Hi on my assignment i have got slightly confused as to what exact figures to include as the initial investment and closing investment for each of the given projects below:

Costs and timings Small Large
Investment costs £’000 £’000
Preparatory costs (planning, legal etc.) 800 5,500
Land Purchase Cost (year 0) 9,000 28,000
Total Interest expense 1,200 2,500
Equipment (year 1) 16,000 48,000

Dear Sir,
I have question for pay back period calculation.
Net cash flow is (30,000) after 2 years and 3rd year’s cash inflow is 40,000, pay back period calculation for 3rd year is 30,000/40,000 x 12 month= 9 month.
So payback period should be 2 years and 9 months instead of 2.75 month?
Thanks.

9 months is 9/12 of a year (there are 12 months in a year), or 0.75 years.
So the payback period is 2 years 9 months, or 2.75 years – both are the same thing!

I came across a question in the BPP revision kit where they added 1 to the discounting factor of an annuity. For example: Net cash inflow for 5 years in advance @ 10% coc, which i feel checking through the annuity table should be 3.791× the investment but what was calculated is 1+3.17 × by the initial investment( 4yrs @ 10% +1) i dont know why. Please help as i am confused.

In future you must ask this sort of question in the Ask the Tutor Forum and not as a comment on a lecture.
You have not said which question in the Revision Kit, but I would guess that the first receipt is immediate. The annuity factor alone applies when the first receipt is in one years time.

This is basic accounting from Paper F3!
You divide the cost less expected scrap value by the expected life. You need to watch the Paper F3 lectures on depreciation for full details.

There can be other reasons, apart from depreciation, as to why the profit might be different from the cash inflow such as the not all sales are cash-based, some of them are on credit as well. Is my understanding correct? If yes then shouldn’t we have to account for them as well?

Hello! My question is that why do we add the scrap value to the initial investment while calculating the average investment for the calculation of average rate of return?

If an asset cost 10,000 and ends up being worth zero, then the average value is 5,000.
If an asset costs 10,000 and ends up still being worth 1,000, then the average value must be higher! It is (10,000 + 1,000) / 2 = 5,500.

Dear John,
when we calculate the average investment of balance sheet for ARR calculation, why we simply divided by 2, why not by total numbers of years ?
I am sorry if its a silly question to u!!!!!! but i really didnt get it. thank you.

Just imagine that you started the week with $100 in your pocket and ended the week with only $10 in your pocket.

How much did you have on average in your pocket? Surely on average you had (100+10)/2 = $55. (You would not divide by 7 because there are 7 days in the week).

It is the same principle for ARR – to get the average value of the investment.

Why do we divide the initial investment simply by 2 in order to find the average investment.Whydon’t we divide the initial investment by the total number of years? You’ve already answered a similar question but I didn’t get the logic!

The value in the Statement of financial position (balance sheet) will fall each year because of depreciation, from its original cost down to its scrap value.

We want the average value in the SOFP, which will be half way between the original cost and the scrap value.

While calculating average profit p.a.
Total operating cash flows is 100,000. here we have not added the scrap value of $10,000; like we did in finding net present value.

Could you please explain why we don’t take into account scrap value when calculating the average profit? When we sell the machine at the end of 4 year we will get the $10 000 for it. This is our income.

Also I have two more questions. Unfortunately, I cann’t find link to forum, that’s why I write them here.
I’ve made practise question 6 Gold.

1. In answers payback period is calculated as = 4 + 1/8 = 4.125. How you get 1/8? I calculated it as = 4 + 1000/23000 (cash flow for year 5) = 4.04.

2. I don’t agree with the answer b, part ii.
The question is “Is it worth equipping the new premises”.
In answers you take the market value of the new premises into consideration.
But for me – market value is not a cash flow and it doesn’t depend on the way of equipment. I think that market value is irrelevant information. And also it’s told that Bronze has recently expanded into new premises. This means Bronze has already bought it.

1. The cash flow in year 5 is 8,000 (the 15,000 will not come until the very end of the year).

2. They have indeed already bought new premises. However, they are deciding whether or not to move into them. If they don’t move in then they sell them for 2.6M, so it is an opportunity cost of using them.

