ILM Level 5 Certificate in Management
Making a Financial Case
Making a
Financial
Case
1
Contents
Module introduction
Understanding costs and costing systems
Direct and indirect costs
Fixed and variable costs
Break even analysis
The contribution method
Costing systems: marginal and absorption costing
Absorption costing
Activity-based costing
Profit improvement
Investment decisions
Investment appraisal methods
The payback period method
The accounting rate of return method
Discounted cash flow methods: NPV and IRR
Net present value
Internal rate of return
Risk in investment appraisal
Risk analysis
The criteria matrix
Management and control of investment projects
Summary
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Unit Introduction
Welcome to the ‘Making a Financial Case’ unit. There are two key learning
outcomes to this unit:


To understand the financial concepts used to inform management
decisions
Be able to make a financial case to inform a management decision
In the first part of the unit, you will be introduced to a number of key principles in
terms of understanding costs and costing systems. The second part of the unit is
concerned with exploring a range of capital investment appraisal methods. The
key focus for the assessment of this unit is an Improvement Report, not to be
completed until you have attended “Managing Improvement”.
The specific areas to be covered are as follows:









Differentiate between the direct and indirect costs of the business
Identify the fixed and variable costs of the business
Use break-even and contribution analysis
Understand the principles of three costing systems
Consider some simple strategies for profit improvement
Understand and apply the main investment methods used in business
Discuss the strengths and weaknesses of each method
Understand the importance of risk and the need for sensitivity analysis
Identify a structure for controlling and reviewing capital projects
Understanding Costs and Costing Systems
Cost control and management is a key basis for competitive advantage. An
understanding of how to categorise costs and how certain costs behave is,
therefore, going to be of great value to you in your decision making role, and will
be of significant value to your organisation. This is a key area covered in this
section.
If you are going to survive and prosper as an organisation, you must ensure that
all the business costs are covered by the fees that you charge for your service.
This includes the direct costs of the product/service and the organisation’s
overheads – but how do we deal with the overheads? In this section, you will look
at three different costing methods, each of which has a specific purpose, and will
serve to provide you with answers to this question.
The knowledge of how much the business needs to sell in order to cover the
costs of operating and start making a profit would be of great value, providing a
clear business target. In this section, you will see how ‘break-even analysis’ and
‘contribution analysis’ can be used to provide this information.
3
Within this section of the unit we will be covering the following topics:







Direct and indirect costs
Fixed and variable costs
Break even analysis
Contribution analysis
Marginal and absorption costing
Activity-based costing
Profit improvement
Direct and Indirect Costs
In order to charge an appropriate fee for the product/service provided and for the
organisation to make a genuine profit/surplus, we need to be able to identify both
the costs directly associated with providing that specific product/service (the
direct costs) and those overhead costs which are incurred as a result of generally
running the business (the indirect costs). If we assume that the key front line
service of the University are the lectures, we could identify the direct costs as
follows:
Direct Costs
Direct
Materials
Direct
Labour
Direct
Expenses
Front Line Service
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


The direct labour would be the lecturers
The direct materials would include a number of items but perhaps, most
obviously, the handouts provided to students during a lecture
Whilst we may not always allocate direct expenses to the service, this
could include any specific equipment or service that we have had to buy
in; in this example it is a web host provider – Fasthosts.
Now we need to consider the indirect (overhead) costs which could be as follows:
Indirect ‘Overhead’ Costs



The property rates for the University
Heating and lighting
... and, of course, administration and management support represented by
the typical manager above
These represent just some of the potentially huge indirect costs that are incurred
in order to run the operation. The table below presents a general breakdown of
these costs.
5
Cost
Direct Costs:
These costs are
directly
attributable to the
provision of the
front line service.
Code
Cost Category
Description
A
Direct Labour
The people who directly
make the product, or
provide the front line
service
B
Direct Materials
Any materials consumed in
the process /provision of
the front line service
C
Direct Expenses
Associated directly with the
provision of the service, eg.
hire of specialised
equipment, any royalties
payable as commission
D
Indirect
labour
Managers, supervisors,
maintenance and cleaning
staff
E
General
administration
General office staff and
office materials
F
Reception
Staff
G
Marketing and
distribution
Advertising, selling,
promotions, transport costs,
marketing and distribution
staff
H
Buildings
occupancy
Rent/rates, property taxes,
insurance, heating, lighting,
water rates, electricity,
repairs and maintenance
Indirect Costs:
These costs are
commonly known
as ‘overheads’.
They comprise
those factors that
are not directly
attributable to the
provision of the
front line service,
eg.
It is entirely up the business as to how it decides to categorise costs. There are
no accounting standards to which the business should conform.
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Activity: Now consider your own operational area and see if you can divide it up
into the front line service and support service and, consequently, make a brief list
of the potential direct and indirect costs.
Direct Costs
Indirect Costs
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Fixed and Variable Costs
The ability to monitor and control costs requires an understanding of the nature
of costs, ie how certain costs behave. The difference between fixed and variable
costs is a case in point.
Fixed Costs: in
the short-term
stay the same
each month
Variable Costs: vary
with changes in activity

Fixed Costs are those costs which do not alter with changes in
organisational activity, eg. the property rates will remain the same each
month regardless of how well or how badly the organisation is doing.

