Transcript Slide 1

Accounting for Management Decisions
WEEK 11
CAPITAL INVESTMENT DECISIONS
READING: Text CH 11
pp.548 - 572
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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Learning Objectives
• Identify the essential features of investment
decisions
• State the 4 common capital investment appraisal
methods
• Demonstrate an understanding of the ‘accounting
rate of return method (ARR)’
• Demonstrate an understanding of the ‘payback
method (PP)’
• Demonstrate an understanding of the ‘net
present value method (NPV)’
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Learning Objectives cont’d
• Demonstrate an understanding of the ‘internal
rate of return method (IRR)’
• Explain the notion of present values (PV) and
identify alternative means of determining present
values
• Convert forecast profit flows into cash flows
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The Nature of Investment Decisions
• The essential feature of investment decisions is
the time factor
• Making an outlay of cash which is expected to
yield economic benefits to the investor at some
other (future) point in time
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The Nature of Investment Decisions cont’d
Investment decisions are of crucial importance for
the following reasons:
• Large amounts of resources are often involved,
therefore if mistakes are made, the effect can
be catastrophic
• It is often difficult and expensive to
abandon/withdraw from an investment once it
has been made
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Methods of Investment Appraisal
There are 4 main methods used in practice to
evaluate investment opportunities:
1. accounting rate of return (ARR)
2. payback period (PP)
3. net present value (NPV)
4. internal rate of return (IRR)
Some smaller businesses may use informal methods
such as manager’s instincts/intuition
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
Accounting Rate of Return (ARR)
ARR takes the average accounting profit
the investment will generate, and expresses it as
a % of the average investment in the project as
measured in accounting terms:
Average annual profit
ARR =
x 100%
Average investment to earn that profit
The calculation requires 2 figures:
- The annual average profit
- The average investment for the particular project
- Note that this method uses profit not cash
- See eg on p.550 and Activity 11.2, pp.550-51
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ARR cont’d
ARR Decision Rules:
• For any project to be accepted, it must achieve a
target ARR as a minimum;
• If there are competing projects that exceed the
minimum rate, the one with the highest ARR would
normally be chosen
Advantages of ARR:
• Easy to calculate and understand
• Is a measure of profitability consistent with ROA
(based on accrual performance)
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Accounting Rate of Return cont’d
Problems with ARR:
• ARR uses accounting/accrual profits, however
over the life of a project, cash flows matter
more than accounting profits
• ARR fails to take into consideration the time
value of money
• The ARR method presents averaging difficulties
when considering competing projects of different
size.
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Capital Investment problems/limitations
ARR:
Project cost:
Annual profit:
2010
2011
2012
2013
2014
$000
(160)
20
40
60
60
20
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
$000
(160)
$000
(160)
10
10
10
10
160
160
10
10
10
10
10
Payback Period (PP)
PP = The length of time taken to recover the amount
of the investment
Payback = Initial investment/annual cash inflow
If the annual cash inflow varies, then payback is when
the cumulative cash inflows equal the initial
investment
Decision Rules:
• For a project to be acceptable it would need to have
a maximum payback period
• If there are competing projects, the project with the
shorter payback period would be chosen
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Payback
Advantages of PP:
• Quick and easy to calculate, emphasises the short
term
• See eg on p.553 and Activity 11.3 & 11.4, pp.55153
Disadvantages of PP:
• Disregards timing of cash flows, excludes post
payback period cash flows
• See eg on p.553 and Activity 11. p.554
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Capital Investment problems/limitations
PP:
Project cost:
Annual profit:
2010
2011
2012
2013
2014
2015
2016
$000
(160)
$000s
(160)
$000
(160)
20
40
60
60
20
200
300
10
10
10
10
160
40
50
160
10
10
10
10
50
100
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Net Present Value (NPV)
NPV Method:
NPV = PVinflows – PVoutflows
• NPV is the sum of the cash flows associated with a
project, after discounting at an appropriate rate,
reflecting the time value of money
• Time value of money: $1 received today is worth
more than $1 received in 10 years time
NPV Decision Rules:
• Accept the highest positive NPV, reject all
negative NPVs.
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NPV cont’d
Advantages of NPV:
• Considers all of the costs and benefits of each
investment opportunity
• Makes allowance for the timing of these costs
and benefits
• Considers the time value of money
Disadvantages of NPV
• More difficult to calculate, less easily understood
• Does not determine actual rate of return or a
relative measure of return
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NPV cont’d - Using Discount Tables
• Deducing the PV of the various cash flows used in
the NPV method is laborious, with each cash flow
being multiplied by 1/(1+r)n
• A quicker method is to refer to a table of discount
factors (in appendix at end of ch 11) for a range of
values of r and n
• A discount factor is a rate applied to future cash
flows to derive the PV of those cash flows
• Opportunity rate is usually referred to as the
discount rate and is effectively the reverse of
compounding
• Financial calculators and spreadsheets are also a
practical approach to dealing with calculating the PV
of future cash flows
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Capital investment decisions
11.1 Self assessment question
Beacon Chemicals Ltd is considering the construction
of new plant to produce a chemical named X14. The
capital cost is estimated at $100,000 and if
construction is approved now the plant can be erected
and commence production by the end of 2008.
$50,000 has already been spent on research and
development work.