In future, you must ask in the forums or questions other than on the lectures will not be answered. There is a tab at the top of the page that says on it ‘ACCA Forums’!!

You have said that if he cast the depreciation, I am a little confused that how you took 80,000 did you just assumed it or the examiner would tell us what value to use , If you give some explanation on this it would be very nice of you .

Thank You I am getting F9 lectures very easily and I can understand them all credit goes to you .

The total depreciation is the difference between the initial cost and the scrap value (both of which are given in the question – I assume that you have downloaded the Course Notes?).

Sir , today i was doing ARR questions in a class , and i have deducted the scrap value from the cost of machine but my lecturer told me its a wrong method , but i was doing this every time when i have scrap value in a question , i m confused , i don’t know what to do , help me sir please ..

For ARR you need the average investment in the Statement of financial position (balance sheet). This is (initial investment + scrap value) /2.

Think about this. Suppose you bought a machine with a cost of 100,000 and a scrap value of zero. The value in the SOFP would fall each year (because of depreciation) and the average value would be 50,000.

Now suppose you bought the same machine with the same cost, but with a scrap value of 20,000. The value in the SOFP would again fall each year, but only down to 20,000.

Surely, the average value in the second case would be higher than in the first case?

The average value in the second case would be (100,000 + 20,000) / 2 = 60,000.

I hope that makes sense.
You might find the free lectures on investment appraisal useful 🙂

(and I am surprised that your lecturer did not explain to you the reason for adding the scrap value!!)

No Sir , i m talking about deducting the scrap value from the cost of machine when you are working out total depreciation , like e.g total cashflows less total depreciation (cost – scrap value) and my lecturer didn’t deduct the scrap value from the cost of machine , the average investment part i already understood by your lectures thanks..

The total depreciation over the life of the machine will certainly be the initial cost less any scrap value.
I cannot think of a situation that would result in your lecturer telling you different. It seems very strange!

(He was definitely talking about ARR calculations, and not discounted cash flow calculations?)

Thanks a lot Sir , i owe you , i have been passing all the ACCA papers of which you taught us because the way you teach is more effective , I do really enjoy your lectures and thank you for your very interesting lectures , I appreciate everything and I’ve learned a lot’ ..

Sir,i am from Pakistan and i understand the method of taking Average Balance Sheet Value But i have one question that,can we use the other way for taking the Average Balance Sheet value, like this one;
Add Year 1st+2nd+3rd+4th Balance Sheet Values And then Divide the Total with 4.(i have try this one and i got less then $45000)
And if not then why not we can use this Method.
ThankYou.

In real life there is no rule – you can do whatever you think is more sensible. What you suggest is fine, but even then you would have to decide whether to use opening balance sheet values each year or average values each year, or closing values – each would give different answers and there is no one ‘correct’ way.

However in the exam you will be expected to do it the way in the notes and lecture (unless you were specifically told to do different, which is very unlikely).

Suppose that this morning you had $100 and you were spending all day so at the end of the day (10 hours later) you had nothing left.

What was the average amount of money in your pocket? Surely, on average you had $50 – you would not divide by 10 and say that it was $10.

Same example, but this time you still had $20 left at the end of the day. In that case on average you would have had more money – (100 + 20) / 2 = on average $60.

Hope that makes sense. If not then say and I will try and explain in another way 🙂

the lecture shows that payback time is 2.75 years, it’s simply add first 2 years cash inflow and a proportion of 3rd year cash inflow. However you didn’t take present value of these inflows into account. Actual payback time should be longer than 3 years if we convert these inflows to present value.

But that is how we calculate the payback period – we do not discount the cash flows.

If you are asked for the ‘discounted payback period’ then you do discount the flows (and the discounted payback period will indeed be longer than the normal payback period).

Hi Sir
When we are calculating Average Book Value of the Asset, aren’t we supposed to calculate per annum? I got a bit confused and I actually calculated the depreciation in linear method. However, why do we calculate ARR in that way?
i.e. Average profit per annum from an investment/ Average Book Value of the Asset.

