Chapter 12a

Capital expenditure budgeting

Capital and revenue expenditure
Capital and revenue income
Overview

Capital expenditure budgeting

Capital vs revenue Budgets

Expenditure Income Other

 Capital and revenue expenditure 1
Capital expenditure

• Acquisition of non-current assets

• Improvement in their earnings capacity
for example, conversion of hand-driven machinery to power-driven machinery and expenditure enabling a firm to
produce a large quantity of goods.
• Treated as non-current assets in the statement of financial position
• Depreciated through the statement of profit or loss
 Capital and revenue expenditure 2
Revenue expenditure

• For purpose of trade

• To maintain asset's existing earnings
• Expensed through the statement of profit or loss
• The correct/consistent calculation of profit depends on the correct/ consistent
classification of items as revenue or capital
Question to consider
Explain briefly the effect on the final accounts if capital expenditure is
treated as revenue expenditure.

If capital expenditure is treated as revenue expenditure, profits will be

understated in the statement of profit or loss and non-current assets
will be understated in the statement of financial position.
Answer
If capital expenditure is treated as revenue expenditure, profits will be
understated in the statement of profit or loss and non-current assets
will be understated in the statement of financial position.
 Capital and revenue income
• Capital income is the proceeds from the sale of non-trading assets.
• Revenue income is derived from
(a) The sale of trading assets
(b) Interest and dividends received from investments held by the business
 Chapter summary
1. Capital versus revenue expenditure
 Capital expenditure involves investment in non-current assets with longer term benefits for
the company, eg new building.
 Revenue expenditure is for the purpose of trade, eg inventories for sale or repairs to existing
assets.

2. Capital versus revenue income

 Capital income is the proceeds from non trading activities, eg selling non-current assets.
 Revenue income comes from trade, eg sales.
Chapter 12b • Project appraisal
• Payback period

Methods of project • The time value of money

• Discounted cash flow
appraisal
 Syllabus learning outcomes
• Explain and illustrate the difference between simple and compound interest, and between
nominal and effective interest rates.
• Explain and illustrate compounding and discounting.
• Explain the distinction between cash flow and profit and the relevance of cash flow to
capital investment appraisal.
• Identify and evaluate relevant cash flows for individual investment decisions.
• Explain and illustrate net present value (NPV) and internal rate of return (IRR) methods of
discounted cash flow.
• Calculate present value using annuity and perpetuity formulae.
• Calculate NPV, IRR and payback (discounted and non-discounted).
• Interpret the results of NPV, IRR and payback calculations of investment viability.
Overview

Methods of project appraisal

Payback NPV IRR

Simple Discounted
Tackling the exam

Example
Question
 The time value of money 1
Would you rather have $1,000 now or $1,000 in one year's time?
Most people would say now.
It can be invested for future enjoyment.
There is less risk if it is taken now – despite hopes and promises it may not appear in a year!
 The time value of money 2
Say current interest rates were 10%.
If $1,000 is offered now or in a year then the choice is really

$1,000 now worth $1,000 now worth

$1,100 in 1 year $1,000 in 1 year

So two amounts of cash, received or paid at different times cannot be directly compared.
They must be adjusted for their different times.
 The time value of money 3
To compare amounts received at different times we convert the amounts as at the present time
– and we call these present values.
To calculate present values you need to understand compounding and discounting.
 The time value of money 4
Compound interest is when the interest accumulates.
Interest is calculated on the original amount and on interest so far.
Eg:
• Year 1 $1,000  10% = $100
• Year 2 $1,100  10% = $110
• Year 3 $1,210  10% = $121

• Or we can use the formula.

 The time value of money 5

S = P(1 + r)n
Where S = future value of investment
P = amount invested now
r = rate of interest
n = number of years of investment

After three years at compound 10%, $1,00 will become:

$1,000  (1 + 0.1)3 = $1,331
Question to consider
$800 is placed on deposit for five years at a rate of interest of 14%
compound.
How much will be in the account at the end of the period?

$800  (1 + 0.14)5 = $1,540.33

Answer
 The time value of money 9
Discounting is the reverse of compounding.
Compounding – find the future value of a sum invested now
Discounting – considers a sum receivables in the1future
2
and establishes its equivalent value
n
today
Remember the compounding formula was:
S = P(1 + r)n
We can rearrange this formula to calculate the amount we would have to invest now to build up
an investment to a particular size.

P = S / (1 + r)n
Where S = future value of investment
P = amount invested now
r = rate of interest
n = number of years of investment
 The time value of money 10
We can use this discounting formula to find a present value.
For example, the present value of $1,000 received at the end of two years using 10% is:
12
$1,000 / 1.12 = $826.45
n

P = S / (1 + r)n
Where S = future value of investment
P = amount invested now
r = rate of interest
n = number of years of investment
Question to consider
What is the present value of $1,000 received at the end of three years
using a 10% interest rate?

