Challenges in advanced management accounting

Transcription

1 Chaenges in advanced management accounting

2 About this free course This free course is an adapted extract from the Open University course B392 Advanced management accounting This version of the content may incude video, images and interactive content that may not be optimised for your device. You can experience this free course as it was originay designed on OpenLearn, the home of free earning from The Open University: There you aso be abe to track your progress via your activity record, which you can use to demonstrate your earning. Copyright 2016 The Open University Inteectua property Uness otherwise stated, this resource is reeased under the terms of the Creative Commons Licence v4.0 Within that The Open University interprets this icence in the foowing way: Copyright and rights faing outside the terms of the Creative Commons Licence are retained or controed by The Open University. Pease read the fu text before using any of the content. We beieve the primary barrier to accessing high-quaity educationa experiences is cost, which is why we aim to pubish as much free content as possibe under an open icence. If it proves difficut to reease content under our preferred Creative Commons icence (e.g. because we can t afford or gain the cearances or find suitabe aternatives), we wi sti reease the materias for free under a persona enduser icence. This is because the earning experience wi aways be the same high quaity offering and that shoud aways be seen as positive even if at times the icensing is different to Creative Commons. When using the content you must attribute us (The Open University) (the OU) and any identified author in accordance with the terms of the Creative Commons Licence. The Acknowedgements section is used to ist, amongst other things, third party (Proprietary), icensed content which is not subject to Creative Commons icensing. Proprietary content must be used (retained) intact and in context to the content at a times. The Acknowedgements section is aso used to bring to your attention any other Specia Restrictions which may appy to the content. For exampe there may be times when the Creative Commons Non- Commercia Shareaike icence does not appy to any of the content even if owned by us (The Open University). In these instances, uness stated otherwise, the content may be used for persona and noncommercia use. We have aso identified as Proprietary other materia incuded in the content which is not subject to Creative Commons Licence. These are OU ogos, trading names and may extend to certain photographic and video images and sound recordings and any other materia as may be brought to your attention. Unauthorised use of any of the content may constitute a breach of the terms and conditions and/or inteectua property aws. We reserve the right to ater, amend or bring to an end any terms and conditions provided here without notice. A rights faing outside the terms of the Creative Commons icence are retained or controed by The Open University. Head of Inteectua Property, The Open University 2 of 59 Thursday 11 February 2016

3 Contents Introduction 4 Learning Outcomes 5 1 Strategic management accounting Defining strategic management accounting Comparison of strategic and traditiona management accounting 8 2 Strategic customer anaysis The customer seection decision Determining customer profitabiity 12 3 Principes of project appraisa Reevant cash fows and sunk costs The time vaue of money, discounting and present vaue Why does the vaue of money depend on time? Using the WACC as the discount rate for a project Probems with using the WACC as the discount rate for a project Using the CAPM to find a project-specific cost of equity Probems with using the CAPM to find a project-specific cost of equity Using a spreadsheet to mode project evauation 34 4 Deaing with risk and uncertainty in project appraisa Risk and uncertainty Simpe adjustments to dea with increased risk Using probabiity and future cash fows to dea with risk Modeing sensitivity anaysis The vaue of information 48 5 End-of-course exercises 49 Concusion 55 Keep on earning 55 Gossary 56 References 58 Acknowedgements 59 3 of 59 Thursday 11 February 2016

4 Introduction Introduction This free course focuses on seected chaenges for organisations that management accounting concepts and techniques may be usefu to address. The aim is to deveop an understanding of some strategic approaches that contribute to the successfu navigation of mid- to ong-term chaenges to create sustainabe organisations. This is an advanced free course that requires a prior understanding of basic management accounting approaches. This OpenLearn course is an adapted extract from the Open University course B392 Advanced management accounting 4 of 59 Thursday 11 February 2016

5 Learning Outcomes After studying this course, you shoud be abe to: understand and describe strategic management accounting make decisions based on customer profitabiity using activity costing incorporate risk and uncertainty in project appraisa.

6 1 Strategic management accounting 1 Strategic management accounting The purpose of this first section is to focus on how management accounting has adapted to the demand for it to pay a roe in strategic management. This is part of the broader organisationa and environmenta pressure on management accounting to change to remain reevant. 1.1 Defining strategic management accounting Strategic management accounting (SMA) was first discussed in the iterature of the ate 1980s as a response to concerns about management accounting osing its reevance for business practice (Rosender and Hart, 2003). SMA is sti not ceary defined, so writers emphasise different perspectives and techniques or avoid defining it atogether. Exampes of different definitions are provided beow. Box 1 Definitions of strategic management accounting SMA refers to a variabe portfoio of mainy financia information geared towards aiding strategic decision making... Bhimani and Bromwich (2010, p. 48) Strategic management accounting (SMA) is usuay described in ways which pace emphasis on factors externa to an organization (Bromwich and Bhimani, 1994). Simmonds (1981) defines the concept as the provision and anaysis of management accounting data for use in deveoping and monitoring business strategy. Consistent with the notion of achieving competitive advantage, he advocates that attention be paid to competitors reative eves and trends in such factors as costs, prices, market share, cash fow and financia structure. Coad (1996, p. 387) SMA is identified as a generic approach to accounting for strategic positioning, defined by an attempt to integrate insights from management accounting and marketing management within a strategic management framework. Rosender and Hart (2003, p. 255) Strategic management accounting is the process of identifying, gathering, choosing and anaysing accounting data for heping the management team to make strategic decisions and to assess organisationa effectiveness. Hoque (2003, p. 2) Strategic management accounting is the form of management accounting in which emphasis is paced on information that reates to factors externa to 6 of 59 Thursday 11 February 2016

7 1 Strategic management accounting the entity, as we as non-financia information and internay generated information. CIMA (2005, p. 54) The definitions emphasise different aspects of SMA. Rosender and Hart (2003) use a marketing perspective which is appropriate for their customer focus. Coad (1996) gives prominence to the externa and competitor view, whie the other definitions simpy combine definitions of accounting with the term strategy. The definition from CIMA (2005) focuses on the type of information that is most ikey to be usefu. One reason for the variation in definitions is that the form of SMA that evoves in an organisation, ike accounting in genera, depends on the organisationa context. There is not a one-size-fitsa definition. So whie the diversity reduces the carity on the topic of SMA it may aso refect the possibiity of appropriatey taioring it to different settings. Activity 1 Strategy and the overap between functions in organisations Spend about 10 minutes on this activity. A strategic focus for management accounting resuts in it overapping with other functiona perspectives within the organisation, not just marketing as highighted by Rosender and Hart (2003). Think about the situation of new product deveopment to identify the overaps that may occur with other functiona areas. Discussion A strategic focus on deivering vaue to the customer requires integrated ways of organising around the vaue chain. The speciaist areas of production and product deveopment, corporate management, human resources, procurement, finance, and aw need to work together and with accountants to achieve a coherent view of the organisation s strategy. For exampe, the deveopment of a new product may be based on marketing s projections about demand for features, but its design shoud aso be infuenced by cost efficiency which wi invove consuting with peope responsibe for procuring raw materias from suppiers and the production team responsibe for factory foor operations. Human resources may be invoved where the avaiabiity of additiona skied workers is an issue or where the working conditions of current empoyees may be changed. Lawyers wi be invoved in determining the ikeihood that the deveopment can be patented. Corporate management and finance wi be invoved if the new product represents a change in strategy for the organisation and significant, new capita investment is required. Once again the accountant shoud have a roe in the process of evauating the capita project. In cooperating it is important that a speciaists are abe to contribute their perspectives, and are aso abe to accept and integrate the importance of other views to achieve a coherent view. It is perhaps easier to see the connections needed for a specific project ike this. It is more difficut to ensure that cooperation among speciaist areas in an organisation is achieved in an ongoing way. It is refected in the move away from functiona speciaisation in organisations to a more organic structure around teams. Another way to refine our understanding of strategic management accounting is to contrast it with the roe and techniques that were traditionay associated with the management accounting function or so-caed traditiona management accounting. 7 of 59 Thursday 11 February 2016

8 1 Strategic management accounting 1.2 Comparison of strategic and traditiona management accounting It is not surprising that the focus of SMA mirrors the features identified as important in strategic management; that is, a onger term focus, the environment externa to the organisation and a future rather than historica perspective. This emphasis contrasts with the traditiona focus of management accounting (see Tabe 1). Tabe 1 The focus of traditiona vs strategic management accounting Traditiona management accounting Historica Singe entity Singe period Singe decision Introspective Manufacturing focus Existing activities Reactive Overooks inkages Strategic management accounting Prospective Reative position Mutipe periods Sequences, patterns Outward ooking Competitive focus Possibiities Proactive Embraces inkages Extract from Wison and Chua (1993, p. 530) as quoted by Wickramasinghe and Aawattage (2007, p. 245) Activity 2 Information sources for strategic management accounting Spend about 10 minutes on this activity. Consider what information sources may be usefu to evauate the organisation s position reative to its competitors in an industry. To begin the exercise it is important to define what is meant by position. It coud be market share or it coud be in terms of cost structure, size, financia stabiity, product differentiation, etc. Assume for this activity that the concern is around market share and financia stabiity because two competitors are rumoured to be considering a merger. Discussion The marketing department may have access to industry associations that produce and disseminate market data. Usuay this works on the basis that each member organisation that contributes to the survey is entited to receive the resuts. Aternativey it may be necessary to commission market research or undertake it inhouse if the organisation has the necessary resources and skis. It is then possibe to compare the interna information about product saes with the externa data about the market to get a sense of reative position (either in unit saes or saes revenue). Financia stabiity may be a concern if the potentia combined competitor is ikey to use its increased size to gain access to the share market (if it is going to become pubicy isted) or to raise debt. In considering its reative financia position, the organisation needs to consider its position, incuding its cash fows and working capita to support increased price competition or to se on better terms to distribution networks. It may 8 of 59 Thursday 11 February 2016

9 1 Strategic management accounting aso need to consider its everage in absoute and reative terms. If the new competitor reduces cash infows from saes for a period of time, coud it survive and service its debt and other commitments onger than others in the industry? This information may not be very timey, but it shoud be avaiabe through annua and interim reports for competitors. Having connections in the capita markets and financia services sectors may hep with eary warning of any significant competitor raising capita. Overa, it is important to understand the focus of the information required and be prepared to cooperate and communicate with others in the organisation who may be in a better position to provide it. Just ooking at the information generated internay wi not be sufficient. Research has found that in practice the approach to strategic management accounting is at best partia (Scapens and Jazayeri, 2003). Certainy providing information and anaysis in some of the categories isted in Tabe 1 presents particuar chaenges. In genera terms, the type of information that wi be usefu in strategy formuation is more broadbased and informa than interna, narrowy defined and historica data. Enterprise resource panning systems faciitate the integration of interna information in an organisation, aowing easier generation of data about customers and suppiers. However, identifying future opportunities requires stepping outside the reguar systems of information recording and processing in such systems. Management accountants need to identify what isn t being done, not just what has happened. Broadening the basis of the management accounting system aso requires abandoning the beief that everything of vaue can be measured in monetary terms. Whie Bhimani and Bromwich s (2010) definition of SMA above emphasises financia information, other authors stress the vaue of non-financia information such as the industry s predicted unit saes, market share, etc. (Hoque, 2003). Beyond these concerns, environmenta impacts that have no direct cost to the organisation but impose costs on the pubic or future generations (externaities) are increasingy important to organisations when they are considering strategy. A chaenge facing strategic management accounting, and accounting more broady, is how to represent these amost unquantifiabe issues in reports and decisions. A strategic approach to management accounting aso requires coection of data from the externa environment. This may in part be a reguar process of monitoring competitors share prices, accounting reports, newspaper reports and socia media on the internet. However, it aso requires an eement of informa coection of information by individuas in the organisation who are part of arger networks of contacts. Making connections between events in the wider environment to trigger the identification of opportunities cannot be programmed into a system. The management accounting information and toos that wi be most appropriate wi depend on the organisationa context and purpose. For exampe, even though broad based, outward ooking data may be important in choosing a cost eadership strategy, its impementation requires accurate and timey cost information as part of tight contros and forma systems. This approach fits we with the traditiona management accounting techniques of budgeting and variance anaysis. The paradox of strategic management accounting is that, whie the need for it is cear, exacty what it is, is not! It is not uncommon, however, for service functions ike management accounting to evove with the changes in organisations, just as the organisations are changing in response to the pressures they face. Not defining SMA too cosey aows the fexibiity that is needed to appy appropriate toos and change them as 9 of 59 Thursday 11 February 2016

