should be adopted
• How the risk of nonpayment can be reduced.
 MANAGEMENT OF CASH
Why Hold Cash?
According to economic theory, there are 3 motives for holding cash.
They are:
(1) Transaction motive: In order to meet day-to-day commitments such as
payment of wages, overheads and goods purchased to be paid at due dates.
(2) Precautionary motive – if future cash flows are uncertain for any reason, it
would be prudent to hold a balance of cash.
(3) Speculative motive – A business may decide to hold cash in order to be in a
position to exploit profitable opportunities as and when they arise.
 HOW MUCH CASH SHOULD BE HELD?
The decision as to how much cash a particular business should hold is a difficult
one. This decision is usually influenced by the following factors:

1. The nature of the business- some businesses such as utilities (water &
electricity) may have predictable cash flows and so can hold lower cash
balances.
2. The opportunity cost of holding cash- where there are profitable
opportunities, it may be wiser to invest in those opportunities than to hold a
large cash balance.
3. The availability of near liquid assets- if a business has marketable securities
or stocks which may easily be liquidated, then the amount of cash held may
be reduced.
4. Availability of borrowing- if a business can borrow easily, (and quickly);
there is less need to hold cash.

5. Interest rates/cost of borrowing: When interest rates are high, the

option of borrowing becomes less attractive.

OPERATING CASH CYCLE

When managing cash, it is important to be aware of the operating cash
cycle of the business.

This may be defined as the time period between the outlay of cash
necessary for purchase of stocks and the ultimate receipt of cash from sale
of the goods.
The operating cash cycle is important because it has a significant influence
on the financing requirements of the business.

The longer the cash cycle, the greater the financing requirements of the
business and the greater the financial risks.
For a business, which buys and sells on credit, the operating cash cycle
can be calculated from the financial statements by the use of certain ratios,
as follows;
Average stock turnover period + (plus) Average settlement period for debtors –
(minus) Average payment period for creditors = (equals) Operating cash
cycle.
HOW A COMPANY CAN REDUCE THE CASH CYCLE
If a company has a long stock holding period, it can reduce the level of
stock held.
Imposing tighter credit control, offering discounts or charging interest on
overdue accounts can reduce average settlement period for debtors.
However any policy decisions concerning stocks and debtors must take
account of current trading conditions.

The cycle could also be reduced by extending the period of credit taken to
pay suppliers. However, this option must be giving careful consideration.
MANAGEMENT OF TRADE CREDITORS

To monitor the level of trade credit taken, management can calculate the
average settlement period for creditors; as we have already seen, it is
calculated as follows:
Trade creditors
Credit purchases * 365 days

However, this provides an average figure, which can be distorted.

A more informative approach would be to produce an ageing schedule for

creditors.
MANAGEMENT OF BANK OVERDRAFTS

Bank overdrafts are flexible form of borrowing and are cheap, relative to
other sources of finance. For this reason, the majority of UK companies
employ bank overdraft to finance their business.

Although in theory, bank overdrafts are short-term source of finance, in

practice they can extend over a long period of time as many businesses
continually renew the overdraft facility with the bank.
The decision concerning whether or not to have a bank overdraft should first
consider the purpose of borrowing.

Overdrafts are most suitable for overcoming short-term funding problems

(for example, increases in stockholding requirements owing to seasonal
fluctuations) and should be self liquidating.

For longer term funding problems or borrowings, which are not self-
liquidating, other sources of finance may be more suitable.
END OF CHAPTER
 Chapter five

METHODS OF INVESTMENT APPRAISAL

INTRODUCTION

The process of allocating or budgeting capital is usually more involved than

just deciding on whether or not to buy a particular asset.

Management of a company will frequently face broader issues like whether

or not they should launch a new product or enter a new market.

Decisions such as these will determine the nature of a firm’s operations for
years to come primarily because non-current asset investments are generally
long-lived and not easily reversed once they are made.
Bravery, information, knowledge and a sense of proportion are essential
ingredients when undertaking the onerous task of investing other people’s
money,

….. but there is another element which is also of crucial importance, that
is, the employment of an investment appraisal technique which leads to the
“correct” decision; a technique which takes into account the fundamental
considerations.
In April 2003, Toyota South Africa announced that it is to invest R1.7 billion in a
new export programme to supply vehicles to Europe, the rest of Africa as well as
the Caribbean, as the next stage of an expanding multi-billion rand roll-out of
exports.
Toyota’s announcement offers an example of a capital budgeting decision.
EVIDENCE ON THE EMPLOYMENT OF APPRAISAL TECHNIQUES

A number of surveys enquiring into the appraisal methods used in

practice have been conducted over the past 25 years.

