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# Cost and Management Accounting 2nd edition

CHAPTER 14

14.1 An investment of R200 000 is expected to generate an after tax cash flow of R80 000 in year 1
and another R65 000 in each of years 2 and 3. If the cost of capital is 15%, what is the internal
rate of return for this investment?
A. 4.2%
B. 2.6%
C. 6.9%
D. 8.5%

14.2 Looking at capital budgeting, the relevant cash flows for the project are least likely to include:
A. Opportunity costs
B. Tax benefits
C. Residual value of the project
D. Depreciation

14.3 ABC wants to know its weighted average cost of capital. The cost of equity is 18% and the cost
of debt is 12%. If the debt:equity ratio is 40%, what is the WACC?
A. 3.4%
B. 12.6%
C. 16.3%
D. 15.6%

## 14.4 The cost of equity is:

A. Higher than the cost of debt
B. Lower than the cost of debt
C. Equal to the cost of debt
D. None of the above
Cost and Management Accounting 2nd edition

14.5 A five-year project has an initial investment of R160 000. The project is expected to earn net
annual cash flows of R50 000 for each of the five years. The discount rate is 15. The net present
value is:
A. R90 000
B. R7 608
C. R20 239
D. None of the above

14.6 When choosing between mutually exclusive projects, the following project(s) will be accepted:
A. The project with the highest net present value (NPV)
B. The project with the highest accounting rate of return (ARR)
B. All the projects with positive NPVs
D. None of the above

## The following information is related to Questions 14.7 to 14.9 below:

No Limits (Pty) Ltd has limited capital of R200 000 to invest in the following projects:
Year Project A Project B Project C Project D
0 (100 000) (60 000) (120 000) (80 000)
1 30 000 (40 000) 60 000 (100 000)
2 60 000 60 000 60 000 120 000
3 70 000 85 000 60 000 130 000
NPV 17 482 6 475 16 994 ?

## 14.7 The net present value of project D is:

A. R70 000
B. R9 528
C. Negative
D. None of the above
Cost and Management Accounting 2nd edition

## 14.8 The discounted payback period for project C is:

A. 2 years
B. 2.57 years
C. Does not pay back
D. None of the above

14.9 Ranking projects A, B and C according to the profitability index of each project will give the
following ranking (from highest to lowest PI):
A. Project A, project B, then project C
B. Project B, project A, then project C
C. Project A, project C, then project B
D. None of the above

## 14.10 Company A is considering the following mutually exclusive projects:

Investment A Investment B Investment C
Net present value R230 000 R400 000 R100 000
Internal rate of return 18% 15% 13%

## Which investment should be chosen?

A. Investment A
B. Investment B
C. Investment C
D. None of the above

14.11 A new delivery truck costs R2 million and a tax capital allowance of 20% is allowed on the
straight line basis over five years. Assume a corporate tax rate of 28%. The annual cash tax
saving each year as a result of the tax capital allowance is:
A. R112 000
B. R400 000
C. R560 000
D. None of the above
Cost and Management Accounting 2nd edition

14.12 If an investment of R6 000 generates after tax cash flows of R600 in year 1; R1 500 in year 2;
R3 000 in year 3; and R4 500 in years 4 and 5 respectively, and the cost of capital is 20%, the
net present value of the project would be:
A. R1 256
B. R1 200
C. R1 550
D. R2 256

14.13 When evaluating project A and project B, which are mutually exclusive, the payback method
recommends project A, because of its short payback period, while the net present value method
recommends project B, because of its higher positive NPV. Determine which project(s) will
finally be recommended.

## A. Both projects A and B

B. Project A
C. Project B
D. None of the above

14.14 A company’s managers are considering investing in a project that has an expected life of five
years. The project is expected to generate a positive net present value of R240 000 when cash
flows are discounted at 12%. The expected net cash flows of the project is R120 000 in each of
the five years. (CIMA: November 2014)

Calculate the percentage decrease, to the nearest 0.1%, in the annual net cash inflow that would
cause the managers to reject the project from a financial perspective
A. 50.0%
B. 55.5%
C. 40.0%
D. None of the above
Cost and Management Accounting 2nd edition

14.15 A company is considering an investment project for which the possible cash inflows and their
respective probabilities are given in the table below:
Year 1 Year 2
Cash inflow Probability Cash inflow Probability
R R
200 000 0.2 100 000 0.6
300 000 0.7 320 000 0.4
360 000 0.1

