Chapter 5 • Practical aspects of investment appraisal
Provided that the recognition of the timing difference in Example 5.1 (the £40,000)
is correctly adjusted for, operating accounting flows can be used as a surrogate for the
(more strictly correct) cash flows.
Failure to make this adjustment to accounting flows will tend to cause a bias in the
appraisal, usually giving a more favourable impression than justified by the facts. It
will tend to give this more favourable impression because accounting flows do not
reflect the fact that, as in Example 5.1, sales are usually made on credit so that the cash
inflows may lag some time behind the sale. While it is true that an opposite effect is
caused by the fact that the business is likely to buy its raw materials on credit, this
opposite effect is itself likely to be offset by the fact that the business probably holds
inventories of raw materials and perhaps finished goods as well.
In any case, for projects that are likely to be favourably considered by the business,
the sales revenues will tend to be larger than the operating costs. Also, sales are usu-
ally made on credit whereas some significant operating costs (for example, wages) are
payable more or less immediately.
With capital expenditure, and any possible disposal proceeds, it is necessary to
identify specifically when these cash flows occur. Depreciation charged in arriving at
operating profits needs to be eliminated.A project to manufacture widgets, if undertaken, will start on 1 January with the purchase of
(and payment for) a widget-making machine. Materials for use in the manufacture of widgets
will be bought in January and paid for in February, and these will be used in production in
February. February’s production will be sold in that month, on credit, and customers will pay
in April. If the monthly purchase of raw materials is £10,000 and the monthly sales revenue
from widgets £20,000, then once the project gets under way the working capital investment
at any given moment will be£
Trade receivables (two months at £20,000 p.m.) 40,000
Inventories (one month at £10,000 p.m.) 10,000
50,000
Less: Trade payables (one month at £10,000 p.m.) 10,000
40,000( This assumes that the level of activity, the inventories holding and the credit periods
remain constant.) So to take account of the difference between operating accounting flows
and cash flows we could treat the £40,000, which is the magnitude of the difference between
accounting and cash flows, as an initial investment of the project.
We should also need to treat it as a receipt at the end of this project. This is logical
because, during the last few months of the project, more cash would be received from sales
revenue than sales revenue made; credit customers will continue to pay after the end of the
project for two months. Inventories will not be bought during the last month of production,
though suppliers of inventories bought the previous month will need to be paid during that
last month.Example 5.1