1 Bruce Bowhill University of Portsmouth ISBN: © 2008 John Wiley & Sons Ltd.

Chapter 4 Capital Investment Decisions © 2008 John Wiley & Sons Ltd.

3 Types of investment projects 1) Expansion. Market penetration through increased sales of existing products. Sales of new products in existing markets. Sales of new products in new markets. Mergers with other organisations. 2) Cost reduction 3) Replacement of existing assets. 4) Non-profit earning projects. Statutory requirements, e.g. safety or pollution control equipment following new legislation on such areas. ‘Altruistic’ purposes, for example the construction of medical facilities for the staff of employees or for the community. © 2008 John Wiley & Sons Ltd.

4 Cash flows –Investment in new assets Fixed assets Working capital –Operating cash flows –Tax effects –Recoveries at end of project © 2008 John Wiley & Sons Ltd.

5 Three investment projects A B C Year £’000 £’000 £’ ,000 -1,000 -1, ,300 1, © 2008 John Wiley & Sons Ltd.

6 Payback Project A cash flow Year In yearCumulative £’000 £’ ,000 -1, , ,300 1,300 Project A payback is 4 years © 2008 John Wiley & Sons Ltd.

7 Advantages of payback:- (1) Cash flow is crucial to many companies. Measures the net cash generated by the project in the shorter-term. (2) It can be used as a filter to reject projects, without the need to consider all the cash flow implications. (3) It is a simple and easy to understand rule and can be used for small projects where a simple decision rule is adequate. Disadvantages of payback:- (1) It does not consider the cash flows after the payback cut-off point. After four years for project A for example, there will be a major cash inflow, but this has been ignored (2) Ignores the timing of cash flows and the cost of capital. Cash flows in later years are treated as being as important as the cash flows in earlier years. © 2008 John Wiley & Sons Ltd.

8 Accounting Rate of Return (ARR) is the average annual profit divided by the initial investment. Average annual profit = Profit Number of years of the project Profit = cash flows from trading activities - non cash items such as the cost of depreciation. For project A Net cash flow from trading 2,300,000 Depreciation 1,000,000 Profit over the five years is 1,300,000 The average profit = £1,300,000 = £260,000 5 A.R.R. = £260,000 = 26% £1,000,000 © 2008 John Wiley & Sons Ltd.

9 Advantages of A.R.R.:- The ARR technique is popular because 1) It is familiar to many managers, for example, divisional managers are often assessed on accounting measures such as return on capital employed or return on investment. 2) It considers the whole life of the project Disadvantage:- A.R.R. treats all cash flows as being equally important even though early cash flows are ‘worth’ more than later cash flows. © 2008 John Wiley & Sons Ltd.

10 Net present value Cash flows to be earned in the future are worth less than current cash because:- 1) Interest. The funds can be invested in a bank and earn interest. 2) Risk. The higher the risk involved in an investment, the higher will be the return that will be required by the investor to compensate for the risk. 3) Inflation. With inflation, future cash flows will purchase less than cash available now. © 2008 John Wiley & Sons Ltd.

11 Discounting If it is known that £1 will be earned in 1 years time, then at a discount rate of 10%, it would be necessary to invest approximately 91 pence now. This can be calculated by reversing the compound interest calculation, i.e. P (1 + i ) The discount factor is the factor by which future cash flows are discounted to arrive at to-days monetary value. Similarly £1 earned at the end of year 2 is the equivalent of having approximately £ today i.e. invest £ at 10% over two years and this will result in an investment of approximately £1. © 2008 John Wiley & Sons Ltd.

12 Project A cash flow Year Cash flow in year Discount factor Present value £’000 £’ , At a discount rate of 10% the project earns a net present value of £525,000 © 2008 John Wiley & Sons Ltd.

13 Advantages of NPV (1) NPV takes into account the amount and timing of all cash flows. (2) Finding a positive NPV project is the same thing as adding to shareholders' wealth. © 2008 John Wiley & Sons Ltd.

14 Internal Rate of Return The Internal Rate of Return (IRR) is the discount rate that gives an NPV equal to zero. For project A - The net present value is £525,000 at a 10% discount factor and -£111,000 at a 25% discount factor. I.R.R = Lowest discount rate + difference in discount rate x NPV at lowest discount rate Difference in NPV’s For this example:- I.R.R. = 10% + 15% x £525,000 (£525,000+£111,000) = 10% + 12% = 22% © 2008 John Wiley & Sons Ltd.

15 Advantages I.R.R.:- (1) For most projects IRR actually gives the same project selection as NPV. (2) IRR may be better for communicating than NPV. A comment such as the “internal rate of return is 22% on this project” may seem more meaningful than “the NPV of this project is £525,000”. Note that the percentage return is not the same as the ARR. Disadvantages I.R.R.:- The IRR technique can have more than one IRR, also some projects have no IRR. © 2008 John Wiley & Sons Ltd.

16 Decision rule for accepting projects Payback method: Each organisation should decide on how quickly an investment must pay back its cash. ARR method: Projects with ARRs greater than or equal to the organisations hurdle rate should be accepted. NPV method: Accept all positive NPV projects. IRR method: Accept all projects with IRRs greater than or equal to the organisations hurdle rate. © 2008 John Wiley & Sons Ltd.

17 Project A Project B Project C Payback 4 years 3.75 years 3 years A.R.R. 26% 25% 16% N.P.V. £525,000 £577,000 £327,000 I.R.R % 24.50% 21.50% © 2008 John Wiley & Sons Ltd.

18 Sad Ltd is considering purchasing one of two machines to manufacture a new product. Machine 1 Machine 2 £ £ Capital cost -460, ,000 Expected cash inflows form operations by year : £ £ 1190,000160, ,000120, ,000120, ,000120, ,000110, , ,000 The expected scrap value of machine 1 is £30,000 and machine 2, £20,000. Each machine is expected to last 6 years. The cost of capital is 14% © 2008 John Wiley & Sons Ltd.

19 Incremental analysis between machines 1 and 2 Year Difference in Cash flow Discount factor Present value £’000 £’ Net present value 10.7 Net present value of machine 1 is £10,700 more than machine 2 © 2008 John Wiley & Sons Ltd.