Accounting for Management Decisions

1
Accounting for Management Decisions

• WEEK 11
• CAPITAL INVESTMENT DECISIONS
• READING Text CH 11
• pp.548 - 572

2
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)

3
Learning Objectives contd

• 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 contd

• 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
• accounting rate of return (ARR)
• payback period (PP)
• net present value (NPV)
• internal rate of return (IRR)
• Some smaller businesses may use informal methods
  such as managers 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
• 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

8
ARR contd

• 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 contd

• 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 000 000 000
• Project cost (160) (160) (160)
• Annual profit
• 2010 20 10 160
• 2011 40 10 10
• 2012 60 10 10
• 2013 60 10 10
• 2014 20 160 10

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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.551-53
• 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 000 000s 000
• Project cost (160) (160) (160)
• Annual profit
• 2010 20 10 160
• 2011 40 10 10
• 2012 60 10 10
• 2013 60 10 10
• 2014 20 160 10
• 2015 200 40 50
• 2016 300 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 contd

• 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 contd - 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/(1r)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 contd

• 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 contd

• 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 depn 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 contd

• Required
• Deduce the relevant annual cash flows associated
  with building and operating the plant.
• Deduce the PP
• Calculate the NPV using a discount rate of 8

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Capital investment decisions contd

• a) Relevant cash flows

(000s) 2008 2009 2010 2011 2012 2013
Sales 80 120 144 100 64
Loss of CM (15) (15) (15) (15) (15)
VC (40) (50) (48) (30) (32)
FC (8) (8) (8) (8) (8)
Operating cash flows Operating cash flows 17 47 73 47 9
Working Cap (30) 30
Capital cost (100)
Net relevant cash flows (130) 17 47 73 47 39
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Capital investment decisions contd

• 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 contd

• c) NPV

Net cashflow PV factor 8 PV cashflow
Construction costs (130) 1.000 (130)
Cashflows
Year 1 2009 17 0.926 15.74
Year 2 2010 47 0.857 40.28
Year 3 2011 73 0.794 57.96
Year 4 2012 47 0.735 34.55
Year 5 2013 39 0.681 26.56
NPV 45.09
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NPV contd

• 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 contd

• 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 contd

• 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