business finance

MEASURING A PROJECT’S BENEFITS
AND COSTS (RELEVANT CASH FLOW)

The incremental cash flows that matter in determining a relevant cash
flow. Therefore, the cash flow associated with the proposed
investment projects should be considered first. Cash flow of an
investment project can be divided into three main types:

1. The initial outlay (IO)
2. Annual cash Flow after tax ( the differential cash flows over

the project’s life)
3. Terminal Cash Flow

Initial Investment (initial outlay)

Initial outlay also called initial investment refers to the immediate cash
outflows required by a company to start a project.

IO is the immediate cash outflow required by the company to start a
project. IO can be divided into two types:

1. The initial investment for the purchase of new assets
2. The initial investment for the purchase of new assets to replace

older assets.

MEASURING A PROJECT’S BENEFITS
AND COSTS (RELEVANT CASH FLOW)

INITIAL OUTLAY

Items included in the calculation of the initial investment to
purchase a new property are:
The cost of new assets

Expenditures for capital assets such as the cost of installation,
transportation and insurance

Changes in working capital - for example if a company wants to
open new stores, new additions to working capital (like stocks) may
be required to start business operations in the branch. Tax cash
expenses should be included in the calculation of Io

 training costs or other expenses should be considered if the costs
are incurred specifically for the project and these costs will be
considered after the relevant tax (net of tax)

Investment tax credits - credits that can be claimed that investment
from the financial policies of to encourage investment on long-term
assets

 Net income (ie income after tax) from sale of old asset

Additional working capital

MEASURING A PROJECT’S BENEFITS
AND COSTS (RELEVANT CASH FLOW)

ASSESSING TAX INCURRED DUE TO SALES OF OLD ASSETS – IMPACT ON
INITIAL OUTLAY
Net income (after tax) from sale of old asset:
1) The assets were sold at prices above the old book value:
Example:
Original cost of machine = RM30, 000
Book Value of RM20, 000
Sale at = RM24, 000
profit = RM24, 000 - RM20, 000 = RM4, 000

Assuming 40% tax, sales tax payments from the old machine profit is RM1, 600
T(0h.i4s ×m4e0a0ns0t)hat net income after tax from sale of old machinery is RM22, 400
(RM24 ,000-RM1, 600)
Impact on IO cashflow
Inflow – sales of asset (RM20,000)
Outflow – income tax (RM1600)
2) the old assets are sold at a price equal to book value:

Example:
Original cost of machine = RM30, 000
Book Value of RM20, 000
Sale at = RM20, 000
profit = RM20, 000 - RM20, 000 = 0

This means that net income after tax from sale of old machinery is RM20, 000

Impact on IO cashflow
Inflow – sales of asset (RM20,000)
Outflow – nil

MEASURING A PROJECT’S BENEFITS
AND COSTS (RELEVANT CASH FLOW)

ASSESSING TAX INCURRED DUE TO SALES OF OLD ASSETS –
IMPACT ON INITIAL OUTLAY
3) long assets sold at a price less than book value:

Example:
Original cost of machine = RM30, 000
Book Value of RM20, 000
Sale at = RM18, 000
Loss = RM18, 000 - RM20, 000 =RM2, 000

Assuming 40% tax, sales tax savings from the loss of an old machine
is a 800 (0.4 × 2000)

This means that net income after tax from sale of old machinery is
RM18, 800
(RM18, 000 + 800)

Impact on IO cashflow
Inflow – sales of asset (RM20,000) and tax gain on loss of
disposal ( RM800)
Outflow – nil

MEASURING A PROJECT’S BENEFITS
AND COSTS (RELEVANT CASH FLOW)

GENERAL FORMAT INITIAL OUTLAY

RM

Cash Outflow:

Cost Of New Assets xx
Purchase Price xx
Import Duty xx
Shipping Cost xx
Installation xx
Insurance xx
Training (After Tax) xxx
Cost Of The Machine

investment tax claims xx xx
(A * rate * tax rate of investment tax credits) (xx)
Add: Working Capital Requirement xxx
xx
- Increase In Inventories xx
- Increases In Account Payable xxxx

Less Cash inflow
- Sales proceed of ole machine
- Tax gain (xx × 28%)
Net initial outlay

MEASURING A PROJECT’S BENEFITS
AND COSTS (RELEVANT CASH FLOW)

Annual cash Flow after tax (the differential cash flows
over the project’s life)

Cash Flow That Occur throughout The Useful Life of the Project.

Example If The Project Lasts For 5 Years Refer To The Annual Cash
Flows That We Will Receive Or Pay From Year 1 To Year 5.

Benefits Costs
Increase in sales Increase in electricity expense
Decrease in labour costs or
salaries Increase in maintenance expense
Decrease in cost of defects
Decrease in operating expenses Increase in advertising expense
Increase in operating expense

How to calculate Annual cash Flow after tax

Profits Cash flow

Benefits : xx
xx
Increase in revenue xx xxx

Decrease in cost of defects xx (xx)
xx
xxx
(xx)
Less : cost xx
xx
Increase in operating expenses (xx) (xx)

xx xxx

Less : increase in depreciation

(xx)

xx

Net profit before tax xx

Less: taxation (28%) (xx)

Net profit after tax xx

After tax differential cash flows

MEASURING A PROJECT’S BENEFITS
AND COSTS (RELEVANT CASH FLOW)

Terminal Cash Flow RM
How to calculate Terminal Cash Flow after tax xx
xx
Salvage value of new machine (net of tax) xxx
Working capital recovered
Terminal cash flow

Example 1

Excel Berhad is currently using a moulding machine that was purchased five
years ago with a remaining useful life of five years. The company is analysing a
proposal by the production department to replace the machine. The new
machine can be purchased at RM 500,000 and will have a 5 year useful life. If
the machine is used till the end of its useful life, it can be sold at RM 50,000.
However, the company needs to pay another RM 25,000 to modify the machine
for its special function.

The existing machine was bought for RM 300,000 with an expected salvage
value of RM 30,000. However, if the company decides to sell the machine now, it
can be sold at RM 120,000.

Since the new machine is more efficient, it would require additional raw
materials of RM 20,000 and accruals are expected to increase by RM 15,000.
Sales are expected to increase by RM 150,000 per year. However, production
cost will also go up by RM 60,000 every year. The cost of defects can be
reduced by RM 10,000 per annum and the company can also reduce of
production workers. Hence, labour cost is expected can also reduce the number
of production worker. Hence, labour cost is expected to be reduced by RM
75,000 per year

It is the policy of the company to use the straight line method to depreciate all
its fixed assets. The corporate tax rate is 28%. Investment on tax credit can be
claimed 10%.

You are required to compute the following:
1. Initial outlay
2. Differential cash flows
3. Terminal cash flows

PROJECT VALUATION TECHNIQUES

The selection of projects:
Condition of mutual exclusion - States can only choose one project. This
may be due to companies experiencing capital constraints, time or labour.
The situation is not independent - Companies can select multiple projects as
long as many of those projects that meet the criteria established by the
company

The techniques can be used for capital budgeting are:

a) Payback Period
b) the net present value (NPV)
c) Profitability Index (PI)
d) Internal Rate of Return (IRR)

a) PAYBACK PERIOD

One of the most popular technique is the simplest technique. Payback
Period is a reference to a number of years needed to recover the money
invested during the early stages of investment (Io). Payback Period called
the number of years.
Decision criteria
It is the number of year needed for a project to return its initial investment.
The earlier the payback is better
The selection criteria for a project:
A project will:
Selected : Payback Period < period required by the company
Rejected : Payback Period > period required by the company

PROJECT VALUATION TECHNIQUES

Formula:
Number of years before year of recovery + CF for the recovery year

 CF in the recovery year
Payback Period advantages:
a) Computation of the technique is simple
b) Used as the first technical evaluation prior to use the techniques so as
guidelines for the selection of a project.
Payback Period Weaknesses:
a) Not taking into account cash flows after the payback period. This is
because a project may have a large cash flow after payback period
b) Not taking into account the present value of money
Example 1:

ABC Company is currently making an assessment on three potential
projects. Information for the three projects are as follows;

Initial investment Project X Project Y Project Z
(RM) 100,000 50,000 95,000

Year Annual cash flow after tax
1 40,000 15,000 35,000
2 35,400 25,000 35,000
3 33,600 20,400 35,000
4 30,500 18,000 25,000

You are required to calculate Payback Period for the three projects above.
State which project should be selected by ABC Company if the required
payback period is 3 years with the following conditions:
a) The removal of each
b) The independent

PROJECT VALUATION TECHNIQUES

NET PRESENT VALUE (NPV):
Is a valuation technique that takes into account the present value of money.
In general, the present value of RM1 at the present time would not be the
same value for the past 10 years. NPV for a project is equal to the present
value of annual cash flow after tax minus the initial investment (Io)
The present value of annual cash flow after tax is dependent on the cost
of capital or required rate of return by a company.
NPV = Present value of annual cash flow after tax - the initial investment
(Io)
The selection criteria for a project:
A project will:
Received: NPV> 0 (positive) – ACCEPT Project – the higher the better
Less: NPV <0 (the negative) - REJECT Project
Net Present Value Advantages
It uses cash flows and therefore is able to reflect the true timing of the
flows involved.
It uses the time value of money concept to compare the benefits and costs
of a project. Earlier returns are always preferred than later returns.
It allows the company to know the exact impact of the project on the firm’s
value. A positive NPV project will increase the value of the firms by the
same amount. This is consistent with the goal of firm maximize
shareholder’s wealth.

Net Present Value Weaknesses:
In order to calculate NPV, we need to make long term forecast of future
cash flows.
We also need to determine the discount rate to be used and hence it is
time consuming
** based on Example 1, calculate the NPV If the rate of return required
is 13%

PROJECT VALUATION TECHNIQUES

PROFITABILITY INDEX
Profitability index is the ratio obtained when the present value of annual
cash flow after tax divided by the initial investment. PI can be calculated
by the following equation:
PI= Present value of annual cash flow after tax

The initial investment ( )

The selection criteria for a project:

A project will:
Received: PI > 1.0 - ACCEPT Project
Less: PI <1.0 -REJECT Project
INTERNAL RATE OF RETURN (IRR)
Internal rate of return is a most appropriate technique to determine the
actual rate of return for any one project. Although these techniques before
taking the present value of money, but it is only based on the rate of
return required by the company.
IRR was defined as the interest rate (cost of capital) that equates the
present value of annual cash flow with an initial investment or in other
words NPV equal to zero.
Present value of annual after tax cash flow = initial investment
IRR = Present value of annual cash flow after tax = the initial investment
TPV = Io , NPV = 0
The selection criteria for a project:

A project will: : IRR > required rate of return
ACCECPTED : IRR <required rate of return
REJECT

If IRR is equivalent to the cost of capital, the company may take the
decision whether to accept or reject the investment project.

PROJECT VALUATION TECHNIQUES

Steps in IRR
Step 1
Find the present value of annual cash flow after tax on the capital costs
required by the company.
Step 2
If the present value obtained is smaller than Io, the present greater value
to be obtained. The present value of the greater will be obtained if
factored in the cost of capital is lower than the cost of capital required by
the company.

If the present value obtained is greater than Io, the smaller the present
value to be obtained. The present value of the smaller would be obtained
if factored in the cost of capital is greater than the cost of capital
required by the company.
Step 3:
Then arrange your answers over as the chart below:
IRR = d % + −



Rate of discount XX ෍

X % (d) XX xx
IRR XXX (a) xx
Y% (e)
Difference XXX (b)

** based on Example 1, calculate the IRR and PI. Then give suggestions to
which project should be invested in.

CHAPTER 7
LEVERAGE

(CLO1)

Learning outcome

THE CONCEPT OF RISK

Introduction

In business leverage means using fixed costs @ fixed
expenses to increase profitability.

