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OHT 10.1 Making capital investment decisions OBJECTIVES You should be able to: Explain the nature and importance of investment decision making Identify the four main investment appraisal methods used in practice Use each method to reach a decision on a particular practical investment opportunity Discuss the attributes and defects of each of the methods © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.2 Business Exhibit 10.1 Expenditure on additional fixed assets as a percentage of: Annual sales Associated British Foods plc Start of year fixed assets 10.1 28.6 The Boots Company plc 3.2 7.6 British Airways plc 9.3 7.0 19.9 17.0 5.0 20.1 J D Wetherspoon plc 25.1 24.1 Manchester United plc 27.5 20.5 Stagecoach Group plc 6.0 5.4 Tesco plc 8.5 20.1 79.4 11.8 BT plc British Sky Broadcasting Group plc Vodafone Group plc © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.3 Methods of investment appraisal Four methods of evaluation Accounting rate of return (ARR) Payback period (PP) Net present value (NPV) Internal rate of return (IRR) © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.4 Accounting rate of return (ARR) ARR = © Pearson Education Limited 2003 x 100% Average annual profit Average investment to earn that profit Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition Payback period (PP) OHT 10.5 Payback period (PP) © Pearson Education Limited 2003 The payback period is the length of time it takes for the initial investment to be repaid out of the net cash inflows from the project. Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition The cumulative cash flows of each project in Activity 10.6 OHT 10.6 Initial outlay Payback period Project 1 Yr 1 Project 2 Yr YY 11 2 Project 3 Yr 1 0 Yr 2 Yr 3 Yr 3 Yr 2 100 Yr 4 Yr 5 Y Y 4 5 Yr 3 200 Yr 4 300 Yr 5 400 500 600 700 800 900 Cash flows (£000) © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.7 The factors influencing the discount rate to be applied to a project Interest foregone Discount rate Inflation Risk premium © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent OHT 10.8 £1 0 1 2 3 4 5 6 7 8 9 10 Years into the future © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.9 Why NPV is superior to ARR and PP NPV fully addresses each of the following: The timing of the cash flows The whole of the relevant cash flows The objectives of the business © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.10 Internal rate of return (IRR) Internal rate of return (IRR) © Pearson Education Limited 2003 The internal rate of return is the discount rate, which, when applied to the future cash flows of a project, will produce an NPV of precisely zero. Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.11 The relationship between the NPV and IRR methods 70 NPV (£000) 60 50 40 30 20 IRR 10 0 10 20 30 40 Rate of return (%) © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.12 Dealing with questions relating to investment appraisal Some practical points Relevant cash flows Year-end assumption Opportunity costs Interest payments Taxation Other factors Cash flow not profit flow © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.13 Investment appraisal in practice Many surveys have tended to show: Businesses using more than one method to assess each investment decision An increased use of the discounting methods (NPV and IRR) over time Continued popularity of ARR and payback period A tendency for larger businesses to use the discounting methods and to use more than one method © Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition