Accounting for Managers: Interpreting accounting information for decision-making

SOLUTIONS TO CASE STUDIES 463

overhead as the principal measure of profitability, it would be likely to discontinue
the Cryod!

Case study 6: Serendipity PLC

The first comment to be made is in relation to the accuracy of the expected
additional cash inflows and outflows, which are notoriously difficult to assess. The
proposer of the capital investment will need to have some information to support
the revenue growth projections and expected cost increases.
The ROI calculations are important, although as is common with ‘cap ex’
proposals, the higher ROIs are in later years. A fuller picture may be seen by
looking at the average ROI over the life of the investment. Average profits are
£560,000 (total profits/5) and average investment is £2.5 million (£5 million/2).
The average ROI is therefore 22.4% (560/2,500).
Given a cost of capital of 8% used in the NPV calculation (which needs to be
verified as the weighted average cost of capital for Serendipity), a residual income
approach may also present a fuller picture (Table A4.6).
The total RI over the project is £2 million.
The NPV produces a positive £1.225 million at a cost of capital of 8%. Again, to
present a fuller picture, an internal rate of return calculation shows the discount
rate that equates to a nil NPV. The IRR is 16.8%, which is double the cost of capital,
a more meaningful figure than the NPV residual value.
Finally, a payback calculation shows that on a cash flow basis the investment is
paid back after three years and two months (Table A4.7).

Table A4.6 Serendipity

12345

Residual income

Profit after tax 245 455 700 700 700

Cost of capital on asset value 8%

Cost of capital on asset value 320 240 160 80 0

Residual income − 75 215 540 620 700

Table A4.7 Serendipity

Year0123456

Payback
Net cash flow −5,000 1,350 1,545 1,805 1,700 1,700 − 300
Cumulative −5,000 −3,650 −2,105 − 300 1,400 3,100 2,800
300 / 1 , 700 = 176
× 12 = 2 .1months