10 2 Strategic customer anaysis needed. The comparison with a stricty traditiona approach to management accounting highights some stark differences in the focus and types of information usefu for SMA. However, it is important to distinguish between the roe of SMA in supporting the formuation of strategy and its impementation. It may be that many of the traditiona management accounting approaches to panning, performance evauation and contro at the operationa eve wi pay an important part in turning deiberate and emergent strategy into reaised strategy. The research evidence that adoption of SMA is imited is chaenging for accountants since strategy formuation is a contested area in which management accountants must contribute effectivey aongside other professionas (Activity 1). The next section takes a perspective that may be controversia, that is, that some customers may not be worth having! 2 Strategic customer anaysis By the end of this section you shoud be abe to: expain the need to choose which customers to dea with and on what basis criticay evauate the widey used traditiona approaches to customer profitabiity anaysis cacuate customer profitabiity using activity costing undertake a Pareto anaysis of customers or groups of customers. 2.1 The customer seection decision An important strategic decision, in addition to which products or services to produce/ provide, is which customers to dea with and on what basis. In any organisation, not a customers can be considered equa in terms of the size of their actua or potentia purchases (and profitabiity) and the demands they pace on the organisation s resources. Market segmentation provides a means to identify which existing and potentia customers the organisation shoud focus on. However, even within market segments, some customers wi be considered more important than others and it is necessary for an organisation to decide which it shoud focus its attention on. This is an aspect of reationship marketing. Customer reationship marketing (CRM) describes the need to estabish, maintain and enhance reationships with customers and other partners at a profit, so that objectives of both parties invoved are met (Grönroos, 1994, p. 348). Even in the simpest way of ooking at exchanges in the for-profit sector, there is a range of possibiities. At one extreme, there are what are referred to as transaction-based exchanges: here, buyer and seer simpy exchange products and services for money and at the end of the exchange there is very itte ikeihood that they wi do business with each other again. A one-off purchase from a mobie snack bar at the annua fun fair coud be an exampe. The two parties do not need to trust each other as they immediatey see what each side is getting in the exchange, and after a if they have never met before and are not ikey to do so again, what basis for trust coud there be? 10 of 59 Thursday 11 February 2016

11 2 Strategic customer anaysis At the other end of the continuum are very ong-term exchanges that wi perhaps span many years. These may we invove peope making promises to each other and they wi probaby require substantia eves of trust, in addition to a contract and monitoring of performance. Such ong-term exchanges are often referred to as being reationship based. Buiding ong-term reationships with customers is considered to be particuary important in many professiona service organisations, such as aw or accountancy firms. But ong-term externa buyer seer reationships can aso exist in the non-profit sector for exampe, peope who give reguar donations to their favourite charity. It is, therefore, important for an organisation to decide what kind of reationship, if any, it wishes to have with its customers. It is possibe to categorise customers on the basis of the costs and subsequent profit that a reationship woud generate. This is shown in Figure 1. Figure 1 Categorisation of customers by cost and profitabiity (Source: Koter et a., 2005, p. 30) For a commercia organisation, the extent to which it shoud enter into a reationship is ikey to be determined (in arge part) by the potentia profitabiity of the customer. Customers can be categorised into four groups: Seeping giants: these customers generate a ot of profit, and are undemanding and do not necessariy want much from the reationship. Power traders: these customers provide a arge amount of profit but are demanding in their needs. Pets: these customers produce a sma amount of revenue and have no rea need for a reationship with the organisation. Deinquents: these customers provide itte profit but are the most demanding in their needs for a reationship. The most difficut group to dea with is the deinquents. In some instances it wi not be possibe to remove these customers and they wi have to be deat with. In these instances, opportunities shoud be provided to aow them to access products/services that are ess ikey to upset them. If this is not possibe then the organisation wi simpy have to accept that they exist and find ways of coping with their behaviour. One important aspect of customer reationship marketing is key account management (KAM). But as Miman and Lucas observe, one of the most probematic aspects of KAM is devising and making operationa, meaningfu criteria for key account definition and monitoring of performance. Ten customers represented about fifty per cent of our saes ast year. Five years ago it was about thirty customers. We can t afford to ose any of them. Yet I 11 of 59 Thursday 11 February 2016

12 2 Strategic customer anaysis often wonder whether our tender oving care is misdirected and costing us an arm and a eg. (Financia Controer of a US software company). (1998, p. 11) They cite this (p. 12) and numerous simiar comments extracted from their research, as reinforcing the assertion that effective KAM needs to be underpinned by sound financia data and the use of appropriate decision-support toos. These comments raise the foowing questions: Does the KAM activity add vaue to the operations? Are the returns from individua accounts commensurate with the costs incurred in serving them? What measures shoud be used to assess key account reationships? How can the joint efforts of marketing/saes and accounting/finance managers be brought to bear on KAM to enhance best practice? Miman and Lucas report the foowing insights gained from their research into KAM practice which tend to be overooked by marketing/saes managers who rey argey on intuition rather than systematic financia anaysis of customers. Banket measures of performance (e.g. target return on saes/investment) may grossy distort the vaue of individua key accounts to the seing company. Key accounts at different stages of reationa deveopment may require different approaches to performance measurement. The best way to monitor performance at the eary stages of buiding a key account reationship might we be customer share growth and cash fow rather than a punitive financia ratio that wi demotivate those peope tasked with account deveopment and penetration. Attribution of customer-reated costs has been noted as one of the main stumbing bocks in key account profitabiity anaysis. Service and support costs vary with customer order size, type and mix. Some customers are more demanding than others and they often attempt to shift responsibiity for support on to the seing company beyond reasonabe imits. There is much work to be done in anaysing the cost trade-offs associated with varying eves of service/support, escaation procedures, and charging for specia treatment previousy regarded as free. Section 2.1 has discussed the customer seection decision which is necessary because some customers wi be more attractive than others. This has impications for the basis on which the organisation wishes to dea with any particuar customer if at a. An important factor in for-profit organisations is the actua or potentia profitabiity of the customer. Management accountants have an important potentia roe to pay in determining customer profitabiity as discussed in the Section Determining customer profitabiity For commercia enterprises, customer profitabiity (actua or potentia) wi be a major factor in deciding which customers to dea with and what type of reationship to cutivate. 12 of 59 Thursday 11 February 2016

13 2 Strategic customer anaysis The traditiona management accounting approach was to assume that seing product X to one customer was pretty much the same (in terms of profitabiity) as seing it to another. This assumption was refected in common management accounting practice, which was to cacuate product costs and measure product profitabiity, but not cacuate the cost of serving particuar customers in order to measure customer profitabiity. However, the profitabiity of a particuar product can vary enormousy across customers. The 80:20 rue (the so-caed Pareto rue, named after the Itaian economist Vifredo Pareto) often appies to customer profitabiity: 80% of profit comes from 20% of customers. Consequenty, the decision as to which customers to dea with and on what basis, is a very important one. Yet many organisations management accounting systems do not provide adequate information on customer profitabiity. Even where customer profitabiity is measured, the approach taken is often inadequate. The probem and a possibe soution are described in Box 2. Box 2 Measuring customer profitabiity Two common approaches are: 1 ony measuring customer profitabiity at the eve of gross margin (i.e. saes vaue minus product cost) 2 assigning average cost by function (e.g. saes order processing cost is typicay 2% of saes vaue). The first approach is inadequate because gross margin is not a good guide to true profitabiity. Evidence suggests that seing and distribution, service and support costs may constitute up to 60% of saes vaue. Christopher (1992) gives a typica checkist of attributabe (i.e. to particuar customers) costs: cost of saes commissions saes cas key account management time order processing costs promotiona costs non-standard packaging and unitisation dedicated inventory hoding costs dedicated warehousing costs materia handing costs transport costs documentation/communication returns/refusas credit taken. Yet ony the first of these wi normay be refected at the gross margin eve. 13 of 59 Thursday 11 February 2016

14 2 Strategic customer anaysis The second approach is inadequate due to the enormous variabiity of cost among different customers. Beis-Jones (1989) cites evidence of cost variabiity by function as foows: Tabe 2 Function Seing and order taking 2 20 Storage and distribution 2 35 Production and purchasing Marketing and advertising 1 20 Genera administration Cost as percentage of saes vaue Activity-based costing (ABC) techniques may provide a basis for ascertaining the costs attributabe to a particuar customer. ABC works by assigning costs to products or customers according to their consumption of the activities that give rise to costs. This may be contrasted with the traditiona approach which apportions functiona/departmenta costs on some, more or ess arbitrary, voume basis (e.g. percentage of saes vaue). ABC views the organisation as a range of activities which often cross traditiona functiona boundaries. (These however are activities at a much more disaggregated eve than the vaue chain activities e.g. machine set-ups and production scheduing are activities which woud be the concern of ABC, yet woud be subsumed under operations in the vaue chain framework. Simiary, raising purchase orders and inspection of incoming goods are exampes of activities which woud be subsumed under inbound ogistics in the vaue chain, but woud be the concern of ABC.) The range of activities necessitated by serving different customers can vary enormousy and so consequenty can the rea costs. ABC impementation consists of two stages: 1 An activity anaysis: this is a detaied exercise to identify the activities performed at a fairy disaggregated eve, based typicay on interviews with empoyees. The resources consumed by each activity are then determined and hence its cost. 2 Costing customers: this invoves determining how much of each activity serving a particuar customer wi require. The activities which form the basis for aocating overheads are caed cost drivers. Exampes of cost drivers are: number of saes invoices raised as a basis for aocating saes invoicing costs; number of customer compaints as a basis for charging the costs of handing customer compaints. (Adapted from Miman and Lucas, 1998, pp ) Activity 3 The inadequacy of traditiona management accounting systems for customer reationship marketing (CRM) Spend about 10 minutes on this activity Write some notes expaining why traditiona cost and management accounting systems may not provide adequate support for customer reationship marketing and what the ikey adverse consequences of this faiure might be. Discussion 14 of 59 Thursday 11 February 2016

