Static Methods

Abstract

This chapter considers simple ‘static’ analysis methods that assess the absolute and relative profitability of an investment for a time span of one (average) period.

These methods focus on a single financial measure, and other target measures are ignored. Target measures analysed and compared are costs, profits, average rates of return and the static payback periods of investment projects.

Assessment Material

1.1 Exercise 2.1 (Cost Comparison Method)

A car manufacturer wants to use the cost comparison method to assess whether he should continue to buy in a special component or manufacture it in-house instead. Two companies are offering different types of equipment to produce the part, giving the following data:

Table 2.6 Data for the two machines A and B

The variable costs are in proportion to the volume produced; the above data relate to the capacity being fully utilised. The unit buying in price for the parts is €10.

• (a) Which of the alternatives (machine A, machine B or buying in (alternative C)) would you recommend if the number of these special components required each year was 6,000 units?

• (b) Which machine would you select if the required volume was 10,000 units per year?

• (c) Which assumptions have you used in question a) in respect of the amount of capital tied up? What other assumptions has the cost comparison been based on?

• (d) Describe the changes in average depreciation and interest that occur if, instead of straight-line depreciation, the declining balance method of depreciation for machine B is used, whereby

  • (d1) The rate of depreciation is 30 % followed by a switch to the straight-line method to reach the liquidation value of €0.

  • (d2) Depreciation is carried out until there is a liquidation value of €10,000.

  It is not necessary to calculate the results; just discuss the general impact on the project appraisal.

1.2 Exercise 2.2 (Cost Comparison Method)

The cost comparison method is to be applied in assessing two alternative investment projects, A and B, as well as alternative C (buying in from outside). The following data are available:

Table 2.7 Data for the investment projects A and B

The items can be bought in at a unit price of €1.50 for volumes of up to 10,000 units.

• (a) Ascertain the cost functions C_A, C_B and C_C for the various alternatives.

• (b) Which alternative is preferred when the production volume is

  • (b1) 4,000 units?

  • (b2) 8,000 units?

  • (b3) 10,000 units?

  What costs arise with this alternative?

1.3 Exercise 2.3 (Profit Comparison, Average Rate of Return and Payback Method)

A company is planning to undertake an investment project. The following data have been calculated for two alternatives, A and B:

Table 2.8 Data for the alternatives A and B

Ascertain the preferred project using

• (a) The profit comparison method.

• (b) The average rate of return method.

• (c) The static payback method.

Further reading: see recommendations at the end of this part.