1. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 1 Accounting for Management Decisions WEEK 11 CAPITAL INVESTMENT DECISIONS READING: Text CH 11 pp.548 - 572

2. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 2 Learning Objectives Identify the essential features of investment decisions State the 4 common capital investment appraisal methods Demonstrate an understanding of the ‘accounting rate of return method (ARR)’ Demonstrate an understanding of the ‘payback method (PP)’ Demonstrate an understanding of the ‘net present value method (NPV)’

3. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 3 Learning Objectives cont’d Demonstrate an understanding of the ‘internal rate of return method (IRR)’ Explain the notion of present values (PV) and identify alternative means of determining present values Convert forecast profit flows into cash flows

4. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 4 The Nature of Investment Decisions essential time The essential feature of investment decisions is the time factor outlay benefits other Making an outlay of cash which is expected to yield economic benefits to the investor at some other (future) point in time

5. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 5 The Nature of Investment Decisions cont’d crucial Investment decisions are of crucial importance for the following reasons: Large mistakes Large amounts of resources are often involved, therefore if mistakes are made, the effect can be catastrophic difficultexpensive It is often difficult and expensive to abandon/withdraw from an investment once it has been made

6. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 6 Methods of Investment Appraisal There are 4 main methods used in practice to evaluate investment opportunities: ARR 1.accounting rate of return (ARR) PP 2.payback period (PP) NPV 3.net present value (NPV) IRR 4.internal rate of return (IRR) instincts Some smaller businesses may use informal methods such as manager’s instincts/intuition

7. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 7 ARR Accounting Rate of Return ( ARR ) average accounting profit average investment in the project ARR takes the average accounting profit the investment will generate, and expresses it as a % of the average investment in the project as measured in accounting terms: 2 The calculation requires 2 figures: average profit - The annual average profit average investment - The average investment for the particular project profit - Note that this method uses profit not cash - See eg on p.550 and Activity 11.2, pp.550-51

8. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 8 ARR cont’d ARR Decision Rules: target For any project to be accepted, it must achieve a target ARR as a minimum; competing highest If there are competing projects that exceed the minimum rate, the one with the highest ARR would normally be chosen Advantages of ARR: Easy Easy to calculate and understand profitability Is a measure of profitability consistent with ROA (based on accrual performance)

9. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 9 Accounting Rate of Return cont’d Problems with ARR: profits cash flows ARR uses accounting/accrual profits, however over the life of a project, cash flows matter more than accounting profits fails ARR fails to take into consideration the time value of money difficulties The ARR method presents averaging difficulties when considering competing projects of different size.

10. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 10 Capital Investment problems/limitations ARR:$000$000$000 Project cost:(160)(160) (160) Annual profit: 2010 20 10 160 2011 40 10 10 2012 60 10 10 2013 60 10 10 2014 20160 10

11. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 11 PP Payback Period ( PP ) timerecover PP = The length of time taken to recover the amount of the investment Payback = Initial investment/annual cash inflow varies cumulative If the annual cash inflow varies, then payback is when the cumulative cash inflows equal the initial investment Decision Rules: maximum For a project to be acceptable it would need to have a maximum payback period shorter If there are competing projects, the project with the shorter payback period would be chosen

12. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 12 Payback Advantages of PP: easyshort Quick and easy to calculate, emphasises the short term See eg on p.553 and Activity 11.3 & 11.4, pp.551- 53 See eg on p.553 and Activity 11.3 & 11.4, pp.551- 53 Disadvantages of PP: timingexcludes Disregards timing of cash flows, excludes post payback period cash flows See eg on p.553 and Activity 11. p.554 See eg on p.553 and Activity 11. p.554

13. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 13 Capital Investment problems/limitations PP: $000$000s$000 Project cost:(160)(160) (160) Annual profit: 2010 20 10 160 2011 40 10 10 2012 60 10 10 2013 60 10 10 2014 20160 10 2015 200 40 50 2016 300 50 100

14. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 14 NPV Net Present Value ( NPV ) NPV Method: NPV = PV inflows – PV outflows sum discountingNPV is the sum of the cash flows associated with a project, after discounting at an appropriate rate, reflecting the time value of money moreTime value of money: $1 received today is worth more than $1 received in 10 years time NPV Decision Rules: positivereject negative Accept the highest positive NPV, reject all negative NPVs.

15. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 15 NPV cont’d Advantages of NPV: all Considers all of the costs and benefits of each investment opportunity timing Makes allowance for the timing of these costs and benefits time value Considers the time value of money Disadvantages of NPV difficult More difficult to calculate, less easily understood Does not determine actual rate of return or a relative measure of return

16. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 16 NPV cont’d - Using Discount Tables Deducing the PV of the various cash flows used in the NPV method is laborious, with each cash flow being multiplied by 1/(1+r) n quickertable appendix A quicker method is to refer to a table of discount factors (in appendix at end of ch 11) for a range of values of r and n discount factor A discount factor is a rate applied to future cash flows to derive the PV of those cash flows rate Opportunity rate is usually referred to as the discount rate and is effectively the reverse of compounding Financial calculators and spreadsheets are also a practical approach to dealing with calculating the PV of future cash flows

17. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 17 Capital investment decisions 11.1 Self assessment question Beacon Chemicals Ltd is considering the construction of new plant to produce a chemical named X14. The capital cost is estimated at $100,000 and if construction is approved now the plant can be erected and commence production by the end of 2008. $50,000 has already been spent on research and development work. Estimates of revenues and costs arising from the operation of the new plant appear below:

18. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 18 Capital investment decisions cont’d 11.1 Self assessment question Estimates of revenues and costs: 20092010201120122013 Sales price ($ per unit)100120 10080 Sales volume (units)8001,0001,2001,000800 VC ($ per unit)50 403040 FC ($000)30

19. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 19 Capital investment decisions cont’d lostIf the new plant is constructed, sales of some current products will be lost and this will result in a loss of CM of $15,000 p.a. over its life. $20,000The accountant has informed you that the FC include depreciation of $20,000 p.a. on new plant, and an allocation of $10,000 for fixed overheads. A separate study shows that if the new plant was built, its construction would incur additional overheads, excluding dep’n of $8,000 p.a. and it would require additional working capital of $30,000. For the purposes of initial calculations ignore taxation.

20. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 20 Capital investment decisions cont’d Required: a)Deduce the relevant annual cash flows associated with building and operating the plant. b)Deduce the PP c)Calculate the NPV using a discount rate of 8%

21. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 21 Capital investment decisions cont’d a) Relevant cash flows: ($000s) 200820092010201120122013 Sales 8012014410064 Loss of CM (15) VC (40)(50)(48)(30)(32) FC (8) Operating cash flows174773479 Working Cap (30)30 Capital cost (100) Net relevant cash flows(130)1747734739

22. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 22 Capital investment decisions cont’d b) PP: Initial investment:$130 Cumulative cash flows Year 1$ 17 Year 2 47= 64; 66 remaining 73 Year 3 73 repaid third Therefore the plant will have repaid the initial investment by the end of the third year of operations. The payback period is close to 2 years, 11 months (ie 66/73 x 12 mths = 10.8 mths = 11)

23. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 23 Capital investment decisions cont’d c) NPV: Net cashflow PV factor 8% PV cashflow Construction costs(130)1.000 $(130) Cashflows: Year 1: 2009 170.926+ 15.74 Year 2: 2010 470.857+ 40.28 Year 3: 2011 730.794+ 57.96 Year 4: 2012 470.735+ 34.55 Year 5: 2013 390.681+ 26.56 NPV $45.09

24. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 24 NPV cont’d The discount rate and the cost of capital: costfinance appropriate The cost to the business of the finance it will use to fund the investment if it goes ahead is effectively the opportunity cost and is therefore the appropriate discount rate to use in NPV assessments not It would not be appropriate to use the specific cost of capital as the discount rate for NPV assessments as earlier or later projects might have different specific funding not It would also not be appropriate to use different discount rates for different projects WACC The overall weighted average cost of capital (WACC) – an average of financing opportunities available to the firm - should be used as the discount rate

25. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 25 NPV cont’d Why NPV is superior to ARR and PP timing not The timing of the cash flows - discounting the various cash flows when they are expected to arise acknowledges that not all cash flows occur simultaneously relevant all The whole of the relevant cash flows - NPV includes all of the relevant cash flows irrespective of when they are expected to occur objectivesonly directly The objectives of the business - NPV is the only method in which the output bears directly on the wealth of the business

26. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 26 NPV cont’d limitations Two potential limitations with NPV: unknown not The actual return percentage is unknown: NPV simply reveals if the projected return is either higher (+) or lower (-) than the discount rate not how much higher or lower Rankingnot Ranking of alternative projects: NPV does not enable ranking of positive projects and therefore the best investment strategy may not be determined

27. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 27 Discounted Payback not initial The PP method does not take into consideration the time value of money, whereas discounted payback compares the initial cost with the cash inflows after discounting.

28. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 28 Internal Rate of Return (IRR) IRR Method: rate IRR = The rate at which PV inflows = PV outflows IRR Decision Rule: highest Accept the highest IRR, specify a minimum required return Advantages of IRR: all actual Is based on all cash flows, incorporates the time value of money, specifies an actual expected return Disadvantages of IRR: Difficultmultiple Difficult to calculate, there may be multiple returns, is not based on wealth increments

29. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 29 Some Practical Points Relevant Relevant costs should be determined and used eg ignore costs already incurred, past costs etc; Future Future costs should also in some cases be ignored eg costs that will be incurred whether or not the project goes ahead; included; Opportunity costs arising from benefits foregone must be included; Taxation Taxation on profits and also tax relief should be accounted for; Interestnot Interest payments should not be included when using DCF techniques as the discount factor already takes account of cost of financing.

30. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 30 Investment Appraisal in Practice more one Research shows that businesses use more than one method to assess each investment decision; more practice; NPV and IRR seem to be the more popular methods used in practice; limitations ARR and PP continue to be popular despite their limitations and the rise of popularity of the DCF methods; Largediscounting Large businesses tend to use the discounting methods and apply multiple methods for each decision.

31. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 31 Investment evaluation and Planning Systems Investment Investment evaluation methods are an important part of the planning and decision-making process Cash flow competent Cash flow estimates need to be prepared in a competent manner such that the implications of following through on the estimates are clear integrated Capital investment appraisal needs to be fully integrated/included in the broader strategic planning and decision making system planning Strategic planning should be the means through which investments must pass so that all aspects can be considered eg human, behavioural, environmental etc