Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.1 Chapter 4 Making capital investment decisions LEARNING OUTCOMES You should be able to: Identify and discuss the four main investment appraisal methods found in practice Explain the nature and importance of investment decision making Explain the key stages in the investment decision-making process Use each method to reach a decision on a particular investment opportunity

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.2 The nature of investment decisions Large amounts of resources are often involved It is often difficult and/or expensive to bail out of an investment once undertaken

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.3 The scale of investment by UK businesses Source: Annual reports of the businesses concerned for the financial years ending in 2009 Business Expenditure on additional non-current (fixed) assets as a percentage of: Annual sales End of year revenue non-current assets Tate and Lyle plc Severn Trent Water Wm Morrison Supermarkets plc Ryanair Holdings plc Go-Ahead Group plc Marks and Spencer plc British Airways plc British Sky Broadcasting

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.4 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)

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.5 Accounting rate of return (ARR) Average annual operating profit × 100% Average investment to earn that profit ARR =

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.6 ARR decision rule Where two (or more) competing projects exceed the minimum rate, the one with the higher (or highest) ARR should be selected For a project to be acceptable, it must achieve a target ARR as a minimum

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.7 Payback period (PP) 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.

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.8 PP decision rule If two (or more) competing projects have payback periods shorter than the maximum payback period, the project with the shorter (shortest) payback period should be selected For a project to be acceptable, it should have a shorter payback period than the maximum payback period set by the business

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.9 The cumulative cash flows of each project in Activity 4.6 Project 1 Project 3 Project 2 Yr 1 Cash flows (£000) Y2Y2 Yr 3 Yr 1 Yr 2 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Y1Y1 Payback period Initial outlay Yr 3 Yr 4 Yr 5 Y5Y5 Y4Y4 Source: P. Atrill and E. McLaney, Accounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.10 Interest foregone Inflation Required return Risk premium Factors influencing the return required by investors from a project Source: P. Atrill and E. McLaney, Accounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.11 NPV decision rule If two (or more) competing projects have positive NPVs, the project with the higher (or highest) NPV should be selected If the NPV of a project is positive, it should be accepted; if it is negative it should be rejected

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.12 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent 1/( ) Year Present value of £1 1/( ) 1 1/( ) 2 1/( ) 3 1/( ) 4 1/( ) 5

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.13 Why NPV is better than ARR and PP The whole of the relevant cash flows The objectives of the business The timing of the cash flows NPV fully addresses each of the following:

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.14 Internal rate of return (IRR) 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

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.15 IRR decision rule Where there are competing projects, the one with the higher (or highest) IRR should be selected For a project to be acceptable, it must meet a minimum IRR requirement. (This should be the opportunity cost of finance.)

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.16 The relationship between the NPV and IRR methods NPV (£000) Rate of return (%) IRR –10 Source: P. Atrill and E. McLaney, Accounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.17 The IRR method providing more than one solution Rate of return (%) –40 –30 –20 – NPV (£000)

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.18 Some practical points related to investment appraisal Year-end assumption Cash flows not profit flows Interest payments Other factors Past costs Common future costs Opportunity costs Taxation

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.19 Investment appraisal in practice Many surveys have shown the following features: NPV and IRR have become increasingly popular Continued popularity of the PP and ARR methods Businesses tend to use more than one method Larger businesses rely more heavily on NPV and IRR than smaller businesses

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.20 Managing the investment decision Stage 1 Stage 2 Stage 3 Determine investment fund available Identify profitable project opportunities Define and classify proposed projects

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 4.21 Managing the investment decision (Continued) Stage 4 Stage 5 Stage 6 Evaluate the proposed project(s) Approve the project(s) Monitor and control the project(s)