The cash flows for year 1 and year 2 are independent. The initial cash outflow for the project is
R300 000 and the company’s cost of capital is 10% per annum. Ignore tax and inflation.
(CIMA: September 2014)

The expected value of the net present value of the project will be closest to:
A. R174 000
B. R134 160
C. R115 372
D. R291 736
Cost and Management Accounting 2nd edition

14.16 The management of a hotel is considering expanding its facilities by providing a gymnasium
and spa for the use of guests. It is expected that the additional facilities will result in an increase
in the occupancy rate of the hotel and in the rates that can be charged for each room.

The cost of refurbishing the space, which is currently used as a library for guests, and installing
the spa, is estimated to be R100 000. The cost of the gymnasium equipment is expected to be
R50 000. The gymnasium and spa will need to be refurbished and the equipment replaced every
four years. The equipment will be sold for R15 000 cash at the end of year 4. This amount
includes the effect of inflation.

The hotel’s accountants have produced a feasibility report at a cost of R10 000. The key
findings from their report, regarding current occupancy rates and room rates are as follows:

##  Current occupancy rate: 80%

 Number of rooms available: 40
 Current average room rate per night: R250

Occupancy rates, following the opening of the gymnasium and spa, are expected to rise to 82%
and the average room rate by 5%, excluding the effect of inflation.

## 1. Staffing of the gymnasium and spa

 Number of employees: 4
 Average salary per employee: R30 000 per annum

 The current budgeted overhead absorption rate for the hotel is R80 per square metre
per annum.
 The area required for the gymnasium and spa is 400 square metres.
 The hotel’s annual overheads are expected to increase by R42 000 directly as a result
of opening the gymnasium and spa.

3. Inflation
Inflation is expected to be at a rate of 4% per annum and will apply to sales revenue,
overhead costs and staff costs. The rate of 4% will apply from year 2 to each of the
subsequent years of the project.
Cost and Management Accounting 2nd edition

4. Taxation
The hotel’s accountants have provided the following taxation information:

##  Tax capital allowance available on all costs of refurbishing, installation and

equipment: 25% reducing balance per annum.
 Taxation rate: 30% of taxable income. Half of the tax is payable in the year in which
it arises, the balance is paid the following year.
 Any losses resulting from this investment can be set off against taxable profits made
by the company’s other business activities.
 The company uses a post-tax money cost of capital of 12% per annum to evaluate
projects of this type.

Required:

(a) Calculate the net present value (NPV) of the gymnasium and spa project.

(b) Calculate the post-tax money cost of capital at which the hotel would be indifferent to
accepting/rejecting the project.

(c) Discuss an alternative method for the treatment of inflation that would result in the same
NPV. Your answer should consider the potential difficulties in using this method when
taxation is involved in the project appraisal.

## (CIMA: September 2010)

14.17 A small regional airport is modernising its facilities in anticipation of significant growth in the
number of passengers using the airport. It is expected that the number of passengers will
increase by 10% per annum as a result of a ‘low cost’ airline opening new routes to and from
the airport.

At present, the airport has only one food outlet selling sandwiches and other cold foods and
drinks. To improve the facilities available to customers, the management of the airport is
considering opening a restaurant selling a range of hot food and drinks. The cost of fitting out
the new restaurant, which will have to be fully refurbished after four years, is estimated to be
R350 000. These assets are expected to have a residual value of R30 000 at the end of four
years.
Cost and Management Accounting 2nd edition

A firm of consultants carried out an extensive study in relation to this project and did so at a
cost of R30 000. The key findings from their report, regarding expected revenue and
contribution from the restaurant, are as follows:

##  Demand in year 1: 500 customers per day

Future demand for the restaurant is expected to rise in line with passenger numbers.

##  Average salary per employee: R20 000 per annum

 The annual budgeted fixed overhead of the airport which will be apportioned to the
restaurant is R80 000.

 The annual overheads apportioned to the cold foods outlet will be R30 000.

