Chapter 21
Long-term decision making: Capital investment appraisal
Learning Outcomes
After completing this chapter you should be able to:
- Introduce and explain the nature of capital investment.
- Outline the main capital investment appraisal techniques.
- Appreciate the time value of money.
- Explain the use of discounting.
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Chapter Summary
- Capital investment decisions are long-term, strategic decisions, such as building a new factory.
- Capital investment decisions involve initial cash outflows and then subsequent cash inflows.
- Many assumptions underpin these cash inflows and outflows.
- There are five main capital investment techniques. Two (payback and accounting rate of return) do not take into account the time value of money. Three do (net present value, profitability index and internal rate of return).
- Payback is the simplest method. It measures how long it takes for a company to recover its initial investment.
- The accounting rate of return uses profit not cash flow and measures the annual profit over the initial capital investment.
- The profitability index is similar to NPV. It compares the total NPV cash flows with the initial investment.
- Net present value discounts estimated future cash flows back to today's values.
- Internal rate of return establishes the discount rate at which the project breaks even.
- Sensitivity analysis is often used to model future possible alternative situations.
Introduction
Management accounting can be divided into cost recovery and control, and decision making. In turn, decision making consists of short-term and long-term decisions. Whereas strategic management sets the overall framework within which the long-term decisions are made, capital investment appraisal involves long-term choices about specific investments in future projects. These projects may include, for example, investment in new products or new infrastructure assets. Without this investment in the future, firms would not survive in the long term. However, capital investment decisions are extremely difficult as they include a considerable amount of crystal ball gazing. This chapter looks at five techniques (the payback period, the accounting rate of return, net present value, the profitability index and the internal rate of return) which management accountants use to help them peer into the future.
Nature of Capital Investment
Capital investment is essential for the long-term survival of a business. Existing property, plant and equipment, for example, wears out and needs replacing. The capital investment decision operationalises the strategic, long-term plans of a business. As Figure 21.1 shows, long-term capital expenditure decisions can be distinguished from short-term decisions by their time span, topic, nature and level of expenditure, by the external factors taken into account and by the techniques used.
Capital budgeting is a term which is often used for capital investment decisions. As Real-World View 21.1 shows, there is a distinct difference between capital and operating expenditures.
REAL-WORLD VIEW 21.1Capital and Operating Expenditures
Capital budgeting refers to the planning and control process associated with capital expenditures. Capital expenditures, often referred to as capital investments, are expenditures for projects not intended for immediate consumption. Accordingly, capital expenditures increase, or at least maintain, the capital assets of an organization. The term capital assets as used above, refers to what economists usually call capital goods … Accountants usually refer to capital assets as fixed assets [property, plant and equipment].
In contrast to capital expenditures, operating expenditures relate to items that will only benefit the current operating period. Technically speaking, capital and operating expenditures are costs in that they both require the use of resources. Operating expenditures are usually thought of as an expense because the resources are consumed during the current period and the associated benefits are also assumed to be derived during the current period. Capital expenditures are treated as investments because the resources, or at least part of them, are not consumed during the current period and the benefits derived from such resources are received over more than the current period. However, the proportion of capital investments consumed (i.e., the proportion of capital consumption) during the acquisition period becomes an operating expenditure.
Source: Abridged from L.A. Gordon, M.P. Loeb and C.Y. Tseng (2005), Capital budgeting and informational impediments: a management accounting perspective in A. Bhimani Contemporary Issues in Management Accounting.
Capital investment decisions are thus usually long-term decisions, which may sometimes look 10 or 20 years into the future. They are often the biggest expenditure decisions that a business faces. Some examples of capital investment decisions might be deciding whether or not to build a new factory or whether to expand into a new product range. A football club, such as Manchester United, for example, might have to decide whether or not to build a new stadium. A common capital expenditure decision will involve choosing between alternatives. For example, which of three particular stadiums should we build? Or which products should we currently develop for the future? These decisions are particularly important given the fast-changing world.
A key problem with any capital investment decision is taking into account all the external factors and correctly forecasting future conditions. As the quotation by A.J.P. Taylor at the start of the chapter stated: ‘There are no maps to the future.’ In Real-World View 21.2 Peter Aytan wonders why everything takes longer to finish and costs more than originally budgeted.