Leverage deals with the different types of financing and
indicates the amount of debt used to support the firm’s
resources and operations.

This chapter deals with the alternative means of
influencing earnings and risk through changes in the
financial mix.

Generally increase in leverage would result in increased
return and risk.

We will introduce one of the tools that financial
managers use to plan the firm’s financial mix by taking
into account the operating aspects.

The tool is the break even analysis; we will cover relation
to the degree of operating leverage (DOL).

WHAT IS RISK

Risk is defined as the relative dispersion or
variability in the firm’s expected earnings before

interest and taxes (EBIT)

Classification of risk

RISK

Unsystematic risk Systematic risk (non-
(diversifiable risk) diversifiable risk)

Business Financial
risk risk

Variability Uncertainty Can be Variability Direct Relates to
in a firm’s with measure in profit result of the firms
the firm inability to
EBIT investment using induced by financin meet in the
earning CV the use of
g debt
debt decision obligation
capital

CONCEPT OF LEVERAGE

In business, leverage means using fixed costs of
fixed expenses to increase profitability.
The concept of leverage will see the effect of fixed
costs in operations and finance companies, and
identify their impact on the returns and risks.
Business leverage can be divided into three types :

1. Degree of Operating Leverage (DOL)
2. Degree of Financial Leverage (DFL)
3. Degree of Combined Leverage (DCL)

Degree of Operating Leverage (DOL)

To see the impact on EBIT due to changes in the level
of sales. The higher the operating leverage, will give a

great impact on EBIT in the event of any change in the
level of sales.

To measure this change, the degree of operating leverage
(DOL) is used to determine the effect on EBIT due to
changes in the level of sales.

DOL = Contribution
EBIT

TYPES OF LEVERAGE

Degree of Financial Leverage (DFL)

It is the effect on earnings per share (EPS) due to changes
in EBIT. To measure the rate of change, the degree of
financial leverage (DFL) is used to determine the effect on
EPS due to the occurrence of any change in EBIT.
DFL = EBIT

EBT
DFL = EBIT / EBIT – I – (PD/1-T)
* If there are preferred dividen (PD)

Degree Of Combined Leverage (DCL)

The degree of combined leverage, also known as the
degree of total leverage refers to the percentage change
in a firm’s earnings per share that results from a given
percentage change in the firm’s sales. DCL of a firm at a
particular level of sales is equal to the percentage change
in earnings per share resulting from the percentage change
in sales.

DCL will see the effect on EPS due to changes in the level
of sales.

DCL = DOL X CFL

BREAK EVEN ANALYSIS

Break-even Analysis

Break-even analysis, also known as cost-volume-profit
analysis, is simply a mathematical formula to determine
the sales level at which the firm neither incurs a loss nor
makes a profit.

It studies the relationship between sales volumes and
variable cost, fixed cost and profits.

A method used to determine the level of sales or total
sales value to be obtained in order to cover all operating
costs.

Break-even point (units) = Fixed Cost
Contribution margin per unit

Break-even point (RM) = Fixed Cost
Contribution margin / Sales ratio

If the company set the amount of profit targets to be
achieved, the formula for the break-even point is:

Target Profit + Fixed Cost
Selling price per unit - Variable cost per unit

CLASS EXERCISE

Example 1

Income Statement for LOTUS Berhad is as follows :

Sales (10,000,000 X RM1) RM
(-)Variable cost 10,000,000
(6,000,000)
(-) Fixed cost 4,000,000
EBIT (2,500,000)
Interest 1,500,000
Earning before tax
Tax (500,000)
Net Income 1,000,000
(350,000)

650,000

a) Based on the information above, you are required to calculate
i. The degree of operating leverage
ii. The degree of financial leverage
iii. The degree of combine leverage
iv. Break even point in unit and RM

b) If sales increase by 20%, what will happen on :
i. Earning before interest and tax (EBIT)
ii. Earning per share

c) Provide income statement to show increased sales by 20% and
prove your answer in (b) above.
d) Calculate the percentage change in Earning per share if EBIT
increased by 25%.