The results from surveys conducted by Pike and also by Glen Arnold
and Panos Hatzopoulos are displayed in Table 2.1 and 2.2.

 Payback remains in wide use, despite the increasing application of

discounted cash flow techniques; internal rate of return is at least as
popular as net present value.
• However, NPV is gaining rapid acceptance. Accounting rate of return
continues to be the laggard, but is still used in over 50 percent of large
firms.

One observation that is emphasized in many studies is the tendency for

decision markers to use more than one method.

In the 1997 study, 67percent of firms used three or four of these
techniques, these methods are regarded as being complementary rather
than competitors.
Table 2.1.
Proportion of Companies Using Technique
Pike Surveys
1975(%) 1980(%) 1986(%) 1992(%)
Pay back 73 81 92 94
ARR 51 49 56 50
IRR 44 57 75 81
NPV 32 39 68 74

Pikes Studies focused on 100 large UK firms.

Table 2.2.
Arnold and Hatzopoulos Surveys (1997)
Small(%) Medium(%) Large(%) Total(%)
Payback 71 75 66 70
ARR 62 50 55 56
IRR 76 83 84 81
NPV 62 79 97 80

Capital budget (per year) for companies in Arnold and Hatzopoulos study
approx.
 Small: £1-50m. Medium: £1-100m. Large: £100m+
THE PAYBACK PERIOD

 The payback period for a capital Investment is the length of time before the
accumulated stream of forecasted cash flows equals the initial investment.

 It is the length of time it takes for an investment to be repaid out of the net
cash inflows from a project. The decision rule is that if a project’s
payback period is less than or equal to a predetermined threshold figure; it
is acceptable

 We can illustrate how to calculate a payback with the example below.

Fig. 1 Net Project Cash flows
Year
0 1 2 3 4

-£50,000 £30,000 £20,000 £10,000 £5,000

Figure 1 shows the cash flows from a proposed investment project.

The question to be asked here is, how many years do we have to wait until the
accumulated cash flows from this investment equal or exceed the cost of investment?
As figure 1 indicates the initial investment is £50,000. After the first year, the firm
recovered £30,000, leaving £20,000.

The cash flow in the second year is exactly £20,000, so this investment pays for
itself in exactly two years. Put another way, the payback period is two years.

If we require a payback period of say, 3 years or less, then this investment is
acceptable.
Now that we know how to calculate the payback period on an investment, using the
payback period rule for making decisions is straight forward.
A particular cut-off time is selected say, two years, and all investment projects that have
payback periods of two years or less are accepted and all of those that pay off in more than
two years are rejected.
Consider the example in the table below:
Year Net Cash flows Cumulative Cash flows Net
£000 £000 £000
0 (100) (100)
1 20 (80) (20-100)
2 40 (40) (40-80)
3 60 20 (60-20)
4 60 80 (60+20)
5 20 100 (20+80)
6 20 120 (20+100)

 The payback period for this investment is nearly three years, that is, it will
be nearly three years before the £100,000 outlay is covered by the inflow.
Example 3 – Mutually Exclusive Projects

Project 1 Project 2 Project 3

Year £000 £000 £000
0 (200) (200) (200)
1 40 10 80
2 80 20 100
3 80 170 20
4 60 20 200
5 40 10 500
6 40 10 20
 The payback period for each project is three years and so the payback
period approach would regard the projects as being equally acceptable.
ADVANTAGES OF PAYBACK PERIOD

It is quick and easy to calculate and can be easily understood by

managers.

Projects which can recoup their cost quickly are reviewed as more
attractive than those with longer payback periods.

Research undertaken by Glen Arnold suggests that Payback is rarely

used as a primary investment technique, but rather as a secondary
method which supplements the more sophisticated methods.
DISADVANTAGES
1. The first drawback of the Payback Period rule is that it makes no
allowance for the time value of money.
It ignores the need to compare future cash flows with the initial
investment after they have been discounted to their present values.

2. In example three, the payback for each of the project is three years and so
the payback approach would regard the projects as being equally
acceptable .