I would appreciate it if you could explain this a bit 🙂

Furthermore, I know this is nothing relating to PayBack Period. But don’t you think, the longer the Payback period, the lower the value of that money? As in the PV of the inflow decreses.

In real life you might be more interested in the ARR year by year. However normally in the exam we simply calculate the average. It does not matter whether we depreciate on a straight line basis or some other way – in total the depreciation will be the difference between the cost and the scrap value, which method of deprecation we use.

With regard to the payback period, what you say about the present value may well be true. However, companies use a range of measures, and one big problem with NPV’s is that the further into the future we are estimating the cash flows, the more it becomes almost a guess. The shorter the payback period, the more certain we will be that we will really get the cash back.

you have $50000 in year two but you still need $30000 to make $80000.Therefore,30000/40000( ie the cash flows in the 3rd yr) = 0.75 yrs add 2yrs.Hope this helps

Dear jhon,
Once again a great job with this chapter, you have made F-9 so easy to comprehend. I have great understanding of calculations but have certain ambiguities in rationing behind NPV and ARR so I would appreciate if you can answer my uncertainty in number order as it makes easy for me to understand.
1) NPV for example 1 is (positive) 6660 and example 4 (negative) 9104. Other than being positive or negative does the value itself means anything at all, e.g. profit of 6660 or loss of 9140. Other than the sign of value, what does the value itself mean?
2) My previous understanding was that NPV calculates expected profit, but if it is not the case and we know for a fact that “NPV formula” DOES NOT take into consideration our expectations of cash needed to run the business or pay dividends or acquisition of other companies etc.
A) Why do we say that NPV needs to be positive and reject the project if NPV is negative? Even if NPV is negative how do we know the cash generated (cash flows) will not be sufficient to take care of cash needs since NPV Formula do not take into account our expected cash needs.
B) If NPV does not calculate expected profit and does not take account of our cash needs what is the purpose of NPV?
3) In example 8, we calculated profit considering only depreciation expense, but in real life are we going to consider raw material and labor costs associated with the machine? Because unless ALL expenses are deducted from revenue we cannot get net profit.
4) Suppose revenue generated by a machine in year two is 10,000 and expenses relating to this revenue are 1000 in running costs and 2000 in raw material used at this particular machine. Ignoring exam, for practical purposes can we use 7000 instead of 10,000 as a cash flow and will NPV then reflect net profit. Regardless of the debate whether ARR is better or this new method of calculating NPV, could it not be at least an alternative method to calculate expected profit.
5) Assume figures of Point-3 are result of an investment made in agricultural land (agricultural land does not depreciate) in this scenario could this new method of NPV used to calculate net profit and could it now be an alternative method to ARR.
6) Which book are you using to prepare f-9 lectures and which exam kit would you recommend e.g. Kaplan or BPP or any other?
Regards

The NPV is measuring the cash surplus or deficit from investing in a project, after accounting for the interest.
It does not measure profitability.
The future cash needs are not relevant at all. If an investment generates a cash surplus then it is worth borrowing money to invest in it – we will be able to repay the borrowing together with interest and end up with a surplus.

The reason it is cash that is so important (rather than profits) is that it is cash that is needed to pay dividends and it is cash that is need for further investment. Therefore in theory the object should be to invest in projects that give cash surpluses.

The cash flows we look at are the net cash flows after charging all cash expenses (i.e. the cash profit).
Your point 4 is not a new method – we look always look at the operating cash flows (which means the net cash flow after all cash expenses).

This chapter of the notes is just going through the arithmetic as revision of Paper F2. You should watch the next chapter which goes through how we get the cash flows – this is the important bit for the exam (the arithmetic for discounting etc. is just following rules and was already examined in F2).

I do not use a book to prepare lectures – I have been teaching it for 40 years 🙂

The books by all the approved publishers are fine.

Will you consider labor and raw material used to generate cash flows from a particular machine in its cash expenses.(not talking about the whole company jut the machine/project under investigation)
You mentioned two points in your reply, first that NPV does not measure profit but later mentioned that my point 4 is not a new method because cash flows are net operating cash flows after deducting all cash expenses does this include cost of raw material, labor and other costs related to this particular machine. If yes than it means NPV is net profit (not for the whole company but only for this particular investment).