 The airport’s overheads are expected to increase by the following annual amounts as a
direct result of the opening of the restaurant:

o Audit: R10 000

## 3. Cold foods outlet

The average contribution from the sale of cold foods is R2.50 per customer. If the
restaurant is not opened, it is expected that the cold foods outlet will sell to 1 200
customers per day in the coming year and in subsequent years the customer numbers
will rise in line with passenger numbers.
Cost and Management Accounting 2nd edition

If the restaurant is opened, the consultants expect sales from the existing cold foods
outlet to initially reduce by 40% in year 1 and then to increase in line with passenger
numbers.

The airport’s financial director has provided the following taxation information:

##  Tax depreciation: 25% reducing balance per annum.

 The first year’s tax depreciation allowance is used against the first year’s net cash
inflows.
 Taxation rate: 30% of taxable profits. Half of the tax is payable in the year in which
it arises, the balance is paid the following year.
 Any taxable losses resulting from this investment can be set against profits made by
the airport company’s other business activities since the airport company is
profitable.

The airport company uses a post-tax cost of capital of 8% per annum to evaluate projects of this
type. Ignore inflation.

Required:

## Calculate the net present value (NPV) of the restaurant project.

14.18 The managing director of a company has been presented with the details of three potential
investment projects. He has very little experience of project appraisal and has asked you for
help.

## Project A Project B Project C

Expected NPV R150 000 R180 000 R180 000
Standard deviation of expected NPV R10 000 R50 000 R30 000
IRR 12% 12% 10%

The three projects will require the same level of initial investment. The projects are mutually
exclusive and therefore the managing director can only choose one of them.
Cost and Management Accounting 2nd edition

Required:

Interpret the information for the managing director (your answer should include an explanation
of the factors he should consider when deciding which project to undertake).

## (CIMA: May 2010)

14.19 WIDGET is a listed group which operates a number of manufacturing facilities within its home
country, Country F. The currency of Country F is the R.

WIDGET has R700 million funds available for capital investment in new product lines in the
current year. Most products have a very limited life cycle. Four possible projects have been
identified, each of which can be started without delay.

## Project Initial Net annual Project term PV of cash NPV

investment cash inflows (years) flows arising (Rm)
(Rm) after the after the
initial initial
investment investment
(Rm) (Rm)

## D 350 124.0 6 510 160

Notes:
1. The projects are non-divisible and each project can only be undertaken once.
2. Apart from the initial investment, annual cash flows are assumed to arise at the end of
the year.
3. A discount rate of 12% has been used throughout.
4. Ignore taxation.

## (CIMA: September 2012)

Cost and Management Accounting 2nd edition

Required:

## (a) Prioritise the projects according to each of the following measures:

 Net present value (NPV)
 Profitability index (PI)
 Payback (undiscounted)

(b) Explain the strengths and weaknesses of each of the prioritisation methods used in (a)
above as the basis for making investment decisions in the context of capital rationing for
non-divisible projects.

14.20 JK is a profitable international pharmaceutical company that develops, produces and markets
drugs that are licensed as medication. The pharmaceutical industry has grown rapidly and faces
challenges in preventing and controlling environmental pollution. Over the past few years there
has been growing pressure on the industry from government, shareholders and other
stakeholders to improve its environmental management performance. JK has taken a proactive
approach to environmental management and has invested significant resources introducing
pollution prevention and clean manufacturing practices into its operation in order to reduce
waste and minimise negative environmental impacts. The company has used marketing and
advertising campaigns to develop an image as a company that is at the cutting edge of ‘green’
technology.

## As part of its environmental management programme, JK is considering investing in a new

system that will significantly reduce hazardous emissions and waste.

## Initial investment R60 million

Useful life 6 years
Residual value R12 million
Annual income from sale of recycled waste R5 million
Annual savings in waste disposal costs R5.5 million
Annual fixed maintenance costs per annum R1.5 million
Other annual fixed operating costs per annum R10.6 million
(including depreciation)
Cost and Management Accounting 2nd edition

JK has experienced a number of external environmental failures over the past few years which
have resulted in total costs to JK, including government fines of R20 million per annum. The
environmental officer has estimated that, as a direct result of this investment, future external
environmental failure costs that will be borne by JK and their associated probabilities are as
follows:

environmental
failure costs
R18 million 30%
R12 million 25%
R10 million 35%
R5 million 10%

## The company uses expected value for this type of analysis.

Depreciation of the initial investment will be calculated using the straight line method and has
been included in other fixed operating costs.

