Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury MANAGEMENT AND COST ACCOUNTING SIXTH EDITION COLIN DRURY

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury Part Three: Information for decision-making Chapter Thirteen: Capital investment decisions 1

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.1 © 2000 Colin Drury 1.The objective is to accept all those investments whose returns are in excess of the cost of capital. 2.A firm should invest in capital projects only if they yield a return in excess of the opportunity cost of an investment (also known as the minimum ate of return, cost of capital, discount/hurdle rate).

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.2 © 2000 Colin Drury 3.Opportunity cost of investment = returns available to shareholders in financial markets from investments with the same risk as the project.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.3a © 2000 Colin Drury Compounding and discounting 1. Compounding expresses today ’s cash flows in future values. FV n = V 0 (1 +K )n Total End of year Interest earned investment £ × × × ×

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.3b © 2000 Colin Drury 2. Discounting is the process of converting future cash flows into a value at the present time. Present value (V 0 ) = FV n (1 +K )n 3. £ receivable in year 2 has a PV of: £ = £ ( ) 2

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.4a © 2000 Colin Drury The concept of net present value (NPV) 1. By using DCF techniques and calculating PVs we can compare the return on capital projects with an alternative equal risk investment in securities traded in the financial market. 2. The four projects shown below are identical to the risk-free security illustrated on sheet Therefore, they have a NPV of zero.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.4b © 2000 Colin Drury A B C D £ £ £ £ Project investment outlay End of year cash flows Year Year Year Year Present value = (1.10) 2 (1.10) 3 (1.10) 4 = = = = NPV =PV – Investment cost 4. The decision rule is to accept only those projects with positive NPVs (e.g.if the investment costs above were less than £ then the projects would be preferable to investing in financial securities and they would have positive NPVs).

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.5a © 2000 Colin Drury Calculating NPVs 1.NPV = FV 1 / (1+K) + FV 2 / (1+K) 2 + FV 3 / (1+K) 3 + FV n / (1+K) n - I 0 2. Example (£000’s) NPV = £300/ £1 000/(1.10) 2 + £400/(1.10) 3 - £1 000 = £399.7 or use the discount tables (appendix A) Year £000’s Disc. Factor PV (£000) Less investment cost NPV

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.5b © 2000 Colin Drury 3.If annual cash flows are constant, the cumulative discount tables can be used (appendix B): Example (£000’s) Cash flows are £600 per annum for 3 years, the discount rate is 10% and the investment outlay is £1 000: NPV = (£600 x 2.487) - £1 000 = £492.2

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.6 © 2000 Colin Drury Internal rate of return (IRR) 1.NPV = FV 1 / (1+IRR) + FV 2 / (1+IRR) 2 + FV n / (1+IRR) n - I 0 Example (£000’s) NPV = £300/(1.31) + £1 000/(1.31) 2 + £400/(1.31) 3 - £1 000 = IRR is approximately 31%. The decision rule is to accept the project if IRR is greater than the cost of capital. 3.Example NPV at 25% = £84.8 (say 85) NPV at 35% = - £66.53 (say - 67) Using interpolation: IRR = 25% + 85/152 x (35%- 25%) = 30.59%

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.7 © 2000 Colin Drury Fig 13.7 The calculation of IRR

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.8 © 2000 Colin Drury Comparison of NPV and IRR 1. NPV is preferred to IRR because: IRR can incorrectly rank mutually exclusive projects. IRR NPV % £ Project A Project B IRR is expressed in percentage terms: Investment Y (1 year life) yields a return of 50% (I 0 =100) =£50 Investment Z (1 year life) yields a return of 25% (I 0 =£1 000) =£250 If the remaining £900 from Y only yields £100 then Z is preferable. IRR assumes internal cash flows are reinvested at the IRR, whereas NPV assumes they are invested at the cost of capital. Unconventional cash flows (–, +,–)can result in multiple rates of return.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.9a © 2000 Colin Drury Payback method 1. Measures the length of time that is required for a stream of cash flows from an investment to Recover the original cash outlay required by the investment. The payback method suggests A but B has the higher NPV.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.9b © 2000 Colin Drury 2. Limitations Ignores time value of money. Ignores cash flows after the payback period. 3. Widely used Simple to understand. Appropriate where liquidity constraints exist and a fast payback is required. Appropriate for risky investments in uncertain markets. Often used as an initial screening device.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.10a © 2000 Colin Drury Accounting rate of return 1. Calculated by dividing the average annual profits from a project into the average investment cost. Project X Years £000 ’s £000 ’s Book value Cash flow Depreciation (8) (8) (8) Profit Average return = Average profit (3) = 25% Average investment (12)

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.10b © 2000 Colin Drury 2.Project Y Years £000 ’s £000 ’s £000 ’s £000 ’s Book value Cash flow Depreciation (8) (8) (8) Profit Average return = 3 = 25% 12 3.Project Y also has a 25%return, but the cash flows are received later and NPV is less than X.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury The effect of performance measurement Use overhead as transparency

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.12a © 2000 Colin Drury The effect of performance measurement There is a danger that managers will be motivated to choose the investment that maximizes their performance measure rather than maximizing NPV. NPV calculations (decision model) X YZ £000 ’s £000 ’s £000 ’s Machine cost initial outlay (time zero) Estimated net cash flow (year 1) Estimated net cash flow (year 2) Estimated net cash flow (year 3) Estimated NPV at 10%cost of capital 77 (52)52 Ranking 1 3 2

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.12b © 2000 Colin Drury Performance measurement criteria Profits X Y Z £000 ’s £000 ’s £000 ’s Year 1 (37)103 (237) Year 2 83 (37)(237) Year Total profits Return on investments X Y Z % % % Year 1 (4.3)11.9 (27.5) Year (6.4) (41.3) Year Average

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.13a © 2000 Colin Drury Stages in the capital investment process 1.Search for investment opportunities  Without a creative search for new investment opportunities appraisal techniques are worthless 2.Initial screening  Preliminary assessment to ascertain if projects satisfy strategic and risk criteria 3.Project authorizations  Approval by top management committee or lower levels (below specified ceilings) based on financial appraisal and strategic considerations.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 13.13b © 2000 Colin Drury 4.Control during the installation stage  Periodic reports required on over/under spending relative to stage of completion, estimated costs to complete and estimation completion date compared with original estimates 5.Post-completion audit  Involves a comparison of the actual results with those included in the investment proposal.  Difficult to undertake because it is not easy to isolate the actual cash flows that stem from individual projects.  Recriminatory post-mortems should be avoided.