The payback method cannot distinguish between those projects which

pay back a significant amount at an early stage and those which do not.
In example three, project three repays £180,000 in year 2 while projects
one and two pay £120,000 and £30,000 respectively.

3. Another drawback of the payback rule is that it ignores receipts or

cash flows beyond the payback period. This may lead to rejection of long
term profitable projects. More generally, using a payback period rule will
tend to be bias towards shorter term investments.

4. Another short coming is the arbitrary selection of the cut-off

point. There is no theoretical basis for setting the appropriate time period
and so guesswork, whim and manipulation take over.
 DISCOUNTED PAYBACK
With discounted payback the future cash flows are discounted prior to
calculating the payback period. This is an improvement on the simple
payback method, in that; it takes into account t the time value of money.

The discounted payback period is the length of time until the sum of the
discounted cash flows is equal to the initial investment. The discounted
payback rule would be:

‘…Based on the discounted Payback rule, an investment is acceptable if its

discounted payback is less than some specified number of years,
• The process of discounting relies on a variant of the compounding
formula;
F= P (1+r) n where;
F= future value
P= Present Value
r= interest rare
n= number of years over which compounding takes place.

E.g. If a saver deposited £100 in a bank account paying interest at 8%

per annum , after three years , the account will contain £125.97. The
figure was arrived at using the above formula as follows:
F= P (1+r) n = 100(1+0.08)3 = £125.97

The formula can be changed so that we can answer the following

questions: How much must I deposit in the bank now to receive
£125.97 in three years at an annual interest rate of 8%.

P=F/ (1+r) n
or F* 1/ (1+r) n

P= 125.97/ (1+0.08)3= 100

If we consider the case of Example 4, we can discount the net cash
flows of projects A, B and C using a discount rate of 10 percent as
follows.

To get the discounted payback, we have to discount each cash low at
10 percent and then add them up and then subtract the initial
investment capital from it.

The discounted payback method is therefore based the NPV rule that
projects with a positive NPV are selected. The NPV formula is as
follows;

NPV= FO+F1/ (1+r) n

where;
where;

FO = cash flow at time zero and

F1= cash flow at time one (t1)
r= rate of interest and
n= number of years.

To calculate the discounted payback for projects A, B, and C IN EXAMPLE 4,

the NPV formula becomes.
NPV= FO+F1/ (1+r) 1 + F2/ (1+r) 2+ F3/ (1+r) 3…………+ F6/ (1+r) 6

t=n t=n
NPV = ∑ FO+Fn/ (1+r) n or NPV = ∑ Fn/ (1+r) n- FO
t=1 t=1

Where
Fn= the net cash flow at the end of year n
F0= the initial investment outlay at t= 0
r =the discount rate based on the opportunity cost of capital
n = the projects expected life cycle.
For example 4, the discounted Payback is as follows:

Project A
-10+6/1.1+2/ (1.1)2+1/ (1.1)3+1/ (1.1)4+2/ (1.1)5+2/ (1.1)6= £0.913m

Project B
-10+1/1.1+1/ (1.1)2+2/ (1.1)3+6/ (1.1)4+2/ (1.1)5+2/ (1.1)6= -£0.293m

Project C
-10+3/1.1+2/ (1.1)2+2/ (1.1)3+2/ (1.1)4+15/ (1.1)5+10/ (1.1)6= £12.208m
Project A has a positive NPV and is therefore shareholder wealth
enhancing.

Project B, has negative NPV; the firm would be better served by

investing the £ 10m in the alternative that offers a 10 percent return .

Project C had the largest positive NPV and is therefore the one that
creates most shareholder wealth.

Example 5-class work (refer to the handout)

ACCOUNTING RATE OF RETURN

The accounting rate of return (ARR) is also commonly referred to as the

Return on Investment (ROI) or the Return on Capital Employed (ROCE).

There are many ways in which this measure can be derived, its base form
being the ratio of some measure of accounting profit to a corresponding
measure of capital outlay.
One of the more common ways of deriving this ratio for decision
making is to calculate a project’s average profit after
depreciation but before any allowance for taxation and divided
this by the average capital employed during the life of the
project.
• Let us consider a simple example:
• Example 6
• A project requires an initial capital outlay of $500,000 and has a life of 5
years, at the end of which it can be sold as scrap for $50,000.
Let us consider a simple example:
Example 6
A project requires an initial capital outlay of $500,000 and has a life of 5
years, at the end of which it can be sold as scrap for $50,000. The expected
annual profits over this period for the project are:

Year $
1 40,000
2 100,000
3 160,000
4 120,000
5 30,000
ARR= Average Annual Profit/Average Capital Employed*100
Average Annual Profit ;
(40,000+100,000+160,000+120000+30,000)/5= $90,000

Average Capital Employed:

$500,000+$50,000/2=$275,000

ARR= 90,000/275,000*100=32.73%.

