Financial analysis in the OCR F248 Flavoursome Food case study

Have you got the right financial analysis skills to decide between the biodigester and the option of relocation?! The OCR F248 specification expects you to be able to use break even analysis, payback period and to interpret decision trees. This blog takes a quick look at Average Rate of Return (ARR), with a focus on a couple of points: costs would be involved with the biodigester since it “would require samples to be checked on a daily basis, as well as regular maintenance” (lines 113-114 of the case study). Furthermore, “at the end of its 20 year lifetime the biodigester would need to be replaced” (lines 118-119).

Both the biodigester and relocation options have relatively long payback periods: 5 years for the former and a whopping 10 years for the latter. On that basis alone, the biodigester looks like a better bet.

But there’s other key information to consider: in particular, which option offers the best Average Rate of Return (ARR)? To work out ARR you need to perform the following calculation:

1. Add up the net forecast returns over the life of the investment project.
2. Subtract the cost of the initial investment to derive a profit figure for the project.
3. Divide this anticipated profit figure by the total number of years for which you have data. This gives you an average profit per year figure.
4. Divide your average profit per year figure by the cost of that investment. The answer, expressed as a percentage, is the ARR of the project.

Just pause for a moment and consider point 1. The case study doesn’t tell us what those figures are, but when FFL Ltd performs this calculation, the attractive financial returns will obviously reflect the fact that: “a feasibility study suggests that enough heat and electricity would be produced … to run the entire farm … FFL would even be able to sell some electricity to the National Grid” (lines 101-104). This is a significant benefit, given the contribution made by energy bills to FFL’s costs, and the frightening predictions about future energy prices made in Appendix 4. Further benefits are also anticipated: “liquid waste from the digester would be used as a fertiliser … the solid waste would be bagged and sold as compost” (lines 104-106). The biodigester offers some attractive returns.

Equally, these financial returns will have to subtract the costs involved with the biodigester since it “would require samples to be checked on a daily basis, as well as regular maintenance” (lines 113-114 of the case study). In summary, the net total forecast returns will have to add up the financial rewards, but subtract the financial costs.

Now consider point 2: the investment has to be paid for. “At the end of its 20 year lifetime the biodigester would need to be replaced” (lines 118-119). In other words, your calculations need to assume that after 20 years the biodigester has zero residual value. That means its value will have depreciated away to nothing.

• An ARR figure should therefore address the payback from of an investment project, the costs of running the project and the depreciation of assets bought for that project.

The F248 toolkit supporting this case study is available here. It contains further detailed guidance on all aspects of financial analysis for the case study, including turning forecast returns into net present value (NPV) terms.