The company’s financial director has provided the following taxation information:

 Tax depreciation: 25% per annum of the reducing balance, with a balancing adjustment in
the year of disposal.
 Taxation rate: 30% of taxable profits. Half of the tax is payable in the year in which it
arises, the balance is paid in the following year.

The company uses a cost of capital of 12% per annum to evaluate projects of this type. Ignore
inflation. (CIMA: November 2012)

Required:

(a) Evaluate the investment in the proposed system using net present value as the basis of your
evaluation. Your workings should be shown in Rm to one decimal place.
(b) (i) Calculate the payback period for the investment.
(ii) Discuss the advantages and disadvantages of payback as a method of investment
appraisal.
(c) Explain TWO factors related to JK’s approach to environmental issues that should be
considered before making a final decision about the project.
Cost and Management Accounting 2nd edition

14.21 JK manufactures high quality tablet PCs using just-in-time (JIT) production methods. The
market has grown significantly over the past few years and is expected to continue to grow. JK
is planning to launch a new model, the Supertab. The introduction of the Supertab will have no
impact on sales of existing models as it is expected to appeal to a different segment of the
market.

The company has already spent R2 million marketing the new model but will require a further
investment of R20 million in production equipment. The project has a life of five years at the
end of which the equipment will have a residual value of R5 million. Depreciation is calculated
using the straight line method. It is expected that the total capital investment will be eligible for
a taxation capital allowance.

Sales and production of the Supertab over its life cycle are expected to be:
Year 1 50 000 units
Year 2 60 000 units
Year 3 75 000 units
Year 4 30 000 units
Year 5 30 000 units

The selling price in year 1 and year 2 will be R500 per unit. The selling price will be reduced to
R400 in year 3 and will remain at this level for the remainder of the project.

The total variable cost of the Supertab, including labour, materials and variable overhead costs
is estimated to be R200 per unit and this is expected to remain constant throughout the life of
the project. Each unit is estimated to take 1.25 machine hours to produce. Fixed overheads are
charged to products using an absorption rate of R120 per machine hour. The additional fixed
overheads expected to be incurred directly as a result of increasing the production capacity is
R8 million per annum including depreciation charges.

Additional working capital of R6 million will be required at the start of the project.

1. Taxation

## JK’s financial director has provided the following taxation information:

 Tax capital allowance: 25% per annum of the reducing balance, with a balancing
adjustment in the year of disposal.
Cost and Management Accounting 2nd edition

 Taxation rate: 30% of taxable income. Half of the tax is payable in the year in which
it arises, the balance is paid in the following year.
 JK has sufficient taxable income from other parts of its business to enable the offset
of any pre-tax losses on this project.

2. Other information

A cost of capital of 12% per annum is used to evaluate projects of this type. Ignore
inflation.

## (CIMA P1: Nov 2013)

Required:

(a) Evaluate whether JK should introduce the new model. You should use net present value
(NPV) as the basis of your evaluation. Workings should be rounded to the nearest R0.1
million.

## (ii) The discounted payback period

14.22 LM is a supermarket chain that operates 500 stores. The company’s sales have fallen behind its
competitors as it currently does not offer its customers an online shopping service.

It is considering a proposal to establish an online shopping service using the technology of PQ,
an existing online retailer.

## 1. Sales revenue and gross profit

The number of customers using the online delivery service in the first five years is
estimated to be as follows:
Year 1 100 000 customers per week
Year 2 120 000 customers per week
Year 3 150 000 customers per week
Year 4 160 000 customers per week
Year 5 170 000 customers per week
Cost and Management Accounting 2nd edition

Customers are expected to spend an average of R200 per week. Delivery to customers
will be free of charge. The expected gross profit margin is 20% of selling price.

## 2. Loss of existing in-store sales

It is estimated that 30% of customers purchasing online would have purchased in store if
the online facility was not available. The sales revenue per customer and gross profit
margin on on-line sales will be same as that for in-store sales.

3. Capital expenditure

LM will purchase a fleet of delivery vehicles costing R15 million. The vehicles will
have a useful life of five years and will be depreciated on a straight line basis. They will
have no residual value at the end of the five-year period. The vehicles will be eligible
for wear and tear.