Note that the denominators for the first two stages of this calculation were 5
and 2 respectively .In (a) 5 was used to give the average annual profit ,
while in (b) 2 was used to give the simple average of capital deployed
throughout the entire five year life of the project.
• Once the ARR has been determined , a simple accept / reject decision
is then made on the basis of the percentage return achieved.

• Providing the ARR , which in this case was 40%, exceeds some
predetermined ‘target’ rate of return, the project is accepted ,
otherwise , it is rejected.

• In the case of competing projects, the decision rule is to accept the

one with the higher ARR provided that it is larger than the target rate.
Example 7
Consider the following Projects .They both have a five year life and require an
initial investment of £ 200,000 with anticipated scrap value of £ 0.

Year Project A Project B Project C Project D

1 £10,000 £50,000 £5,000 £13,000
2 £20,000 £40,000 £18,000 £37,000
3 £30,000 £30,000 £88,000 £10,000
4 £40,000 £20,000 £6,000 £15,000
5 £50,000 £10,000 £2,000 £20,000

ARR= Average Annual Profit /Average Capital

employed
A(i) 150,000/5=30,000 B(i) 150,000/5=30,000
A (ii) 20,000-0/2=100,000 B(ii) 20,000-0/2=100,000
Project A: ARR Project B: ARR
=30,000/100,000*100 =30,000/100,000*100
ARR=30% ARR=30%

ADVANTAGES OF ARR
One of the advantages are its ease of calculation , the fact that it considers the
accounting profit flows throughout….

….the life of a project and that it produces a percentage rate of return which is a
ratio commonly used by market analyst and others when measuring the
profitability of a company.
DISADVANTAGES OF ARR
Since this is an accounting ratio, non-cash items such as depreciation
are included.

The production of a ratio in percentage terms fails t reflect the

absolute size of investment and, although the whole life of individual
projects are considered, this method fails to distinguish between the
differing lives of mutually exclusive projects.

Finally and most fundamentally, the ARR method ignores the timing of
the earnings stream of projects.
An illustration of this is provided by example 7 which compares two
projects each having a five year life and requiring an initial investment of
£200,000 with an anticipated scrap value of £ 0.
DISCOUNTED CASH FLOW TECHNIQUES

• The time value of money

• One of the incentives to save is the possibility of gaining a higher level of
future consumption by sacrificing some present consumption.

• It is therefore apparent that compensation is required to induce people to

make a consumption sacrifice. Compensation will be required for at least
three things.
Time:
That is individuals generally prefer to have £ 1.00 today than £ 1.00 in five
years time. That is, the utility of £1.00 now is greater than £1.00 received
in five years from hence.

 The rate of exchange between certain future consumption is the pure rate
of interest .This occurs even in a world of no inflation and no risk .

If you live in such a world you might be willing to sacrifice £100 of
consumption now if you were compensated with £104 to be received in one
year .This would mean that your pure rate of interest is 4%.
Inflation:
The price of time (or the interest rate needed to compensate for time
preference) exists even when there is no inflation simply because people
generally prefer consumption now to consumption later.

If there is inflation, then the providers of finance will have to be

compensated for that loss in purchasing power as well as for time.

Risk:
o The promise of a receipt of a sum of money some years hence generally carries with
it an element of risk; the payout may not take place or the amount may be less
than expected.
o Risk simply means that the future return has a variety of possible values.
Thus the issuer of a security, whether it be a share, a bond or a bank
account must be prepared to compensate the investor for time, inflation
and risk involved, otherwise no one will be willing to buy the security.
Different investment a categories, carry different degrees of uncertainty
about the outcome of the investment.
For instance, an investment on the Russian stock market, with its high
volatility is regarded more risky than buying shares I B.P. with its steady
growth prospects. Investors require different risk premiums o top of the
RFR to reflect the perceived level of extra risk. Thus:
Required Return= RFR+ Risk Premium
(Time Value of money)
 DISCOUNTED CASH FLOW
The Net Present Value and Internal Rate of Return techniques, both being
discounted cash flow methods take into account the time value of money.

