Prepared by Hanady Ali Osman Block 4 Section 3 (Part I) The impact of innovation on business functions Prepared by Hanady Ali Osman

Innovation in Accounting & Finance Capital investment model (Page 34 binder) Organisational environment Strategic Planning Formal CI systems Implementation Analysis and Acceptance Monitoring and Post-audit Identification of potential investments Project definition And screening Feedback Organisational personnel 2

Investment appraisal in organizational life (Pg. 39/40 Binder) Lumijarvi (1991) investigated the methods used by project champions to convince fund-holders within organizations. He classified their judgments into four main types of arguments: Economic arguments Strategic arguments Non-economic arguments Production technology arguments 3

Companies should accept innovations where: (Page 34 binder) Benefits > Costs Revenues Reduction in costs Economic and social benefits to donor-or-tax-funded public service users Expenditure of the innovating organisation Environmental & social costs. 4

CIA Techniques (Page 267 text) Models for profit-making firms: The payback period (PP) method. Accounting rate of return (ARR) The net present value (NPV) method The internal rate of return (IRR) method 5

CIA Techniques (Page 43 Binder) Models for non- profit or tax-funded firms: Cost-benefit analysis Cost-effectiveness analysis 6

Why do investment decisions tend to be more important to investors? 7

Importance of Investment decisions to investors Large amounts of resources are often involved; if mistakes are made with the decision, the effects on the business could be significant It is often difficult and/or expensive to ‘bail-out’ of an investment once it has been undertaken 8

Accounting Rate of Return (ARR) Method (Page 269 text) The ARR method takes the average accounting profit that the investment will generate and expresses it as a percentage of the average investment in the project as measured in accounting terms. 9

Accounting Rate of Return (ARR) Method (Page 269 text) Average annual profit X 100% Average investment to earn that profit 10

Accounting Rate of Return (ARR) Method e.g. a three-year project with a projected net income of $100 in year1, $2000 in year2, and $4000 in year3. The cost is $9000 which will be depreciated by straight line method over the project life. The salvage value equals to zero. What is the ARR.? 11

Accounting Rate of Return (ARR) Method Note that average investment = (cost + salvage value)/2. Decision-rule: if ARR >ROE , then we accept the project. 12

Advantages of ARR method (Page 269-72 text) A measure of profitability that many believe is the correct way to evaluate business. Produces % figure of return that manager feel comfortable with Easy to compare % returns on different investments to help make a decision Links in with ROE as a method of measuring business performance 13

Disadvantages of ARR method (Page 269-72 text) Focuses on accounting profitability rather than cash flows Ignores time value of money (opportunity cost) Create problems when considering different investments’ size 14

Payback period method (Page 273 text) The PP method is the length of time it takes for the initial investment to be repaid out of the net cash inflows from the project. 15

Payback period method (Page 273 text) Net cash Cumulative flow cash flows Immediately (Cost of machine) (100) (100) 1 years’ time (NP before dep.) 20 (80) 2 years’ time (NP before dep.) 40 (40) 3 years’ time (NP before dep.) 60 20 4 years’ time (NP before dep.) 60 80 5 years’ time (NP before dep.) 20 100 5 years’ time (Disposable proceeds) 20 120 Payback period = 2 2/3 years 16

Advantages of PP method (Page 274-5 text) Quick and easy to calculate Easily understood Focuses upon the short run, thus avoids the problems of forecasting far into the future. An improvement on ARR in respect of the timing of the cash flows. It emphasizes the importance of liquidity 17

Disadvantages of PP method (Page 274-5 text) Not a measure of profitability PP ignores the timing of the cash flows Ignores cash flows beyond the payback period PP cannot distinguish between projects having the same payback period Not a suitable measure to deal with risk 18

Example of PP for 3 projects (Page 274 text) Time Cash flow Project 1 Project 2 Project 3 Immediately (time 0) (200) 1 year’s time 40 10 80 2 year’s time 20 100 3 year’s time 170 4 year’s time 60 200 5 year’s time 500 19

