capital decision

Slide 1Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
ACCOUNTING FOR MANAGEMENT DECISIONS
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Learning Objectives
State the four common capital investment appraisal methods
Demonstrate an understanding of the ‘accounting rate of return method’
Demonstrate an understanding of the ‘payback method’
Demonstrate an understanding of the ‘net present value method’
Learning Objectives cont’d
Demonstrate an understanding of the ‘internal rate of return method’
Explain the notion of present values and identify alternative means of determining present values
Convert forecast profit flows into cash flows
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 point in time
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 ‘bail out’ of an investment once it has been made
Methods of Investment Appraisal
There are four main methods used in practice to evaluate investment opportunities:
accounting rate of return (ARR)
payback period (PP)
internal rate of return (IRR)
Some smaller businesses may use informal methods such as manager’s instincts
Accounting Rate of Return (ARR)
ARR takes the average accounting profit the investment will generate, and expresses it as a percentage of the average investment in the project as measured in accounting terms:
The calculation requires two figures:
The annual average profit
Note that this method uses profit not cash
Accounting Rate of Return 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 that is consistent with ROA (based on accrual performance)
Accounting Rate of Return cont’d
Problems with ARR:
ARR uses accounting profit, 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
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
Payback
Disadvantages of PP:
Disregards timing of cash flows, excludes post payback period cash flows
Net Present Value (NPV)
NPV = PVinflows – PVoutflows
Net present Value 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:
Net present value
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
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 (see appendix at end of chapter 11) for a range of values of r and n
A discount factor is a rate applied to future cash flows to derive the present value 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
Capital investment decisions
11.1 Self assessment question
Beacon Chemicals Ltd is considering the erection of a new plant to produce a chemical named X14. the new plant’s capital cost is estimated at $100,000 and if its construction is approved now the plant can be erected and commence production by the end of 2008. $50,000 has alread been spent on research and development work.
Estimates of revenues and costs arising from the operation of the new plant appear below:
2009
2010
2011
2012
2013
If the new plant is erected, sales of some current products will be lost and this will result in a loss of contribution of $15,000 per year over its life.
The accountant has informed you that the fixed costs include depreciation of 420,000 per annum 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 depreciation, of $8,000 per year, and it would require additional working capital of $30,000. for the purposes of your initial calculations ignore taxation.
Required:
Deduce the relevant annual cash flows associated with building and operating the plant.
Deduce the payback period
Calculate the net present value using a discount rate of 8%
Capital Investment Decisions
a)Relevant cash flows
Capital Investment decisions
Year 3 77
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.
c)Net present value
Net Present Value (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 be inappropriate to use different discount rates for different projects
The overall weighted average cost of capital (WACC) should be used as the discount rate
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
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
Discounted Payback
Whereas the payback period (PP) method does not take into consideration the time value of money, discounted payback compares the initial cost with the cash inflows after discounting
Internal Rate of Return (IRR)
IRR Method:
IRR Decision Rule:
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
Internal Rate of Return (IRR) cont’d
Some Practical Points
Relevant costs should be determined and used, e.g. ignore costs already incurred, past costs etc.
Future costs should also in some cases be ignored e.g. 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
Investment Appraisal in Practice
Research shows that businesses tend to 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 shortcomings and the rise of popularity of the DCF methods
Large businesses tend to use the discounting methods and apply multiple methods for each decision
Investment Appraisal and Planning Systems
Investment appraisal 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 in the broader strategic planning and decision making system

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