32 accounting profits and cash flows in capital

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32 Accounting profits and cash flows In capital investment appraisal it is more appropriate to evaluate future cash flows than accounting profits, because: • profits cannot be spent, cash is what ultimately counts – profits are only a guide to cash availability: they cannot actually be spent • profit measurement is subjective – the time period in which income and expenses are recorded, and so on, are a matter of judgement • cash is used to pay dividends – dividends are the ultimate method of transferring wealth to equity shareholders. Therefore, Cash flows are a better measure of the suitability of a capital investment
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17 33 Relevant costs The only cash flows that should be taken into consideration in capital investment appraisal (with the exception of ROCE) are: • cash flows that will happen in the future, and • cash flows that will arise only if the capital project goes ahead. These cash flows are direct revenues from the project and relevant costs. Relevant costs are future costs that will be incurred or saved as a direct consequence of undertaking the investment and that differ among the alternatives. • Costs that have already been incurred are not relevant to a current decision. For example, suppose a company makes a non- returnable deposit as a down payment for an item of equipment, and then reconsiders whether it wants the equipment after all. The money that has already been spent cannot be recovered and so is not relevant to the current decision about obtaining the equipment. 34 Relevant costs • Costs that will be incurred anyway, whether or not a capital project goes ahead, cannot be relevant to a decision about investing in the project. Fixed cost expenditures are an example of ‘committed costs’. For the purpose of investment appraisal, a project should not be charged with an amount for a share of fixed costs that will be incurred in any event. • Non-cash items of cost can never be relevant to investment appraisal. In particular, the depreciation charges on a non-current asset are not relevant costs for analysis because depreciation is not a cash expenditure. • Accounting treatment of costs is often irrelevant (e.g. depreciation, inventory valuation, methods of allocating overheads) because it has no bearing on cash flows, except to the extent that it may affect taxation payable.
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18 35 Investment Appraisal To make a more informed decision, more sophisticated techniques need to be used. Importance of time- value of money 36 Time Value of Money This concept recognizes that the present value of a pound received in the future is less than today’s pound. The further into the future the receipt is expected to occur, the smaller its present value. When a company invests in capital assets, it sacrifices present pounds in exchange for the opportunity to receive future pounds.
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19 37 Time Value of Money The present value of cash inflows decrease as the time expected receipt increases because: 1. Lost opportunity to earn interest 2. Risk 3. Inflation 38
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