© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.1 Making capital investment decisions OBJECTIVES You should be able to: Identify the four main investment appraisal methods used in practice Explain the nature and importance of investment decision making Discuss the attributes and defects of each of the methods Use each method to reach a decision on a particular practical investment opportunity

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.2 Exhibit 10.1 Business Expenditure on additional fixed assets as a percentage of: Annual sales Start of year fixed assets Tesco plc Vodafone Group plc Manchester United plc Stagecoach Group plc British Sky Broadcasting Group plc J D Wetherspoon plc British Airways plc BT plc Associated British Foods plc The Boots Company plc

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.3 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)

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.4 Accounting rate of return (ARR) Average annual profit Average investment to earn that profit ARR = x 100%

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.5 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.

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.6 The cumulative cash flows of each project in Activity 10.6 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

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.7 Interest foregone Inflation Discount rate Risk premium The factors influencing the discount rate to be applied to a project

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.8 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent £1 Years into the future

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 10.9 Why NPV is superior to 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:

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT 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.

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT The relationship between the NPV and IRR methods NPV (£000) Rate of return (%) IRR

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT Dealing with questions relating to investment appraisal Some practical points Relevant cash flows Opportunity costs Taxation Cash flow not profit flow Year-end assumption Interest payments Other factors

© Pearson Education Limited 2003 Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition OHT Investment appraisal in practice Many surveys have tended to show: An increased use of the discounting methods (NPV and IRR) over time Continued popularity of ARR and payback period Businesses using more than one method to assess each investment decision A tendency for larger businesses to use the discounting methods and to use more than one method