Factors influencing the discount rate to be applied to a project (Page 276-8 text) Interest foregone Inflation Discount rate Risk premium 20

Discounted cash flows techniques (Page 275 text) These are appraisal methods that take account of all the costs and benefits of each investing opportunity which, also makes a logical allowance for the timing of those costs and benefits. 21

Net Present Value method (Page 281 text) This method calculates the present value of all the money coming in from the project in future and then sets it against all the money being spent on the project today. Projects are only worth carrying out if the NPV is positive-otherwise just put your money in the bank and earn some interest. 22

Net Present Value method (Page 281 text) Time Cash flow Calculation of PV PV Immediately (time 0) (100) (100)/(1+0.2)0 1 year’s time 20 20/(1+0.2)1 16.67 2 year’s time 40 40/(1+0.2)2 27.78 3 year’s time 60 60/(1+0.2)3 34.72 4 year’s time 60/(1+0.2)4 28.94 5 year’s time 20/(1+0.2)5 8.04 24.19 23

Net Present Value method (Page 281 text) The decision taken by the NPV is: If NPV is positive the project is accepted If NPV is negative the project is rejected 24

Using discount tables (Page 281 text) Discount tables are easier ways to calculate the present value of various discount rates (r) over different periods of time (n), instead of calculating each through: 1/(1+ r)ⁿ 25

Advantages of NPV (Pg. 283 text) Considers timing of the cash flow Takes the opportunity cost of money into account A single measure takes the amount and timing of cash flows into account Can consider different scenarios i.e. what if? Takes account of business objectives- assumed to be profit maximising. Positive NPVs enhance wealth whilst negative reduces wealth. 26

Disadvantages of NPV Complex to calculate and communicate The meaning of the result is often misunderstood Only comparable between projects if the initial investment is the same 27

Internal Rate of Return (IRR) method (Page 284 text) The IRR is the discount rate that, when applied to the future cash flows of a project, will produce an NPV of precisely zero. It involves trial and error at different discount rates. When the NPV equals zero the rate of interest can be compared with pre-set criterion internal to the firm, or with the prevailing rate of interest. 28

The relationship between NPV & IRR method (Page 285 text) 70 60 50 40 30 20 10 NPV ($000) IRR 10 20 30 40 Rate of return (%) 29

Advantages of IRR Projects with different initial values can be compared. The one with the highest IRR would be selected All cash flows are taken into account Timing of cash flows taken into account. 30

Disadvantages of IRR It does not address the issue of wealth generation – it does not differentiate between the scale of the investment I competing projects. 31

Investment appraisal offers the following analysis Decision making against a background on uncertainty Balance risks against potential rewards Questioning reliability of data 32

Helpful Exercises Activities 10.1 to 10.17 of Chapter 10 of Atrill & McLaney, Accounting & Finance for non specialist, 2001. 33

Donor-Funded and Tax-Funded Organizations (Pg. 43 Binder) Innovation and economic appraisal and analysis of innovative developments is important in profit-making business as well as in non-profit-making business. Cost benefit analysis Cost effective analysis 34

Cost benefit analysis (Pg. 43 binder) This analysis is based on the principle that a project should achieve the greatest potential gain from a given cost, and should not be undertaken unless their benefits exceed its costs. Here cost and benefits expressed on financial terms (money). 35

Cost effective analysis (Pg. 43 binder) This analysis the costs of alternative ways of achieving a similar outcome are compared, the one with the lower costs being considered more cost effective. Here cost and benefits need not expressed on financial terms (money). 36

Donor-Funded and Tax-Funded Organizations (Pg. 44 Binder) Risk analysis in non-profit projects is important as in profit-projects. Government organizations have come to two types of risk: Fiscal risk: not opening up a government’s treasure chest through providing projects with open-ended funding. Political risk: taking account of how projects will be seen by political backbenchers, the press and media, and by voters. Note that cost effective analysis has uses in the profit-making firms, in which the intended outcome of the innovation is decided upon, and the issue is to compare the cost of alternative ways of achieving this outcome. 37