Corporate Finance
Assignment One

by

 Andrew Brabner

Introduction

Investment project evaluation is an important matter for companies. There are often a variety of different investment opportunities amongst which a company can choose or there is the problem of capital rationing in which limited capital is available for investment. Whatever the particular problem, companies need tools to aid them in selecting the correct opportunity, so that the maximum possible value will be added and they need to be able to do so without referring back to the shareholders and to ask them for their particular preferences.

There are various methods of investment appraisal, of which three will be discussed and implemented here in order to supply the company directors with the bes  possible advice. The first being the Net Present Value (NPV) calculation that considers relevant future cash flows and subsequently discounts them at the opportunity cost of capital (the Internal Rate of Return (IRR) is similar and will be discussed in more detail later) and the other being the Accounting Rate of Return (ARR) that bases its analysis upon pure, non-discounted, accounting data.

Relevant Cash Flows

Two major methods of project appraisal – NPV and Internal rate of Return (IRR) – are based upon the future relevant cash flows of the project. To use these methods correctly the relevant cash flows have firstly to be defined. On the next page you can see, in Table 1, a column entitled “Total”. This lists all the various types of income / expense / cash flow that were presented by the directors. From these, the cash flows have to be selected that amongst other things:

• Are future cash flows and not past
• Have an additional / incremental direct impact on the project
• Have a cash impact e.g. are not just simply accounting measures

These will then be the relevant cash flows that can be further used in the project appraisal process. These can be seen in the Table1 column entitled “relevant cash flows” .

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Table 1

(Please note that the full distribution of the cash flows over the projects’ life can be seen in Appendix I)

The first two items in the above table (ref (a)), are not relevant cash flows because they have either already occurred or have been irreversibly committed to. These are “sunk costs” from the past and will not be effected by the decision to accept or reject the project.

Ref (b) refers to the required purchase price of machinery and should be included as a relevant cash flow. The difference to the above purchased machinery under ref (a) is that in this case the cash flow lies in the future and not in the past. Therefore the outcome of the project evaluation will have an influence. Both items under ref (c) refer to the depreciation arising from the machinery purchased. In both cases the depreciation should not included as a relevant cash flow. This is primarily for two reasons. The first is that depreciation is an accounting measure and not a flow of funds. Depreciation attempts to match the cost of the asset with the stream of revenues produced by it, but has nothing to do with the timing of an actual flow of funds. The second is that if we were to include at least the depreciation on the additional equipment, we would be double accounting the negative cash flow, as we have already included the acquisition cost of the additional equipment as a cash flow.

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