P1 examiner article

8/7/2019 P1 examiner article

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nancial management

>study notes PAPER P1

PERFORMANCE OPERATIONSThe senior examiner for paper P1 offers a step-by-step guide totackling a topic thats likely to crop up at every level: a project appraisal.

An airport is modernising itsfacilities in anticipation thatpassenger numbers will riseby 10 per cent a year becausea low-cost airline has openednew routes to it.

The airport has one foodoutlet, which sells cold foodonly, so the management isconsidering opening arestaurant that would sell arange of hot meals. The costof fitting out the restaurant,which would need to be fullyrefurbished after four years, isestimated at $350,000. It isexpected to have a residualvalue of $30,000 by then.

A consultancy hasconducted a feasibility studycosting $30,000. Its findingson expected revenue andcontribution from therestaurant are as follows:

Average revenue percustomer: $9.

Average variable cost percustomer: $5. Demand in the first year:500 customers a day.Demand for the restaurant

is expected to rise in line withpassenger numbers. The airportis open 360 days a year.

Other relevant informationis listed below. 1 Staffing the restaurantFour employees will berequired in the first two years.Another person will be neededin years three and four. Theaverage annual salary will be$20,000 per head. 2 OverheadsThe annual budgeted fixedoverhead of the airport that willbe apportioned to the restaurantis $80,000. The annualoverhead apportioned to thecold food outlet will be $30,000.

Overheads are expected to riseby the following annual amountsas a direct result of the openingof the restaurant: electricity,$40,000; advertising, $20,000;and auditing, $10,000. 3 The cold-food outletThe average contribution fromthe sale of cold food is $2.50per customer. If the restaurantis not opened, its expected thatthe cold-food outlet will sell to1,200 people a day in thecoming year and that customernumbers will rise in line withpassenger numbers.

If the restaurant is opened,the consultancy expects salesfrom the cold-food outlet to fallby 40 per cent in the first yearand then to increase in line withpassenger numbers.

The airports financedirector has provided thefollowing taxation information:

Tax depreciation: 25 percent reducing balance a year. The first years taxdepreciation allowance isused against the first yearsnet cash inflows. The taxation rate is 30 percent of taxable profits. Half of the tax is payable in theyear in which it arises andthe balance is paid thefollowing year. Any taxable losses resultingfrom this investment can beset against profits made bythe airport companys otherbusiness activities, sincethe organisation as a wholeis profitable.The airport uses a post-tax

cost of capital of 8 per cent ayear to evaluate projects of thistype. Inflation can be ignored.

You are required to calculatethe net present value of therestaurant project ( 16 marks ).

Part (a) of question four from paper P1, May 2010 (edited)

The arrival of the 2010 CIMA syllabusresulted in significant changes to the contentof the syllabus for paper P1. The section of the previous (2005) P1 syllabus covering thecontrol and performance measurement of responsibility centres and most of the sectionon budgeting were transferred to paper P2.The P1 syllabus now includes: projectappraisal (25 per cent) and dealing with

uncertainty (15 per cent), both of which werepreviously in the old P2 paper; and managingshort-term finance (20 per cent), which wasin the old P7 paper.

You need to have a thorough knowledgeof project appraisal techniques throughoutyour CIMA studies they are first examinedat certificate level. You should expect to be


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in the analysis in year zero ( see line 1 of table3). But the consultants fee of $30,000 is notrelevant. This is a sunk cost ie, it hasalready been incurred. It cant affect the costof the project whether it goes ahead or not,so it should be omitted from the analysis.

You are then given information on theexpected contribution from opening therestaurant. The year-one contribution is:500 passengers x 360 days x $4 contributionper passenger = $720,000.

Some candidates calculated the revenueand variable costs separately. Thats fine, aslong as you remember to take one from theother, but it is much quicker to calculate the

required to apply them in exams all the wayup to the final T4 part B Case Study paper.These methods are used extensively inpractice, too, and as a managementaccountant you will need to be able toapply them to real situations.

Mays exam included a 25-mark questionon project appraisal. I will take you throughpart (a) of the question in detail ( see panel,page 42 ). It would be good practice for youto attempt the question first and thencompare your answer with the followingsuggested approach and the solutionshown in table 3 on page 46.

As with any other question, you must firstread carefully through the full scenario andthe requirements before you start anycalculations. Ensure that you understandexactly what youre being asked to do bychecking the verbs used in the question are you being asked to calculate, adviseor evaluate, for example? These all meandifferent things, so they require differentapproaches. The list of verbs and theirdefinitions are included on the last page of the question paper.

The question in the May 2010 paperhas quite a detailed scenario. Its about aregional airport thats considering opening arestaurant to cater for an anticipated increasein passenger numbers. You are told that therestaurant will need to be refurbished afterfour years and that the asset will have aresidual value of $30,000. So now you knowthe length of the project and that in year fouryou will have a cash inflow of $30,000 inrespect of the residual value ( see line 2 of table 3 ). You next need to identify, from theinformation given, which of the revenue andcosts are relevant to the investment appraisal.

The initial investment of $350,000 isclearly a relevant cost and should be included

contribution per passenger and use thisfigure. Note that the airport is open for only360 days a year. A number of students used365 days to calculate the revenue not a bigerror, but an example of their failure to readthe question properly.