15 2 Strategic customer anaysis Customer reationship marketing (CRM) requires knowedge/understanding of customer profitabiity, rather than just turnover/revenue, since the cost of serving different customers differs greaty and is not necessariy proportiona to the revenue generated by them. In the eary days of industria capitaism, the emphasis was on standardisation and economies of scae; seing a product to one customer was pretty much the same, in terms of profitabiity, as seing it to another. This situation was exempified by Henry Ford s famous statement concerning the product offered to his customers: They can have any coour, as ong as it s back! In today s much more competitive business environment, this is not often the case, with the modern emphasis on customer service and catering for the differing demands of different customers. Measuring customer profitabiity is therefore as important as measuring product profitabiity as it is ikey to be a major factor infuencing the sort of reationship that is deveoped with a particuar customer. Customer costing is of vita importance, yet many organisations do not undertake this in any systematic way. Traditiona costing systems focus on product costs rather than customer-reated costs; this is ikey to resut in deaing with, and perhaps even giving preferentia treatment to, unprofitabe customers and/or, conversey, faiing to court highy profitabe ones Tracing of costs to customers In order to appy the activity-based costing approach it is necessary to identify the cost driver for a particuar indirect cost and then estabish a cost driver rate for charging the cost to a particuar cost object, be it a product or customer. For exampe, the cost driver for saes order processing cost might be the number of orders taken. If the tota saes order processing cost for a period is 150,000 and the number of orders taken is 1,000, then the cost driver rate wi be: Equation 1 Order processing costs shoud then be aocated to customers at a rate of 150 for every saes order received from the customer. Activity 4 Cacuate customer profitabiity using activity based costing Spend about 25 minutes on this activity. (This activity is adapted from Gad and Becker, 1995, pp ) Apha Ltd has three customers: Beta, Gamma and Deta. The management accountant has coected the foowing data concerning saes, transactions and costs reating to the three customers, as foows: Tabe 3 Beta Gamma Deta Saes revenue 120, ,000 90, of 59 Thursday 11 February 2016

16 2 Strategic customer anaysis Number of orders paced Number of units sod Warehouse foor space occupied (square metres) Tabe 4 Apha s indirect costs and cost drivers Order taking (number of orders taken) 1, Packing (number of units packed) 5, Dispatch (number of units dispatched) 4, Warehousing (cost of foor space occupied by goods) 1, Account administration (number of orders taken) 2, The gross profit on saes (based on the standard profit margin) is 30%. The directy traceabe service and support costs (consisting of seing, deivery, financing and settement discounts) for each customer are as foows. Tabe 5 Beta: 13,120 Gamma: 18,476 Deta: 13,620 Using activity based costing, cacuate the net profit for each of the three customers. Note: You can assume that the number of units packed is the same as the number of units dispatched/sod. Answer Tabe 6 Cacuation of cost driver rates Order taking = 1,534/118 Packing = 5,250/1,250 Dispatch = 4,312.50/1,250 Warehousing = 1,007/95 Account administration = 2,242/118 = per order = 4.20 per unit = 3.45 per unit = per square metre of foor space = per order Tabe 7 Customer activity costs Activity Beta Gamma Deta Ord. taking = = = 507 Packing = 1, = 2, = 1, of 59 Thursday 11 February 2016

17 2 Strategic customer anaysis Dispatch = W housing = Acc. admin = Tota act y 1, = = = 1, = = 1, = 1, ,029 6,361 4,956 traced costs Tabe 8 Customer profitabiity anaysis Beta Gamma Deta Saes revenue 120, ,000 90,000 Gross profit (30% of saes) 36,000 45,000 27,000 Directy traceabe service/support costs 13,120 18,476 13,620 Tota activity costs (as per above anaysis) 3,029 6,361 4,956 Net profit 19,851 20,163 8,424 Discussion The cacuations show that the ranking of customers in terms of tota profit is the same as in terms of saes revenue: Tabe 9 Beta Gamma Deta Revenue 120, ,000 90,000 Ranking Net profit 19,851 20,163 8,424 Ranking However, if profitabiity in terms of profit as a percentage of saes revenue is considered, a different picture emerges: 17 of 59 Thursday 11 February 2016

18 2 Strategic customer anaysis Tabe 10 Beta Gamma Deta Revenue 120, ,000 90,000 Ranking Net profit as % of revenue 16.5% 13.4% 9.4% Ranking This is because both indirect costs and directy traceabe service and support costs are (proportionatey) highest for Deta and owest for Beta (with Gamma in between): Tabe 11 Indirect costs as % of revenue Direct support as % of revenue Beta Gamma Deta 2.5% 4.2% 5.5% 10.9% 12.3% 15.1% This anaysis indicates that Deta consumes a proportionatey (reative to saes revenue) higher amount of indirect and support resources than the other two customers. Gamma consumes significanty more resources than Beta, so that, athough saes for Gamma are 25% higher than for Beta, the difference in profit is amost negigibe. It is appropriate at this point to add a cautionary note. Activity based costing has considerabe potentia for providing more accurate product and customer costing, but it is based on a number of assumptions which may not aways hod true in practice. It effectivey assumes a inear reationship between activities and costs which may not be reaistic due to the existence of fixed costs and joint costs. It aso assumes that the costs of individua activities are independent of each other and therefore separabe (Noreen, 1991) which may aso not aways be the case. These assumptions imit the possibe appication of activity based costing in practice (Bhimani and Bromwich, 2010) Appying Pareto anaysis to customer profitabiity It is often usefu to distinguish between the most important few and the ess important many in order to determine where management attention shoud be directed in keeping customers happy and/or cutivating reationships. The Pareto rue, that 80% of something is accounted for, or caused by, 20% of something ese, often appies to customer profitabiity. These may not be the exact proportions but the genera principe, that a high proportion of something is accounted for by a sma proportion of something ese, nevertheess often appies. Based on the assumed existence of this reationship, it can be hepfu for management to undertake a Pareto anaysis. For exampe, customers may be grouped by profitabiity to hep management decide where their efforts shoud be directed, for exampe in KAM or CRM. It is quite common to find that the top 20% of customers generate about 80% of tota profit, the next 30% generate about 10% of tota profit and the remaining 50% of customers 18 of 59 Thursday 11 February 2016

19 2 Strategic customer anaysis generate about 10% or ess of the tota profit, as iustrated by the foowing exampe of DJM Ltd. Exampe 1 Customer profitabiity anaysis DJM Ltd has 20 customers and has undertaken a Pareto anaysis of customer profitabiity as shown beow. Tabe 12 Customer Profit ( 000s/ year) Tota profit (%) A 2, B 2, C 1, D 1, E F G H I J K L M N O P Q R S Cumuative profit (%) T Tota 10, (rounded) It is usefu to cassify the top four customers as Cass A customers and treat these as key accounts. The next six customers are treated as Cass B customers, with ess effort devoted to keeping them happy. A other customers receive reativey itte attention. It is sometimes hepfu to iustrate the resuts of a Pareto anaysis in a Pareto diagram, which shows the impact of each customer group on tota profit, see Figure of 59 Thursday 11 February 2016

20 3 Principes of project appraisa Figure 2 Pareto diagram for customer profitabiity Stop and refect Internet retai outets such as Amazon have thousands of customers in many countries. How coud such companies use customer profitabiity anaysis? They can no doubt trace the purchase history and reated costs of each individua, but it may be usefu to have categories of customer. Geographic region is one obvious category, gender or age might be others. Can you think of more possibiities? This section has discussed how, in addition to knowing the costs (and hence the profitabiity) of providing particuar products or services, an organisation shoud know the cost of serving different customers to determine their respective profitabiity. Many organisations cost and management accounting systems have focused ony on product (rather than customer) costing. Increasingy, however, the impact of competitive pressures on profits is making it necessary for organisations to know the profitabiity of different customers. Activity based costing, athough originay deveoped for product costing, can be adapted for this purpose. The next section ays the foundation for an important technique for addressing a different strategic chaenge making decisions about investments in projects. 3 Principes of project appraisa At the end of this section you shoud: be abe to distinguish between reevant and non-reevant cash fows be abe to expain the time vaue of money, and why discounting is carried out 20 of 59 Thursday 11 February 2016

21 3 Principes of project appraisa know how to use a company s WACC as a discount rate and discuss its drawbacks be abe to cacuate an appropriate discount rate by using the CAPM and discuss its drawbacks be abe to use a spreadsheet to mode a discounted cash fow anaysis. Before we examine specific appraisa techniques, we sha review and expand on some of the principes underying them. At this more advanced eve it is important that you not ony know how to perform techniques, but aso why they are carried out in the way they are, and how this affects which technique is most appropriate for a task. This wi hep you to expain them to other peope if necessary, and deepen your understanding of the techniques themseves, aowing you to recognise their strengths and imitations too. We review the type of costs that are incuded in an appraisa; how to decide if costs are reevant or not; why we shoud ignore sunk costs; and aso whether there are opportunity costs incurred which woud not normay be identified on an accounting budget of a project s financia costs. Peope have a tendency to take sunk costs into account; however, doing so means that irreevant information may be infuencing a decision, so the optima decision may not be made. We ook in depth at the reated concepts of discounting, the time vaue of money, and present vaue (of future cash fows). These are the foundation of discounted cash fow (DCF) techniques, which is based around the idea that 1 received or paid today does not have the same economic vaue as 1 received or paid at some point in the future. We wi discuss the causes of the time vaue of money. Discounted cash fow techniques such as net present vaue and interna rate of return require us not ony to take account of the time vaue of money, but to estimate what it is by using a discount rate. We show how the weighted average cost of capita, discussed in the previous course, can be used as a discount rate to take account of the time vaue of money, and aso review the potentia probems with this technique. If we decide that the WACC is not an appropriate discount rate, the capita asset pricing mode (CAPM) is another method to cacuate a discount rate. We review how this can be used, and ook at the potentia probems with this method too. 3.1 Reevant cash fows and sunk costs When carrying out a quantitative investment appraisa, you need to work out which costs and revenues shoud be incuded in the anaysis. Costs and revenues that shoud be incuded are caed reevant cash fows. Activity 5 Reevant costs and revenues Spend about 5 minutes on this activity. Name three characteristics that a reevant cost or revenue has. Discussion 1 It must be a cash fow. This excudes accounting charges such as depreciation, which aim to refect how an asset is used over its economic ife and do not affect actua cash fows, whereas we are ony interested in the timing of cash being paid or received. 21 of 59 Thursday 11 February 2016

22 3 Principes of project appraisa 2 It must be incrementa This means that a cash fow wi change, as a resut of making a decision. Costs or revenues which wi take pace regardess of the decision made are not incrementa. 3 It must arise in the future. Costs or revenues which have aready occurred cannot be affected by a decision taken now, so they are irreevant to decisions about the future. The main principe to remember is that you want to know what wi happen to cash fows if one decision is taken compared with an aternative decision. (This aternative coud be the status quo or it may be an aternative project under consideration). In order to decide if a cash fow is reevant, ask yoursef: How wi a cash fow change as a resut of this decision being made? If the answer is that it won t change, then it is not a reevant cash fow for that particuar decision. A cost which has aready been incurred (so is a past not a future cash fow), is caed a sunk cost and is not reevant. In addition a cost which has not occurred yet, but cannot be avoided in the future regardess of the decision, is aso a sunk cost. Even though it is a future cash fow, it wi be incurred irrespective of the decision made, so is not reevant to the decision. Aso note that the reevant cash fow is the ony part of a cash fow that wi change depending on the decision. This may not be the entire cash fow. For exampe if a new machine wi reduce the raw materias used in production from 20,000 to 15,000, the reevant cash fow is a saving of 5,000: the incrementa difference between the figures. Simiary, overheads such as saaries, heating, etc. are ony incuded if they wi increase or decrease if the project goes ahead. Even then, ony the change in cash fow is reevant to the cacuations used in investment appraisa. Reevant costs (cash outfows) of a project coud incude: the initia investment in purchasing new equipment extra staff costs for manning new equipment or providing new services additiona infrastructure or marketing to support the new goods or services provided additiona tax payabe on any expected profits from a project an increase in working capita required as a resut of a project (a factor that is often ignored!) revenue which woud have been earned if the project did not go ahead, which is no onger earned due to a project going ahead. This revenue is caed an opportunity cost of the project. Reevant revenue (cash infows) incudes: increases in revenue reductions in cash outfows due to cost savings, e.g.: ess raw materia to be purchased in the future reductions in staff abour time which resut in ower staff cost reduction in overheads which can be directy attributed to the project for exampe, reduction in energy cost or fue cost due to greater efficiency cash fow from the disposa of od equipment 22 of 59 Thursday 11 February 2016