Variable Costs are those costs which will vary directly with changes in
organisational activity, eg. if the volume of work increases beyond the
capacity of full time staff, then there may be a need for either overtime
working, temporary staff, or casual staff etc. You may already have found
that some costs have a fixed element and a variable element, eg. a phone
bill may have a standing charge for the line rental, and a variable charge
for the amount of phone useage; these cost are known as semi-variable.
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For the focus of this activity, let’s use the example of the Olympic
swimming pool. Working with a partner consider which of the following costs
should be treated as fixed or variable by ticking the appropriate column.
Question
Direct Materials:
Direct materials
Direct Labour:
Swimming pool attendant’s wages
Fixed
Cost Area
Variable
Activity:
Swimming pool attendant’s overtime
Overheads:
Promotional literature
Lighting
Business rates
Salesperson’s commission
Advertising
Activity: Consider your own operational are – what are your fixed and variable
costs?
Fixed Costs
Variable Costs
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Break-Even Analysis
Clearly, if the organisation is going to be profitable, then both its fixed and
variable costs need to be covered by sufficient revenue generation. Break-even
analysis is a tool designed to help calculate how much revenue needs to be
generated in order to cover both these costs. Essentially, it helps to:

calculate the total costs of producing a product/providing a service

forecast the revenue that needs to be generated in order to cover costs
and start making a profit
The break-even point occurs where total costs equals total revenue
Any revenue below the break-even point is at a financial loss to the organisation
for that particular product/service. Once revenue has exceeded the break-even
point, then the organisation will be operating at a profit.
REVENUE
VARIABLE
COSTS
K EVE
N
REVENUE/COSTS
BR E A
TOTAL
COSTS
FIXED
COSTS
SALES(UNITS)
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To illustrate this concept, you can construct a break-even table. For this exercise,
let’s use the example of the University’s sports centre
Activity:

The centre has fixed costs of £10,000 per month

It charges an entry fee to the centre of £1.50

It incurs variable costs per customer, eg electricity to power fitness
machines, use of shower etc, of £0.50 per customer.
The monthly break-even point can be calculated by completing the table
below.
Demand
Fixed
Costs
Variable
Costs
Total Costs
(no. of
customers)
£10,000
(£0.50 per
customer)
multiply by
demand
(no. of
customers)
(Fixed Costs + (£1.50 per
Variable Costs) customer)
multiply by
demand
(no. of
customers)
0
10,000
0
Sales
Revenue
10,000
0
2,000
4,000
6,000
8,000
10,000
12,000
The break-even point (BEP) =
customers.
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The Contribution Method
There is a more simple way of performing the same analysis. However, you still
need to know the following:

Fixed costs

Variable costs per customer (unit)

Price per customer (unit)
The difference between the price and variable cost per unit is a kind of profit
figure known as the contribution, because it is the amount that each sale
contributes towards:

The payment of fixed costs

The generation of a surplus (profit)
Example:
(Less)
Price
Variable cost
Contribution
£
1.50
0.50
1.00
Break-Even Point (BEP)
=
Fixed costs / contribution per unit
Therefore the BEP
=
10,000 / 1
=
10,000 units of demand
Activity
Using the contribution method, calculate the following break even points
(BEPs).
(The original figures may change for each subsequent calculation where stated.
You should always use the most recent figure. The BEP should be expressed
in units of demand. Use the table below, to enter your calculations.)
The first BEP has been calculated for you. Follow exactly the same approach to
calculate the BEPs for scenarios 2 to 6.
Scenario: The sports centre has expanded and it is now including some
premium extra value added services in the price charged to the customer, hence
the increased entry price. This decision is taken in a bid to compete with two new
private leisure centres which have opened locally.
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1.
Fixed costs:
Variable costs per customer:
Price per customer:
2.
Falling customer demand: a reduction in the price to £7 per customer
entry fee.
3.
Increase in demand after Christmas: increase in the selling price to £11
per customer entry fee.
4.
Increase in energy costs. Variable costs are increased by £2 per customer
to £8.50 per customer entry fee.
5.
Recession: selling price reduced to £9 per unit, variable costs remain at
£8.50 per unit
6.
Selling price remains at £9 per unit during recession. Efficiency savings
reduce fixed costs to £9,000.
1
£15,000
£6.50
£9
Selling Price
(less)
Variable Costs =
Contribution
Fixed costs /
Contribution per
unit
Break-Even
Point
(in no. of units)
9.00
6.50
2.50
15,000/2.50
6,000 units
2
3
4
5
6
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As you can see, changes in the input variable costs, eg. increase in material,
labour, energy costs, can have a significant effect on profit margins. The decision
has to be taken as whether the business should absorb these increases thus
shielding the customer, or increase the selling price, thus passing the costs onto
the customer. This will depend upon a number of factors, including competitor
activity, economic conditions, and the anticipated effect that pricing decisions will
have on demand.
Costing Systems
The aim of a costing system is to ensure that all the costs of an organisation
are recovered by being charged to that part of the organisation making the
money.
The following are 3 different techniques used in cost accounting as an aid to
management decision-making:



Marginal costing
Absorption costing
Activity-based costing
Marginal Costing
Marginal costing is a technique for dealing with variable costs. It recognises that
fixed costs vary with time rather than activity and attempts to identify the cost of
producing one extra unit, eg:
In theory, providing for one extra unit will incur an increase in the
variable costs (direct materials, direct labour and, probably, direct
expenses) – this increase is the marginal cost.
Absorption Costing
This method:

Absorbs all costs (both direct and a proportion of the indirect ‘overhead’
costs) into each unit