Forecasting the Future
Trouble ahead
Why does everything take longer to finish and cost more than we think it will? The Channel Tunnel was supposed to cost £2.6 billion. In fact, the final bill came to £15 billion. The Jubilee Line extension to the London Underground cost £3.5 billion, about four times the original estimate. There are many other examples: the London Eye, the Channel Tunnel rail link.
This is not an exclusively British disease. In 1957, engineers forecast that the Sydney Opera House would be finished in 1963 at a cost of A$7 million. A scaled-down version costing A$102 million finally opened in 1973. In 1969, the mayor of Montreal announced that the 1976 Olympics would cost C$120 million and ‘can no more have a deficit than a man can have a baby’. Yet the stadium roof alone – which was not finished until 13 years after the games – cost C$120 million.
Source: Trouble Ahead, Peter Aytan, New Scientist, 29 April 2000, vol. 166, no. 2236, p. 43. © 2000 Reed Business Information Ltd, England. Reproduced by permission. http://www.newscientist.com/article/mg16622364.600-trouble-ahead.html
The basic decision is simply whether or not a particular capital investment decision is worthwhile. In business, this decision is usually made by comparing the initial cash outflows associated with the capital investment with the later cash inflows. We can distinguish between the initial investment, net cash operating flows for succeeding years and other cash flows.
(i) Initial Investment
This is our initial capital expenditure. It will usually involve capital outflows on infrastructure assets (for example, buildings or new plant and machinery) or on working capital. This initial expenditure is needed so that the business can expand.
PAUSE FOR THOUGHT 21.1A football club is contemplating building a new stadium. What external factors should it take into account?
There are countless factors. Below are some that might be considered.
- How much will the stadium cost?
- How many extra spectators can the new stadium hold?
- How much can be charged per spectator?
- How many years will the stadium last?
- What is the net financial effect when compared with the present stadium?
- How confident is the club about future attendance at matches?
(ii) Net Cash Flows
These represent the operating cash flows expected from the project once the infrastructure assets are in place. Normally, we talk about annual net cash flow. This is simply the cash inflows less the cash outflows calculated over a year. For convenience, cash flows are usually assumed to occur at the end of the year.
(iii) Other Flows
These involve other non-operating cash flows. For example, the taxation benefits from the initial capital expenditure or the cash inflow from scrap.
Assumptions in Capital Investment Decisions
A big problem in any capital investment decision is the assumptions that underpin it. Can you think of any of these?
- Costs of initial outlay
- Tax effects
- Cost of capital
- Inflation
- Cash inflows and outflows over period of project.
These, in turn, may depend on pricing policy, external demand, value of production etc.
Capital Investment Appraisal Techniques
Capital investment decisions (i.e., the capital budgeting process) need to be planned and co-ordinated (see Soundbite 21.1). Probably the key way by which this can be done is using capital investment appraisal techniques.
SOUNDBITE 21.1Capital Budgeting
‘Capital budgeting serves to plan, coordinate, and motivate activities throughout an organisation. The budgeting process defines a set of rules to govern the way in which managers at different levels of the hierarchy produce and share information about investment projects.’
Source: T. Pfeiffer and G. Schneider (2010) Capital Budgeting, Information Timing, and the Value of Abandonment Options, Management Accounting Research, 21, p. 238.
The five main techniques used in capital investment decisions are payback period, accounting rate of return, net present value, profitability index and internal rate of return. An overview of these five techniques is presented in Figure 21.2. These techniques are then discussed below. However, it is important to appreciate that, in practice, multiple approaches are used and that different companies will use the techniques in different ways.
It is important to realise that the payback period and the accounting rate of return take into account only the actual cash inflows and outflows. However, net present value, the profitability index and the accounting rate of return take into account the time value of money.
Time Value of Money
Why do you think it is important to take into account the time value of money?
There is an old saying that time is money! In the case of long-term capital investment decisions, it certainly is. Would you prefer £100 now or £100 in 10 years’ time? That one is easy! But what about £100 now or £150 in five years’ time? There is a need to standardise money in today's terms. To do this, we need to attribute a time value to money. In practice, we take this time value to be the rate at which a company could borrow money. This is called the cost of capital. If our cost of capital is 10%, we say that £100 today equals £110 in one year's time, £121 in two years’ time and so on. If we know the cost of capital of future cash flows we can, therefore, discount them back to today's cash flows.
