Life cycle costing - Financial Performance

mhep

Hope someone can help me. I am on my very last exam, Financial Performance, but I have failed it 3 times. There are various issues for me, but one is that the two texts that I am using do not have the information that I need.

(Also what is the difference between 2010 and 2013 when asked for e-learning resources on the website?)

I began to revise the Lifecycle costing. The texts have about one paragraph on it but the exam has one section on it. I began the e-learning provided on the AAT website on Lifecycle costing, but ran into a problem that I cannot get my head around and the texts are useless.

I am fine with the annual running costs, but the second example gives a cost of capital of 12%. I do not understand how to use this information or what it means. The last annual running cost under year 6 gives a larger number which I cannot figure out. I assume it has something to do with the12%, but of what? With the examples that state how much the company can recoup by selling the asset, the amount is deducted from the running cost, and the number is a negative. I understand that.

What is cost of capital and how do I use the information to calculate the correct figures for the question?

Many thanks for an help.

Mimi

SandyHood

Dear Mimi
Can you define Life Cycle Costing?
Do you understand what "discount rate" means or "present value (PV) factor? They mean exactly the same as "cost of capital".
I will try and find an example for you.

While I'm having a look, please can you check whether either of the books you are using is this one?
http://eu.dummies.com/store/product/Management-and-Cost-Accounting-For-Dummies-UK-Edition.productCd-1118650492.html
Chapter 11 looks at Life Cycle Costing

Claireshep2793

Hi Mimi,

I've had a look and the figure of £330 under year 6 comes from £80,000 running costs and decommissioning costs of £250,000. As far as i'm aware cost of capital does not effect the calculations?

Best of luck I'm sitting my 4th attempt at this exam at the end of January, last one for me too!

Claire

SandyHood

Example question taken from an old (paper based) exam

SandyHood

Step by step guide to part a

SandyHood

Steps for parts b and c

SandyHood

Dear Claireshep2793

The £330,000 cash flow calculation is absolutely right.
The 12% refers to the discount factor row. Effectively a cash flow in year 6 has to be discounted to find its present value. At 12% and taking 6 years the discount factor is 0.507. This is shown in the row below the net cash flow. 330 x 0.507 = 167

SandyHood

Cost of capital is the company's interest rate that it applies to projects that require finance. If you invest £10,000 into a business idea and hand over the money today. If the business idea lasts for 1 year and you take £10,000 out at the end of the year you would have effectively tied £10,000 up for a year for no cash benefit.
Worse, at today's value £10,000 (which you have to wait a year before you receive it) isn't worth the same as £10,000 today. So in the example, you would have a negative NPV if you invest £10,000 and 12 months later take £10,000 back.
How much does the future cash flow have to be reduced by? It depends on the company. But this company has a 12% cost of capital. You could say £10,000 in a years time would be divided by 112% to find how much it is worth today.
After all if you want to compound a bank deposit you take the deposit and multiply by 100% to keep it at the same value and add on the interest rate. (If you earn 12% interest you can multiply by 112%). Discounting means that you divide instead of multiplying.

The discount rate is calculated as 1/1+interest rate
£10,000 coming in in one year has a present value of £8.928.57
I got it by saying £10,000 divided by 112%
I could have said 1/1.12 or 100%/112% = 0.8929 and then multiplied by £10,000 to give £8,929 - just as valuable as the other calculation

So if money we wait 1 year for is discounted at 0.8929, then if we have to wait 2 years the discount rate will be 1/1.12 and the answer divided by 1.12
and for 6 years you divide 1 by 1.12 six times. If you then round off the answer it is approximately 0.507
the
That, I hope links the discount rate to the cost of capital. You need to know the link, but all your exam questions will give you "ready to use" discount rates so it won't be tested within a calculation part of task 9.