Remember – direct costs are directly attributable to the product/service
being provided, eg. staff labour time
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Absorption Costing

Absorbs all costs (both direct and a proportion of the indirect costs) into
each unit made and sold

Remember – direct costs are normally directly attributable to the front line
service, eg. labour time
Example: the sports centre allows admission only through a one year
membership scheme. It has 2 key income earning facilities: its gym
and sports hall. It allocates the direct costs for each facility
accordingly. Remember, these would comprise the direct labour
(gym and sports hall staff), direct materials, and any direct
expenses. In some cases, the direct expenses may include the
power to run the machines. As there are no strict guidelines, the
decision is down to the sports centre as to how it categorises and
allocates costs. However, the direct costs are really straightforward
to allocate:
Gym
Direct Costs
eg. £30,000 for the year
based on 100 members
Sports Hall
Direct Costs
eg. £25,000 for the year
based on 100 members
But what about the indirect ‘overhead’ costs, eg. business
rates?
Let’s look at this in simple terms. If each of the above sports centre facilities
accounted for 50% of sales, the decision could be made to allocate 50% of the
centre’s indirect (overhead) costs to both the gym and the sports hall
respectively. This would determine the total cost of providing the facility for the
year, eg.
Gym
Direct Costs +
50% of Indirect ‘Overhead’ Costs
= Total Cost
16
Based on the volume of forecast sales, it is now possible to calculate the total
cost of providing a service for either the gym or the sports hall, eg.

If total indirect (overhead) costs for the sports centre over the period are
forecast to be £20,000, then:
o 50% of £20,000
=
£10,000
=
the total indirect costs to be allocated to the gym for the
period
I
Total Costs for
running the Gym
for a year
(based on 100
members)
Direct Costs (£30,000) +
50% of Indirect ‘Overhead’ Costs
(£10,000)
= Total Cost (£40,000)
Calculating the Total Cost to be allocated to each
Membership Fee
Scenario 1:



Based on 100 paying members
Direct costs for running the gym for the year = £30,000
Indirect costs allocated to the gym = £10,000
1. Direct costs to be allocated to each annual membership fee:

£30,000 direct costs / 100 customers = £300
2. Indirect costs to be allocated to each annual membership fee:

£10,000 indirect costs allocated / 100 customers = £100
3. Total costs per member:

£300 direct costs + £100 indirect cost = £400
4. The membership card fee for the gym is, therefore, £400 plus the profit
margin
17
Scenario 2:



Based on 500 paying members
Direct costs for running the gym for the year = £50,000
(these have now increased owing to the increase in the number of
members from 100 to 500)
Indirect costs allocated to the gym = £10,000
Activity:
A. Calculate the membership card fee (excluding profit margin) based on the
information provided for scenario 2
B. What are the implications for the profit margin if 100 membership cards
are sold, or if 500 membership cards are sold?
Key Point: The lower the sales, the greater the proportion of indirect costs that
each membership card (unit sold) will incur.
When is it appropriate to use each technique?

Absorption Costing - when forecasting demand for the year ahead –
because at this stage of planning, we need to ensure that all costs will be
absorbed into the forecast demand for the period.

Marginal Costing - when taking on a non-forecast job – assuming that
forecast demand is on target, the indirect overhead costs will have already
been accounted for; we have, therefore, the opportunity to cost the job
only taking into consideration an increase in the variable costs (the
marginal cost).
To compare both costing techniques in action let’s look at the following
mini case study
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Mini-Case: Promobikes
Promobikes’ manufacturing costs for producing 100 fitness bicycles in one month
are:
£
Direct Materials
(£20 per bike)
2000
Direct Labour
(£25 per bike)
2500
4500
Factory Overheads
3500
Total Cost of producing 100 bikes
8000
The selling price is £100 per bike.
Activity
1.
2.
What is the cost of producing one bike under:

The marginal costing technique (remember we’re only concerned
with the variable costs)?

The absorption costing technique?
A major retail store offers to buy:

Either A.
50 bikes each month at a price of £60 each

Or
100 bikes each month at a price of £40 each
B.
What decision would you make on options a and b above? (It is assumed
that these sales will be produced in addition to existing production of 100
bikes per month.)
To do this, complete the summary profit statements table below:
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Existing
Production:
100 bikes @
£100 per
bike
Sales Revenue per month:
£
100 bikes @ £100 each
50 bikes @ £60 each
100 bikes @ £40 each
Total Sales Revenue
Less Production Costs:
Direct Materials (£20 per unit)
Direct Labour (£25 per unit)
Fixed Factory Overheads
Total Production Costs
Gross Profit
(Total Sales Revenue less
Total Production Costs)
Existing
Production:
100 bikes @
£100 per
bike
Existing
Production:
100 bikes @
£100 per
bike
Plus
Plus
Option A:
50 bikes @
£60 each
£
Option B:
100 bikes @
£40 each
£
Only enter figures in the blank white spaces. The shaded areas are
deliberately intended to be left blank.
Recommendation
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Activity-based Costing (ABC)
Manufacturing accountants have developed an array of methods for allocating
indirect overhead costs, ABC being the latest method. This method conforms to
the following process:



identify each necessary supporting activity in the production process and
collect costs into a separate pool for each identified activity
develop a measure for each activity, eg. a measure for the engineering
department may be hours, whereas the measure for the maintenance
department may be square metres
use activity measures as cost drivers to allocate costs to products
Product A
bnbnbnvgfb
Product B
200 hours engineering time
bnbnbnvgfb
20 hours engineering time
91%
engineering
cost allocated
9% enginnering
bnbnbnvgfb
cost allocated
bnbnbnvgfb
bnbnbnvgfb
The idea is that that the engineering department’s time is expensive and should
be paid for appropriately. The hourly rate charge for their time could be £100
plus. The logic of the ABC method is that the engineering cost per hour should
be allocated on the basis of the number of hours (cost driver) required by each
product.
Consequently, if the cost of the maintenance department is £10 per square foot
per year, and if product A uses 75% of the floor space and product B 25%,
product A would be charged with 75% of the maintenance cost. Of course, the
opposite could be true, in which case, product B would be allocated 75% of the
maintenance cost.
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Profit Improvement
Activity: in what ways can the profitability of an organisation be improved?
There are, to the best of my knowledge, only three ways (legally!) to improve the
profitability of a business



Sell more of your products and services
Raise your prices (or reduce your discounts)
Reduce your costs
How do you think your competitors would react to each of these scenarios?
They probably wouldn’t even know if you reduced costs and, even if they did,
what could they do about it … your cost structure is exclusive to your business.
So, cost reduction is probably the often the first consideration when trying to
improve profitability.
To increase profits, you do not need to sell more, but operate efficiently through
disciplined control of costs … by everyone in the organisation.
What if you could cut costs by 1%, sell 1% more and increase prices (or
reduce discounts) by 1% … all at the same time? How much would you
have increased net profitability by?
Not 3%, but 24%!! See over the page …… and a 1% shift isn’t asking a lot of a
business.
Consider the following example:
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STARTING SITUATION
SALES
VARIABLE COSTS
£50.00
OVERHEADS
£100
£40.00
PROFIT
£10.00
REDUCE COSTS BY 1%
SALES
VARIABLE COSTS
£49.50
OVERHEADS
£100
£39.60
PROFIT
£10.90
RAISE PRICES BY 1%
SALES
VARIABLE COSTS
£49.50
OVERHEADS
£101
£39.60
PROFIT
£11.90
INCREASE SALES BY 1%
SALES
VARIABLE COSTS
£50.00
OVERHEADS
£102
£39.60
PROFIT
£12.40
A 24% INCREASE!
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Cost Efficiency
Activity: using the post-it notes and flip chart pens provided in the workshop,
identify opportunities for greater cost efficiency within your operational area or
other areas in the University that you have observed. Note the outcome of this
exercise below.
24
Investment Decisions
In this second key area of the module, we will be exploring a range of capital
investment methods. But what is the difference between capital expenditure and
revenue expenditure?
Revenue and Capital expenditure are slightly different items. Revenue
expenditure is money that is spent on items that are only going to be used (or
performed) once, such as printer paper, stock, repairs, petrol etc. These items
would go under expenses in the profit and loss account.
Capital Expenditure is money spent by a business on items that are going to be
used more than one time, for example machinery, buildings and vehicles. These
items would appear on the Balance Sheet as a fixed asset and would be
depreciated over their useful life, the depreciation being deducted as an expense
in the Profit and Loss Account. We will be looking at Cash Flow, the Profit and
Loss Account, and the Balance Sheet, in the next Finance module.
The focus of this module is on capital expenditure. To remind you of the
objectives for this part of the module presented earlier, they are as follows:




Understand and apply the main investment methods used in business
Discuss the strengths and weaknesses of each method
Understand the importance of risk and the need for sensitivity analysis
Identify a structure for controlling and reviewing capital projects
All expenditure within an organisation is made with a view to deriving a benefit
from it. Some forms of expenditure are, by their nature, short-term with an
expectation that their benefit is short-lived, eg. investment in stocks of raw
materials or component parts.
Longer term investment involves what are termed as capital expenditure (capex)
decisions. This inevitably necessitates significant payments at the outset with
smaller returns over time which, hopefully, will achieve the desired, projected
benefits. Wrong decisions can, of course, be disasterous.
Therefore, important decisions need to be made on whether to invest, what to
invest in, when to make the investment, and how project viability will be
determined.
But, why do you need to invest at all? There are many reasons why a business
will want to make capital investment decisions. They range from the desire to
expand the business, eg. increase capacity, the need to replace and/or
modernise existing assets, or to comply with legislation, eg. environmental or
health and safety requirements. In summary, ‘doing nothing’ is not an option as
eventually all businesses need to invest, if only to survive!
25
Examples of capital expenditure could include:


The purchase of plant and machinery
The purchase of land and/or buildings
The objectives of investment appraisal can be summarised as:



Whether a particular project is justified in terms of the expected benefits
If there are alternative or competing projects, which one should be chosen
If there is a shortage of funds available, which proposals should be
chosen
The methods that we will be looking at in this section are purely concerned with
the financial aspects of a decision. Any decision should be based also on nonfinancial considerations such as, for example, supplier reliability.
Normally, a number of proposals will be evaluated to see which best meets the
organisation’s objectives and is financially acceptable.
Project Evaluation
Before considering the various methods of project (investment) evaluation it is
important for management to consider the following questions:







Does the project fit within overall objectives of the business?
How will it be funded?
What other resources will be required and timescales?
How long will the project last and what are its key stages?
What is the expected pattern of cash flows?
What are the ‘key sensitivities’ and what if… scenarios?
How does the investment compare with other opportunities available?
Investment Appraisal Methods
There are four key investment appraisal methods used in practice in UK
businesses. These are:




Payback period (PP)
Accounting rate of return (ARR)
Net present value (NPV)
Internal rate of return (IRR)
There is a fifth method, but I wouldn’t recommend it …gut-feeling!
The end goal of whichever method is used, is for the organisation to make an
informed decision as to whether or not to accept a capital investment proposal.
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Payback Period (PP) Method
The PP method measures the time it takes for the inflows of cash from an
investment, to payback the initial investment. Let’s assume that the University’s
Sports Centre has 3 projects in mind for developing the business, for example,
different sports hall layouts combining different activities. Each project is forecast
to generate different cash inflows but cost roughly the same at £10,000 per
project. The business can only choose to go ahead with of the three projects and,
therefore, constructs a table below to make a comparison in order to help the
decision.
Project
Initial Capital
Outlay
A
£10,000
Cash
Inflows
Year
1
2
3
4
5
Total
Payback
Period
B
1,000
1,000
1,000
7,000
10,000
20,000
4 years
Cost
Cash
less
Inflows
cash
inflows
(9,000)
7,000
(8,000)
2,000
(7,000)
2,000
0
0
10,000
0
10,000
11,000
2.5
years
C
£10,00
Cost
Cash
less
Inflows
cash
inflows
(3,000)
1,000
(1,000)
8,000
1,000
2,000
0
0
0
0
1,000
11,000
2.5
years
£10,000
Cost
less
cash
inflows
(9,000)
(1,000)
1,000
0
0
1,000
Evaluation
Project A: As you can see above, project A pays back the original investment in
4 years exactly, the £10,000 being returned by the end of year 4.
Project B: This pays back the investment in two and-a-half years. By the end of
year 2, £9,000 of the £10,000 has been returned in cash inflows from the
investment. The business only needs another £1,000 to payback the full £10,000.
We calculate the payback period as follows:

In year 3, the cash inflow is £2,000, therefore, we divide the £1,000 that is
required to payback the remainder of the original investment, by the
£2,000 which we receive in cash inflows for year 3. This equals 0.5 …
which, in essence equates, crudely, to half a year.
1,000 / 2,000 = 0.5

Therefore, the full payback period for project B is 2.5 years
27
Project C: Although the cash inflows are quite different for project C, the same
payback period of 2.5 years is achieved.

Activity:
If you were advising the Sports Centre management, which of

the
 3 projects would you recommend from a financial perspective? Explain
your
 choice and reasons below.



Activity: Let’s assume that another opportunity for business expansion has
been identified by the Sports Centre. Calculate the payback periods for each of
the three projects below. We will be using exactly the same figures below
throughout the rest of this section, to evaluate the 3 projects using the other
financial appraisal methods:
Project
Initial
Capital
Outlay
Year
1
A
B
£240,000
C
£240,000
£240,000
Cash
Inflows
Cost less Cash
Cost less Cash
Cost less
cash
Inflows
cash
Inflows
cash
inflows
inflows
inflows
60,000
40,000
140,000
2
100,000
40,000
120,000
3
100,000
40,000
48,000
4
80,000
140,000
40,000
5
60,000
140,000
20,000
400,000
400,000
368,000
years
years
years
Total
Payback
Period
Which project would recommend investment in?
28
Advantages of PP:

It is simple in concept and easy to calculate

It makes some recognition of the time value of money. Projects which
recoup their cost quickly are viewed as more attractive than those with
longer payback periods
Disadvantages of PP:

It fails to recognise receipts or expenditure beyond the payback point
Income expected after the payback point has been reached is not recognised.
Any such income could be substantial and long-term or the opposite. PP will not
distinguish, because the income is expected after the payback point. Equally, any
expenditure made after the payback point has been reached will be ignored. So
potentially, substantial dismantling costs or shutdown costs expected at the end
of the project life would be ignored.
29
Accounting Rate of Return (ARR) Method
Whilst the Payback Period measures time not profitability, the ARR method
actually measures profitability. An organisation will set a required rate of return
on its investment. This can, of course, vary from one business to the next. So, if
the required rate of return on an investment is 10%, it would expect the project to
achieve this profit margin. If the investment forecasts a lower rate of return than
10%, it will probably be rejected. It is the only appraisal method which deducts
depreciation from the cashflows.
We will use exactly the same figures as for the payback comparison above. The
rate of return for project A has been presented below for you in order that you
can then calculate the rate of return for projects B and C. The Finance Director
has set a 10% rate of return requirement. Any investment must achieve at least
this 10% target.
Example:
Project: A
Year
1
2
3
4
5
£240,000 capital outlay
Cashflow (less)
Depreciation =
£
£
60
100
100
80
60
Total Net Profit
Evaluation
Rate of Return:
Average Net Profit/
Capital Expenditure x 100
Net Profit
£
48
48
48
48
48
12
52
52
32
12
160
Average Annual Profit: 160/5 years = 32
32 / 240 x 100 = 13.33%
At a rate of return of 13.33%, project A has exceeded the 10% rate of return
target. How will it compare to projects B and C?
You will note that depreciation has been calculated at £48,000 per annum. If you
add up the 5 years of depreciation, the total is £240,000, which is exactly the
same as the original investment. What information does this provide for you
regarding the depreciation method and the forecast residual value of the project
investment? Clearly, the accountant has used the straight line depreciation
method and there is forecast to be no residual value.
30
Activity: complete the rate of return analyses for projects B and C
Project: B
Year
1
2
3
4
5
£240,000 capital outlay
Cashflow (less)
Depreciation =
£
£
40
40
40
140
140
Total Net Profit
Evaluation
1
2
3
4
5
48
48
48
48
48
Average Annual Profit:
Rate of Return:
Average Net Profit/
Capital Expenditure x 100
Project: C
Year
Net Profit
£
%
£240,000 capital outlay
Cashflow (less)
Depreciation =
£
£
140
120
48
40
20
Total Net Profit
Evaluation
Net Profit
£
48
48
48
48
48
Average Annual Profit:
Rate of Return:
Average Net Profit/
Capital Expenditure x 100
%
Activity:
Insert the summary figures into the table below. What are your
conclusions on each of the three projects now?
Project A
Project B
Project C
Payback Period
(PP)
Accounting Rate
of Return (ARR)
31
Advantages of ARR:

It is a measure of profitability rather than pure cash flows

It produces a % figure which is understood and accepted as a means of
measurement
Disadvantages of ARR:

Completely ignores the time value of money

When measuring performance over the whole life of a project, it is cash
flow rather than accounting profit, which is important. Cash is the ultimate
measure of the economic wealth generated by investment. This is
because it is cash which is used to acquire resources and for distribution
to shareholders. Accounting profit is fine for measuring performance over
short periods, but cash is the appropriate measure when considering
performance over the life of a project.
Discounted Cashflow Methods


Net Present Value (NPV)
Internal Rate of Return (IRR)
This method takes account of both the time value of money and the expected
cashflows over the entire life of the project. It recognises that a unit of money
received in the future will be worth less than the same unit of money received
today.
The concept of the ‘time value of money’ suggests that, in investment terms,
money has value depending on the exact date on which it is received or paid.
Suppose I had a commitment to pay you £100 in exactly one year’s time.
However we have both decided that it would be more convenient to both of us, if
I settled the debt today ie one year in advance. How much should I pay you?
Clearly, I would not pay you £100 today, because I am settling the debt one year
early and I will lose the investment value of that £100 for the year. Also you
would gain an investment opportunity, since you would have the £100 one year
early. If you could invest the money at 10% pa interest (perhaps a little unrealistic
these days, but chosen for simplicity!), you would have £110 at the end of the
year (ie the date I was due to repay you).
So, I would pay an amount less than £100 to settle the debt today recognising
the investment opportunity to you and loss of investment opportunity to me. But
exactly how much should I pay to settle the debt today?
The answer is £90.91(£100/1.1), which if you then invested at 10% pa would
earn you £9.09 in interest and therefore give you a total £100 in one year’s time.
32
In investment terms, assuming that the best interest rate you could receive is
10% pa, you would not care whether I paid you £90.91 today or £100 in exactly
one year’s time since both amounts would have the same value to you (that’s
always assuming that you are confident that I will be able to repay in one year’s
time!)
In ‘accountant speak’ we would refer to the amount due to be received or paid on
a specific date as a future value (often abbreviated as FV). Similarly, the
present-day amount that equates to that future value is called a present value
(often abbreviated as PV).
In this example, we have an FV of £100, which we have converted into a PV of
£90.91
So far we have considered the ‘time value of money’ as applied to just one future
payment. Investment Appraisal is far more complicated than that, in that the
investment usually requires a payment at the beginning, possibly additional
payments on future dates and (hopefully) a stream of receipts flowing from the
investment on various future dates.
Present Value (PV) Tables have been developed to help calculate the present
value of money at different rates of interest over different time scales. You can
access these tables by visiting the following website:
www.toolkit.cch.com/tools/npvtab
If we use a 10% discount factor, this means that over 5 years £1 would be
worth the following each year using the discounted rate:
Activity: Using the PV table below, what amount of money, if invested at 10%
per annum interest, would make £1 in 3 years’ time?
End of Year
1
2
3
4
5
Value in £s
0.909
0.826
0.751
0.683
0.621
Answer: ____________________________
33
Net Present Value
The Net Present Value (NPV) measures the value of the money received at
the end of the project, eg. in 5 years’ time. NPV takes into account all of the
costs (except depreciation) and benefits of a project as well as addressing the
issue of timing of cash flows.
The NPV for project A has been presented below for you in order that you can
then calculate the rate of return for projects B and C. For example, for year 1 we
have done the following calculation to find the NPV of the cashflow at the end of
year 1:

£60,000 x 0.909 (the discount rate for year 1 at a rate of 10% = £54,540

Add all the ‘present values’ and deduct from the original investment sum
of £240,000 (in the final column) in order to find the NPV for the whole 5
year life span of the investment.
Project A
Year
0
1
2
3
4
5
Cashflow (x)
Discount Factor (=)
Present
£
10%
£
-240,000
-240,000
60,000
.909
+ 54,540
100,000
.826
+ 82,600
100,000
.751
+ 75,100
80,000
.683
+ 54,640
60,000
.621
+ 37,260
Net Present Value
+ 64,140
34
Activity: now calculate the NPVs of projects B and C using a discounted
cashflow rate of 10%.
Project B
Year
Cashflow (x)
Discount Factor (=)
Present
£
10%
£
-240,000
-240,000
40,000
.909
40,000
.826
40,000
.751
140,000
.683
140,000
.621
Net Present Value
0
1
2
3
4
5
Project C
Year
0
1
2
3
4
5
Cashflow (x)
Discount Factor (=)
Present
£
10%
£
-240,000
-240,000
140,000
.909
120,000
.826
48,000
.751
40,000
.683
20,000
.621
Net Present Value
Conclusions