Wow Mr John! 40 years!! Very impressive!!! Surely it does appear in your performance that you are a master at teaching, yet I didn’t know you have been teaching for 40 years. It is great that highly experienced tutors such as yourself would offer free tuition like this.

Why didn’t we take the scrap value of 10k in 4th year as a cash inflow (like we did in example 1), so the total operating cash flow would be 110.000? Also, why didn’t we then say that the balance at the end of 4th year would be 0, so the average book value would be (80.000 + 10.000) / 2 = 40.000 ? It’s a bit confusing because the example is the same as example 1, but here we treat the scrap value differently.

@crnimeda, For the accounting rate of return, we are not looking at cash flows. The ARR is an accounting measure (average profit per the accounts as a percentage of the average balance sheet value).
With regard to the second point, if the asset was worth nothing at the end of its life, then the average value would indeed be 40,000. However it is worth 80,000 and the start, and still worth 10,000 at the end, and so the the average value is higher at 45,000.

You cannot compare it with example 1 – it is a different way of appraising that is common in real life because shareholders etc are interested in profits. Example 1 looks purely at cash flows.

@neil.farrow, Because is a simple avarage calculation, you have to values 80,000 and 10,000. The mathematical avarege is (80+10)/2. Don’t think about net book value.

What about if the project rquires a working capital at the beginning or anytime within the project life span? How would you compute the payback period? Do you have to add the working capital to the initial investment cost in determining the payback period?

lewis says

Hi on my assignment i have got slightly confused as to what exact figures to include as the initial investment and closing investment for each of the given projects below:

Costs and timings Small Large

Investment costs £’000 £’000

Preparatory costs (planning, legal etc.) 800 5,500

Land Purchase Cost (year 0) 9,000 28,000

Total Interest expense 1,200 2,500

Equipment (year 1) 16,000 48,000

Initial cost 27,000 84,000

Refurbishment of Equipment (year 5) 3,000 6,000

Total cost 30,000 90,000

less Resale value (yr20) 2,000 8,000

Net cost for depreciation 28,000 82,000

Less government grant 3,000 12,000

Net capital cost 25,000 70,000

I have got the ARR as 12% and 9%, was just wondering if this was correct

John Moffat says

You must ask this sort of question in the F9 Ask the Tutor Forum – not as a comment on a question.

May says

Dear Sir,

I have question for pay back period calculation.

Net cash flow is (30,000) after 2 years and 3rd year’s cash inflow is 40,000, pay back period calculation for 3rd year is 30,000/40,000 x 12 month= 9 month.

So payback period should be 2 years and 9 months instead of 2.75 month?

Thanks.

John Moffat says

9 months is 9/12 of a year (there are 12 months in a year), or 0.75 years.

So the payback period is 2 years 9 months, or 2.75 years – both are the same thing!

May says

Thank you Sir.

Oladipo says

Hi John,

I came across a question in the BPP revision kit where they added 1 to the discounting factor of an annuity. For example: Net cash inflow for 5 years in advance @ 10% coc, which i feel checking through the annuity table should be 3.791× the investment but what was calculated is 1+3.17 × by the initial investment( 4yrs @ 10% +1) i dont know why. Please help as i am confused.

John Moffat says

In future you must ask this sort of question in the Ask the Tutor Forum and not as a comment on a lecture.

You have not said which question in the Revision Kit, but I would guess that the first receipt is immediate. The annuity factor alone applies when the first receipt is in one years time.

hormotee says

I am sorry I asked here, the question is number 34.3 & 34.4 of bpp revision kit

John Moffat says

Questions 34.3 and 34.4 in the current revision kit are nothing to do with annuity discount factors!

shreyas says

depreciation charged on straight line basis…. how do we calculate depreciation if its staight line basis?

John Moffat says

This is basic accounting from Paper F3!

You divide the cost less expected scrap value by the expected life. You need to watch the Paper F3 lectures on depreciation for full details.

