Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 1 Chapter 9 Capital investment analysis

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 2 Objectives Describe the two types of capital investment decisions with which managers may be faced: – Accept or reject decisions – Capital-rationing decisions Describe the method of calculation of non- discounting models: – Payback period – Accounting rate of return

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 3 Objectives (continued) Explain the advantages and limitations of non-discounting models. Explain the importance of the time value of money in capital budgeting decisions. Describe the method of calculation of discounting models: – Internal rate of return – Net present value Explain the advantages and disadvantages of discounting models.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 4 Objectives (continued) Apply appropriate long-term decision- making techniques to practical situations involving: – the acquisition of non-current assets – the replacement of existing equipment – leasing or buying.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 5 Capital investment decisions Accept or reject decisions: – Decision determined on a individual basis – Accept if it meets the predetermined criteria. Capital-rationing decisions requiring ranking of multiple decisions: – simultaneous – ranked in order or preference – predetermined criteria – usually rate of return.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 6 Non-discounting models Accounting rate of return (ARR) involves net profit after tax in relation to the investment tied up in the asset. Investment may be initial or average depending on the asset.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 7 Non-discounting models (continued) Payback period involves determining how long it will take future cash flow from the asset to generate the cash to pay for the cost.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 8 Non-discounting models (continued) Advantages of accounting rate of return: The data is easily obtainable from relevant financial statements. Calculations are relatively easy. Results are easily understood by the average person.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 9- 9 Non-discounting models (continued) Limitations of accounting rate of return: It accounts for only profits and not cash flows. It does not account for the timing of profits. It may not be consistent with the goals of maximisation of shareholder wealth because it does not discount cash flows. It does not distinguish between projects of differing magnitudes.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven Non-discounting models (continued) Advantages of the payback period: Calculations are not difficult. Results are easy to understand. This method uses net cash flows not just profits.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven Non-discounting models (continued) Limitations of the payback period: it does not account for profit it does not account for cash flows beyond the pay back period it does not account for the time value of money it does not distinguish between projects of differing magnitudes. it may not be consistent with the goal of maximising shareholder wealth.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven Time value of money in capital budgeting decisions Time value of money is the act of analysing costs and revenues by expressing all flows of profit or cash in a common time frame. Amounts paid or received are generally expressed in present value terms. Present value terms are considered to be discounted, because money loses value with time.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven Calculation of discounting models Net Preset Value (NPV) NPV = Original cost + PV of net cash inflows – Involves calculating the PV of all expected inflows and subtracting from the PV of outflows for a project. – Positive NPV  The project is achieving the desired rate of return – Negative NPV  The project is not returning sufficiently to justify consideration

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven Calculation of discounting models (continued) Internal rate of return: When the NPV is equal to zero, the rate of return is being achieved.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven Advantages and disadvantages of discounting models The advantages for NPV and IRR are: – all flows are compared at the same point in time – projects with differing lives may be compared – both models may be used in replacement decisions.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven Advantages and disadvantages of discounting models (continued) The disadvantages of NPV and IRR are: – the difficulty of determining future cash flows – the difficulty of determining the rate that is to be used for discounting – having to use a financial calculator or appropriate tables.