Comments

  1. avatar 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

    • Profile photo of 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.

      • avatar 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).

      • Profile photo of 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!

  2. avatar 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.

      • Profile photo of 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.

  3. avatar 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?

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