$1,000 / (1 + 0.1)3 = $751.31

Answer
 The time value of money 8 – type of interest
A nominal rate of interest is an interest rate expressed as a per annum figure although the
interest is compounded over a period of less than one year.
The corresponding effective rate of interest is the
1 2 annual percentage rate (APR)
n

Eg a bank quotes an annual rate of 12% (nominal) for a loan but it charges interest each quarter.
This means it charges 3% each quarter.
As we saw above, this is equivalent to 12.55%.
 The time value of money 6 - type of interest
When interest is compounded at intervals of less than a year, an effective annual rate can be
worked out as:

12
(1+r) n– 1 Or (1+r)365/x – 1
Where
r is the rate for each time period
n is the number of months in the time period
x is the number of days in the time period
 The time value of money 7 -
So if you were told that interest was calculated at 3% compounded every quarter, the effective
rate would be:
(1 + 0.03)12/3 – 1 = 0.1255 or 12.55% 12
n

Note that this is higher than simply 4  3% as there is compounding within the year.
Example:
 Past exam question
The following question is taken from the June 2012 exam:

An investor has the choice between two investments. Investment Exe offers interest of 4% per
year compounded semi-annually for a period of three years. Investment Wye offers one interest
payment of 20% at the end of its four-year life.
 Past exam question (cont'd)
What is the annual effective interest rate offered by the two investments?
Investment Exe Investment Wye
A 4.00% 4.66%
B 4.00% 5.00%
C 4.04% 4.66%
D 4.04% 5.00%
(2 marks)
 Answer to past exam question
ACCA examining team's comments

The correct answer is C. The answer can be arrived at by calculation (Investment Exe annual
effective return = 1.022 – 1 = 0.0404 or 4.04% and investment Wye annual effective return =
1.200.25 – 1 = 0.0466 or 4.66%). Alternatively the answer can be 'reasoned' out: investment Exe's
semi annual compounding must result in a higher effective annual rate than 4% (2 × 2%) and a
20% return over a four-year period must have an effective annual rate of less than 5% (20% ÷ 4
years) when the compounding effect is allowed for. Just over 32% of candidates incorrectly
selected option D. This suggests that many find it difficult to convert a multi year rate into an
effective annual rate.
 Project appraisal 1
Investment appraisal techniques attempt to give advice about which projects you should invest
in.
Eg, if you had $100,000 how would you invest that?
You need to compare outlay to return.

Example

• If a construction company buys an excavator, the net inflows generated by it will vary from
year to year.
• As the machine ages, maintenance costs will rise and net income will fall. Eventually the
machine will be sold.
• The company needs some way of deciding whether the investment is likely to be worthwhile.
 Project appraisal 2
The key methods of project appraisal are:

• The payback period

• Discounted payback period
• Net present value
• Internal rate of return (IRR)
 Payback period 1
The payback period is the time taken for the initial investment to be recovered in the cash
inflows from the project.
It's particularly relevant if there are liquidity problems, or if distant forecasts are very
uncertain.
It gives greater weight to cash flows generated in earlier years.
 Payback period 2 – even cash flows
Eg, if a machine cost $40,000 and cash inflows generated from its use were $8,000 each year,
the payback would be:
$40,000 / $8,000 = 5 years
Target paybacks vary widely from business to business.
Note that cash flows are used, not profit.
Payback period 3 uneven annual flows
If inflows are irregular you need to keep track of cumulative cash
inflows.
$ Cash flow $ Cumulative cash
Eg: flow
Year 1 (80,000)
Year 1 (60,000)
Year 1 20,000
Year 2 (35,000)
Year 2 25,000
Year 3 0
Year 3 35,000
Year 4 20,000
Year 4 20,000
Year 5 30,000
Year 5 10,000

You can see that the initial outlay has been recouped by the end of Year
3 – a payback of 3 years.
Payback period 4

Example
P
Q
$'000
$'000
Investment 60 60
Year 1 profits 20 50
Year 2 profits 30 20
Year 3 profits 50 5

Q pays back first, but ultimately P's profits are higher on the
same amount of investment.
Question to consider
A machine was bought for $18,000 and can be sold for $3,000 at the
end of its life.
Pre-depreciation earnings for each of the next 8 years are expected to
be $300, $5,700, $4,200, $1,800, $3,900, $2,800, $4,200, $1,800.
What is the payback period in years and months?
Answer
The payback period is 5 years and 9 months.
Year Cash flow Cumulative cash
flow
1 (18,000)
1 300 (17,700)
2 5,700 (12,000)
3 4,200 (7,800)
4 1,800 (6,000)
5 3,900 (2,100)
6 2,800 700

