this is a lecture from open tuition to benefit from the lecture you should download the free lecture notes from open tuition calm this is the fourth and the last lecture on chapter 7 and as I said in the earlier lectures almost any investment to President Nixon almost all of it will be based on discounted cash flow MVPs possibly internalized a return however you're expected to be aware of two other approaches that businesses may use two alternative approaches which occasionally bits of them get asked but never to any great degree and the first is what we call the accounting the rate of return which is a profits measure now you may remember I said in an earlier chapter that we discounted an earlier lecture on with discounted cash flow we're looking at the cash flows because it's cash we need to pay dividends it's cash we need to buy mere machines but I did say that Shalders the first thing they're going to look at is the profits they're likely to be more concerned about the profitability profits have gone up that looks good if they've gone down its path well accounting rate of return is a profit measure and you'll see in the nose the definition it's the average profits the year from an investment as a percentage of the average Book value the average value in the step to financial position because else watch hours receive statement of profit and loss the profit step to financial position you can see the the book value the carrying value of the assets to show you how we do it example 8 is very simple one but any of these in the exam I'll kept very simple in this way they don't have complicated ones a machine will cost eighty thousand it has an expected life of for you with an expected scrap value of 10,000 the net operating cash flows each year as follows twenty thirty forty ten it wants the accounting rate of return well let's first of all work out the average profit per year well we told what the cash flows are each year and so the total operating cash flow is 20 30 40 10 a total of litter a hundred thousand because that's not the same as the profits because profit is calculated after depreciation so to get the total profit we're making what's the total depreciation gonna be well I know there are various ways we could appreciate it but surely in total if it cost 80 and the scrap value is 10 in total the depreciation will be 70 thousand so the total profit will be 30 thousand we want the average profit per year well it's lasting for years so the average profit thirty thousand divided by four is what 7,500 okay so there's our average profit we want to express that as a percentage if the average book value carrying value in the statement of financial position so what's the average Book value now here be careful people do funny things here let me bind the machine in car safety so I can sit there in the statement of financial position of a balance sheet at eighty thousand each year will depreciate so each year the value will fall and if there was no scrap value it would start at 80 it had fall down to zero the average should be halfway eighty down to zero on average it would be forty thousand what's happening here there is a scrap value so it starts a dainty depreciating Falls each year down to ten well surely if he went from eighty down to zero you'd say the average was fourteen if it's start with eighty and if it's still worth ten at the end the average is a bit higher it's eighty plus 10 over 2 the average value in the balance sheet or statement of financial position eighty thousand at the start the scrap ten thousand at the end the average divided by two so on average forty five thousand and therefore of it accounting rate of return average profit seminar thousand average book value forty-five thousand as a percentage I get sixty in that point six seven percent sorry the pen sister twenty sixteen point six seven now how we'd use that companies that looking at the counting Rachel return they would have a target you know perhaps their existing return on capital employed if at the moment or grow the business is getting ten percent return this is more than turning to be good on the other hand if at the moment we're getting an overall profit return of 20% then come soon to check this at sixteen so you need to compare it with a target in deciding that whether to go ahead and not so I say anything on accounting read to return would be pretty simple in the exam primarily we look at the static cash flow but just to be safe be aware of it finally there's one more methods at the company she was something called the payback period and what the payback period is here where again we do look at cash flows but it's the number of years it takes in cash terms to get back the original investment and I'm not writing that because it's all typed on the next page but let me show you what I mean in the example a machine costs eighty thousand so we pay out eighty thousand now for the payback period we say well how many years will it take us to get back at 80,000 in the first year the cash we get is cash inflow its cashews here we get cash of 20,000 so how much have we had in total 20,000 flowers now how long to get my haters so that's not enough in the second year we get another 30,000 cash so how much have we have in total we've now had a total of 50,000 it's still not enough we need a two in the third year we get 40,000 so how much you have in total we've now have 90 we have got back the full 80 now two things here one thing we can immediately say is we get the money back within three years two years ago got 50 by the end of three years we had 90 we can be more precise if we assume that the money is coming in evenly so you know after the second year we've had 50 we need another 30 if we assume that that 40 in the third year is coming in evenly over the year then to get the extra 30 we need to make it up to 18 will be 30 fortieths it'll be three quarters for the third year after two years you know 15 if the third year 40 is coming in evenly to get an extra thirty thousand they'll take that fraction of the third year at two point seven five years so that's how we calculate the payback period period the waves used again the company will have a targets that we own interesting projects that pay for themselves within four years let's say well I really does very doesn't the reason isn't important to measure this is a longer one how we looking at cash flows and cash is important we said earlier however we choose to appraise we're basing it on and and what's the winner bit of story we're basing it on estimates you know anyone looking a profits of cash were estimating twenty thousand the first year thirty thousand a second so on and I'm sure degree that whereas estimates for next year the year after we may be able to estimate fairly accurately the further into the future were estimating the more it becomes almost a guess if I got another project where the payback period was ten years then again how an earth did I managed to come up with an estimate for eight years took nine years time ten years time I'd be very scared of doing it because he might never pay for itself on the other hand if a project pays for itself within two or three years I'm going to be much more confident that I will at least get the money back and hopefully get carry on getting more afterwards and so that's why I'm a map period is important it's less affected by the uncertainty when were estimating flows now I've shown you three methods discounted cash flow and begin an IRR are both discounted cash flow accounting ready to them a payment period theoretically discounted cash flow is the best most investment appraisal questions in the exam are discounted cash flow however there's a logic to all three methods paying up period it's dealing to an extent without certainty these estimates and counting rate of return look at profitability and what tends to happen is companies will look at a range of measures they won't just look at discounted cash flow they just they won't just look at return on capital they're counting greater return they'll look at several measures and sort of format overall judgment anyway there we are that's the end of the f2 revision in the remaining chapters on this area of the syllabus we'll look at as I said earlier how we get the cash flows in the first place in order to able to do our discounted cash flow