ARR Calculation: Invest Limited

(financial figures in £000)

Assume depreciation is straight line over: 4 years

Thus annual depreciation is investment in equipment is: 25
Deduct from operational cash flows to obtain forecast annual profits:
Annual cash flows -100 36 60 42 10
less Depreciation -25 -25 -25 -25
Operating Profit 11 35 17 -15

Average Profit 12 Average Profit 12

Average Investment -50 OR Initial Investment -100
ARR 24% ARR 12%

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PAYBACK Calculation: Invest Limited
(financial figures in £000)
All in £000
Item Year 0 1 2 3 4
Investment -100
Net cash flows 36 60 42 10
Annual cash flows -100 36 60 42 10
Cumulative -100 -64 -4
Payback is in Year 2
64 60
3.07 years
Payback is in 3rd Year
2 + 4/42 = 2.09 years

MAD L5 2
 NPV Calculation: Invest Limited
(financial figures in £000)

Annual cash flows -100 36 60 42 10

Discount factor 15% 1 0.870 0.756 0.658 0.572
PV -100 31.32 45.36 27.636 5.72
NPV 10.036

As this is positive, this means that the

expectations have not only been met but
exceeded.

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Exercise 6.1: Mylo Limited in text book
Payback and NPV - both cash-based
Half of you do Project , and half do Project
2
A & M QUESTION 8.1 MYLO LIMITED - CALCULATING PAYBACK, and NPV
DISCOUNTING AT COST OF CAPITAL OF 10% ALL FIGURES IN £000s
NOTE THAT THE PROFIT NEEDS TO BE CONVERTED TO 0 1 2 3
CASH BY ADDING BACK THE NON CASH ITEM DEPRECIATION
NET PROFIT/(LOSS) 29 -1 2
ADD BACK DEPRECIATION 31 31 31
CASH FLOWS (INCLUDING INVESTMENT IN PROJ ECT AT TIME ZERO) -100
RESIDUAL VALUE AT END OF PROJ ECT 7
INCREMENTAL CASH FLOWS -100 60 30 40
CUMULATIVE CASH SHORTFALL AT END OF EACH YEAR -100 -40 -10 30
PAYBACK IS in 3RD YEAR - 2.25 YRS (BEING 1 YR x 10/40)
DISCOUNT FACTOR @ 10% APPLIED TO CASH FLOWS 1 0.909 0.826 0.751
PRESENT VALUES -100.00 54.54 24.78 30.04
NPV 9.36

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IRR Calculation
FOR INTERNAL RATE OF RETURN TRY USING 25%
Annual cash flows -100 36 60 42 10
Discount factor 20% 1 0.800 0.640 0.512 0.410
PV -100 28.8 38.4 21.504 4.1
NPV -7.196

ORIGINAL NPV AT 15% 10.036

NPV AT 25% -7.196
SPREAD OF NPVs 17.232

ORIGINAL NPV 10.036

SPREAD OF NPVs 17.232
ORIGINAL/SPREAD 0.582405
GAP BETWEEN DISCOUNT RATES 10%
ORIGINAL/SPREAD X GAP 5.82%
PLUS ORIGINAL DISCOUNT RATE 15%
IRR 20.82%

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 Exercise 6.1: Mylo Limited IRR
IRR PROJ ECT 1 USING 20% TO CALCULATE NPV, IN £000 0 1 2 3
INCREMENTAL CASH FLOWS -100 60 30 40
DISCOUNT FACTOR @ 20% 1 0.833 0.694 0.539
PRESENT VALUES -100 49.98 20.82 21.56
NPV -7.64
IRR INTERPOLATION
CALCULATION
SPREAD 9.36 +7.64 0.551 10% SPREAD
IRR% PROJ ECT 1 = 5.51 15.51%

IRR PROJ ECT 2 USING 20% TO CALCULATE NPV, IN £000 0 1 2 3

INCREMENTAL CASH FLOWS -60 36 16 28
DISCOUNT FACTOR @ 20% 1 0.833 0.694 0.539
PRESENT VALUES -60 29.99 11.10 15.09
NPV -3.816
IRR INTERPOLATION
CALCULATION
6.97 6.97 0.65 10% SPREAD
6.97 PLUS - 3.816 10.78 6.46 16.46%
IRR PROJ ECT 2 16.46%

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 More Work! Exercise 6.2 Page 230

Exercise6.2
ArkwrightMills
0 1 2 3 4 5 6
£m £m £m £m £m £m £m
Investment -1
Operating profit 0.2 0.3 0.3 0.3 0.3
Add back depreciation assume straight line 0.2 0.2 0.2 0.2 0.2
Corporation tax @ 20% of profits -0.04 -0.06 -0.06 -0.06 -0.06
Working capital -0.6 0.6
Cashflows -1.6 0.4 0.46 0.44 0.44 1.04 -0.06
Cumulative cash flows -1.6 -1.2 -0.74 -0.3 0.14 1.18
Payback 3.87 years

Cash flows -1.6 0.4 0.46 0.44 0.44 1.04 -0.06

Discount @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564
Presentvalues -1.6 0.364 0.380 0.330 0.301 0.646 -0.034
NPV 0.387

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1. C. George (Controls) Limited

Many of the incremental cash flows are easily

identified.
There are two key challenges:
 Calculating the savings in variable costs (which
as savings are relevant costs and thus
incremental cash flows)
 Any values to be included in the incremental
cash flows connected to the existing
equipment.
 The treatment of the working capital.
C. George (Controls) Limited

Savings in Variable Costs (based on stable

production/sales of 50,000 units annually)
C. George (Controls) Limited

Cash flows associated with existing

equipment
We could sell it in in 4 years time for £40,000.
If we go ahead with the project we will sell it
at Time Zero (before operations commence)
for £150,000 – clearly an incremental cash
flow...BUT…
By selling it at Time Zero we forego, we give
up, the £40,000 in 4 years time.
Accordingly, that £40,000 is an opportunity
cost of going ahead with the project, a
negative figure at the end of Year 4.
C. George (Controls) Limited
Treatment of Working Capital
Often a scenario will identify a need for extra
working capital to be set aside (see Exercise 6.2
Arkwright Mills – answer on Mad Moodle Week 8
Tab).
For example, it might say that £130,000 working
capital funding needs to be set aside at Time
Zero to support new activities: that will be a
negative incremental cash flow figure at Time
Zero.
At the end of the project that funding would be
released: it would be shown as £130,000 positive
incremental cash flow figure at the end of the
C. George (Controls) Limited

Treatment of Working Capital

This scenario says that inventories will be
reduced by £130,000 as a result of going
ahead with the project.
That figure is a saving and is thus a positive
figure of £130,000 at Time Zero.
Unfortunately that saving will no longer exist
after the end of the project and thus the
impact of the saving will have to be reversed:
there will be a negative incremental cash flow
figure of £130,000 at the end of Year 4.
C. George (Controls) Limited

Incremental cash flows 20 marks available in

total – with 11 marks
available on this page

3
1 1
1 1
2 2
C. George (Controls) Limited

Discounting incremental cash flows at 12%

4 CFO

1
C. George (Controls) Limited

Cash v Profit in CAPEX

0,1,2, 3 or 4 marks

The details above adds a further perspective to the generic

reason for preferring Cash to Profit as an assessment tool
which is Profit is ‘dodgy’ Cash is more certain.