Arun says

Hello John,

There can be other reasons, apart from depreciation, as to why the profit might be different from the cash inflow such as the not all sales are cash-based, some of them are on credit as well. Is my understanding correct? If yes then shouldn’t we have to account for them as well?

Thanks.

John Moffat says

Your understanding is correct.

However we never account separately in DCF calculations for receivables etc. (But they are effectively dealt with in the working capital cash flows).

zaineb15 says

Hello! My question is that why do we add the scrap value to the initial investment while calculating the average investment for the calculation of average rate of return?

John Moffat says

If an asset cost 10,000 and ends up being worth zero, then the average value is 5,000.

If an asset costs 10,000 and ends up still being worth 1,000, then the average value must be higher! It is (10,000 + 1,000) / 2 = 5,500.

zaineb15 says

Thank you sir!

John Moffat says

You are welcome 🙂

yetunde says

Thank you as always,you have made investment appraisal look soo easy,

merci beaucoup!

arman90fy says

Dear John,

when we calculate the average investment of balance sheet for ARR calculation, why we simply divided by 2, why not by total numbers of years ?

I am sorry if its a silly question to u!!!!!! but i really didnt get it. thank you.

John Moffat says

Just imagine that you started the week with $100 in your pocket and ended the week with only $10 in your pocket.

How much did you have on average in your pocket? Surely on average you had (100+10)/2 = $55. (You would not divide by 7 because there are 7 days in the week).

It is the same principle for ARR – to get the average value of the investment.

arman90fy says

Dear john, thank you so much for your very simple convenient example….:)

aliimranacca007 says

Pay back period how u take .75 in 2.75

John Moffat says

After 2 years they have got back 50,000. So they need another 30,000. There is 40,000 in the third year, so 30,000 is 3/4 (or 0.85) of 40,000.

zaineb15 says

Why do we divide the initial investment simply by 2 in order to find the average investment.Whydon’t we divide the initial investment by the total number of years? You’ve already answered a similar question but I didn’t get the logic!

John Moffat says

The value in the Statement of financial position (balance sheet) will fall each year because of depreciation, from its original cost down to its scrap value.

We want the average value in the SOFP, which will be half way between the original cost and the scrap value.

Amit says

While calculating average profit p.a.

Total operating cash flows is 100,000. here we have not added the scrap value of $10,000; like we did in finding net present value.

Amit says

Sincerely sorry sir, this query has already been addressed.

Tatiana says

Hello, Sir!

Could you please explain why we don’t take into account scrap value when calculating the average profit? When we sell the machine at the end of 4 year we will get the $10 000 for it. This is our income.

John Moffat says

Scrap proceeds never appear in profit statements (they do not when we do financial accounts, and ARR is an accounting measure)!!!

We take them into account when we calculate the deprecation, which does appear in the Statement of profit or loss.

Tatiana says

Thank you very much, Mr Moffat.

Also I have two more questions. Unfortunately, I cann’t find link to forum, that’s why I write them here.

I’ve made practise question 6 Gold.

1. In answers payback period is calculated as = 4 + 1/8 = 4.125. How you get 1/8? I calculated it as = 4 + 1000/23000 (cash flow for year 5) = 4.04.

2. I don’t agree with the answer b, part ii.

The question is “Is it worth equipping the new premises”.

In answers you take the market value of the new premises into consideration.

But for me – market value is not a cash flow and it doesn’t depend on the way of equipment. I think that market value is irrelevant information. And also it’s told that Bronze has recently expanded into new premises. This means Bronze has already bought it.

John Moffat says

1. The cash flow in year 5 is 8,000 (the 15,000 will not come until the very end of the year).

2. They have indeed already bought new premises. However, they are deciding whether or not to move into them. If they don’t move in then they sell them for 2.6M, so it is an opportunity cost of using them.

In future, you must ask in the forums or questions other than on the lectures will not be answered. There is a tab at the top of the page that says on it ‘ACCA Forums’!!

Tatiana says

Thank you very much. I think I see your point.