23 3 Principes of project appraisa working capita reeased at the end of a project (note this may be ower than the working capita required at the beginning of the project). Box 3 The faacy of sunk costs The ogic of ignoring sunk costs is cear; and taking them into account is caed a faacy a fauty argument. However, it is a faacy humans are very prone to making and can be difficut to overcome. It often resuts from reuctance to waste money that has been previousy spent (Arkes and Bumer, 1985) or being viewed by others as wasting it. In reaity, money that has aready been spent is gone, and wasting more money to attempt to recoup some does not make sense. Making further investment, on the basis that money has been spent in the past (i.e. on sunk costs), is sometimes known in Engish by the phrase throwing good money after bad money. In fact most anguages have some equivaent phrase, which probaby shows how tempting and widespread this faacy is! Note that those responsibe for previous spending may have a persona incentive to push for further spending to achieve something from a project in order to avoid criticism of their previous decisions. Such thinking is not confined to management accounting situations or even financia situations. In poitics, a common strategy to achieve a desired goa is to spend or commit as much money as possibe at the beginning of a project. Then when peope object, it is argued that the money aready spent shoud not be wasted (hint: it has aready been wasted the money can t be recovered!). A particuary bad exampe of the sunk cost faacy in practice is the Concorde effect : the doomed joint project of the British and French governments with the supersonic commercia jet. Whie it was cear for over 30 years that continuing with the project woud invove osing even more money, it was aways continued because it was fet undesirabe to waste the money aready spent. So, you can see faiing to ignore sunk costs can have very serious consequences! Even though the consequences in management accounting are not usuay as severe, be wary of etting them affect your decisions. Stop and refect Think about the type of project which your organisation (or an organisation you are famiiar with) might invest in. What woud be the reevant costs and revenues that shoud be taken into consideration when deciding if the project shoud proceed? 3.2 The time vaue of money, discounting and present vaue Many projects invove cash fows that occur over severa years and, in order to accuratey assess the benefit that wi be received from projects, it is necessary to take into account the time vaue of money. The time vaue of money refects the fact that cash fows in the future are ess vauabe than those that take pace immediatey. The further into the future they occur, the arger the discount needs to be to refect the greater reduction in vaue. Discounting each future cash fow in proportion to how far it occurs in the future aows us 23 of 59 Thursday 11 February 2016

24 3 Principes of project appraisa to compare a the future cash fows which resut from taking on a project on an equa basis. This equa basis is caed the present vaue of the future cash fows, and which is the equivaent vaue of each future cash fow if it were paid or received today. By converting each future cash fow into its present vaue, you can compare future cash fows that occur at different points of time in the future on a ike-for-ike basis. Converting a cash fow to its present vaue is achieved by discounting using the discount rate, which is the annua discount that must be appied to future cash fows. This technique can be appied to two types of decisions in project appraisa, which are discussed beow. Determining whether or not a project shoud proceed The NPV (net present vaue the tota sum of a the positive and negative reevant future cash fows) of a project is cacuated. A project wi add vaue to an organisation when its net present vaue is positive. Note that net present vaue is not simpy totaing a cash fows from a project to see if they are positive: because of the time vaue of money, cash that is received a ong time in the future has significanty ess vaue than cash paid out now. So a project that produces a ot of cash infows sometime in the future may have positive net cash fows; however, when the time vaue of money is taken into account the net present vaue may actuay be negative. A very simpe exampe of this woud be if a company offered to pay you 110 in 10 years time, if you invest 100 with them now. Despite the net cash fow being 10, this is ceary not a good investment. Infation over 10 years wi mean that 110 in 10 years has significanty ess present vaue than 100 now. (And this is without taking into account the additiona risk that you do not receive the money back, for exampe if the company goes bankrupt over the 10 years and you ose your initia 100.) Choosing between projects Sometimes, there is more than one project avaiabe and ony one can be chosen (perhaps the projects are mutuay excusive, or they both achieve the same objective in different ways). When appraising severa projects, not ony do you have the probem that the actua cash fows cannot simpy be added together, but aso that different projects wi ast for different engths of time and have different patterns of cash outfows and infows over the ifetime of the project. Using net present vaue makes it easy to compare the reative vaue that each project wi provide to the organisation. Once you have discounted the cash fows into present vaues the rest is simpe: simpy find the net present vaue for each project and the highest net present vaue is the best option, at east economicay, as it produces the most vaue for the organisation. 3.3 Why does the vaue of money depend on time? Money has time vaue for severa reasons: the risk that cash fows do not take pace in the future 24 of 59 Thursday 11 February 2016

25 3 Principes of project appraisa the oss of the fexibiity to use money for more profitabe projects, if such opportunities arise whie the money is invested in an ongoing project the oss of vaue of money due to infation the opportunity cost of aternative investments (such as in gits, bonds, or other shares). These can be divided into two types of reasons: underying ones about risk and fexibiity, and ones invoving comparisons with the potentia rates of return from aternative investments Underying factors The risk that cash fows do not take pace in the future The future is uncertain and reying on predictions of the future carries risk. You can invest money now in the expectation of getting future cash infows, but the expected infows may not happen! For exampe, a counterparty that owes you money may go bankrupt, market conditions may change and saes may not meet the forecast eves, efficiencies from a new machine may not be achieved due to manufacturing probems or incorrect assumptions made. There are many things that may go wrong resuting in you not receiving some, or even any, of the money you were expecting, and the further into the future you have to wait to receive it, the more that can go wrong. So the vaue of a future cash fow must be ess than the same sized cash fow that takes pace now or sooner in the future. This is summed up, oosey, in the phrase a bird in the hand is worth two in the bush, meaning it can be preferabe to have something of esser vaue now, rather than the risky prospect of gaining something of greater vaue in the future. The risk of a project is usuay the major factor in choosing a discount rate for a project, because the risk invoved with a project eads to a much higher discount rate than a discount rate based soey on infation or the rate from investments such as bonds. The oss of fexibiity During the time that the funds are invested and committed, an organisation oses the abiity to use those funds for other opportunities that may arise. Sometimes other opportunities wi present a higher return than that avaiabe from the project undertaken, but it is too ate to change the organisation s pan. The time vaue of money can refect what opportunities an organisation might miss by committing funds to a project. In economic terms, having more options can ony make you better off. At worst, you do not use the options and have the same weath as before. Committing funds to a project removes options, and there is a potentia opportunity cost associated with this. In a way, this is the reverse effect of future cash fows having ess vaue due to their risk. Money in the present has greater vaue compared to money in the future, because money now coud be used to invest in other opportunities if they arise, so money now has some extra vaue compared with money in the future. Since cash fows in the future have ess vaue, they shoud be discounted to refect this. 25 of 59 Thursday 11 February 2016

26 3 Principes of project appraisa Comparisons with other rates of return Infation In a but seriousy distressed economies, infation aways occurs. 1 now is worth ess than 1 in the year Simiary 1 is worth more now than 1 wi be in Infation puts a minimum figure on what the discount rate can be, because at the very worst, we want to earn a financia return from a project that is greater than the rate of infation. A financia return ower than the rate of infation is effectivey a negative return in terms of vaue the money you get back has ost vaue compared with the vaue of money invested. It might hep you to think of the discount rate as a kind of infation-pus. As discussed above, infation decreases the vaue of money over time: 1 in the future wi buy you ess than 1 now. However, other reasons for the time vaue of money aso decrease the vaue of money over time cash fows in the future that are more risky, for exampe, are worth ess than cash fows that are certain or known with greater confidence. So the discount rate needs to be raised above the rate of infation to account for the oss of vaue over time from infation, and aso from other factors. The opportunity cost of aternative investments (such as gits, bonds, and shares) This foows on from the oss of fexibiity. Imagine that the fexibiity to invest the cash in another project somewhere ese is not just an abstract benefit: you know about other investments and what the return from them woud be. For exampe, cash can be used in ess risky investments such as gits, bonds and deposit accounts (i.e. savings accounts for organisations). If investing in gits (which are normay considered risk free) woud earn 5% per year, it woud be fooish to invest in any project which had a return of ess than 5% per year, as this return coud be achieved without any of the risk that the project invoves simpy by investing in gits. The risk from a project is usuay higher than investments such as gits or bonds, so ceary, it doesn t make sense to invest money in a project which provides a ower return despite having a higher risk. So in the exampe above, the minimum vaue for the time vaue of money woud be 5% per year, as that is a risk-free aternative use of the cash compared to investing it in a project. When we set a discount rate to appraise a particuar project, what we are impicity saying is that by investing in a typica project of the same risk, we coud earn a return equa to the discount rate. Therefore, if the project under consideration does not produce a return of at east this discount rate, then the project is not providing a sufficient return to compensate for the risk taken, and is not worth investing in. How the discount factor is cacuated, and how it reates to other rates of return Though discount factors are provided to you in the Appendix, you can cacuate the discount factor appicabe to cash fows in any year with a simpe formua. Understanding this formua may aso hep you to understand how discounting works. The formua for the discount factor is: Equation 2 26 of 59 Thursday 11 February 2016

27 3 Principes of project appraisa Where r equas the discount rate as a percentage figure, e.g. 5%, and n equas the number of years into the future when the cash fow takes pace. This formua is equa to: Equation 3 Using some numbers for an exampe now, et s say the discount rate is 5%; 5% expressed as a decima is The discount factor for a cash fow in year 1 woud be: Equation 4 The discount factor for a cash fow in year 3 woud be: Equation 5 Now, what is the ogic behind this? Imagine that a git returns 5% per year, and we base the time vaue of money entirey on this aternative investment. After one year, 100 invested in the git wi be worth 5% more, so wi be 105. A project which returns more than 105 for 100 invested at the present time wi be a better use of that money than investing it in the git (if the risk was the same), whereas a project which returns ess than 105 is not a better use, and the money is better invested in the git. Think about trying to do the reverse now, vauing an expected cash fow in year 1, compared to what is invested at the present time (aso known as year 0). We aready know that 105 in year 1 has the same vaue as 100 in year 0. Appying the discount factor for year 1 to a cash fow in year 1 transforms it into year 0 pounds. Therefore: Equation 6 With some simpe agebra: Equation 7 This resut is now the same as the formua for the discount factor, given above, when n equas 1 and r equas 5%. The discount factor compares a cash fow in a future year with the amount that woud have been needed to be invested in year 0 at the minimum return, 27 of 59 Thursday 11 February 2016