As Real-World View 21.3 shows, amounts spent yesterday can mean huge sums today. Compounding is the opposite of discounting! If we discounted the $136,000,000,000 dollars back from 1876 to 1607 using a 10% discount rate we should arrive at one dollar.
Compound Growth
Compound Interest
From a speech in Congress more than 100 years ago:
It has been supposed here that had America been purchased in 1607 for $1, and payment secured by bond, payable, with interest annually compounded, in 1876 at ten percent, the amount would be – I have not verified the calculation – the very snug little sum of $136,000,000,000; five times as much as the country will sell for today. It is very much like supposing that if Adam and Eve have continued to multiply and replenish once in two years until the present time, and all their descendants had lived and had been equally prolific, then, saying nothing about twins and triplets, there would now be actually alive upon the earth, a quantity of human beings in solid measure more than thirteen and one-fourth times the bulk of the entire planet.
Source: Peter Hay (1988), The Book of Business Anecdotes, Harrap Ltd, London, p. 10.
Each of the five capital investment appraisal techniques is examined using the information in Figure 21.3.
Figure 21.3 Illustrative Example of a Financial Service Company Wishing to Invest in a New On-Line Banking Service
Payback Period
The payback period (see Definition 21.1) is a relatively straightforward method of investment appraisal. It simply measures the cumulative cash inflows against the cumulative cash outflows until the project recovers its initial investment. The payback method is useful for screening projects for an early return on the investment. Ideally, it should be complemented by another method such as net present value. In a study of 14 UK and US companies Carr, Kolehmainen and Mitchell (Management Accounting, 2010, pp. 167–84) found that payback was frequently used with the payback target being between 2.5 to 5 years across 14 UK, US and Japanese companies.
DEFINITION 21.1Payback Period
The payback period simply measures the cumulative cash inflows against the cumulative cash outflows. The point at which they coincide is the payback point.
Specific advantages
- Easy to use and understand.
- Conservative.
Specific disadvantages
- Fails to take into account cash flows after payback.
- Does not take into account the time value of money.
Taking Everfriendly Bank's Falcon project, when do we recover the £20 million? Figure 21.4 shows this is after 3.67 years for project A, 3 years for project B and 2.67 years for project C.
Payback is a relatively straightforward investment technique. It is simple to understand and apply, and promotes a policy of caution in the investment decision. The business always chooses the investment which pays off the initial investment the most quickly. However, although useful, payback has certain crucial limitations.
Limitations of Payback
Can you think of any limitations of payback?
Two of the most important limitations of payback are that it ignores both cash flows after the payback and the time value of money. Thus, a project may have a slow payback period, but have substantial cash flows once it is established. These will not be taken into account. In addition, cash flows in later years are treated as being the same value as cash flows in early years. This ignores the time value of money and may distort the capital investment decision.
Accounting Rate of Return
This method, unlike the other three methods, focuses on the profitability of the project, rather than its cash flow. At its simplest, cash flows less depreciation will equal profit. Thus it is distinctly different in orientation from the other methods. The basic definition of the accounting rate of return is:
However, once we look more closely we run into potential problems. What exactly do we mean by ‘profit’ and ‘capital investment’? For profit, do we take into account interest, taxation and depreciation? For capital investment, do we take the initial capital investment or the average capital employed over its life? Different firms will use different versions of this ratio. In this book, profit before interest and taxation, and initial capital investment are preferred (see Definition 21.2). However, a common alternative is average capital investment. This is because it is similar to conventional accounting ratios and seems logical! The accounting rate of return is easy to understand and use. Its main disadvantages are that profit and capital investment have many possible definitions and, like payback, the accounting rate of return does not take into account the time value of money.
Accounting Rate of Return
Accounting rate of return is a capital investment appraisal method which assesses the viability of a project using annual profit and initial capital invested. There are several ways of defining it. For example, the average annual profit divided by the average capital investment. Our preferred definition is:
Specific advantages
- Takes the whole life of a project.
- Similar to normal accounting ratios.
Specific disadvantages
- Many definitions of profit and capital investment possible.
- Does not consider the time value of money.
- Measures an initial cash flow using a profit measure.
The accounting rate of return is applied to the Everfriendly Bank in Figure 21.5.
Returns on investment are treated very seriously by businesses. In Real-World View 21.4, Vodafone has a projected rate of return of at least 15% on its capital investment. However, it is not absolutely clear from the press extract whether it has used the accounting rate of return.