All 3 projects have positive NPVs

If the business is able to raise funds for the investment at no more than
10% interest, then each project appears to be worthwhile because of the
positive NPVs
35
Activity:
Insert the summary figures into the table below. What are your
conclusions on each of the three projects now?
Project A
Project B
Project C
PP
ARR
NPV
Each method paints a slightly different picture of each project investment
because of their different objectives. It is down to the business as to what it sees
as being more important.
Advantages of NPV:

NPV fully takes account of the time value of money

The whole of the relevant cash flows are taken into account and they are
treated differently according to their timing

The output of the NPV analysis has a direct bearing on the wealth of the
shareholders of the business (positive NPVs enhance wealth, negative
ones reduce it)

It enables projects to be ranked in order of attractiveness. Where a choice
has to be made amongst projects, the business should select the project
with the largest NPV, as this will enhance shareholder wealth more.
Disadvantages of NPV:

The NPV requires the business to calculate an interest rate to use

The NPV calculation is only valid for the interest rate that has been used
36
Internal Rate of Return (IRR)
IRR is similar to NPV in that it also involves discounting cash flows. The IRR is
the discount rate which, when applied to future cash flows, will make them
equate to the initial outlay.

In other words, the IRR is the discount rate, which will have the effect of
producing an NPV equal to zero.

Therefore, if the discount rate is increased sufficiently, eventually a rate
will be identified which will cause the NPV to exactly equal zero at the end
of the project life. This is the IRR
60
50
NPV £'000
40
30
20
IRR
10
10
20
Rate of Return %
When the discount rate is zero, the NPV will be the sum of all the cash flows ie
no account is taken of the time value of money. However, as the discount rate
increases, there is a corresponding decrease in the NPV. When the NPV crosses
the horizontal axis there will be a zero NPV, which equates to the IRR.
Unfortunately, IRR can only be calculated using trial and error!
The calculations for the IRR for Project A have been calculated for you below. A
discount rate of 20% has been identified as the rate which will almost equal zero
by the end of the project life.
37
Project A
Year
Cashflow (x)
Discount Factor (=)
Present
£
20%
£
-240,000
-240,000
60,000
..833
+ 49,980
100,000
..694
+ 69,400
100,000
..579
+ 57,900
80,000
.482
+ 38,560
60,000
..402
+ 24,120
Net Present Value
+ 40
0
1
2
3
4
5

Project B IRR = 15%

Project C IRR = 24%
Where there are competing projects, the one with the highest IRR should be
preferred
Project A
Project B
Project C
PP
ARR
NPV
IRR
Disadvantages of IRR
The main disadvantage of IRR is that it does not address the objective of wealth
maximisation. IRR will always see a return of 30% being preferable to 25%
(assuming that the opportunity cost of finance is lower than this). However the
‘scale of investment’ has been ignored. For example £1m invested at 20% would
make you richer than £0.5m invested at 25%. IRR does not recognise this.
It is preferable to use NPV which is always more reliable and encompassing than
IRR.
38
Risk in Investment Appraisal
Given the nature of capital investments ie typically large outlay with long periods
before returns materialise, if the underlying assumptions are wrong the effect can
be damaging or even catastrophic. So how do you asses the risk involved and
react if it does not go as planned?
In terms of assessing the level of risk, sensitivity analysis should be
considered. This involves a re-assessment of the key assumptions affecting the
project to quantify how the financial performance of the project would be affected
by changes (up and down) in these key assumptions.
Cash Inflows
Sales Prices
and Margins
Project Life
Project
Investment
Operational
Costs
Interest Costs
The process is to test each of the key assumptions to see how changes would
impact on the project, eg. a 10% reduction in the projected cash inflows.
Obviously, these assumptions are not all mutually exclusive and therefore
computer modelling of ‘what if’ is recommended. But, at the end of the day it will
be your judgement (including a view on the non-financial factors) that decides the
level of risk.
39
Risk Analysis
An important component of capital investment appraisal is risk analysis. But what
is risk analysis?
Risk analysis is the process of defining and analysing the dangers to individuals
and businesses posed by potential natural and human-caused adverse events.
Another interpretation could be: the chance of exposure to the adverse
consequences of future events …
The following diagram sets out the process:
1. As a team we need to identify what are the potential risks of the project
investment
2. Assess and classify the risk
3. Decide on how we are going to respond to that risk
4. Review progress and implement measures as and when necessary.
Now let’s put this into action.
Activity: Within your group, identify a potential capital investment programme.
1. Identify the potential risks
2. Assess the risk using the following classification in the probability/impact
matrix below:
40
41
3. Assess how you are going to respond to each risk by selecting one of the
responses below
Response
Avoidance
What this means


Examples
Taking the risk out of the
project altogether
Generally used on RED status
risks




Transference


Mitigation


Transfer the risk to a 3rd party
outside the organisation
Could apply to any High
Impact Risk regardless of
RAG status

Do something to reduce the
probability or impact of the
risk
Good for reducing Red to
Amber or Amber to Green




Acceptance



Accept the risk could happen
and either ignore it or put a
contingency plan in place for
when it occurs
“Ignore” should only be used
for Green status risks
“Contingency” best for Green
status risks but can be
acceptable for Amber. Most
common use is low
probability, high impact risks.