28 3 Principes of project appraisa represented by the discount rate (in this exampe 5%) which woud have resuted in a future cash fow of the same size as the one being discounted. Future cash fows are being discounted at the rate of the minimum return to give their equivaent amount invested in year 0. The additiona factor that makes discounting a difficut concept is that the discount rate represents more than just the minimum return of an aternative investment (5% in the exampe above). The discount rate aso represents the risk that a project invoves, and for this reason is higher than a risk-free aternative investment. However, it is possibe to think of this component as the minimum return necessary to compensate an investor for the additiona risk the project carries. If a hypothetica aternative investment was not risk-free, but had the same risk as the project being considered, the return which woud be necessary to interest investors in that investment is equa to the discount rate that is used for the project appraisa. 3.4 Using the WACC as the discount rate for a project Comparisons with other investments are based on the time vaue of money being inked to the risk of future cash fows. The more risk a project under consideration carries, the higher the time vaue of money for that project wi be. This is because cash fows in the future wi have ess vaue when more risk is attached to them, and management wi require a higher return to undertake the project. It foows that, if an investment with ess risk returns 5%, a more risky use of the same cash (such as a project under consideration) must return more than 5%, in order for the project to be worthwhie and to add vaue to the organisation. How much higher does this return have to be? An obvious answer is that it wi depend on how much more risky the project is; however, in order to appraise the project we need to estimate a precise discount rate. One soution for companies is to use their weighted average cost of capita (WACC). The WACC refects the risk to the future cash fows received by an organisation from its operations. If two companies are expected to produce the same future cash fows but one has a ower WACC, then it wi be more vauabe. This is because the company with ower WACC is seen as having ess risk attached to the cash it wi generate in the future. If the business environment changes, in a way that increases the company s WACC such as the ikeihood that government reguation wi impact on its abiity to generate cash, then the vaue of the company (and its shares) wi decrease. The theory behind using the weighted cost of capita to appraise projects is that the WACC is the cost that the business pays for the capita it uses to invest in its operations. Given the risks of the company s position, investors want the company to give them at east this return, or the risk of investing in the company is not worth bearing. So in order for a project to be worthwhie, it must return at east the WACC. If a company has cash to invest and does not think it can deiver the WACC rate, it woud be better returning this surpus cash to sharehoders in the form of dividends, or repaying its debt, rather than investing it in a project which wi not produce an adequate return. The company wi have to pay out a rate equa to the WACC as the cost of having the capita avaiabe to commit to the project; however, if it actuay receives a return from the project ower than the WACC it has to pay out, the organisation wi ose vaue overa by taking on the project. 28 of 59 Thursday 11 February 2016

29 3 Principes of project appraisa 3.5 Probems with using the WACC as the discount rate for a project Unfortunatey, there are requirements about when the WACC wi be exacty the same as the appropriate discount rate. Business risk For the WACC to be appropriate, the new project must have the same business risk as the company overa, and this wi often not be the case. For exampe, expanding into new markets wi usuay not bear the same business risk as the company s current operations (it wi usuay be higher). If the company has a ower business risk than the project has, risky projects coud be accepted when they shoud not be. Whie if the company has a higher business risk than the project, reativey safe projects may be rejected incorrecty. Financia risk For the WACC to be appropriate, the financia risk of the project must be the same as the financia risk of the whoe company. At the very east, this means that the capita structure of the company shoud not change significanty as a resut of undertaking the project. So either the project is sma enough compared with the overa size of the company for it to fund the project from existing capita, or new funds for the project wi be raised in the same proportions as the existing capita of the business. Other eements of financia risk of a project such as foreign exchange risk may aso be different from the company as a whoe. Foating finance Foating finance is any finance where the interest rate payabe changes as the market interest rate changes (i.e. the finance has a foating rate). Therefore when the market rate changes, the WACC of an organisation that uses foating finance wi aso change. In a ater section you wi see how a discount rate that varies over time can be used for project appraisa however, this does make the cacuations more cumbersome. There is aso the probem that changes in the foating rate in the future are unknown, so how the WACC wi actuay change in the future can aso ony be estimated. These requirements mean that the WACC may be miseading if used as a discount rate. Where the above factors are not significanty different from the company overa, WACC coud be used without changing the resut of project appraisa. However, if you fee that the project is quite different from the company on these requirements, you may want to use another way to cacuate a discount rate; the Section 3.6 ooks at this. 3.6 Using the CAPM to find a project-specific cost of equity In order to adjust for a difference in business risk between the company and a new project, it is possibe to use the capita asset pricing mode (CAPM) to cacuate the 29 of 59 Thursday 11 February 2016

30 3 Principes of project appraisa return on equity that woud be required for the new project. Then this figure can be used to cacuate an effective WACC for the project. Doing this means the project is being treated as if it were an independent business, and the price of equity woud be worked out as if it were a company whose ony operation was the project under consideration. Using the CAPM aows you to appraise a project on the basis of the risk of that project specificay, rather than the risks that appy to the company as a whoe. This aows decisions about whether to proceed with a project to be more accuratey focused. Another benefit is that projects with different risk profies can be compared with each other. Using the same discount rate to appraise different projects is miseading, as it impies that a projects have the same risk profie, whereas riskier projects shoud have their cash fows discounted to a greater extent to refect this. To cacuate the cost of equity for a project, it is necessary to find a group of companies which operate in the industry the new project wi be in. Beta vaues are pubished and avaiabe pubicy, so the average beta vaue for companies in the industry can be cacuated and used to work out the equity cost of capita. Remember, the formua for cacuating the cost of equity is: Equation 8 where: E(R i ) = the expected return on shares of company i = cost of equity R f = the risk-free rate of return E(R m ) = the expected return on the market E(R m ) R f = the expected equity risk premium β i = the beta for the company Activity 6 Using NPV to choose between projects Spend about 15 minutes on this activity. A company wants to choose between two projects. Find the net present vaue of each project, based on the company s cost of capita which is 10%. Assume that the company is entirey financed by equity. Make a recommendation about which project shoud be accepted. Tabe 13 Cash fow ( ) Year 0 Year 1 Year 2 Year 3 Project A (70,000) 30,000 30,000 30,000 Project B (25,000) 10,000 10,000 10,000 Answer Tabe 14 Project A Year of cash fow Tota Cash fow ( ) (70,000) 30,000 30,000 30, of 59 Thursday 11 February 2016

31 3 Principes of project appraisa Discount factor of 10% Discounted cash fow (70,000) 27,273 24,792 22,539 4,604 Tabe 15 Project B Year of cash fow Tota Cash fow ( ) (25,000) 10,000 10,000 10,000 Discount factor of 10% Discounted cash fow (25,000) 9,091 8,264 7,513 (132) The discounted cash fow of Project A is 4,604, compared with ( 132) for Project B. Therefore Project A shoud be accepted. Activity 7 Using the CAPM to cacuate a discount rate Spend about 25 minutes on this activity. The company in Activity 6 is sti choosing between Projects A and B. However, there is now some additiona information. The beta vaue of the company is Assume a risk-free rate of 3% and expected equity risk premium of 8%. The average beta vaue of equity capita for companies in the industry reevant to Project A is 1.5 and the average beta vaue of equity capita for companies in the industry reevant to Project B is Question 1 1 Cacuate the expected return (cost of equity) using CAPM for Projects A and B. Answer Project A The average expected return for this industry is 3.0% + (1.5 8%) = 15% p. a. Project B The average expected return for this industry is 3.0% + ( %) = 6% p. a. Note that the expected return, or cost of capita, for the company s current industry is 3.0% + ( %) = 10% p.a. However, since the business risk in the company s current industry is different from the industries reevant to Projects A and B, knowing the expected return for the company s current industry is not reevant. Indeed, you shoud be abe to see that using 10% as the expected return to assess the new projects is not appropriate, given they both differ from this expected return. Question 2 2 Find the net present vaue of each project, based on the cost of equity for each project impied by CAPM. Again assume that the company is entirey financed by equity. Make a recommendation about which project shoud be accepted. 31 of 59 Thursday 11 February 2016

32 3 Principes of project appraisa Answer Tabe 16 Project A Year of cash fow Tota Cash fow (70,000) 30,000 30,000 30,000 Discount factor of 15% Discounted cash fow (70,000) 26,088 22,683 19,725 (1,504) Tabe 17 Project B Year of cash fow Tota Cash fow (25,000) 10,000 10,000 10,000 Discount factor of 6% Discounted cash fow (25,000) 9,434 8,900 8,396 1,730 So after adjustment for the specific risk that each project wi face, Project A now has a negative net present vaue of ( 1,504), whie Project B has a positive net present vaue of 1, Probems with using the CAPM to find a projectspecific cost of equity Unfortunatey, using the CAPM is not without probems, ike the WACC. We sha briefy ook at these areas now Probems with using industry comparisons to estimate business risk and beta vaue It can be difficut to estimate the beta that a project shoud have as it is difficut to find other companies which are a cose match in business risk to the project under appraisa on account of differences in their operations, finances and strategic positions. Or to put it another way, the risk attributed to a company is not soey determined by what industry it is in. Many other factors come into pay and a of these wi affect its beta. For exampe, companies used for the industry comparison may: se different products vary in size vary in the baance of fixed and variabe costs (operating gearing) vary in the capabiity and reputation of management operate in different industries as we as the one for the project being considered 32 of 59 Thursday 11 February 2016

33 3 Principes of project appraisa vary in potentia for future growth or decine more generay, vary in their strategic position, as identified through techniques such as PESTEL and SWOT anaysis. One pragmatic (if not optima) soution when using the CAPM is to assume that on average, things baance out, and that the average beta of companies operating in the reevant industry is a good estimate for the correct beta the company shoud use when appraising its own project in that industry. (However, note that if the company doing the project appraisa does systematicay differ from other companies on the above factors, it is possibe that the beta it shoud appy when appraising the project shoud be different from the industry average. This is a compicated issue which is beyond the scope of this course.) Arguaby, the expected returns from a company entering a new market shoud aso be higher than those the market expects from a company which is aready estabished in a market. This is because entering a new market is intrinsicay more risky than continuing to operate in one Probems with financia risk Using the average beta from the reevant industry for a project does not eiminate the probem of financia risk mentioned earier. What this means in practice, is that the equity risk of the company that has the project and the comparison industry wi vary depending on how much debt they aso carry (i.e. if there is a difference in their capita structures). As discussed earier, when comparing the company s project with the company as a whoe, there wi be a difference in financia risk if the company s project is funded with a different capita structure from the company as a whoe. (In the activities above, it has been assumed that the company and its project are entirey funded by equity capita.) However, even if the same capita structure is used, there can aso be differences between the company considering a project and the comparison industry whose beta is used to evauate the project. If that industry has a different capita structure on average from the company considering the project, then the comparison industry wi vary in financia risk from the project being considered, and this wi systematicay affect the beta used by the comparison industry Other probems with the CAPM cacuation The risk-free rate can aso be difficut to estimate. Government securities have traditionay been taken as the risk-free rate. However, the financia difficuties in Europe from 2008 onwards and subsequent osses for bond investors have shown that many government equities certainy do come with some risk. Even the UK and the US have suffered credit rating downgrades as a resut of continuing sovereign debt probems (BBC News, 2011). Though their ratings are sti high, the downgrades refect the fact that they are not considered absoutey risk free anymore. CAPM ony produces an expected return for one year at a time so, in theory, when using the expected return as a discount factor, it needs to be estimated separatey for every year of the anaysis. However, note that this is a probem that a types of discounted cash fow methods share and not just using discounted cash fows with a discount rate derived from the CAPM. 33 of 59 Thursday 11 February 2016

