1. Slide 10.1 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Part Three FINANCE Chapter 10 MAKING CAPITAL INVESTMENT DECISIONS

2. Slide 10.2 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 LEARNING OUTCOMES You should be able to: Identify and discuss the four main investment appraisal methods found in practice Explain the nature and importance of investment decision making Explain the methods used to monitor and control investment projects Discuss the strengths and weaknesses of various techniques for dealing with risk in investment appraisal

3. Slide 10.3 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 The nature of investment decisions Large amounts of resources are often involved It is often difficult and/or expensive to bail out of an investment once undertaken

4. Slide 10.4 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 The scale of investment by UK businesses Source: Annual reports of the businesses concerned for the financial years ending in 2013 Business Expenditure on additional non-current (fixed) assets as a percentage of: Annual sales End-of-year revenue non-current assets Wm Morrison Supermarkets plc 5.6 11.1 Vodafone plc 32.4 12.0 Marks and Spencer plc 8.3 13.2 Severn Trent Water Ltd 24.4 6.3 Go-Ahead Group plc 2.3 10.6 J D Wetherspoon plc 7.9 10.2 British Sky Broadcasting plc 9.0 17.8 Ryanair Holdings plc 6.4 6.0

5. Slide 10.5 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Investment appraisal methods Four methods of evaluation Accounting rate of return (ARR) Payback period (PP) Net present value (NPV) Internal rate of return (IRR)

6. Slide 10.6 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Average annual profit Average investment to earn that profit ARR = Accounting rate of return (ARR) × 100%

7. Slide 10.7 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 ARR decision rule Where competing projects exceed the minimum rate, the one with the highest ARR should be selected For a project to be acceptable, it must achieve at least a minimum target ARR

8. Slide 10.8 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Problems with ARR Ignores the timing of cash flows Use of average investment Use of accounting profit Competing investments

9. Slide 10.9 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Payback period (PP) Time taken for initial investment to be repaid out of project net cash inflows

10. Slide 10.10 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 PP decision rule If competing projects have payback periods shorter than maximum payback period, the one with the shortest payback period is selected Project should have a shorter payback period than the required maximum payback period

11. Slide 10.11 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Problems with PP Does not take timing of cash flows fully into account Ignores cash flows after PP Does not take risk fully into account Not related to wealth maximisation objective Arbitrarily determined target payback period

12. Slide 10.12 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 The cumulative cash flows of each project in Activity 10.6 Project 1 Project 3 Project 2 Yr 1 Cash flows (£000) 200 800 600400 900 0 500300 100 700 Y2Y2 Yr 3 Yr 1 Yr 2 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Y1Y1 Payback period Initial outlay Yr 3 Yr 4 Yr 5 Y5Y5 Y4Y4 Figure 10.1 Cumulative cash flows for each project in Activity 10.6

13. Slide 10.13 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Interest foregone Inflation Required return Risk premium The factors influencing the returns required by investors from a project

14. Slide 10.14 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 NPV decision rule If competing projects have positive NPVs, the one with the highest NPV is selected If project NPV is positive, it should be accepted; if it is negative it should be rejected

15. Slide 10.15 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent 0 6543 2 1 7 8910 Years into the future 10 20 30 40 50 60 70 80 90 100 Pence £1 Figure 10.2 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent

16. Slide 10.16 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Why NPV is better than ARR and PP The whole of the relevant cash flows The objectives of the business The timing of the cash flows NPV fully addresses each of the following:

17. Slide 10.17 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Internal rate of return (IRR) The discount rate, which, when applied to the future project cash flows, produces a zero NPV

18. Slide 10.18 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 IRR decision rule If competing projects exceed minimum IRR requirement, the one with the highest IRR is selected Project must meet a minimum IRR requirement. (The opportunity cost of finance)

19. Slide 10.19 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 The relationship between the NPV and IRR methods NPV (£000) Cost of capital (%) 10 20 30 40 50 60 70 0 1020 30 40 IRR −10 0 Figure 10.3 The relationship between the NPV and IRR methods

20. Slide 10.20 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Problems with IRR Does not directly address wealth maximisation Ignores the scale of investment Has difficulty with unconventional cash flows

21. Slide 10.21 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Some practical points related to investment appraisal Past costs Common future costs Opportunity costs Taxation Year-end assumption Cash flows not profit flows Interest payments Other factors

22. Slide 10.22 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 The main investment appraisal methods Investment appraisal methods Discounted cash flow methods Net present value Internal rate of return Accounting rate of return Payback period Non-discounted cash flow methods Figure 10.4 The main investment appraisal methods

23. Slide 10.23 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Investment appraisal in practice Many surveys have shown the following features: NPV and IRR have become increasingly popular Continued popularity of the PP and ARR methods Businesses tend to use more than one method Larger businesses rely more heavily on NPV and IRR than smaller businesses

24. Slide 10.24 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 A multinational survey of business practice US UKGermanyCanadaJapanAverage IRR4.004.164.084.153.293.93 NPV3.884.003.504.093.573.80 Payback period 3.463.893.333.573.523.55 Response scale: 1 = Never 5 = Always