Estimates of revenues and costs arising from the
operation of the new plant appear below:
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Capital investment decisions cont’d
11.1 Self assessment question
Estimates of revenues and costs:
2009
2010
2011
2012
2013
Sales price ($ per unit)
100
120
120
100
80
Sales volume (units)
800
1,000
1,200
1,000
800
VC ($ per unit)
50
50
40
30
40
FC ($000)
30
30
30
30
30
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Capital investment decisions cont’d
• If the new plant is constructed, sales of some current
products will be lost and this will result in a loss of
CM of $15,000 p.a. over its life.
• The accountant has informed you that the FC include
depreciation of $20,000 p.a. on new plant, and an
allocation of $10,000 for fixed overheads.
• A separate study shows that if the new plant was
built, its construction would incur additional
overheads, excluding dep’n of $8,000 p.a. and it
would require additional working capital of $30,000.
• For the purposes of initial calculations ignore
taxation.
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Capital investment decisions cont’d
Required:
a) Deduce the relevant annual cash flows associated
with building and operating the plant.
b) Deduce the PP
c) Calculate the NPV using a discount rate of 8%
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Capital investment decisions cont’d
a) Relevant cash flows:
2008 2009 2010
($000s)
Sales
80 120
Loss of CM
(15) (15)
VC
(40) (50)
FC
(8)
(8)
Operating cash flows
17
47
2011
2012
2013
144
(15)
(48)
(8)
73
100
(15)
(30)
(8)
47
64
(15)
(32)
(8)
9
Working Cap
(30)
Capital cost
(100)
Net relevant cash (130)
30
17
47
73
47
39
flows
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Capital investment decisions cont’d
b) PP:
Initial investment:
$130
Cumulative cash flows
Year 1
$ 17
Year 2
47 = 64; 66 remaining
Year 3
73
Therefore the plant will have repaid the initial
investment by the end of the third year of operations.
The payback period is close to 2 years, 11 months
(ie 66/73 x 12 mths = 10.8 mths = 11)
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Capital investment decisions cont’d
c) NPV:
Construction costs
Cashflows:
Year 1: 2009
Year 2: 2010
Year 3: 2011
Year 4: 2012
Year 5: 2013
Net
PV factor
cashflow
8%
(130)
1.000
17
47
73
47
39
NPV
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
0.926
0.857
0.794
0.735
0.681
PV
cashflow
$(130)
+ 15.74
+ 40.28
+ 57.96
+ 34.55
+ 26.56
$45.09
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NPV cont’d
The discount rate and the cost of capital:
• The cost to the business of the finance it will use to
fund the investment if it goes ahead is effectively the
opportunity cost and is therefore the appropriate
discount rate to use in NPV assessments
• It would not be appropriate to use the specific cost of
capital as the discount rate for NPV assessments as
earlier or later projects might have different specific
funding
• It would also not be appropriate to use different
discount rates for different projects
• The overall weighted average cost of capital (WACC)
– an average of financing opportunities available to the
firm - should be used as the discount rate
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NPV cont’d
Why NPV is superior to ARR and PP
• The timing of the cash flows - discounting the
various cash flows when they are expected to arise
acknowledges that not all cash flows occur
simultaneously
• The whole of the relevant cash flows - NPV
includes all of the relevant cash flows irrespective of
when they are expected to occur
• The objectives of the business - NPV is the only
method in which the output bears directly on the
wealth of the business
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NPV cont’d
Two potential limitations with NPV:
• The actual return percentage is unknown: NPV
simply reveals if the projected return is either higher
(+) or lower (-) than the discount rate not how much
higher or lower
• Ranking of alternative projects: NPV does not
enable ranking of positive projects and therefore the
best investment strategy may not be determined
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Discounted Payback
The PP method does not take into consideration
the time value of money, whereas discounted
payback compares the initial cost with the
cash inflows after discounting.
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Internal Rate of Return (IRR)
IRR Method:
• IRR = The rate at which PVinflows = PVoutflows
IRR Decision Rule:
• Accept the highest IRR, specify a minimum required
return
Advantages of IRR:
• Is based on all cash flows, incorporates the time
value of money, specifies an actual expected return
Disadvantages of IRR:
• Difficult to calculate, there may be multiple returns,
is not based on wealth increments
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Some Practical Points
• Relevant costs should be determined and used
eg ignore costs already incurred, past costs etc;
• Future costs should also in some cases be
ignored eg costs that will be incurred whether or
not the project goes ahead;
• Opportunity costs arising from benefits foregone
must be included;
• Taxation on profits and also tax relief should
be accounted for;
• Interest payments should not be included
when using DCF techniques as the discount
factor already takes account of cost of financing.
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Investment Appraisal in Practice
• Research shows that businesses use more than
one method to assess each investment decision;
• NPV and IRR seem to be the more popular
methods used in practice;
• ARR and PP continue to be popular despite their
limitations and the rise of popularity of the DCF
methods;
• Large businesses tend to use the discounting
methods and apply multiple methods for each
decision.
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Investment evaluation and Planning Systems
• Investment evaluation methods are an important
part of the planning and decision-making process
• Cash flow estimates need to be prepared in a
competent manner such that the implications of
following through on the estimates are clear
• Capital investment appraisal needs to be fully
integrated/included in the broader strategic planning
and decision making system
• Strategic planning should be the means through
which investments must pass so that all aspects can
be considered eg human, behavioural,
environmental etc
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