34 3 Principes of project appraisa 3.8 Using a spreadsheet to mode project evauation In practice the factors to be incuded in a project evauation decision are ikey to be more detaied and compex than in the exampes above. It is usefu to mode them in a spreadsheet that can be used for different projects and to aow different scenarios to be anaysed quicky and easiy. In this section we wi work through an exampe of a spreadsheet designed for this purpose. You wi watch four videos which show you how to buid a spreadsheet discounted cash fow mode. The four videos show a range of techniques and compement each other so watch them in the order they are presented. In your first viewing, watch the four videos one after the other. They are: Layout and formuae Using input ranges Cacuate the interna rate of return Cacuate payback A the videos use the foowing investment scenario: A company pans to invest 1,000,000 in a new product that wi generate revenues (cash receipts) of 300,000 in Year 1, 500,000 in Year 2 and 600,000 in Years 3 to 5. Costs (cash payments) wi be 25% of revenues (cash receipts) and are paid in the same year as the reevant cash receipts. This company uses a 10% discount rate for projects of this type. The corporate tax rate is 28%. Taxation cash fows occur in the same year as the reevant taxabe receipts and payments. There are no taxation cash fows arising from the investment of 1,000,000. Cacuate the NPV, the IRR and the payback period of this investment. Now watch the videos: Video content is not avaiabe in this format. Video 1 Layout and formuae 34 of 59 Thursday 11 February 2016

35 3 Principes of project appraisa Video content is not avaiabe in this format. Video 2 Using input ranges Video content is not avaiabe in this format. Video 3 Cacuate the interna rate of return Video content is not avaiabe in this format. Video 4 Cacuate payback 35 of 59 Thursday 11 February 2016

36 4 Deaing with risk and uncertainty in project appraisa You can see the DCF spreadsheet (soution) here. Spreadsheets can be usefu toos for decision making, but it is very important that they are constructed and tested carefuy. Research suggests that poory designed and controed spreadsheets are reasonaby common in business and can cause sizabe osses (Powe et a, 2009). This section has ooked at the principes which are the foundation of the project evauation. These incude what information to incude in an appraisa, using concepts such as reevant cash fows, sunk costs and opportunity costs. The time vaue of money and how project appraisas account for it by using a discount rate were discussed. Some approaches to estimating the discount rate, and their advantages and disadvantages, were discussed and the use of a spreadsheet to mode discounted cash fow decisions introduced. When performing project appraisa for decisions in practice, you woud need to decide what the appropriate discount rate to use is, and the information in this section shoud hep you do that. The guidance about designing a spreadsheet shoud aso assist in appying this understanding to practica situations, but note the warning from research studies that it is important to be very carefu using any too - but spreadsheets in particuar! 4 Deaing with risk and uncertainty in project appraisa During this course, we have deat with information as if the cash fows from decisions are known with certainty. The cash fows used to cacuate NPV have been suppied to you without any reference to how accurate they are or whether they are ony estimates from a range of vaues. Information about this is needed, because in rea ife the future is never known for certain and we are interested in the range of outcomes which coud occur, not just the best estimate of what might happen. Investment decisions are particuary susceptibe to risk and uncertainty, because the cash infows from an investment can take pace over many years or even decades. The number of years these cash fows wi ast; how arge these cash fows wi be; and whether they wi even take pace at a are a uncertainties. 36 of 59 Thursday 11 February 2016

37 4 Deaing with risk and uncertainty in project appraisa This section ooks at risk and uncertainty in more detai, and how it can be taken into account during project appraisa. This section begins with a discussion on the difference between risk and uncertainty, and typica attitudes which peope have towards risk and uncertainty. We discuss some simpe ways to adjust the discount rate and payback period to take risk into account. We expain how combining cash fows with their probabiities of occurring can be used to provide information about the expected vaues for the outcomes of projects. Finay the vaue of further information when making decisions is defined. At the end of this section you shoud: be abe to discuss the technica definitions of risk and uncertainty, and the range of attitudes which can be taken towards them be abe to demonstrate some simpe adjustments to NPV anaysis to dea with risk know how to cacuate probabiity-weighted cash fows, and expain why this approach is effective when risk is present in NPV anaysis be abe to appy probabiities to future outcomes, and expain why this is an aternative to an increased discount rate be abe to expain the meaning of vaue of information. 4.1 Risk and uncertainty The terms risk and uncertainty tend be used interchangeaby in norma anguage; however, they have different technica meanings, set out by Knight (2012). Take a situation where there are severa possibe future outcomes. We cannot say which wi occur, but if we can assign probabiities to the ikeihood of each possibe outcome occurring, we have a situation of risk. (These probabiities can be determined by reference to the reative frequency of outcomes that happened in the past. Aternativey they may be estimated from market research or using the expertise and experience of the staff invoved in a project.) If we cannot assign probabiities to the ikeihood of each possibe outcome occurring, we have a situation of uncertainty. Note that, technicay, risk and uncertainty do not necessariy have negative connotations. They simpy mean that future outcomes are not known with certainty. Where they are present, it means that cash fows coud be better or worse than their estimated vaues. However in everyday use, risk and uncertainty are typicay used to mean outcomes which are worse than a eve previousy predicted, so be aware of this difference. You may notice that despite the definitions above, there is sti a grey area between risk and uncertainty. Whie we may aways be abe to estimate probabiities of certain outcomes occurring, the degree to which these probabiities are accuratey known is aso subject to uncertainty. For exampe, if I am roing a die or tossing a coin, I know exacty the probabiities that the possibe outcomes have. However, a situation where you know the probabiities for certain is unikey in business situations. A manager trying to forecast demand for a new product may be abe to estimate the probabiity of achieving saes of 500,000, 1,000,000 and 1,500,000 as 20%, 50% and 30%, respectivey, based on past saes for simiar products. However the probabiities themseves are not known with certainty. The amount of uncertainty wi vary depending on the situation, so there wi be varying amounts of uncertainty about the risks faced! In practice, you woud have to use your judgement to decide whether probabiities can be 37 of 59 Thursday 11 February 2016

38 4 Deaing with risk and uncertainty in project appraisa estimated accuratey enough for risk anaysis to be worthwhie, or whether the project shoud be treated as having uncertain outcomes without probabiities attached to them Attitudes towards risk In this course, we have taken the attitude that decision-makers are risk neutra. This means that they seect the option which produces the greatest NPV, regardess of how risky the option is. If the same decision was taken many times, seecting the option with the greatest expected vaue each time woud produce the highest vaue in the ong run. However, many decisions taken in business are one-off decisions, not decisions which are repeated many times. In this context, other attitudes towards risk are often taken. Peope can be risk averse, meaning that they avoid risk. The technica definition of a risk-averse decision-maker is someone who wi sacrifice higher expected vaue in order to avoid risk. Note that this definition is different from the common definition of simpy avoiding risk where it is present. Here is an exampe to demonstrate what this means. Imagine you are offered a bet: you win 9,000 if you ro a six on a die, but you pay 1,500 if you ro any other number. Woud you take the bet? The expected vaue of the bet is in your favour: 38 of 59 Thursday 11 February 2016

39 4 Deaing with risk and uncertainty in project appraisa So the expected vaue = ( 1,250) + 1,500 = 250 A risk-neutra person woud accept the bet, since it has a positive expected payoff: the average gain on the bet is 250 per time. However many peope woud refuse such a bet, and demonstrate that they are risk averse in this case. A risk-averse attitude is common in many peope, and in business decision-makers to some extent. Peope often prefer to stick with what they have for exampe, a profitabe and ow risk business, rather than risk osing this for the (better than average) chance of making more money or expanding the business successfuy. It is aso possibe to be risk seeking, meaning unsurprisingy that peope seek out risk in order to get better returns. The technica definition of a risk-seeking decision-maker is someone who wi sacrifice higher expected vaue in order to take on risk. Note that this is different from the common definition of someone who is simpy wiing to take risks: a riskneutra decision-maker wi aso do this when the expected vaue is in their favour. Suppose the bet above is changed sighty so the payoff for a six is ony 6,000. The expected vaue of the bet is now: Equation 9 Equation 10 So the expected vaue is ( 1,250) + 1,000 = ( 250). Someone who was risk neutra woud now reject the bet, because the expected vaue is negative and the bet wi ose money on average. However a risk-seeking individua woud sti take the bet despite the expected vaue being negative, because taking the bet increases the risk they are exposed to. Obviousy, risk-seeking individuas in this definition are unusua. Most peope wi accept some risk in return for a greater average return, and peope vary in how much reward they require for additiona risk. However, few peope wi take on more risk at the same time as making the expected vaue worse on average being risk-taking is usuay meant as a reative term. Amost everyone is risk-averse to some extent, and how risk-taking someone is, is a measure of how cose to being risk-neutra they are. The ayman definitions fit in better with how most peope use these terms (and aso how they are used throughout this course). Risk-seeking peope are simpy peope more ikey to take on risk than risk-averse peope. For exampe, risk-seeking investors woud be more ikey to invest in stocks, attracted by the higher potentia returns on offer, whie riskaverse investors may invest in bonds and gits, which have itte risk attached to them but have ower expected returns. 39 of 59 Thursday 11 February 2016

40 4 Deaing with risk and uncertainty in project appraisa By investing in riskier investments such as stocks, risk-seeking investors are actuay increasing their expected return not decreasing it, because the ong-term average return of stocks is historicay higher than bonds. So these risk-seeking investors are reay just risk-neutra investors (in the technica sense of the term) who are taking the option with the highest expected vaue and are not deterred by the higher overa risk. Note that the technica and common definitions of risk-averse investors tend to be more simiar. For exampe, in decining to invest in stocks, investors are both avoiding risk (the common definition), and aso reducing their expected return in order to do so (the technica definition) Attitudes towards uncertainty Uncertainty exists when we know that severa different outcomes coud occur, but we do not have estimates of the probabiity of each of these outcomes happening. In this scenario, there are severa rues we can use to guide our decision making caed: maximax, maximin, and minimax regret. Minimax is oosey equivaent to being risk averse, since it seeks to minimise the worst outcome that coud occur. Maximax is roughy simiar to being risk seeking, since it seeks to maximise the best outcomes that occur. 4.2 Simpe adjustments to dea with increased risk Deaing with risk can be reativey simpe: the techniques beow are quick ways to incorporate some understanding of the risk of a project into the project appraisa. Whie they are not the most sophisticated methods avaiabe, they benefit from being easy to understand and impement, and are certainy better than making no adjustment for risk. The foowing subsections discuss how the discount rate and payback period can be adjusted, and carify that the discount rate does not need to be adjusted for cash fows which occur further in the future, if the discount rate is used appropriatey to cacuate a discount factor for each year Risk and the discount rate Remember that in Section 3, you saw that the reasoning behind the discount rate is that it represents the return that woud be demanded by investors in order to invest in a project. The higher the risk of a project, the higher the return that woud be demanded to invest in that project. A higher rate compensates an investor for the possibiity that the future cash fows are not actuay received. A higher risk means that future cash fows are ess certain, so where the risk of a project is higher, a higher discount rate shoud be used. So, the most basic way to adjust the discount rate for increased risk is to discount future cash fows by an appropriate amount. Throughout most of this course, the discount rate has been suppied to you as the cost of capita or the required return. Using the cost of capita is acceptabe if a project has the same risk as the on-going operations in an organisation. However, if the project has a risk different from the norma operations in an organisation, a different discount rate shoud be used to refect this. Section 3 discussed how the CAPM can be used to estimate the risk of a project by using the beta of companies which undertake simiar projects or operate in the same industry as a comparison. 40 of 59 Thursday 11 February 2016