Ahmad Masood Faqiri says

Dear John Sir,

You have said that if he cast the depreciation, I am a little confused that how you took 80,000 did you just assumed it or the examiner would tell us what value to use , If you give some explanation on this it would be very nice of you .

Thank You I am getting F9 lectures very easily and I can understand them all credit goes to you .

Thanks 🙂

John Moffat says

The total depreciation is the difference between the initial cost and the scrap value (both of which are given in the question – I assume that you have downloaded the Course Notes?).

fahad says

Sir , today i was doing ARR questions in a class , and i have deducted the scrap value from the cost of machine but my lecturer told me its a wrong method , but i was doing this every time when i have scrap value in a question , i m confused , i don’t know what to do , help me sir please ..

John Moffat says

For ARR you need the average investment in the Statement of financial position (balance sheet). This is (initial investment + scrap value) /2.

Think about this. Suppose you bought a machine with a cost of 100,000 and a scrap value of zero. The value in the SOFP would fall each year (because of depreciation) and the average value would be 50,000.

Now suppose you bought the same machine with the same cost, but with a scrap value of 20,000. The value in the SOFP would again fall each year, but only down to 20,000.

Surely, the average value in the second case would be higher than in the first case?

The average value in the second case would be (100,000 + 20,000) / 2 = 60,000.

I hope that makes sense.

You might find the free lectures on investment appraisal useful 🙂

(and I am surprised that your lecturer did not explain to you the reason for adding the scrap value!!)

fahad says

No Sir , i m talking about deducting the scrap value from the cost of machine when you are working out total depreciation , like e.g total cashflows less total depreciation (cost – scrap value) and my lecturer didn’t deduct the scrap value from the cost of machine , the average investment part i already understood by your lectures thanks..

John Moffat says

Sorry for misunderstanding your question.

The total depreciation over the life of the machine will certainly be the initial cost less any scrap value.

I cannot think of a situation that would result in your lecturer telling you different. It seems very strange!

(He was definitely talking about ARR calculations, and not discounted cash flow calculations?)

fahad says

Thanks a lot Sir , i owe you , i have been passing all the ACCA papers of which you taught us because the way you teach is more effective , I do really enjoy your lectures and thank you for your very interesting lectures , I appreciate everything and I’ve learned a lot’ ..

John Moffat says

You are very welcome, and thanks a lot for your comments 🙂

osmanuaepak@yahoo.com says

Sir,i am from Pakistan and i understand the method of taking Average Balance Sheet Value But i have one question that,can we use the other way for taking the Average Balance Sheet value, like this one;

Add Year 1st+2nd+3rd+4th Balance Sheet Values And then Divide the Total with 4.(i have try this one and i got less then $45000)

And if not then why not we can use this Method.

ThankYou.

John Moffat says

In real life there is no rule – you can do whatever you think is more sensible. What you suggest is fine, but even then you would have to decide whether to use opening balance sheet values each year or average values each year, or closing values – each would give different answers and there is no one ‘correct’ way.

However in the exam you will be expected to do it the way in the notes and lecture (unless you were specifically told to do different, which is very unlikely).

osmanuaepak@yahoo.com says

Thank You Sir.

John Moffat says

You are welcome 🙂

Tyler says

Sir, for the A.R.R part, why do we divide by 2 for the average balance sheet value? Should we divide by 4 as it has an expected life of 4 years?

John Moffat says

Suppose that this morning you had $100 and you were spending all day so at the end of the day (10 hours later) you had nothing left.

What was the average amount of money in your pocket? Surely, on average you had $50 – you would not divide by 10 and say that it was $10.

Same example, but this time you still had $20 left at the end of the day. In that case on average you would have had more money – (100 + 20) / 2 = on average $60.

Hope that makes sense. If not then say and I will try and explain in another way 🙂

Tyler says

Yup, makes sense with the above illustration, sir. Thank you very much 🙂

John Moffat says

You are welcome 🙂

helensqq says

Hi John,

the lecture shows that payback time is 2.75 years, it’s simply add first 2 years cash inflow and a proportion of 3rd year cash inflow. However you didn’t take present value of these inflows into account. Actual payback time should be longer than 3 years if we convert these inflows to present value.