Payback in year 6.
2,100 / 2,800 = 0.75 0.75  12 months = 9 months
Example
Solution
 Payback period 5
Advantages

• Simple to calculate and understand

• Concentrates on short-term, less risky flows
• Can identify quick cash generators
 Payback period 6
Disadvantages

• Ignores total project return

• Ignores time value of money (see next slide)
• Ignores timing of flows after payback period
• Arbitrary choice of cut-off
Discounted payback period
Example-
discounted
payback
period
 Net Present Value Method
The net present value method calculates the present value of all cash flows, and sums them to
give the net present value.
If this is positive, then the project is acceptable.

Eg:
• A machine costs $20,000 and will yield net cash inflows of $8,000, $9,000 and $7,000 at the
end of each of the next three years.
• Is the machine a worthwhile investment?
 Discounted cash flow 3
If no account is taken to timing differences then:

• Cost = $20,000
12
• Cash inflows = $24,000 n

However we know that it is not valid to compare the cash flows without adjusting for different
timings.
 Discounted cash flow 4
Time 0 means now.
A discount factor of 1 means no discount (because it is now). (Discount factor = 10%)
12
Time Cash flow Discount Present
n
(A) factor (B) value
(AB)
0 (20,000) 1 (20,000)

1 8,000 1 / 1.1 7,273

2 9,000 1 / 1.12 7,438

3 7,000 1 / 1.13 5,259

NPV: (30)

The present values are added to give an NPV of ($30).

As this is negative, the machine purchase is not worthwhile.
 Discounted cash flow 5
To make discounted cash flow calculations easier we use discount tables.
These will be provided in the exam and look similar to this.
12
Period 1% 2% 3% 4% 5% n 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909

2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826

3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
 Discounted cash flow 6
So if we had used the tables in our previous example, it would have looked like this:

Time Cash flow (A) 1 2Discount Present

nfactor (B) value (AB)
0 (20,000) 1 (20,000)

1 8,000 0.909 7,272

2 9,000 0.826 7,434

3 7,000 0.751 5,257

NPV: (37)
• You can see that this gives a slightly different NPV.
 Tackling the exam

In the exam always use the discount factor tables where possible.
 Discounted cash flow 7
Annuities and perpetuities:

• Annuities are an annual cash payment or receipt which is the same amount every year for a
12
number of years. n
• Eg a cash flow of $8,000 every year
Time Cash flow (A) Discount Present
factor (B) value (AB)
0 Nil 1 Nil
1 8,000 0.909 7,272
2 8,000 0.826 6,608
3 8,000 0.751 6,008
NPV: 19,888
 Discounted cash flow 8
Annuities and perpetuities:

• This is the same as

12
$8,000  (0.909 + 0.826 + 0.751) = $8,000n  2.486 = $19,888
Time Cash flow (A) Discount Present
factor (B) value (AB)
0 Nil 1 Nil
1 8,000 0.909 7,272
2 8,000 0.826 6,608
3 8,000 0.751 6,008
NPV: 19,888
 Discounted cash flow 9
Annuities and perpetuities:

• This is the same as

12
$8,000  (0.909 + 0.826 + 0.751) = $8,000  2.486
n
= $19,888

Or, we could use the annuity tables and look up the annuity factor for three years at 10%.
The table gives us 2.487.
Notice that this is slightly different from adding up the discount factors individually.
 Question to consider
A project would involve a capital outlay of $120,000. Profits (before
depreciation) would be $30,000 per year. The cost of capital is 12%.
Would the project be worthwhile if it lasts:

(a) Five years

(b) Seven years
Answer
If the project lasts five years, it will not be worthwhile.

Years Cash flow Discount factor Present value

$ 12% $
0 (120,000) 1.000 (120,000)
1–5 30,000 pa 3.605 108,150
NPV (11,850)
Answer (cont'd)

If the project lasts seven years, it will be

worthwhile.

Years Cash flow Discount factor Present value

$ 12% $
0 (120,000) 1.000 (120,000)
1–7 30,000 pa 4.564 136,920
NPV 16,920
Annuities and perpetuities:
•
Discounted cash flow 10
You may get a question with a more complicated annuity.
• Eg what is the present value of $10,000 costs incurred each year from years 3 to 6 when the cost of capital is 10%?
• We need to take the annuity factor for years 1 to 6 and deduct the annuity factor for years 1 to 2. This will give us a factor for
years 3 to 6 only.