41 4 Deaing with risk and uncertainty in project appraisa Risk and the payback period A simiar way to adjust for risk is to shorten the ength of the payback period, a technique known as adjusted payback period. A shortened payback period means that a project must pay back the initia investment more quicky in order to be acceptabe. However it is sti not recommended, as it sti has a the issues of the payback period that make it ony somewhat usefu as a heuristic. NPV is the superior method of deaing with risk: if the discount rate is cacuated correcty then cash fows further into the future wi be given ess weight due to higher discounting, but they wi sti be given some weight, rather than being ignored if they are after the payback period. The same method of decreasing the acceptabe payback period can aso be used with the discounted payback period. This is an improvement on the payback period but sti has most of the same probems. Aso note that, whether you use the standard payback period or an adjusted one, and standard or discounted payback, the decision rue about whether to accept a project is sti arbitrary. How many years is an acceptabe payback time? There is no right answer since the payback rue does not consistenty produce the best decision. Increasing the discount rate to dea with higher risk is a bunt instrument, but if risk is accounted for propery in setting a discount rate, then the decision rue is sti cear: accept any project where NPV is greater than zero Risk and time deay Peope sometimes think that if cash fows occur further into the future, they are riskier so shoud be discounted at a higher rate. This is incorrect: the discount rate is aready appied and compounded each year, so cash fows further into the future are discounted at a higher rate in proportion to the amount of time you have to wait unti they occur. If risk is constant over time (e.g. the same discount rate is appied for each additiona year), then the discount rate aready takes into account the increased risk with greater time into the future. 4.3 Using probabiity and future cash fows to dea with risk One way to dea with risk is by using estimated cash fows in NPV anaysis that take into account the range of outcomes that coud occur in the future. In fact, this has aready been done impicity when taking about cash fows in earier sections: it is rare that the vaues of future cash fows that wi occur are known precisey. Estimated cash fows using the probabiity of different vaues of the cash fows aows NPV anaysis to take into account the possibiity that actua cash fows are better or worse than expected. This aso aows adjustment for when there is a chance that cash fows may not occur at a (i.e. they may have zero vaue). An extension of this technique is to assign probabiities to different possibe future scenarios and cacuate the expected NPV for each scenario. The probabiity of each scenario can then be used to cacuate an overa probabiity-weighted NPV. This probabiity-weighted NPV is used to decide whether the project shoud go ahead. 41 of 59 Thursday 11 February 2016

42 4 Deaing with risk and uncertainty in project appraisa Estimating future cash fows In this course, future cash fows have been presented to you as if they are concrete predictions of what wi occur. However, this is not stricty what they are. The cash fows used when cacuating NPV are the best estimates of future cash fows. The cash fows do not represent the best case scenario and the purpose of the discount rate is not to refect the risk that the best case scenario may not occur. The best estimate of a cash fow shoud be an unbiased estimate. This means that the actua outcome may be higher or ower than the estimate, however on average the errors in estimates shoud baance each other out. Another name for an unbiased estimate is the expected vaue, which was mentioned earier in this section. The discount rates refect the risk that the best estimate of a cash fow coud be wrong, and a higher risk means that the actua vaue coud be further from the estimate than a cash fow with ower risk wi be different from its estimate. At the extreme, an estimate which wi definitey occur has no risk attached to it, since there wi be no difference between the estimated cash fow and the actua cash fow (and it woud be discounted at the risk-free rate). It foows that you shoud avoid estimating best-case cash fows and then using a higher discount rate to try to adjust for the fact that the best-case estimate may not occur. The cash fows used shoud be a fair estimate of what is expected to happen, which is neither optimistic nor pessimistic. Activity 8 Cacuating unbiased estimates of cash fows Spend about 10 minutes on this activity. A company is considering a project and needs to estimate the saes the project wi generate in year 1. The tabe beow gives different eves of saes that might occur, with their respective probabiities. Cacuate the unbiased estimate of the revenue from saes which shoud be used when cacuating the NPV of the project. Tabe 18 Saes revenue Probabiity 400, , , of 59 Thursday 11 February 2016

43 4 Deaing with risk and uncertainty in project appraisa Answer Tabe 19 Saes revenue Probabiity Probabiity weighted cash fow 400, , , , , ,000 Tota 540,000 So in the discounted cash fow cacuation to cacuate NPV, 540,000 woud be used as the year 1 saes figure Cacuating probabiity-weighted cash fows instead of increasing the discount rate As mentioned above, it is tempting to try to estimate the increase of the discount rate rather than try to estimate the probabiity of certain outcomes occurring. However this practice shoud be avoided if possibe (it is sometimes known as adding a fudge factor, obviousy not a term of approva!). Ideay, major sources of risk that stem from one unknown outcome shoud be deat with separatey and then the remaining cash fows discounted at a ower discount rate. For exampe, imagine that the project in Activity 8 aso carries a risk that the project wi not be approved by reguators, and consequenty no saes wi be made. If the project was originay going to be discounted at 10%, the company may now fee the project s extra risk means it shoud be discounted at 15%. However a better approach is to estimate the probabiity of the undesirabe outcome occurring. Tabe 20 shows the situation where there is a 20% probabiity of the project not being approved, and if it does go ahead, the ikey revenue figures are in the same proportion as before. Tabe 20 Cacuating a probabiityweighted cash fow for saes revenue Saes revenue Probabiity Probabiity weighted cash fow 400, , , , , ,000 Tota 432, of 59 Thursday 11 February 2016

44 4 Deaing with risk and uncertainty in project appraisa So the cash fow used in an NPV cacuation woud be estimated as an expected vaue of 432,000 to take account of the possibiity of a zero sae revenue Estimating probabiities for scenarios instead of increasing the discount rate Here is a simiar scenario. Say a project requires an 800,000 investment to deveop a new product. If the market demand for the product is good, an expected income of 125,000 per year in perpetuity wi be generated. However, if demand is poor the income in perpetuity wi ony be 75,000. The company estimate good demand at ony 50% ikeihood, so uses a discount rate of 25% rather than their cost of capita of 10% (which is the standard return for seing estabished products in their industry). Discounted cash fow cacuations show that the project is not worthwhie: Equation 11 Equation 12 Equation 13 So the NPV of the project equas ( 400,000), and the project is ceary not worth pursuing. However, this is using the discount rate to account for the uncertainty in the success of the project, not the uncertainty of the project once it is estabished. To ook at it another way, the company justified using a arge discount in the first year because the demand is unknown. However, after the outcome of the first year is known, wi the eve of additiona risk be as high for the second and subsequent years? The answer is probaby no: after the first year, whether the product is successfu or unsuccessfu, cash fows in the second year and onwards wi continue to be high or ow, depending on the outcome of the first year. So a further discount of 25% for income in the second year, third year, etc. is not warranted. (Obviousy this is a simpification, since cash fows from a new product are unikey to be constant each year.) If we coud resove the uncertainty about the success of the product, we coud avoid using this fudge factor in the discount rate. The company thinks that if it carried out some market research before investing in the project, it woud be abe to determine whether demand for the product woud be good or poor. This market research woud cost 25,000 and take pace just before paying out the 800,000 investment. The two scenarios can now be ooked at separatey. Since the market research removes the risk of how we the product is received, the discount rate for the norma seing of products in this industry can be used, rather than for aunching products. 44 of 59 Thursday 11 February 2016

45 4 Deaing with risk and uncertainty in project appraisa Good demand Equation 14 Equation 15 Equation 16 Poor demand Equation 17 Equation 19 So the project is actuay worth undertaking if there is good demand, but not if there is poor demand. If the company knew in advance there was poor demand, it woud not actuay invest in the project, whereas with good demand the project has an NPV of 450,000 and woud be invested in. However, a company may be reuctant to invest in the project whie there is risk about the eves of demand, in case there was poor demand and the project generated negative NPV. So it woud want to carry out the market research to remove this risk. In this scenario, the company can find out whether there woud be good demand by spending an additiona 25,000 on market research, before having to decide whether to go ahead with the 800,000 investment. So, the decision to make now is whether to go ahead with the market research! To do this, we cacuate the expected NPVs of the project with and without paying for market research first. Once the market research is competed, the company wi know whether demand wi be good or poor, and wi invest or not depending on this knowedge. The probabiityweighted NPV of the project can be cacuated, taking into account that the company wi have to pay for the market research to make its decision about investment. The probabiity-weighted NPV of the project is found by mutipying the NPV in each case by its estimated probabiity, and deducting the cost of the market research. The probabiities of good demand and poor demand have aready been estimated as 50% for each by the company. 45 of 59 Thursday 11 February 2016

46 4 Deaing with risk and uncertainty in project appraisa Good demand Project goes ahead. Equation 20 Equation 21 Equation 22 Poor demand The project does not go ahead. Equation 23 Equation 24 Equation 25 Market research This is undertaken in both scenarios. Equation 26 Equation 27 Equation of 59 Thursday 11 February 2016

47 4 Deaing with risk and uncertainty in project appraisa Equation 29 There wi be a positive NPV of 200,000 with the benefit of the market research, even after paying for the market research itsef, so the project wi go ahead. This demonstrates the benefits of trying to determine the probabiities of future outcomes, rather than simpy adjusting the discount rate higher to account for increased uncertainty. 4.4 Modeing sensitivity anaysis Spreadsheets aow us to see the impact of different possibe outcomes on the net present vaue of the project. This form of sensitivity anaysis can be very hepfu as it aows us to see the effect of a singe or a combination of possibe outcomes as 'what if' scenarios. The foowing materia shows the use of spreadsheets in this context. First watch the video Sensitivity anaysis which shows you how to carry out break-even sensitivity anaysis in investment appraisa. Break-even sensitivity anaysis finds the percentage change from the origina vaue, in each of the project s inputs in turn, that is required to achieve a zero NPV. The input or variabe that shows the smaest change is the most sensitive. The most sensitive variabes are the variabes where sma changes or deviations from the project s pan wi have a greater impact on the outcome, or NPV, than changes in other variabes. Knowing which variabes are the most sensitive heps you focus on the high risk areas of a project. It aows further testing of assumptions regarding the forecasts and projections associated with the sensitive variabes. The sensitive variabes wi be monitored cosey by managers if the project goes ahead. A company pans to invest 1,000,000 in a new product that wi generate revenues (cash receipts) of 300,000 in Year 1, 500,000 in Year 2 and 600,000 in Years 3 to 5. Costs (cash payments) wi be 25% of revenues (cash receipts) and are paid in the same year as the reevant cash receipts. This company uses a 10% discount rate for projects of this type. The corporate tax rate is 28%. Taxation cash fows occur in the same year as the reevant taxabe receipts and payments. There are no taxation cash fows arising from the investment of 1,000,000. Cacuate the NPV of this investment. This time, carry out break-even sensitivity anaysis on the inputs of this investment. Watch the video: Video content is not avaiabe in this format. Video 5 Sensitivity anaysis 47 of 59 Thursday 11 February 2016

48 4 Deaing with risk and uncertainty in project appraisa Make your own notes. You can see the Sensitivity anaysis (soution) here. 4.5 The vaue of information You saw in the exampe in Subsection that by determining whether or not the product wi be a success in advance, the company can increase the expected NPV from the project by 225,000. Without this information the project woud not go ahead at a so the NPV woud be zero. With this information the company has a 50% chance of gaining an NPV of 450,000, so the expected vaue is 50% of 450,000. The increase of 225,000 in NPV, attributabe to hoding information that is used in decisions about whether to proceed with projects, is sometimes caed the vaue of information. More formay, the vaue of information is the weighted average of the increase in vaue which having that information wi generate. The NPV that woud be achieved with the information is compared with the NPV that woud be achieved without the information for each possibe scenario. Tabe 21 shows this for the exampe above: Tabe 21 Demonstrating the probabiity-weighted increase in NPV from having information about demand Good demand NPV With information about demand 450,000 0* Without information about demand 0* 0* Difference in NPV from information 450,000 0 Probabiity of scenario Difference from information weighted by probabiity of that scenario Tota of differences in NPV weighted by probabiity of each scenario 225, ,000 Poor demand NPV * project not undertaken 48 of 59 Thursday 11 February 2016