Rates of Return
Rates of Return are of key interest to businesses. Dan Roberts looked at Vodafone AirTouch. Its finance director Ken Hydon indicated that its estimated future rate of return was at least 15% and added that:
‘Although the £6 bn cost of Vodafone's new UK licence will be spread over its 20-year lifespan, most of the estimated £4 bn network spending and handset subsidy will be required in the first four or five years’.
Source: Dan Roberts, Telecommunications group releases internal targets to counter criticism it overpaid for licence, Financial Times, 31 May 2000.
Net Present Value
The net present value, profitability index and internal rate of return can be distinguished from the payback period and accounting rate of return because they take into account the time value of money. Essentially, time is money. If you invest £100 in a bank or building society and the interest rate is 10%, the £100 is worth £110 in one year's time (100 × 1.10), and £121 in two years’ time (100 × 1.102, or 110 × 1.10).
We can use the same principle to work backwards. If we have £110 in the bank in a year's time with a 10% interest rate, it will be worth £100 today (£110 × 0.9091, i.e. 100 ÷ 110). Similarly, £121 in two years’ time would be worth £100 today (£121 × 0.8264, i.e. 100 ÷ 121).
Discounting
You are approached by your best friend, who asks you to lend her £1,000. She promises to give you back £1,200 in two years’ time. Your money is in a two-year fixed ecological bond and earns 6%. Putting friendship aside, do you lend her the money?
To work this out, we need to compare like with like. We could either work forwards (i.e., multiplying £1,000 by the 6% earned over two years (1.062) = £1,123.60). £1,000 today is worth £1,123.60 in two years’ time. Or more conventionally, we work back from the future using the time value of money, in this case 6%.
Therefore, as £1,200 in two years’ time is the equivalent of £1,068 today you should accept your friend's offer as this is £68 more than you currently have.
Fortunately, we do not have to calculate discount rates all the time! We use discount tables (see Appendix 21.1 at the end of this chapter). So to obtain a 10% interest rate in two years’ time, we look up the number of years (two) and the discount rate (10%). We then find a discount factor of 0.8264!
As Definition 21.3 shows, net present value uses the discounting principle to work out the value in today's money of future expected cash flows. Cash flows are normally determined by the rate at the end of the year. The cost of capital is used as the discount rate. Conventionally, the cost of capital is taken as the rate at which the business can borrow money. However, the estimation of the cost of capital can be quite difficult. In Chapter 22 we look in more detail at how companies can derive their cost of capital. Cost of capital is a key element of capital investment appraisal. Essentially, a business is seeking to earn a higher return from new projects than its cost of capital. If this is achieved, the projects will be viable. If not, they are unviable.
Net Present Value
Net present value is a capital investment appraisal technique which discounts future expected cash flows to today's monetary values using an appropriate cost of capital.
Specific advantages
- Looks at all the cash flows.
- Takes into account the value of money.
Specific disadvantages
- Estimation of the cost of capital may be difficult.
- Assumes all cash flows occur at the end of a period (normally a year).
- Can be complex.
Behavioural factors can also play their part in making a decision. For instance, Graham Cleverly (Managers and Magic, 1971, p. 86) commented:
If a company decides it will only go ahead with projects that show a discounted return on investment of better than 15 per cent, anyone putting forward a project will ensure that the accompanying figures indicate a better than 15 per cent return.
Additionally, he went on to state:
If the criterion is raised to 20 per cent, the figures will be improved accordingly. And there is no way in which the person analysing the project can contest those figures – unless he can find a flaw in the performance of the projection rituals.
Figure 21.6 applies net present value to the Everfriendly Bank.
When using net present value, it is useful to follow the steps in Helpnote 21.1.
HELPNOTE 21.1Calculating Net Present Value
- Calculate initial cash flows.
- Choose a discount rate (usually given), normally based on the company's cost of capital.
- Discount original cash flows using discount rate.
- Match discounted cash flows against initial investment to arrive at net present value.
- Positive net present values are good investments. Negative ones are poor investments.
- Choose the highest net present value. This is the project that will most increase the shareholders’ wealth.
Discount Tables
Using the discount tables given in Appendix 21.1, what are the following discount factors:
(i) 8% at 5 years, (ii) 12% at 8 years, (iii) 15% at 10 years, (iv) 20% at 6 years, and (v) 9% at 9 years.
