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rate of sales within the project. A bigger project means bigger capital invest-

ment. This adds to capital employed which is the denominator of the ROACE

calculation. The numerator is profit and this is the profit that is being earned

by the smaller projects which were started in earlier years.

If growth is at a constant rate we can model its effect by taking each col-

umn in the AFS and dividing it by a growth factor. The project year 1 column

is unchanged but a company that is starting a project of this size and that

The base case assumption was an average selling price of $1,700.

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I am i no ng s i l s a io s where proj s are in effect divestments with initial cash inflows fol-

m ignoring special situations here projects re n t iv men s i h i i l sh os

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lowed by subsequent cash outflows.

Growth is good since the individual projects have a positive NPV. Hence growth means that the

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NPVs that will be earned are always getting bigger.

130 The five financial building blocks

is growing must have started a smaller project the previous year and even

smaller ones in the years before that. We can model this by taking the figures

for year two and dividing them all by one plus the growth rate and the year

three numbers by one plus the growth rate squared and so on. The adjusted

numbers are then added up. We finish up with a new set of numbers as illus-

trated below which assumes 5% growth:

Sum of all projects â€“ 5% growth $m

Income statement

Sales revenue 8.1

Variable costs âˆ’1.7

Contribution 6.4

Fixed costs âˆ’0.9

Amortisation âˆ’2.6

Pre-tax profit 3.0

Tax âˆ’0.9

Profit 2.1

Balance sheet

Fixed assets 13.8

Accounts receivable 1.0

Inventories 0.4

Accounts payable âˆ’1.0

Working capital 0.4

Capital employed 14.2

ROACE 15.0%

Funds flow

Profit 2.1

Amortisation 2.6

Working capital 0.0

Capital investment âˆ’3.3

Funds flow 1.4

All of the numbers in the income statement23 are lower than those in the

previous table. Why is this?

Note that a careful comparison of the balance sheet will also show that fixed assets are lower in the

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growing company but that the capital investment is higher. This is a function of the particular profile

of capital investment in this example. The investment in the first year is partially offset by the scrap

value of the scaffolding in the final year. There is no capital investment in the intervening years. So

in the growth case the much lower scrap value coming from the smaller project started several years

ago means that overall investment is higher. This situation is not typical.

131 Building block 4: Planning and control

The methodology is such that the initial yearâ€™s investment is maintained.

If growth is, say, 5% then the previous year the project that was started must

have been 5% smaller and so on. So a company that is growing at a steady rate

and that implements a project of a given size this year will be smaller overall

than a company that implements the same size project but is not growing.

Each project that the growing company has invested in will offer the same

relative return but they will all have been smaller.

The impact of growth has two important effects. First, ROACE falls a lit-

tle. In this case it falls to 15.0%.24 Second, the funds flow is no longer equal

to profit. It is now substantially less than profit. This is because growth needs

to be funded.

So now we have two more ways to aid our words and music understand-

ing of company performance. A company that is growing will have a small

reduction in ROACE and a much larger decrease in the extent to which it can

afford to pay out its profit as a dividend.

Here then is a further big advantage of adopting the AFS approach to

project evaluation. We can easily see the implications for the accounting per-

formance of the company of implementing projects that are like a particular

project that is under consideration. Furthermore, we can see what the impact

of growth will be. All that we need to do is add up the lines in our project

spreadsheet. I call this approach â€˜the company as Î£ projectsâ€™ in recognition of

the Î£ operator from mathematics.25

Overheads and sunk costs

The above approach, which treats a company as a series of projects, has, I

believe, intuitive appeal but it is missing two features which serve to distort

the way that we look at projects. These concern the impact of fixed overheads

and sunk costs.

When a project is presented for approval its economic indicators should be

calculated by comparing a â€˜with projectâ€™ world with a â€˜without projectâ€™ world.

The NPV is based on incremental cash flows. This means that any overheads

which are unaffected by the project will not be included in the cash flow

I should stress again that ROACE is the only number in this table which is not simply calculated by

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adding up the lines in the project spreadsheet. ROACE is specifically calculated given the accounting

data and in particular includes back-calculating what the opening capital employed will be given

the change in capital employed inferred by the capital investment, the amortisation and the working

capital change.

For the non-mathematical, the Greek letter Î£ (pronounced sigma) means â€˜the sum ofâ€™.

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132 The five financial building blocks

projections. This will include, for example, the cost of the chief executive

who will, presumably, be running the company irrespective of the particular

project. Also excluded from the project NPV calculation will be any sunk

costs. Sunk costs are money that has already been spent on the project, for

example on the initial design work that was necessary in order to prepare the

financial estimates.

So it is unlikely that a company will look as favourable as would be implied

by the simple extrapolation from a single project. A better model would treat

the company as a series of projects plus overheads and sunk costs. The over-

heads number would be the sum of all of the costs in a company that were not

project costs. The sunk costs would be the project costs incurred on a project

prior to its approval.

Suppose that in our scaffolding example with 5% growth there were cor-

porate overheads of $300,000 per annum. This covered the cost of the board

of directors, the finance department, etc. Suppose also that the pre-sanction

costs on a typical project were $100,000. This covered the cost of the project

development team and the specific pre-sanction analysis. Overall then,

$400,000 of costs would be excluded in the simple company as the sum of

its projects model. A full company model would allow for these. In principle

one would allow for all consequent effects including not only the tax relief

associated with costs but also working capital impacts. In practice one might

simply model the costs and their associated tax relief but not any working

capital effects.

The effect of including these assumptions is shown here:

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