Net Cash Flows for Investments (Cambridge International A-Level Accounting)

Future net cash flows

Spec point — future net cash inflows and outflows arising from the project

What is investment appraisal?

• Investment appraisal is a process to assess the financial viability of a project or a purchase
• Methods of investment appraisal use future cash inflows and outflows of the project

How do I calculate the future net cash flows?

• Use a table format for these calculations

  • Each row represents a year

• For each year, calculate the proceeds and costs associated with the project

  • These might be based on the number of units sold
  • These might be based on percentages of other amounts

• Do not include depreciation costs

  • Remove these costs from the fixed costs if they are included

• For each year, calculate the net cash flow by:

  • adding together the proceeds
  • subtracting the costs

• Include a row for Year 0

  • This contains the initial costs

• The net cash flow is negative for Year 0, but it should be positive for most (if not all) of the other years

Exam Hint These questions tend to be worth a good number of marks. Take your time, as most marks lost by students are due to numerical errors rather than lack of understanding.

Check carefully whether fixed costs include or exclude depreciation. Depreciation charges should not be included because they do not affect cash flows.

Worked Example The directors of D plc are considering the purchase of a new machine to manufacture a newly developed product, Product Omega. The directors intend to manufacture the product for only four years, after which the machine will have zero residual value.

The following estimated information is available regarding the project:

1. Capital expenditure: The new machine will cost $220 000, payable immediately (Year 0). An additional machine upgrade costing $30 000 will be required at the end of Year 2 to maintain production capacity.
2. Sales volume:

Year	Units
1	3 000
2	4 500
3	5 000
4	2 500

1. Selling price and variable costs:

• The selling price will be $80 per unit for all four years.
• Direct materials and direct labour will cost $50 per unit.

1. Fixed costs: Fixed overheads (excluding depreciation) specifically related to the project are expected to amount to $45 000 each year.

Complete the following table by calculating the net cash flow for each year of the project.

Year	Capital expenditure ($)**	Revenue ($)	** Variable costs ($)**	**Fixed costs ($)	Net cash flow ($)
0
1
2
3
4

Answer:

Calculate the revenue and variable costs for each year

Year	Revenue	Variable costs
1	3 000 × $80 = $240 000	3 000 × $50 = $150 000
2	4 500 × $80 = $360 000	4 500 × $50 = $225 000
3	5 000 × $80 = $400 000	5 000 × $50 = $250 000
4	2 500 × $80 = $200 000	2 500 × $50 = $125 000

Calculate the net cash flows for each year by including the capital expenditure and the fixed costs

Year	Capital expenditure ($)**	Revenue ($)	** Variable costs ($)**	**Fixed costs ($)	Net cash flow ($)
0	(220 000)				(220 000)
1		240 000	(150 000)	(45 000)	45 000
2	(30 000)	360 000	(225 000)	(45 000)	60 000
3		400 000	(250 000)	(45 000)	105 000
4		200 000	(125 000)	(45 000)	30 000