FDM9 Capital investment appraisal 1 Capital investment appraisal 1

FDM9 Capital investment appraisal 1 Capital investment appraisal 1 What is investment appraisal? Why is it important? What do managers need to consider? The process Different methods –Payback –Net present value Reading: Management Accounting for Business chapter 6

FDM9 Capital investment appraisal 1 What is investment appraisal? The way organisations make decisions about investments in long-term assets –Machines –Buildings –Systems May involve making decisions about several alternatives An important part of the planning and control processes

FDM9 Capital investment appraisal 1 Capital investment and the organisation’s strategy Projects likely to be of strategic importance Usually involve substantial costs or benefits Costs and benefits span number of years Often affect entire organisation Aim to increase shareholder value

FDM9 Capital investment appraisal 1 Why is the decision making process important? Large amounts of resources are involved –Time –Money Can be difficult to stop a project once it is started May be limited funds available Need to make sure that decisions are made on a sound basis

FDM9 Capital investment appraisal 1 What do managers need to consider? How does this relate to strategic objectives? Do the benefits exceed the costs? The cost of the project Is this the best use for the funds we have? The income and cash flows resulting from it – as accurately as possible Timing of the costs and benefits

FDM9 Capital investment appraisal 1 Other considerations Legal, regulatory and ethical issues – do we have to do this? Political issues Product and market requirements –Quality –Need for new products Personnel and other organisational issues

FDM9 Capital investment appraisal 1 Possible reasons for deciding to undertake a project Improves competitive advantage Increased revenue or reduced costs –lead to improved profits Enhances services Decreases maintenance requirement Is required to satisfy regulatory or legal requirements

FDM9 Capital investment appraisal 1 The process Identify the project Evaluate options Authorise expenditure Implement project Monitor – during and after implementation

FDM9 Capital investment appraisal 1 What costs should be considered? Focus on cash flow not profit Relevant costs –Those relevant to the decision –Future costs –Costs and benefits which arise or change as a direct consequence of the decision

FDM9 Capital investment appraisal 1 Non-relevant costs Sunk costs – already spent Committed costs – which have to be paid anyway Notional costs – accounting costs where no actual expense is incurred Most fixed costs

FDM9 Capital investment appraisal 1 Payback period How long is it before the cash flows in equal the amount invested? Quick to calculate Simple to understand Takes account of the timing of cash flows Based on cash flow not profit

FDM9 Capital investment appraisal 1 Payback period - issues Example – three projects with the same payback period Ignores timing of cash flows within the payback period Does not take account of cash flows after the payback period

FDM9 Capital investment appraisal 1 Discounted cash flow – net present value Method which considers all the costs and benefits of each investment opportunity Allows for the timing of the costs and benefits –Considers the time value of money

FDM9 Capital investment appraisal 1 Time value of money Money now is worth more than the same money later: –Interest –Risk, uncertainty –Inflation If you could receive £20,000 in one years time And if you could make 20% return on any investments made now What amount would you be prepared to accept now?

FDM9 Capital investment appraisal 1 Present value The amount which, if invested today at 20%, would grow to £20,000 in one years time If this amount is called PV then: PV + (PV × 20%) = £20,000 Or PV × ( ) = £20,000 PV = £20,000 / 1. 2 = £16,667

FDM9 Capital investment appraisal 1 Present value (2) What if this time we looked at the amount which, if invested today at 20%, would grow to £20,000 in two years time? Reinvest the original amount plus the interest and get 20% on that Then PV × ( ) 2 = £20,000 PV = £20,000 / ( ) 2 Present value of cash flow in year n = actual cash flow of year n divided by (1 + r) n Where r represents the interest rate expressed as a decimal

FDM9 Capital investment appraisal 1 Net present value Present value = the value now of future year’s cash flow Net present value = sum of present values for every year of a project Express each year’s cash flow in similar terms to make direct comparison between the sum of all inflows and outflows over time Base calculation on an interest rate which represents the opportunity cost of capital –Referred to as the discount rate –Reflects compensation required for interest lost and risk A project is worthwhile if the net present value is positive –The benefits are greater than the cost

FDM9 Capital investment appraisal 1 Using present value tables To calculate present value, need to multiply by 1/(1 + r) n which is the discount factor Present value tables show values of the discount factor for range of values of r and n Look at the column for 20% and the row for one year – discount factor is Present value of £20,000 in one year’s time is × £20,000 or £16,660 The same result as before (except for roundings!)