John Moffat says

But that is how we calculate the payback period – we do not discount the cash flows.

If you are asked for the ‘discounted payback period’ then you do discount the flows (and the discounted payback period will indeed be longer than the normal payback period).

sdmaalex says

Hi Sir

When we are calculating Average Book Value of the Asset, aren’t we supposed to calculate per annum? I got a bit confused and I actually calculated the depreciation in linear method. However, why do we calculate ARR in that way?

i.e. Average profit per annum from an investment/ Average Book Value of the Asset.

I would appreciate it if you could explain this a bit 🙂

Furthermore, I know this is nothing relating to PayBack Period. But don’t you think, the longer the Payback period, the lower the value of that money? As in the PV of the inflow decreses.

sdmaalex says

*decreases

John Moffat says

In real life you might be more interested in the ARR year by year. However normally in the exam we simply calculate the average. It does not matter whether we depreciate on a straight line basis or some other way – in total the depreciation will be the difference between the cost and the scrap value, which method of deprecation we use.

With regard to the payback period, what you say about the present value may well be true. However, companies use a range of measures, and one big problem with NPV’s is that the further into the future we are estimating the cash flows, the more it becomes almost a guess. The shorter the payback period, the more certain we will be that we will really get the cash back.

pamelah says

How did you get the 2.75yrs in Example 9

realhams says

you have $50000 in year two but you still need $30000 to make $80000.Therefore,30000/40000( ie the cash flows in the 3rd yr) = 0.75 yrs add 2yrs.Hope this helps

John Moffat says

Thanks Realhams – lovely explanation 🙂

Irfan says

I can never thank enough. Just watched all the chapter 7 lectures and they are so good and easy to understand. Thank you John thank you open tuition.

sarmad738 says

Dear jhon,

Once again a great job with this chapter, you have made F-9 so easy to comprehend. I have great understanding of calculations but have certain ambiguities in rationing behind NPV and ARR so I would appreciate if you can answer my uncertainty in number order as it makes easy for me to understand.

1) NPV for example 1 is (positive) 6660 and example 4 (negative) 9104. Other than being positive or negative does the value itself means anything at all, e.g. profit of 6660 or loss of 9140. Other than the sign of value, what does the value itself mean?

2) My previous understanding was that NPV calculates expected profit, but if it is not the case and we know for a fact that “NPV formula” DOES NOT take into consideration our expectations of cash needed to run the business or pay dividends or acquisition of other companies etc.

A) Why do we say that NPV needs to be positive and reject the project if NPV is negative? Even if NPV is negative how do we know the cash generated (cash flows) will not be sufficient to take care of cash needs since NPV Formula do not take into account our expected cash needs.

B) If NPV does not calculate expected profit and does not take account of our cash needs what is the purpose of NPV?

3) In example 8, we calculated profit considering only depreciation expense, but in real life are we going to consider raw material and labor costs associated with the machine? Because unless ALL expenses are deducted from revenue we cannot get net profit.

4) Suppose revenue generated by a machine in year two is 10,000 and expenses relating to this revenue are 1000 in running costs and 2000 in raw material used at this particular machine. Ignoring exam, for practical purposes can we use 7000 instead of 10,000 as a cash flow and will NPV then reflect net profit. Regardless of the debate whether ARR is better or this new method of calculating NPV, could it not be at least an alternative method to calculate expected profit.

5) Assume figures of Point-3 are result of an investment made in agricultural land (agricultural land does not depreciate) in this scenario could this new method of NPV used to calculate net profit and could it now be an alternative method to ARR.

6) Which book are you using to prepare f-9 lectures and which exam kit would you recommend e.g. Kaplan or BPP or any other?

Regards

John Moffat says

The NPV is measuring the cash surplus or deficit from investing in a project, after accounting for the interest.

It does not measure profitability.

The future cash needs are not relevant at all. If an investment generates a cash surplus then it is worth borrowing money to invest in it – we will be able to repay the borrowing together with interest and end up with a surplus.

The reason it is cash that is so important (rather than profits) is that it is cash that is needed to pay dividends and it is cash that is need for further investment. Therefore in theory the object should be to invest in projects that give cash surpluses.

The cash flows we look at are the net cash flows after charging all cash expenses (i.e. the cash profit).

Your point 4 is not a new method – we look always look at the operating cash flows (which means the net cash flow after all cash expenses).

This chapter of the notes is just going through the arithmetic as revision of Paper F2. You should watch the next chapter which goes through how we get the cash flows – this is the important bit for the exam (the arithmetic for discounting etc. is just following rules and was already examined in F2).

I do not use a book to prepare lectures – I have been teaching it for 40 years 🙂

The books by all the approved publishers are fine.

sarmad738 says

Will you consider labor and raw material used to generate cash flows from a particular machine in its cash expenses.(not talking about the whole company jut the machine/project under investigation)

You mentioned two points in your reply, first that NPV does not measure profit but later mentioned that my point 4 is not a new method because cash flows are net operating cash flows after deducting all cash expenses does this include cost of raw material, labor and other costs related to this particular machine. If yes than it means NPV is net profit (not for the whole company but only for this particular investment).

mahoysam says

Wow Mr John! 40 years!! Very impressive!!! Surely it does appear in your performance that you are a master at teaching, yet I didn’t know you have been teaching for 40 years. It is great that highly experienced tutors such as yourself would offer free tuition like this.

Great job!

fixanawaz says

The lecture stops after some seconds and starts from the beginning. Pls help.

esther1974 says

am failing to access most of the lectures .feed back saying “shockwave flash has crashed”. how can i get over this?

crnimeda says

Why didn’t we take the scrap value of 10k in 4th year as a cash inflow (like we did in example 1), so the total operating cash flow would be 110.000? Also, why didn’t we then say that the balance at the end of 4th year would be 0, so the average book value would be (80.000 + 10.000) / 2 = 40.000 ? It’s a bit confusing because the example is the same as example 1, but here we treat the scrap value differently.

crnimeda says

@crnimeda, correction, average book value (80.000 + 0) / 2 = 40.000

John Moffat says

@crnimeda, For the accounting rate of return, we are not looking at cash flows. The ARR is an accounting measure (average profit per the accounts as a percentage of the average balance sheet value).

With regard to the second point, if the asset was worth nothing at the end of its life, then the average value would indeed be 40,000. However it is worth 80,000 and the start, and still worth 10,000 at the end, and so the the average value is higher at 45,000.

You cannot compare it with example 1 – it is a different way of appraising that is common in real life because shareholders etc are interested in profits. Example 1 looks purely at cash flows.

cris1993 says

Why Might ARR be relevant to DCF Calculations ??? thanks

John Moffat says

@cris1993, it isn’t relevant for DCF – it’s a different approach

. However, it is a common way of appraising and can be examined in F9.

Neil.Farrow says

Hi, why is the SFP average value 80+10 please in ARR please? Why add the scrap value?

maxyboy1712 says

@neil.farrow, Because is a simple avarage calculation, you have to values 80,000 and 10,000. The mathematical avarege is (80+10)/2. Don’t think about net book value.

mjabbin says

But why do you divide it by 2

sheffernb says

I just love this Lecturer. He gets straight to the point and makes it look easy. Thank you Sir!!

lolo822 says

Dear Sir,Is ARR the same as ROCE in terms of calculations?

John Moffat says

@lolo822, Yes – the two are really the same.

aduuni says

I am happy with this lecturer as he made this so easy. I have always done it the wrong way.

Thanks

jewel086 says

Thanks

lchale says

I can not play any vedio lecture of F9 as server is not available.

Can any one help me?

richoab says

What about if the project rquires a working capital at the beginning or anytime within the project life span? How would you compute the payback period? Do you have to add the working capital to the initial investment cost in determining the payback period?

John Moffat says

@richoab, Interesting question 🙂

Best to ignore the working capital.

The reason is that we assume that we get back the working capital whenever the project finishes.

richoab says

Straight to the point; Thanks

leachon439 says

very good as usual