Question 4.1: Billingsgate Battery Company has carried out some research t...
Billingsgate Battery Company has carried out some research that shows that the business could provide a standard service that it has recently developed.
Provision of the service would require investment in a machine that would cost £100,000, payable immediately. Sales of the service would take place throughout the next five years.
At the end of that time, it is estimated that the machine could be sold for £20,000.
Inflows and outflows from sales of the service would be expected to be as follows:
| Time | £000 | |
| Immediately | Cost of machine | (100) |
| 1 year’s time | Operating profit before depreciation | 20 |
| 2 years’ time | Operating profit before depreciation | 40 |
| 3 years’ time | Operating profit before depreciation | 60 |
| 4 years’ time | Operating profit before depreciation | 60 |
| 5 years’ time | Operating profit before depreciation | 20 |
| 5 years’ time | Disposal proceeds from the machine | 20 |
Note that, broadly speaking, the operating profit before deducting depreciation (that is, before non-cash items) equals the net amount of cash flowing into the business. Broadly, apart from depreciation, all of this business’s expenses cause cash to flow out of the business. Sales revenues tend to lead to cash flowing in. Expenses tend to lead to it flowing out. For the time being, we shall assume that working capital – which is made up of inventories, trade receivables and trade payables – remains constant. This means that operating profit before depreciation will tend to equal the net cash inflow.
To simplify matters, we shall assume that the cash from sales and for the expenses of providing the service is received and paid, respectively, at the end of each year. This is clearly unlikely to be true in real life. Money will have to be paid to employees (for salaries and wages) on a weekly or a monthly basis. Customers will pay within a month or two of buying the service. Yet making the assumption probably does not lead to a serious distortion. It is a simplifying assumption, that is often made in real life, and it will make things more straightforward for us now. We should be clear, however, that there is nothing about any of the four methods that demands that this assumption is made.