Reduce the scope of the
project to remove the risky
task from it
Buy in specialists to eliminate
a skills gap
Supplement a team to
eliminate a capacity issue
Cancel the project!
Insure against the risk, we do
this without thinking on our
premises burning down!
Use fixed price or shared risk
contracts with 3rd parties
where risk of overspend is
identified (which in turn leads
to other risks)
Introduce QA and Testing
procedures to deal with
product quality risks (Reduces
probability)
Develop change management
processes to reduce risk of
resistance to the project
(Reduces probability)
Bring tasks that could cause
delay forward in the project
schedule (Reduces Impact)
Invest in backup and recovery
solutions as a contingency for
an IT system failure
4. Complete the risk assessment template below
42
Risk
No.
Description of
Risk
Risk
Category
Probability:
H, M, L
Impact:
H, M, L
Response
43
Screening Other Criteria: The Criteria Matrix
Another method for screening decisions is the criteria matrix. An example of this
is presented on the next page. In this scenario, the purchasing department of an
organisation has decided to renew its fleet of 4 wheel drive vehicles. It has
shortlisted 4 vehicles from the original list of ten:

Honda CR –V

Nissan X-Trail

Toyota Rava

Land Rove Freelander
The purchasing team have decided upon the criteria against which each vehicle
will be screened, eg. price, miles per gallon (on an urban basis) and so on. Each
criteria has been weighted with a score out of 10 (ie. the importance attached to
that criterion).
The team will meet together to discuss the 4 options and rate them against the
criteria. Ratings will, in this case, be out of 4 (4 being high). The reason for this
maximum rating is because all the criteria are quantifiable so the vehicle will
either be rated:

Highest = 4 down to

Lowest = 1
Scores will then be awarded by multiplying the weighting against the rating.
Activity: working in pairs, complete the matrix and discuss the results. A note of
caution; be mindful that each criteria needs to be scored in its own right, eg.

Price: the lowest price should achieve the highest rating 4

MPG (urban): the highest MPG should achieve the highest rating 4

Cost per mile: the lowest cost should achieve the highest rating 4

Service intervals: the highest service interval should achieve the highest
rating 4

0 to 60 mph: the quickest acceleration should achieve the highest rating 4.
Sorry ... it’s a bit of a ‘sad’ criterion isn’t it! We haven’t included ‘style’ as a
44
criterion here for obvious reasons, although there would be nothing
stopping you.
45
Price
10
£20,150
£19,800
£19,600
£22,000
MPG
(Urban)
8
35
32
29
28
Cost per
mile
7
45.7p
44.4p
46.0p
43.8p
Service
Intervals
5
12,500
12,000
10,000
15,000
0 to 60
Mph
3
10.5
secs.
12.4
secs.
12.6
secs.
15.2
secs.
Score (W x R)
Rating (R)
Out of 4
Land Rover
Freelander
Score (W x R)
Rating (R)
Out of 4
Toyota Rava
Score (W x R)
Rating (R)
Out of 4
Nissan X-Trail
Rating (R)
Out of 4
Weighting (W)
Honda CR – V
Criterion
Score (W x R)
Criteria Matrix – (for screening financial and non-financial options)
TOTAL
SCORES
46
Management and Control of Investment Projects
We have focused on the appraisal methods used to evaluate projects, but this is only part of
the story. The overall management of projects is also a key role and often overlooked,
particularly in evaluating what happened compared with the original assumptions (the postaudit).
The project investment process can be described in 5 steps as follows:
Step 1
Funds available for projects will be conditioned by borrowing capability as well as internal
funds available.
Step 2
How do you identify profitable project opportunities? The search process should enable and
incentivise staff who have good ideas. This is often dismissed or overlooked. You also need
to look outside the business at technological developments, customer needs, market
conditions etc.
Step 3
The screening of proposals to ensure that they meet the predetermined project criteria is
vital. Key questions that will need addressing are:








Does the project fit within overall objectives?
How will it be funded?
What other resources will be required and timescales?
How long will the project last and what are its key stages?
What is the expected pattern of cash flows?
What are the ‘key sensitivities’ and what if..?
What are the NPV and IRR of the project and how does this compare with other
opportunities available?
What impact will inflation and taxation have on the project?
47
Step 4
Projects that don’t meet the agreed criteria should be rejected, but remember the nonfinancial aspects. Also take into account the exhausted project team, staff morale etc and
ensure they understand/accept why the project was rejected.
Step 5
The oft forgotten step! Managers will need to actively project manage and review progress at
regular intervals. Information will need to be generated that compares actual versus planned
expectations and corrective action taken if required. A number of project management
techniques exist to support this step.
An important part of this step is the ‘post –audit’
Capital investment decisions are made on the basis of estimates (income, expenditure,
timing etc). But how accurate are these estimates? Key questions might be








What was the actual expenditure?
When did the expenditure occur?
Are current estimates of future expenditure still valid?
What was the actual income?
When was the income realised?
Are estimates of future income realistic?
Have the non-financial benefits been realised?
What have we learnt from this project?
Summary
The choice of project will depend on the relative importance to the business of:
 Liquidity
 Profitability
 Cost of capital investment
The PP method will be important where the liquidity characteristics of a project need to be
reconciled with the liquidity position of the business, and speedy cash inflows are the key
requirement for the business. The ARR method will be used where the profitability of a
project is important. The discounted cashflow method will be used where the true economic
value of an investment is important.

All investment methods are based on forecast cashflows – the difficulty is forecasting
accurately.

Remember also that the non-financial features of a project should be taken into
account.
48