That gives you the revenue for the firstyear, but youre also told that revenue willincrease in line with passenger numbers,which are forecast to rise by 10 per cent ayear. All you need to do, therefore, is increasethe contribution year on year by 10 per cent(see line 3 of table 3 ).

Staff costs are $20,000 per employee ayear. There will be four employees in years

nancial management

PAPER P1>study notes

2 Calculating the tax payments

Year 1 Year 2 Year 3 Year 4Net cash flows ($) 138,000 166,800 178,480 213,328Tax depreciation ($) (87,500) (65,625) (49,219) (117,656)Taxable profit ($) 50,500 101,175 129,261 95,672Taxation at 30% ($) 15,150 30,353 38,778 28,702

1 Calculating the tax depreciation

Time Reducing Taxbalance ($) depreciation ($)

Year 1 350,000 87,500Year 2 262,500 65,625Year 3 198,875 49,219Year 4 147,656 147,656 30,000

320,000


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nancial management

one and two, and five employees in yearsthree and four, so calculating that is noproblem (see line 5 of table 3 ).

The overhead costs are a bit morecomplicated. Again, it is important tounderstand which of the costs are relevantand which arent. Any apportioned orabsorbed fixed costs are generally notrelevant to an investment decision. Theonly fixed costs that are relevant are theincremental fixed costs ie, the fixedcosts that are going to increase as a resultof opening the restaurant. In this case theonly relevant overheads are the cost of theelectricity, advertising and audit ie, $70,000a year ( see line 6 of table 3 ).

You then come to the cold-food outlet.This was a tricky area for candidates andcaused some of them a few problems.Opening the restaurant will cause a reductionin sales at the cold-food outlet ie, it givesrise to an opportunity cost. What youretrying to calculate is the financial effect on theexisting business of opening the restaurant.Once you have recognised this, calculatingthe opportunity cost is straightforward.First, you need to work out the existingcontribution of the cold-food outlet asfollows: 1,200 passengers x 360 days x$2.50 = $1,080,000. The new restaurant willresult in a 40 per cent reduction in sales atthe cold-food outlet, so the opportunity costis $1,080,000 x 40% = $432,000. This has tobe deducted from cash flows and will also

need to be adjusted for the increase inpassenger numbers ( see line 4 of table 3 ).

You have now worked out all the cashflows except the tax payments. The questiongives information on how to treat tax and youshould ensure that you read this especiallycarefully. The first thing to do is calculate thetax depreciation. The initial investment was$350,000 and youre told that taxdepreciation is available at 25 per cent onthe reducing balance. The allowances canbe calculated as shown in table 1 on page42. The only complication arises in year four.In the final year you need to calculate thebalancing allowance. This represents thereducing balance less any residual valuefor the equipment, which was $30,000 ( seeline 2 of table 3 ). A good way to check is toadd up the tax depreciation that you havecalculated and make sure that it totals theinvestment minus any residual value.

Now that you have calculated the taxdepreciation figures, you can deduct thesefrom the projects cash flows and thencalculate the tax payments. Table 2 on page42 shows this calculation. This is simply 30per cent of the taxable profit ie, the cashflows minus the tax depreciation. Dont

P1 further reading

B Scarlett, The Ofcial CIMA Learning System PerformanceOperations , CIMA Publishing, 2009.

PAPER P1>study notes

3 Calculating the net present value

Line Year 0 Year 1 Year 2 Year 3 Year 4 Year 51 Initial investment ($) (350,000)2 Residual value ($) 30,0003 Restaurant contribution ($) 720,000 792,000 871,200 958,3204 Reduction in contribution from cold food ($) (432,000) (475,200) (522,720) (574,992)5 Salaries ($) (80,000) (80,000) (100,000) (100,000)6 Additional overheads ($) (70,000) (70,000) (70,000) (70,000)7 Net cash flows ($) (350,000) 138,000 166,800 178,480 243,3288 Tax payment ($) (7,575) (15,177) (19,389) (14,351)9 Deferred tax payment ($) (7,575) (15,177) (19,389) (14,351)10 Net cash flow after tax ($) (350,000) 130,425 144,048 143,914 209,588 (14,351)

11 Discount factor 1.000 0.926 0.857 0.794 0.735 0.68112 Present value ($) (350,000) 120,774 123,449 114,268 154,047 (9,773)13 Net present value = $152,765 (total of line 12)

forget that you need to check when the taxis payable. The question tells you that half ispayable in the year in which it arises and theother half is payable the following year ( seelines 8 and 9 of table 3 ).

An alternative approach, which manycandidates used, is to calculate the tax effectof the tax depreciation separately. This is fine,but you must remember that it is a taxablebenefit: it should be added to the cash flowsand the benefit needs to be phased in thesame way as the tax payments.

You now have the net cash flows aftertax and all thats left to do is calculate thepresent value for each year and the netpresent value for the project. You need toknow the companys cost of capital orrequired rate of return, because thats therate you will use to discount the cash flows.The question states that the companyspost-tax cost of capital is 8 per cent, so youcan look up the present value tables andobtain the discount factors for years one tofour at a discount rate of 8 per cent ( see line11 of table 3 ). Lastly, multiply the net cashflows after tax by the discount rate andcalculate the net present value ( see the lastline of table 3 ).

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