1 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, Chapter 14 Strategic Investment Decisions

Overview Strategy and capital investment decisions Three methods –Accounting rate of return –Payback –Discounted cash flow Net present value Internal rate of return –Comparison and criticism of techniques 2 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Strategy Alternative views: Objectives SWOT strategic decisions –Ansoff (1988) Logical incrementalism –Quinn (1980) Deliberate & emergent strategies –Mintzberg & Waters (1985) 3 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Strategy & investment appraisal Investment decisions need to be – Consistent with strategy – Able to generate sufficient returns to contribute to overall business returns Types of investment – new facilities for new product/services; – expanding capacity to meet demand; – replacing assets in order to reduce production costs or improve quality or service 4 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Investment appraisal Process –Generate ideas based on opportunities or solutions –Research all relevant information –Consider possible alternatives –Evaluate the financial and non-financial consequences of each –Decide to proceed and implement the proposal –Monitor actual results compared to plan 5 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Investment appraisal Decisions: Decisions: – whether or not to invest – whether to invest in one project or one piece of equipment rather than another – whether to invest now or at a later time 6 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Methods of investment appraisal Accounting rate of return Accounting rate of return Payback Payback Discounted cash flow Discounted cash flow – Net present value (NPV) – Internal rate of return (IRR) 7 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of methods Based on profit or cash flow? Accounts for time value of money? Accounting rate of return ProfitNo PaybackCash flowNo Discounted cash flow Cash flowYes 8© 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Predicting future profits & cash flows Profits and cash flows are estimated and include: –Incremental revenue and operating costs, –Incremental income tax and changes in working capital –These are based on expected market share, volumes, unit prices and costs, etc. All investment decisions involve an initial cash outflow (period 0) All other cash inflows and outflows are assumed to take place at the end of years 1,2,3 etc. Financing decisions are separate decisions. Investment appraisal is concerned with the investment decision Each organization determines its own planning horizon 9 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cash flows for three projects 10 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Accounting rate of return Profit generated as a percentage of the investment Profit generated as a percentage of the investment – investment value is the depreciated value each year – For the whole investment period, the accounting rate of return is the average annual return divided by the average investment Total profits/No. of years Initial investment/2 11 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Depreciated value of investments 12 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

ARR for Project 1 13 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Accounting rate of return – average Similar to the ROI calculation in financial accounting –On an individual asset basis Project 1 –Total profits £25,000 –Average profit £5,000 (£25,000/5) –Average investment £50,000 (£100,000/2) –Average ARR £5,000/£50,000 = 10% 14 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of projects: ARR AlternativeARRRanking Project 110%3 Project 216%1 Project 312%2 15 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Payback (in US, “Break Even”) The number of years it will take to recover the initial investment The number of years it will take to recover the initial investment – cash flow, not profits – the shorter the payback period, the better the investment 16 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Payback Project 1: 4 years Project 2: 3.57 years Project 3: 3 years 17 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of projects: Payback AlternativePaybackRanking Project 14 years3 Project years2 Project 33 years1 18 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Discounted cash flow (DCF) Neither the accounting rate of return nor the payback method considers the time value of money Neither the accounting rate of return nor the payback method considers the time value of money Discounts the future cash flows to present values using a discount rate Discounts the future cash flows to present values using a discount rate (cost of capital) Net present value (NPV) Internal rate of return (IRR) 19 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cost of capital Weighted average cost of capital –Debt: weighted average interest rate –Equity: cost of equity (dividend plus capital growth expected) –May be risk-adjusted –Cost of capital is calculated for each organization by corporate finance staff 20 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Time value of money Assumes compound interest £100 today Plus 10% p.a. interest = £10 = £110 in 1 years’ time Plus £10% interest = £11 = £121 in 2 years’ time Plus 10% interest = £12.10 = £ in 3 years time (Future Value)  Present value brings this sum back to today’s equivalent 21 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Net present value  Present value (PV) of cash flows = cash flow x discount factor (based on number of years in the future and the cost of capital)  Net present value (NPV) = present value of future cash flows – initial capital investment 22 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Present value tables 23 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Net present value for Project 1 24 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Net present value using spreadsheet 25 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Evaluating NPV If the NPV is negative, the project should not be accepted, as the returns do not exceed the cost of capital, and shareholder value is being eroded 26 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of projects: NPV AlternativeNPVRanking Project 1-$5,250 No investment Project 2$7,6501 Project 3$3, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparing NPVs  Cash Value Added (CVA) or profitability index is the ratio of the NPV to the initial capital investment. Cash value added = NPV Initial capital investment 28 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparing the projects using CVA Project 1Project 2Project 3 NPV-5,2507,6503,300 Initial investment 100,000125,000200,000 CVA-5.35%6.12%1.65% RankingNo investment © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Internal rate of return Determines the discount rate which produces a net present value of zero Determines the discount rate which produces a net present value of zero – presents the return on cash flows as an effective interest rate – the project with the highest internal rate of return would be preferred, provided that the rate exceeds the cost of capital 30 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Internal rate of return: By spreadsheet 31 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of projects: IRR AlternativeIRRRanking Project 17.9% No investment – less than 10% cost of capital Project 212.4%1 Project 310.7%2 32 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of projects: all methods 33 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of techniques ARR –where there are high short-term returns, managers may prefer those investments even though the longer term impact may be detrimental to the organization Payback –ignores cash flows after the payback period Discounted cash flow –Boards typically set quite high ‘hurdle’ rates for investing in new assets such that NPV is not relevant 34 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Criticisms of investment evaluation  Assumption that future cash flows can be predicted with some accuracy  Decisions may be made subjectively which are then justified after the event by overly optimistic estimates of future cash flows  NPV approach is limited in high technology situations as it may not capture the ‘richness’ of the investment problem –Shank (1996) 35 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Key points Differentiate profits and cash flows Ranking investments –ARR, –Payback, and –DCF techniques: NPV, CVA & IRR Compare strengths and weaknesses of each method 36 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,