12
n
 Discounted cash flow 11
What is the present value of $10,000 costs incurred each year from years 3 to 6 when the cost of capital is
10%?

• Annuity factor for years 1 to 6 4.355

• Less annuity factor for years 1 to 2 (1.736)
• Annuity factor for years 3 to 6 2.619

• PV of costs = $10,000  2.619 = $26,190

• A perpetuity is an annuity that lasts forever.
• Discounted cash flow 12
The present value of a perpetuity of 'a' per annum, commencing in one year, is PV = a / r
where r is the cost of capital as a proportion.
Example
 Example
• A perpetuity of $2,000 is due to commence immediately. The interest rate is
9%. What is the PV?
 Discounted cash flow 13
The internal rate of return (IRR) technique uses a trial and error method to discover the
discount rate which produces the NPV of zero.
12
n
The internal rate of return method of DCF involves two steps.

• Calculating the rate of return which is expected from a project

• Comparing the rate of return with the cost of capital
 Discounted cash flow 14
• IRR = Aa+  ( B  A)

 a  b 
12
• Where A is the discount rate which provides the positive NPV
n
• a is the amount of the positive NPV
• B is the discount rate which provides the negative NPV
• b is the amount of the negative NPV
 Discounted cash flow 15
NPV and IRR comparison

• For conventional cash flows both methods give the same decision
12
n
NPV

• Simpler to calculate
• Better for ranking mutually exclusive projects
• Easy to incorporate different discount rates
 Discounted cash flow 16
IRR

• More easily understood

12
• Ignores relative size of investments n

• May be several IRRs if cash flows not conventional

 Discounted cash flow 17
Discounted payback method

• The discounted payback method applies discounting to arrive at a payback period after
which the NPV becomes positive.
• It is an adaptation of the payback technique.
• It takes some account of the time value of money.
• To calculate the discounted payback period, we establish the time at which the net present
value of an investment becomes positive.
 Discounted cash flow 18
For example:

Time Cash flow (A) Discount Present value Cumulative

factor (B)
12 (AB) PV
n
0 (20,000) 1 (20,000) (20,000)

1 8,000 0.909 7,272 (12,728)

2 9,000 0.826 7,434 (5,294)

3 8,000 0.751 6,008 714

Discounted payback = 2 years + 5,294 / 6,008
= 2.9 years
NPV: 714
 Discounted cash flow 19
Note
The discounted payback fails to take account of positive cash flows occurring after the end of the payback period.
 Discounted cash flow 20
Relevant costs

• Avoidable cost – is a cost which would not be incurred if the activity to which it related did not exist
• Opportunity cost – benefit which would have been earned but which was given up, by choosing one
option instead of another
• Differential cost – is the difference in the cost of alternatives
• Controllable costs – an item of expenditure which can be directly influenced by a given manager
within a given time span
 Discounted cash flow 21
Non-relevant costs

12
• Sunk cost – past (historical) cost which is not directly relevant in decision making
n
• Fixed costs – unless given an indication to the contrary, assume fixed costs are irrelevant and
variable costs are relevant
• Direct and indirect costs may be relevant or irrelevant depending on the situation
 Past exam question
The following question is taken from the June 2013 exam:

A project has an initial outflow of $12,000 followed by six equal annual cash inflows,
commencing in one year's time. The payback period is exactly four years. The cost of capital is
12% per year.
What is the project's net present value (to the nearest $)?
A $333
B -$2,899
C -$3,778
D -$5,926
(2 marks)
 Answer to past exam question
ACCA examining team's comments

The correct answer is A.

A four-year payback period implies an (equal) annual cash flow of $12,000 ÷ 4 years = $3,000
per year. As these cash flows run for 6 years the NPV is equal to $333 ( – $12,000 + annuity
factor for 6 years @
12% × $3,000 = – $12,000 + 4.111 × $3,000 = $333).
Chapter summary 1
1. Payback period
 Time taken for cash flows to repay the initial investment.

2. Time value of money

 Compensation for the time value of money, recognising that $ today is
worth more than $ in the future, due to inflation, interest and risk.

3. Compounding
 Earning interest on interest already received. Considered non annual
rates of interest – equivalent rates (EAR).

4. Discounted cash flows

 Opposite of compounding, using tables or formula.
Chapter summary 2
5. Net present value
 The net total of the discounted cash flows of the project.

6. Annuities
 A constant sum of money for a fixed period of time, the present
value is calculated using the cumulative discount tables.
 Loan repayments, which included the annuities and the interest.
 Perpetuities – annuity paid or received forever.

7. Internal rate of return

 The discount rate that gives a NPV of zero.