Page 8 - CIMA MCS Workbook November 2018 - Day 1 Suggested Solutions

CIMA NOVEMBER 2018 – MANAGEMENT CASE STUDY

It does not take into account the time value of money. For long projects, this is crucial in
evaluating the value of the cash flows that occur over the life of the project. A particular cash
flow becomes worth less and less the further into the future it occurs. Under payback, cash
inflows after the payback period are effectively ignored.

It could be said that if the business is focused on payback within a couple of years then the time
value of the cash flows over that time period is not too much of an issue.

But tied with the fact that payback ignores any cash flows after the payback period, it could mean
that the company is rejecting projects that would be very beneficial for the business because they
have a slightly longer payback period than the arbitrary target set.

Payback ignores the overall profitability of the project. Just because the cash is paid back within a
certain time period does not mean that it is the best project that is available.

However, the production line automation project may be one that is crucial in order for the
business to survive over the longer term. If a requirement for payback within a couple of years
means that the business can then go on to update its remaining production lines sooner, it may
be that payback was an appropriate tool to use for the project evaluation.

Net present value (NPV)

It is recommended that businesses use net present value for their investment appraisals as it is by
far the most robust method of project evaluation. It takes into account the time value of money,
looks at the entire project and calculates the monetary benefit to the overall business value of
going ahead with a project.

Its only disadvantages are that it is more complex than payback, both to calculate and to explain.
However it is a more objective measure. The payback period may be arbitrarily set, but the NPV
calculation uses a more objectively calculated cost of capital to act as a target return rate.

For Grapple though, this may cause some issues. As it is unlisted and family owned, a cost of
capital will not be available and may be difficult to calculate. An industry average cost of capital
may therefore be used as a proxy discount rate.

It would be wise to calculate an NPV for projects in addition to the evaluation of the payback
period. In this way, projects should not be taken on unless they are beneficial to the business
overall and do not lead to liquidity issues.

There may be nobody in Grapple who has a good understanding of NPV techniques – the finance
director has a financial accounting background so may well have learned this technique as part of
his accounting qualification but not used it for a long time.

Internal rate of return (IRR)

IRR uses the same principles as NPV calculations but calculates the return inherent in a project’s
particular cash flows.
It does not use the cost of capital in its calculation, so could be useful for Grapple where one is
not easily available. However, some level of subjectivity would be needed once the IRR is
calculated in order to determine whether the project is worthwhile or not. Again, a comparison
of the project’s IRR to the industry’s cost of capital could be used.

58 KAPLAN PUBLISHING