t=n t=n
NPV = ∑ FO+Fn/ (1+r) n or NPV = ∑ Fn/ (1+r) n- FO
t=1 t=1
Example 1
Project Alpha, simple cash flow

Year cash flows

0-Now -2000
1 (1year from now) +600
2 +600
3 +600
4 +600

NPV calculation for Project Alpha, assuming that the time value of money is 19%
-2000+600/ (1+0.19) +600/ (1+0.19)2+600/ (1+0.19)3+600/ (1+0.19)4
-2000+504.20+423.70+356.05+299.20
=-416.85
• The NPV rule is as follows;
• NPV0 Accept
• NPV 0 Reject
Example 2.
Let us consider projects C and D assuming the opportunity cost of capital is 10%
Project C Project D
Year cash flows PV Year cash flows PV
0 -20,000 -20,000 0 -20,000 -20,000
1 +12,000 +10,908 1 +8,000 +7,272
2 +8,000 +6,608 2 +8,000 +6,608
3 +8,640 +6,489 3 +4,000 +3,004
4 4 +8,000 +5,464
5 +6,000 +3,726
NPV =+ 4,005 NPV= +6,074
Both projects have positive NPV’s , but if they were mutually
exclusive projects D would be preferred .

This is the reverse situation to the advice that would have been given
by the payback period method .

The difference between payback period and NPV is that the latter takes
into account those cash flows arising after the payback cut off period
and also considers the time value of money.

• Example 3- class work- REFER TO HANDOUT

Example 3- class work
KSB Plc is examining two projects A and B. The cash flows are as follows;
A B
Year £ £
0 -240,000 -240,000
1 200,000 20,000
2 100,000 120,000
3 20,000 220,000

Using discount rates of 8% and 16%, calculate the NPV’s and state which
project is superior.
NPV = NPV= FO+F1/ (1+r) 1 + F2/ (1+r) 2+ F3/ (1+r) 3
Project A @ 8% OR 0.08

-2400+200,000/ (1+0.08) +100,000/ (1+0.08)2+20,0000/ (1+0.08)3

-240,000+185,185+85,734+15,877= £46,796

Project B @ 8% OR 0.08
-2400+20,000/ (1+0.08) +120,000/ (1+0.08)2+220,0000/ (1+0.08)3
-240,000+18,519+102,881+174,643= £56,043

Using 8% discount rate both projects produce positive NPV’s and therefore
would enhance shareholder wealth.
However project B is superior.
Using 16% as the discount rate
Project A @ 16% or 0.16
-2400+200,000/ (1+0.16) +100,000/ (1+0.16)2+20,0000/ (1+0.16)3
-240,000+172,414+74,316+12,813= £19,7543

Project B @ 16% or 0.16

-2400+20,000/ (1+0.16) +120,000/ (1+0.16)2+220,0000/ (1+0.16)3
-240,000+17,241+89,180+140,945= £7,366.

Using 16% discount rate , project A generated more shareholder value so

would be preferred to project B.
This is despite the fact that project B in pure undiscounted cash flow
terms produces an additional £40,000.
 INTERNAL RATE OF RETURN

The internal rate of return (IRR) is the discount rate which when applied to
the future cash flows will make them equal to the initial outlay.
In essence , it represents the yield from an initial investment opportunity .

The IRR takes into account the time value of money .It is the discount rate
which will produce a zero NPV.
The rule for internal rate of return decision is:

If k is greater than r= reject

If k r accept
If the opportunity cost of capital (k) is greater
than the internal rate of return (r) on a project then it must be
rejected.
MERITS OF NPV
o The timing of cash flow – By discounting the various cash flows
associated with each project according to when they are expected to
arise, the NPV takes into account the time value o f money.
The discount factor is based on the opportunity cost of capital.

o The whole of the relevant cash flows-NPV includes all of the relevant
cash flows irrespective of when they are expected to occur.

It treats them differently according to their dates of occurrence but

they are all taken into account.
o The objective of the business- the output of the NPV analysis has
a direct bearing on the wealth of the shareholders of a business
(positive NPV’s enhance wealth, negative ones reduce it).
END OF CHAPTER
QUESTIONS & ANSWERS
 Thank You

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Jan 2014