49 5 End-of-course exercises The vaue of information of 225,000 is the maximum amount that it is worth paying for the market research to determine the demand for the product. Since in this case the market information costs ony 25,000, there is an overa increase in NPV of 200,000 after paying for the market research. Cacuating the vaue of knowing information about a project can highight areas where a company can benefit from putting more resources into resoving uncertainty. Obtaining certain information can change what decisions are made and increase the expected NPV and, if so, it is worthwhie spending some money to obtain that extra information. This section has reviewed how risk and uncertainty arise in project appraisa, and described some techniques to dea with them. The difference between risk and uncertainty and the attitudes towards them that peope can take were discussed. You saw some simpe adjustments which can be made to account for risk; how to combine probabiities and cash fows to account for risk; and how to mode different scenarios in a spreadsheet. You aso earned how to work out the vaue of gaining additiona information when making decisions. 5 End-of-course exercises This section contains two end-of-course exercises. They are designed to aow you to practise what you have earned in the course and hep you to strengthen your understanding of the practica appication of the concepts. Since accounting is an appied discipine this is an important step in your earning. The best approach is to attempt the questions by referring to the materia in the course if you need to, but without ooking at the answers unti you have finished. Exercise 1 Customer profitabiity Spend about 25 minutes on this question (This question is adapted from Bhimani et a., 2008, pp ) Matoaf produces a soft drink which it distributes to a range of retaiers. In addition to the costs of producing the product, Matoaf has identified a number of customerreated costs, as shown beow. Tabe 22 Activity Order taking Saes visits Deivery Product handing Cost driver and rate 200 per purchase order 160 per visit 4 per deivery mie traveed per botte sod Matoaf has coected the foowing data to faciitate a customer profitabiity anaysis for its four argest customers. Tabe 23 Smith Jones Greene Browne Bottes sod 2,000,000 1,600, , , of 59 Thursday 11 February 2016

50 5 End-of-course exercises List price Actua price paid Number of purchase orders Number of saes visits Number of deiveries Mies traveed per deivery Production cost of saes (@ 1 per botte) 2,000,000 1,600, , ,000 Required: Cacuate the operating profit for each customer. Comment on your resuts, and say which customer(s) Matoaf woud find most attractive. Discussion Tabe 24 Smith Jones Greene Browne Saes revenue ( ) 2,240,000 1,888, , ,000 Production cost of saes 2,000,000 1,600, , ,000 Gross profit 240, ,000 14,000 24,000 Gross profit (% of saes vaue) 10.71% 15.25% 9.09% 16.67% Order taking 12,000 10,000 6,000 4,000 Saes visits 1,920 1,600 1, Deivery 4,800 5,760 6,400 1,440 Product handing 8,000 6, Tota customer costs 26,720 23,760 14,240 6,880 Customer costs (% of saes vaue) 1.19% 1.26% 9.25% 4.78% Net profit 213, ,240 (240) 17,120 Net profit (% of saes vaue) 9.52% 14.00% (0.16)% 11.89% The most notabe issues highighted by this anaysis are as foows. (Percentages have been cacuated in the anaysis, as it often provides greater insights to ook at something in terms of its reationship to something ese rather than in absoute terms aone). 1 There is considerabe variation in the gross profit as a percentage of saes and this is due to the discounts from the ist price the customers are receiving. Smith receives a arge discount, but this is understandabe as it is the biggest customer. More surprising is that the biggest discount is received by Greene whose saes voume is extremey ow in reation to the two biggest customers, Smith and Jones. Ceary, this is something that Matoaf s management shoud ook at. 2 Another significant issue reveaed is the difference in customer costs in reation to saes revenue, which together with the discounts offered, have a major impact on the operating profit. Most noticeabe is Greene, whose customer costs (as a percentage of saes) vasty exceed those of the other customers. The primary cause of this seems to be the disproportionate costs of order taking and deivery. 50 of 59 Thursday 11 February 2016

51 5 End-of-course exercises Greene appears to pace a reativey arge number of purchase orders (i.e. it orders ots of sma quantities) and aso receives ots of deiveries of reativey sma amounts. Compared with the most profitabe customer, Jones, Greene s average order is for 4,667 bottes as against Jones s 32,000. A simiar picture emerges with deiveries: the average number of bottes per deivery for Greene is 3,500 whereas for Jones it is 26,667 (made worse by the fact that Greene aso has the ongest deivery distance!) The anaysis reveas (in particuar) that Matoaf shoud renegotiate its terms of trading with Greene, with particuar reference to the generous discount offered and the order/ deivery batch size. In order to be profitabe, and assuming saes voume cannot be increased, Greene woud need to buy the same number of bottes in arger orders and with fewer deiveries. It woud aso need to pay the fu ist price, as the other sma customer, Browne, does. Exercise 2 Risk, uncertainty and sensitivity anaysis Spend about 45 minutes on this question. Adapted from: The Association of Chartered Certified Accountants, Paper F9 Financia Management Practice & Revision Kit for exams in December 2004, Question 27. Umunat Co (FMC, 12/04) Umunat Co is considering investing $50,000 in a new machine with an expected ife of five years. The machine wi have no scrap vaue at the end of five years. It is expected that 20,000 units wi be sod each year at the seing price of $3.00 per unit. Variabe production costs are expected to be $1.65 per unit, whie incrementa fixed costs, mainy the wages of a maintenance engineer, are expected to be $10,000 per year. Umunat Co uses a discount rate of 12% for investment appraisa purposes and expects investment projects to recover their initia investment within two years. Required: (a) (b) (c) (d) Expain why risk and uncertainty shoud be considered in the investment appraisa process. Cacuate and comment on the payback period of the project. Evauate the sensitivity of the project s net present vaue to a change in the foowing project variabes, then discuss the use of sensitivity anaysis as a way of evauating project risk: (i) Sae voume (ii) Saes price (iii) Variabe cost. Upon further investigation it is found that there is a significant chance that the expected saes voume of 20,000 units per year wi not be achieved. The saes manager of Umunat Co suggests that saes voumes coud depend on expected economic states that coud be assigned the foowing probabiities: Tabe 25 Economic state Poor Norma Good Probabiity of 59 Thursday 11 February 2016

52 5 End-of-course exercises Annua saes voume (units) 17,500 20,000 22,500 Cacuate and comment on the expected net present vaue of the project. Discussion (a) (b) A risky situation is one where we can say that there is a 60% probabiity that returns from a project wi be in excess of $100,000 but a 40% probabiity that returns wi be ess than $100,000. If, however, no information can be provided on the returns from the project, we are faced with an uncertain situation. Managers need to exercise caution when assessing future cash fows to ensure that they make appropriate decisions. If a project is too risky, it might need to be rejected, depending upon the prevaiing attitude risk. In genera, risky projects are those whose future cash fows, and hence the project returns, are ikey to be variabe. The greater the variabiity is, the greater the risk. As the cash fows in capita investment decisions might be for severa years ahead, therefore there is bound to be risk invoved in such decisions. Therefore, it is highy ikey that the actua costs and revenues may either be beow or above budget as the work progresses. Assuming that cash fows occur eveny throughout the year: Equation 30 Equation 31 Equation 32 Payback shows how ong it wi take to recover the initia investment. In this case, the payback period exceeds the company s hurde payback period of two years. Therefore, Umunat might be tempted to reject this project. However, a project shoud not be evauated on the basis of payback aone. If a project gets through the payback test, it shoud then be evauated with a more sophisticated investment appraisa technique, such as NPV. Payback ignores the timing of cash fows within the payback period, the cash fows after the end of payback period and therefore the tota project return. It aso ignores the time vaue of money. Tabe 26 Year Investment Contribution Fixed costs Net $ $ $ $ 12% Discount factor Tota 52 of 59 Thursday 11 February 2016

53 5 End-of-course exercises 0 (50,000) (50,000) (50,000) ,000 (10,000) 17, ,285 11,285 Equation 34 Equation 35 Equation 36 (c) (iii) Sensitivity to saes voume For an NPV of zero, contribution has to decrease by $11,285. This represents a reduction in saes of (iv) Sensitivity to saes price As before, for an NPV of zero, contribution has to decrease by $11,285. This represents a reduction in seing price of (v) Sensitivity to variabe cost As before, for an NPV of zero, contribution has to decrease by $11,285. This represents an increase in variabe costs of The basic approach of sensitivity anaysis is to cacuate the project s NPV under aternative assumptions to determine how sensitive it is to changing conditions. Therefore, sensitivity anaysis provides an indication of why a project might fai. Management shoud review critica variabes to assess whether or not there is a strong possibiity of events occurring which wi ead to a negative NPV. Management shoud aso pay particuar attention to controing those variabes to which the NPV is particuary sensitive, once the decision has been taken to accept the investment. (d) Equation of 59 Thursday 11 February 2016

54 5 End-of-course exercises Equation 41 Tabe 27 Year Investment Contribution Fixed costs Net Discount factor $ $ $ $ 12% $ Tota 0 (50,000) (50,000) (50,000) ,325 (10,000) 16, ,852 8,852 The expected net present vaue is positive, but it represents a vaue that woud never actuay be achieved, as it is an amagamation of various probabiities. Examining each possibiity: Tabe 28 Worst case (saes of 17,500 units, 30% probabiity) Year Investment Contribution Fixed costs Net Discount factor $ $ $ $ 12% $ Tota 0 (50,000) (50,000) (50,000) ,625 (10,000) 13, ,118 We aready know the NPV of saes of 20,000 units to be $11,285 Tabe 29 Best case (saes of 22,500, 10% probabiity) Year Investment Contribution Fixed costs Net Discount factor $ $ $ $ 12% $ (882) Tota 0 (50,000) (50,000) (50,000) ,375 (10,000) 20, ,452 23,452 The managers of Umunat wi need to satisfy themseves as to the accuracy of this atest information, but the fact that there is a 30% chance that the project wi produce a negative NPV coud be considered too high a risk. It can be argued that assigning probabiities to expected economic states or saes voumes gives the managers information to make better investment decisions. The difficuty with this approach is that probabiity estimates of project variabes can carry a high degree of uncertainty and subjectivity. 54 of 59 Thursday 11 February 2016

55 Concusion Concusion There are many chaenges facing businesses in dynamic economic environments. In this course we have briefy considered the use of a strategic perspective in management accounting and the appication of this approach to pricing and project evauation. Customer profitabiity anaysis encourages a focus on strategicay evauating customers and the costs and effort the business puts into engaging with them. It draws on an activity based approach to trace the cost of the activities to specific customers. As with a financia anaysis it shoud be considered in the ight of other factors, for exampe whether or not the ess profitabe customer wi hep to open up a new market. Project evauation is fundamenta in a strategic perspective as organisations make decisions about where to invest for competitive advantage in the mid to ong-term future. A compaint about using discounted cash fow anaysis is that it is too difficut to forecast cash fows over five (or even ess) years into the future. In this course we provide the technica understanding for the appication of discounting and techniques that support the expicit consideration of uncertainty and risks to improve the basis for decision making. Keep on earning Study another free course There are more than 800 courses on OpenLearn for you to choose from on a range of subjects. Find out more about a our free courses. 55 of 59 Thursday 11 February 2016