## 4. Contract with the online retailer

The contract with PQ will be for an initial period of five years. LM will pay R340
million to buy one of PQ’s existing warehouses. LM will also invest R90 million to
expand the facility. The expanded warehouse will then be leased back to PQ for five
years for a fee of R20 million per annum. The cost of purchasing the warehouse and the
expansion costs will not be eligible for wear and tear or tax allowances. The warehouse
will have a realisable value of R350 million at the end of the five-year period.

LM will pay 1% of gross profit from the online business to PQ. LM will also pay a fee
of R30 million per annum to license the technology and as a contribution towards PQ's
research and development costs.

## 5. Other operating costs

The online operation will result in additional costs in the first year of R60 million,
including delivery costs but excluding depreciation. This amount will rise by R5 million
each year as the customer numbers increase.

6. Taxation

## LM’s financial director has provided the following taxation information:

Cost and Management Accounting 2nd edition

 Wear and tear: 25% per annum of the reducing balance, with a balancing adjustment
in the year of disposal.
 Taxation rate: 30% of taxable income. Half of the tax is payable in the year in which
it arises, the balance is paid in the following year.
 LM has sufficient taxable income from other parts of its business to enable the offset
of any pre-tax losses on this project.

7. Other information

 A cost of capital of 12% per annum is used to evaluate projects of this type.
 Ignore inflation.

## (CIMA P1: March 2014)

Required:

(a) Evaluate whether LM should go ahead with the proposal to establish an online shopping
service. You should use net present value as the basis of your evaluation. Your workings
should be rounded to the nearest R million.

(b) Explain TWO other factors that LM should consider before deciding whether to go ahead
with the contract.

14.23 QR, a major international cosmetics company, is considering investing in the production and
sale of facial masks. The market for facial masks is growing rapidly and is expected to continue
to grow over the next five years. Market intelligence suggests that the total market size in year 1
will be 50 million units. The company expects the market size to grow at a rate of 10% per
annum. The investment is to be evaluated over a five-year life at which point it is expected that
product innovations will result in a replacement product.

QR’s estimated market share for each of the next five years after the investment is as follows:
Year 1 20%
Year 2 25%
Year 3 30%
Year 4 30%
Year 5 35%
Cost and Management Accounting 2nd edition

QR has spent R25 million developing the product. Investment of R500 million in a new
manufacturing facility will be required at the beginning of year 1. The manufacturing facility
will have an estimated residual value of R120 million at the end of five years. The
manufacturing facility will be depreciated using the straight line method. The project will also
require an investment in working capital of R30 million at the beginning of the project.

The selling price of the facial mask will be R30 per unit and the variable cost per unit will be
R10. The selling price and the variable cost per unit are expected to remain the same throughout
the life of the product.

The new manufacturing facility will be used exclusively for the manufacture of facial masks.
The total fixed manufacturing costs will be R200 million per year including depreciation. It is
anticipated that R50 million per year will be spent in years 1 and 2 and R80 million per year in
years 3, 4 and 5 on technical improvements and marketing the new product.

1. Taxation

## QR’s financial director has provided the following taxation information:

 Tax capital allowance: 25% per annum of the reducing balance, with a balancing
adjustment in the year of disposal.
 Taxation rate: 30% of taxable income. Half of the tax is payable in the year in which
it arises, the balance is paid in the following year.
 QR has sufficient taxable income from other parts of its business to enable the offset
of any pre-tax losses.

2. Other information

 A cost of capital of 12% per annum is used to evaluate projects of this type.
 Ignore inflation.

## (CIMA P1: May 2014)

Required:

(a) Evaluate whether QR should go ahead with the investment. You should use net present
value as the basis of your evaluation. Your workings should be rounded to the nearest R
million.
Cost and Management Accounting 2nd edition

(b) Explain why discounted cash flow techniques should be used when evaluating a long-term
investment project.

(c) Explain the benefits of carrying out a post-completion audit of a long-term investment
project.

## 14.24 PT is a major international computer manufacturing company. It is considering investing in the

production of micro-computers. These computers will be targeted at the education market with
the specific aim of encouraging children to learn computer science at an early age.

Sales of the micro-computers are expected to be 100 000 units in year 1 and then to increase at
the rate of 20% per annum for the remainder of the project life. The project has a life of five
years.