From Appendix 21.1, we have
(i) 0.6806; (ii) 0.4039; (iii) 0.2472; (iv) 0.3349; (v) 0.4604
In practice, calculating net present values becomes very complicated. For example, you have to take into account taxation, inflation, etc. However, net present value is a very versatile technique, allowing you to determine which projects are worth investing in and to choose between competing projects.
Profitability Index
In a sense, the profitability index can be seen as an extension of NPV. It uses the figures derived from NPV calculations to produce a simple index that can be used to evaluate profits. It can thus be seen as a method of interpreting NPV. The Profitability Index is normally defined as:
If the cash flows are more than the initial investment the index is, therefore, above 1. The project should thus be accepted. By contrast, if the cash flows are less than the initial investment, the index is less than 1. The project should thus be rejected. If we look at the Everfriendly Bank then we have the following situation (see Figure 21.7).
In this case, using the company's cost of capital as the discount rate, we would choose project C as the profitability index is the highest. However, in cases where the NPV of the cash flows gave a different result from the profitability index, we would go with the investment which generated the greatest NPV in terms of cash flow. The profitability index can be useful in circumstances where it is necessary to choose between many different projects with positive NPVs, for example, when funds are short. Usually, we use the company's cost of capital as the discount rate.
Internal Rate of Return (IRR)
The internal rate of return is a more sophisticated discounting technique than net present value. As Definition 21.4 shows, it can be defined as the rate of discount required to give a net present value of zero. Another way of looking at this is the maximum rate of interest that a company can afford to pay without suffering a loss on the project. Projects are accepted if the company's cost of capital is less than the IRR. Similarly, projects are rejected if the company's cost of capital is higher than the IRR. The advantages of the internal rate of return are that it takes into account the time value of money and calculates a break-even rate of return. However, it is complex and difficult to understand. In a study of 14 UK and US companies Carr, Kolehmainen and Mitchell (Management Accounting, 2010, pp. 167–84) found that across 14 UK, US and Japanese companies the average IRR target ranged from 16–22% with a premium over cost of capital of between 6.3% and 9.5%.
The Internal Rate of Return (IRR)
‘Annual percentage return achieved by a project at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the discounted cash outflows. It pays a company to invest in a project if it can borrow money for less than the IRR (CIMA (2005) Official Terminology).
Specific advantages
|
Specific disadvantages
|
Source: Chartered Institute of Management Accountants (2005), Official Terminology. Reproduced by Permission of Elsevier.
When calculating the IRR, there are four main steps. These are shown in Helpnote 21.2.
Calculating the Internal Rate of Return (IRR)
- Calculate a positive NPV for all projects.
- Calculate a negative NPV for all projects. Use trial and error. The higher the discount rate, the lower the NPV.
- Calculate out the IRR using the formula:
- Choose the project with the highest IRR. When evaluating a single project, the project will be chosen when its IRR is higher than the company's cost of capital.
The relationship of the internal rate of return to net present value is shown in Figure 21.8 and the internal rate of return is then applied to the Everfriendly Bank in Figure 21.9.
The IRR can be a very useful technique. However, the complexity is often off-putting. In practice, students will be pleased to learn that the calculations to arrive at the IRR are generally done using a computer program. Normally, the results from NPV and IRR will be consistent. However, in some cases, such as projects with unconventional cash flows (e.g., alternating cash inflows and outflows), the NPV and IRR may give different results. In these cases, NPV is probably the most reliable. This is particularly true when there are mutually exclusive projects with a different IRR.
If there was a clash between the results from the different methods then it would be difficult to choose. Different businesses will prefer different methods depending on their priorities. I would probably choose net present value as the superior method. This is because it takes into account the time value of money, is more reliable, and is easier to understand and use than the internal rate of return.
Now that we have calculated the results for the Everfriendly Bank using all four methods, we can compare them (see Figure 21.10). Project C is clearly the superior method.
Before we leave the capital investment appraisal techniques, it is important to reiterate that the results achieved will only be as good as the assumptions that underpin them. This is powerfully expressed by Graham Cleverly (1971) on p. 86 of Managers and Magic:
Where the validity of one's original information is suspect, performing ever more sophisticated calculations seems pointless. Nonetheless, there can hardly be a company in which new projects are not required to be subjected to a ritual calculation of the ‘internal rate of return’, ‘net present value’, ‘payback period’ or some other criterion of profitability.
