Net present value to infinity
  Automatic model
  NPV = NPV of the project/PV of annuity of appropriate years and rate
  Discount Rate
  = ?17,130,000/3.736
  0.155
  = ?29,581,405
  Super model
  = ?18,920,000/3.605
  0.20
  = ?26,241,332
  Having calculated the net present values of the two projects to infinity clearly one can see that the automatic model has a net present value of about ?29.5m whereas super has a lower net present value of about ?26.2m. This means that the automatic model will give a higher return to the shareholders of Samco plc. This is the model the Board should manufacture and sell to their customers, because shareholders? wealth will be maximised by taking this course of action.
  Conclusion
  The main objective of this second article in the area of project appraisal was to demonstrate to readers that cases might not necessarily be straightforward. Aspects such as inflation, taxation and unequal life spans must be understood in order that candidates can competently answer questions requiring an understanding of these further aspects. The scenario in Samco plc should be carefully followed ensuring that you understand how the author has used the available information to answer the question.
  by John Richard Edwards
  01 Oct 2000
  The merits of cash based financial reporting ? for example, it is based principally on facts rather than problematic accounting measurements ? have been known for many years. However, it was not until 1990 (revised 1996) that the Accounting Standards Board made the publication of Cash Flow Statements (FRS 1) a standard requirement for UK companies. FRS 1 tells us that the ?cash flow statement in conjunction with a profit and loss account and balance sheet provides information on financial position and performance as well as liquidity, solvency and financial adaptability?. Wise words, but what do they mean?
  The usefulness of financial statements is enhanced by an examination of the relationship between them; also by comparisons with previous time periods, other entities and expected performance. Value can be further added through the calculation and interpretation of accounting ratios. An examination of accounting textbooks and the pages of accounting periodicals reveals an enthusiasm for rehearsing the potential of ?accounting ratios? demonstrated through calculations of the net profit margin, return on capital employed, current ratio and a host of other ?traditional? measures based on the contents of the profit and loss and balance sheet. But what about the cash flow statement? We have seen that its publication was required by the ASB in order to improve the informative value of published financial information. Indeed, some say it is the most important financial statement. One based on ?hard facts? which has helped prevent financial machinations such as those that are believed to have occurred at companies such as Polly Peck in the 1980s.
  The lack of attention to cash flow-based ratios in accounting textbooks is particularly surprising given their acknowledged role in credit rating assessments and in the prediction of corporate failure. In these and other contexts, the traditional ratios suffer from the same defect as the financial statements (the profit and loss account and balance sheet) on which they are based. Such ratios are the result of comparing figures which have been computed using accounting conventions and ?guestimations?. Given the difficulty of deciding the length of the period over which a fixed asset should be written off, whether the tests which justify the capitalisation of development expenditure have been satisfied, the amount of the provision to be made for claims under a manufacturer?s twelve month guarantee (to give just a few examples), ratios based on such figures are also bound to have limited economic significance. This is not to suggest that the traditional ratios are irrelevant. Clearly this is not so, as they reveal important relationships and trends that are not apparent from the examination of individual figures appearing in the accounts. However, given the fact that cash flow ratios contain at least one element that is factual (the numerator, the denominator or both), their lack of prominence in the existing literature is puzzling.
  Some recognition of cash flow ratios
  The importance of cash flow ratios was dramatically demonstrated, early on, by W. H. Beaver whose 1966 study showed that the most effective predictor of corporate failure was the ratio of cash flow to total debt. Indeed, one of his most surprising findings was that the current ratio proved to be one of the least useful ratios in predicting impending collapse. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business. Colourfully described as a company?s ?life-blood?, a strong cash flow will enable a business to recover from temporary financial problems whereas future negative cash flow will cause even an apparently sound enterprise to move towards liquidation. Expressing the importance of cash differently: a company which descends into a loss-making position often succeeds in making a comeback; one which runs out of cash is unlikely to have a second chance.
  Another US-based writer, Yuji Ijiri, has noted the paradox between the way in which investment decisions are made by business and other entities and the way in which the results of those decisions are *uated. The principal focus for informed investment decisions is cash flows, whether the capital project appraisal method is ?payback? or one of the more sophisticated discounted cash flow-based techniques, namely ?net present value? and ?internal rate of return?. Turning to performance *uation, however, the emphasis usually shifts to techniques such as return on investment. The inconsistency between the two approaches is highlighted by the use of depreciation cost allocation for computing ROI; a calculation which has no place whatsoever in the above project appraisal methods. Ijiri persuasively argues, therefore, the importance of making project appraisal and performance *uation consistent.
  In the remainder of this paper are presented
  · ratios which link the cash flow statement with the two other principal financial statements;
  · ratios and percentages based entirely on the contents of the cash flow statement.
  To illustrate the calculations, the results of Tamari plc for 1998 and 1999 appear in Figure 1. For each ratio is presented both the calculation and a discussion of its significance. Inevitably, there will be some overlap in the messages conveyed by the various ratios presented. This may be due to similarities in the nature of the calculations or to the fact that the results of just one company are used for illustration purposes. The application of the same ratios to different financial facts might well yield additional valuable insights.