The Paper FFM Study Guide references E3 c) and E3 d) require candidates to be able to both discuss the concept of relevant cash flows and identify/evaluate relevant cash flows.
Relevant cash flows can be examined in either a written or calculation format. It is also important that candidates can identify relevant cash flows in order to be able to use them in the context of investment appraisals, for example net present value calculations. Finally, relevant cash flows are not just an important part of the syllabus for Paper FFM as they can also be examined in later studies, for example Paper F9.
A definition often used for relevant cash flows states that they must be cash flows that occur in the future and are incremental.
While on the face of it obvious, only costs or revenues that give rise to a cash flow should be included. Accordingly, for example, depreciation charges should be excluded.
Any relevant cash flow should arise in the future. Anything that has occurred in the past is referred to as a sunk cost and should be excluded from relevant cash flows.
Only cash flows that arise because of the decision being made should be included; any cash flow that would have arisen anyway, sometimes referred to as a committed cost, should be excluded.
While not specifically included in the definition of a relevant cash flow (as noted above) opportunity costs are also relevant cash flows. Opportunity costs are the revenues that are lost (or additional costs that arise) from moving existing resources from their current use and are therefore considered to be incremental cash flows arising in the future to be taken into account.
These definitions sound easy, and candidates often do well when relevant cash flows are examined in a written format. However, it is applying these concepts to a scenario and calculating/identifying the relevant cash flows that can often cause candidates problems, and it is this that I shall now focus on using excerpts from the question in Appendix 1 as examples where possible. Please read the question before continuing.
In the context of whether a business owner will move her business, we are told that ‘Mrs Clip currently advertises her business in the local newspapers and business directories, at a cost of $1,000 per year payable in advance. Mrs Clip will carry on with this advertising…’.
Relevant cash flows from scenario 1
On a relevant cash flow basis, we do not need to be concerned with what has been paid in the past, so the $1,000 per year paid in the past is a sunk cost and can be ignored from relevant cash flows.
What about the $1,000 per year in the future if Mrs Clip continues with the advertising? This would not be included as a relevant cash flow, because it is not incremental. The $1,000 cash flow is being suffered now and will continue in the future, whether or not Mrs Clip moves her business to the town centre premises. The cash flow does not arise because of the decision being made; it arises anyway and is therefore not a relevant cash flow.
A further example of the incremental concept relates to revenue. Revenue from the existing business is $40,000 per year. We are told that if Mrs Clip advertised her move to the town centre premises in the papers only, then revenue would increase by 40%, but if the move was advertised in both the papers and on the radio, then revenue would increase by 45% rather than 40%.
Relevant cash flows from scenario 2
The existing revenue of $40,000 is not incremental. This is the level of revenue that has been earned by the business in the past and will be earned in the future whether or not a move to the town centre premises is made. It is not dependent on the decision being made. In order to get the relevant cash flow, what is required is the incremental revenue – ie the extra revenue that will be earned if the move is made. Thus if the advertising is only in the papers, then the incremental revenue earned will be 40% x $40,000 = $16,000. If the advertising is in both the papers and on the radio, then the incremental revenue will be 45% x $40,000 = $18,000.
Within this question, there were no non-cash flows. However, what if we had been told that Mrs Clip was going to buy salon fittings for $3,000, and these would be depreciated over five years?
Relevant cash flows for scenario 3
The $3,000 paid for the salon fittings would be a relevant cash flow, and incorporated within any relevant cash flow schedule at the time at which the fittings were purchased. However, depreciation is not a cash flow and is therefore not a relevant cash flow. As a result, it the annual depreciation charge should not be included within any relevant cash flow schedule.
Opportunity costs arise less frequently within questions, but when they do, they can cause candidates real problems. There are no opportunity costs within the question we have been considering, but let us look at an example all the same. An opportunity cost arises if a resource is moved from its current use. So let us say that we have labour that is currently being used in manufacturing process A. The following figures are available for manufacturing process A:
|$ per unit|
|Labour (2 hours @ $3 per hour)||6|
Labour is now required for manufacturing process B within the same organisation. Each unit within manufacturing process B uses two hours of labour. No more labour can be hired and so it would have to be moved from manufacturing process A. What is the relevant cash flow for labour in process B?
Relevant cash flows for scenario 4
Using our definition of a relevant cash flow to be a future, incremental cash flow, we can ignore the labour cost of $6 as it is not incremental, it will be paid anyway, either within process A or process B. However, if we move the labour from A to B, the organisation will have to forgo the sales revenue of $25 per unit, but they will not suffer the material cost of $10 per unit or the variable cost of $2 per unit. Thus the net effect, the net cost of moving the labour to process B is ($25 – $10 – $2) = $13 per unit. This $13 is the opportunity cost, the net revenue lost from moving the labour from its current use. You may see a short cut to this calculation – that of adding together the contribution lost of $7 to the labour cost of $6. The total again being $13 per unit. Although this seems theoretically incorrect, as the non-incremental labour cost of $6 is being included, it is just a short cut to the answer.
In a Section B question, candidates need to be able to both explain the principles behind relevant cash flows and be able to identify/calculate such cash flows, possibly for further use within an investment appraisal calculation. The question in the appendix is the typical example and I would strongly recommend you work through the question. The answer is provided in Appendix 2. It is hoped this article will help candidates with these elements.
Written by a member of the Paper FFM examining team
Appendix 1: Question
Mrs Clip runs a hairdressing business from her home. Mrs Clip’s business has expanded, with revenue now reaching $40,000 per year. Mrs Clip is considering moving her business into town centre premises, and employing another hairdresser, who would cost $6,000 per year.
She has found premises that could be leased for $3,500 per year payable in advance.
Mrs Clip currently advertises her business in the local newspapers and business directories, at a cost of $1,000 per year payable in advance. Mrs Clip will carry on with this advertising, but she will also need extensive ‘one off’ advertising to promote the move to the new premises, and the new hairdresser joining the business. This ‘one off’ advertising in the local newspapers will cost $2,000, which will be paid immediately. In addition to advertising the move in the local newspapers, Mrs Clip could advertise the move on the local radio. The cost of this would be $5,000, also payable immediately.
Mrs Clip believes that having a town centre presence and the associated publicity in the local newspapers will increase revenue by 40% in the first year and that it would remain at this new increased level. If Mrs Clip also advertised on the local radio, she believes that revenue would increase by 45%, rather than 40%, and would again remain at this new increased level.
Overheads, excluding advertising, would increase to a total of $4,000 per year. Overheads currently charged to the business are $1,500 per year. Direct costs such as shampoo are budgeted at 5% of revenue.
Assume that all cash flows arise at the year end, unless otherwise stated.
The cost of capital is 10% per annum.
(a) Assuming that both radio and newspaper advertising is used, calculate, over a five-year time period, the net present value of the proposed move to the new premises. On the basis of your calculation, advise Mrs Clip as to whether or not she should move her business into the new premises.
(b) Prepare a net present value calculation over a five-year time period, that justifies the additional spend on radio advertising rather than advertising in newspapers alone.