However, in the majority of cases those involved are themselves not convinced of the validity of the data.
Other Factors
There are many other factors that affect capital investment appraisal. Below we discuss three of the most important: sensitivity analysis, inflation and taxation.
1. Sensitivity analysis
The assumptions underpinning the capital investment decision mean that it is often sensible to undertake some form of sensitivity analysis. Sensitivity analysis involves modelling the future to see if alternative scenarios will change the investment decision. For example, a project's estimated cash outflow might be £10 million, its estimated inflows might be £6 million and its cost of capital might be 10%. All three of these parameters would be altered to assess any impact upon the overall results.
2. Inflation
The effects of inflation should also be included in any future capital investment model. Inflation means that a pound in a year's time will not buy as much as a pound today, as the price of goods will have risen. Therefore, we need to adjust for inflation. This can be done in two ways.
(i) By adjusting future cash flow. Under this method, we increase the future cash flows by the expected rate of inflation. If inflation was 3% over a year we would, therefore, increase an expected cash flow of £100 million by 3% to £103 million. We would then discount these adjusted flows as normal.
(ii) By adjusting the discount rate. If we were using a discount rate of 10%, we would deduct the inflation rate. If inflation was 3%, we would then discount the future cash flows at 7%.
3. Taxation
As we saw in Chapter 8 cash flow and profit are distinctly different. Discounted cash flows are based on cash flows not on accounting profit. In order to arrive at forecast cash flows from forecast profit we must, therefore, adjust the profit for non cash-flow items. In particular, we need to add back depreciation (disallowed by taxation authorities) and deduct any capital allowances. Capital allowances are allowed by the taxation authorities as a replacement for depreciation. They can be set off against taxable profits. Capital allowances thus reduce cash outflows. Normally, companies will pay their taxation nine months after their year end.
Conclusion
Capital investment appraisal methods are used to assess the viability of long-term investment decisions. Capital investment projects might be a football club building a new stadium or a company building a new factory. Capital investment decisions are long-term and often very expensive. It is, therefore, very important to test their viability. Five capital investment appraisal methods are commonly used: payback period; accounting rate of return; net present value, profitability index and internal rate of return. Unlike the last three, the first two do not take into account the time value of money. The payback period simply assesses how long it takes a company's cumulative cash inflows to outstrip its initial investment. The accounting rate of return assesses the profitability of a project using average annual profit over initial capital investment. Net present value discounts back estimated future cash flows to today's values using cost of capital as a discount rate. The profitability index compares the NPVs of the cash flows with the initial investment. Finally, internal rate of return establishes the discount rate at which a project breaks even. All five appraisal methods are based on many assumptions about future cash flows. These assumptions are often tested using sensitivity analysis.
Discussion Questions
Questions with numbers in blue have answers at the back of the book.
| Q1 |
(a) Why do you think capital investment is necessary for companies? (b) What sort of possible capital investment might there be in: (i) the shipping industry? (ii) the hotel and catering industry? (iii) manufacturing industry? |
| Q2 | Discuss the general assumptions that underpin capital investment appraisal. |
| Q3 | Briefly outline the five main capital investment appraisal techniques and then discuss the specific advantages and disadvantages of each technique. |
| Q4 | Why is time money? |
| Q5 | State whether the following statements are true or false. If false, explain why.
(a) The five main capital investment appraisal techniques are payback period, accounting rate of return, net present value, profitability index and internal rate of return. (b) The payback period and net present value techniques generally use discounted cash flows. (c) The accounting rate of return is the only investment appraisal technique that focuses on profits not cash flows. (d) The discount rate normally used to discount cash flows is the interest rate charged by the Bank of England. (e) Sensitivity analysis involves modelling future alternative scenarios and assessing their impact upon the results of capital investment appraisal techniques. |
Numerical Questions
Questions with numbers in blue have answers at the back of the book.
These questions gradually increase in difficulty. Students may find question 6, in particular, testing.
Helpnote. In this question, which has a different format from those encountered so far, it is first necessary to calculate profit before interest and tax (i.e., revenue less expenses and depreciation). After this we need to adjust for interest, taxation, depreciation (based on the initial capital outlay) and other cash flows to arrive at a final cash flow figure.
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