The company’s research and development division has already spent R250 000 on developing
the product. A further investment of R10 million in a new manufacturing facility will be
required at the beginning of year 1. It is expected that the new manufacturing facility could be
sold for cash of R1.5 million, at year 5 prices, at the end of the life of the project. The
manufacturing facility will be depreciated over five years using the straight line method.

The project will also require an investment of R3 million in working capital at the beginning of
the project. The amount of the investment in working capital is expected to increase by the rate
of inflation each year.

The selling price of the new product in year 1 will be R45 and the variable cost per unit will be
R25. The selling price and the variable cost per unit are expected to increase by the rate of
inflation each year.

The micro-computers will be exclusively produced in the new manufacturing facility. The total
fixed costs in year 1 will be R2.5 million including depreciation. The fixed costs are expected to
increase thereafter by the rate of inflation each year.

1. Taxation

## PT’s financial director has provided the following taxation information:

Cost and Management Accounting 2nd edition

 Tax capital allowance: 25% per annum of the reducing balance, with a balancing
adjustment in the year of disposal.
 Taxation rate: 30% of taxable income. Half of the tax is payable in the year in which
it arises, the balance is paid in the following year.
 PT has sufficient taxable income from other parts of its business to enable the offset
of any pre-tax losses.

2. Other information

 A cost of capital of 12% per annum is used to evaluate projects of this type.
 Inflation is expected to be 4% per annum throughout the life of the project.

## (CIMA P1: Nov 2014)

Required:

(a) Evaluate whether PT should go ahead with the investment project. You should use net
present value as the basis of your evaluation. Your workings should be rounded to the
nearest R’000.

(b) Explain TWO other factors that the company should consider before making a final decision

## (i) The internal rate of return (IRR)

(ii) The increase or decrease in the cost of capital, expressed as a percentage of the
original cost of capital, which would change the decision about whether to accept or
reject the project.

14.25 ST operates in a highly competitive market and is considering introducing a new product to
expand its current range. The new product will require the purchase of a specialised machine
costing R825 000. The machine has a useful life of four years and is expected to have a scrap
value at the end of year 4 of R45 000. The company uses the straight line method of
depreciation. The machine would be used exclusively for the new product.

Due to a shortage of space in the factory, investment in the new machine would necessitate the
disposal, for R23 000, of an existing machine which has a net book value of R34 000. This
Cost and Management Accounting 2nd edition

machine, if retained for a further year, would have earned a contribution of R90 000 before
being scrapped for nil value. The machine had a zero tax written down value and therefore there
will be no effect on tax depreciation arising from the disposal of the machine.

The company employed the services of a consultant, at a cost of R29 000, to determine the
demand for the new product. The consultant’s estimated demand is given below:
Year 1 18 000 units
Year 2 24 000 units
Year 3 26 000 units
Year 4 22 000 units

## The new product is expected to earn a contribution of R30 per unit.

Fixed costs of R380 000 per annum, including depreciation of the new machine, will arise as a
direct result of the manufacture of the new product.

1. Taxation

## ST’s financial director has provided the following taxation information:

 Tax allowance: 25% per annum of the reducing balance, with a balancing
adjustment in the year of disposal.
 Taxation rate: 30% of taxable income. Half of the tax is payable in the year in which
it arises, the balance is paid in the following year.
 ST has sufficient taxable income from other parts of its business to enable the offset
of any pre-tax losses on this project.

2. Other information

A cost of capital of 12% per annum is used to evaluate projects of this type. Ignore
inflation.

## (CIMA P1: Nov 2014)

Required:

(a) Evaluate whether ST should introduce the new product. You should use net present value
(NPV) as the basis of your evaluation.
Cost and Management Accounting 2nd edition

## Additional information for parts (b) and (c):

A company is deciding which of two alternative machines (X and Y) to purchase. The useful
lives for machines X and Y are two years and three years respectively. The cash flows
associated with each of the machines are given in the table below:

Year 0 1 2 3
R’000 R’000 R’000 R’000
Machine X (200) 200 230
Machine Y (240) 200 230 240

Each of the machines would be replaced at the end of its useful life by an identical machine.
You should assume that the cash flows for the future replacements of machines X and Y are the
same as those in the table above.

## The company’s cost of capital is 12% per annum.

Required:

(b) Calculate, using the annualised equivalent method, whether the company should purchase
machine X or machine Y.

(c) Explain the limitations of using the annualised equivalent method when making investment
decisions.