MBA7001 Accounting for Decision-Makers

Week 6 Lecture Capital Investment Appraisal

Slide 10.2

Chapter 10 Making capital investment decisions

LEARNING OUTCOMES

CHAPTER 10:
Investment Appraisal Methods

You should be able to:

Explain the nature and importance of investment
decision making

Firsthour 23.11.11

Identify the four main investment appraisal

methods found in practice

Payback
ARR

Use each method to reach a decision on a

particular investment opportunity

Discuss the attributes of each of the methods

1

Atrill and McLaney, Accounting and Finance for Non-Specialists, 7th Edition, Pearson Education Limited 2011

InvestmentAppraisal
Investmentappraisalmethodsusedinpractice
Investmentappraisal theprocessof

appraisingthepotentialinvestmentprojects.
Assessmentofthelevelofexpectedreturns

earnedforthelevelofexpenditure made.
Estimatesoffuture costsandbenefitsover

theprojectslife.
3

Everybusinesswouldliketodoeverything
Butitallcosts
Capitalexpenditureonnewprojectsor
purchases(fixedassets)needstobeplanned
Capitalisalwaysrationed
Scenario:
Yourbusinesswishestoexpanditsproductline
ItisconsideringProductsAandBbutitcanonlyafford
todoone.
Howdoesitdecide?Whatmainfactorsaffectthe
investmentdecision

Howmuchwillitcost?

Investmentappraisalmethodsusedinpractice
HowmuchwillIgetback?
WhenwillIgettheincome?
4maintechniquesavailablerangingfrom
simpletomoderatelycomplex

MULTIPLEAPPRAISALMETHODS:

Nondiscountedcashflowtechniques:

1. Paybackperiod(PBP)
2. Accountingrateofreturn(ARR/ROCE/ROI)
Discountedcashflowtechniques(DCF):

3. NetPresentValue(NPV)
4. InternalRateofReturn(IRR)
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MBA7001 Accounting for Decision-Makers

Week 6 Lecture Capital Investment Appraisal

Objectives(1)

PBP RelevantCashFlows

Nondiscountedcashflowtechniques:

Paybackisacashflow basedtechniqueandso
considerstheRelevantcashflowswhich are:
Future

i)Calculatepaybackperiodand
discusstheusefulnessofpaybackas
aninvestmentappraisalmethod.
ii)Calculateaccountingrateof
return(returnoncapitalemployed)
anddiscussitsusefulnessasan
investmentappraisalmethod.

Incremental
Cashbased
Ignore:
Sunkcosts
Noncashitems
7

Committedcosts

Payback

1.PaybackPeriod(PBP)

When does cash inflow cover cash outflow?

PBP=Thetimeittakesthecashinflows

fromaprojecttoequalthecashoutflows.

Outflow
Inflows:
1
2
3
4
5
6

Decisionrule projectswithaPBPupto

definedmaximumperiodareacceptable;
theshorterthePBP,themoredesirable.

A
(1,000,000)

B
(1,000,000)

250,000
250,000
250,000
250,000
100,000
50,000

100,000
200,000
300,000
300,000
400,000
500,000

Payback
Project A gets repaid after 4 years
Project B is still not repaid only 900,000

The time it takes the cash inflows from

a project to equal the cash outflows

It is 100,000 short
Year 5 project B has 400,000 coming in

Advantages?

Disadvantages?

100,000/400,000 = 25%
25% of year = 3 months

See textbook & extra reading

Thus payback equals 4 years 3 months

[or: 4 yrs + (100/400 x 12)]

MBA7001 Accounting for Decision-Makers

Week 6 Lecture Capital Investment Appraisal

2.AccountingRateofReturn(ARR)
ARR = Average annual PBIT
Average investment

AccountingRateofReturn(ARR)
AlsoknownasReturnonCapitalEmployed(ROCE)or

x 100%

ReturnOnInvestment(ROI).

Where average investment = initial outlay + scrap value

2

Canbeusedtorankprojectstakingplaceoveranumber

ofyears(usingaverageprofitsandinvestment).
Canalsorankmutuallyexclusiveprojects.

OrARR=

AverageannualPBIT x100%
Initialcapitalcosts

Decisionrule projectwithanARRabovea

Profitisafterdepreciationbutbeforeinterestandtax.

definedminimumareacceptable;thegreaterthe
ARR,themoredesirable.

13

AccountingRateofReturn(ARR)
Example Aprojectinvolvestheimmediate
purchaseofanitemofplantcosting110,000.
Itwouldgenerateannualcashflowsof24,400for
fiveyears,startinginYear1.Theplantpurchased
wouldhaveascrapvalueof10,000infiveyears,
whentheprojectterminates.
Depreciationisonastraightlinebasis.

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Workings:
Years

Cash Flow Depreciation

Profit

15

24,400

4,400

(20,000)*

Average investment =

ARR =

Required:

x 100 =

CalculateARR.
15

16

Accounting Rate of Return (ARR)

AccountingRateofReturn(ARR)
AccountingprofitsVS.Cashflows:

ARR = Average annual PBIT

Average investment

Profitscannotbespent

Advantages?

Disadvantages?

Profitsaresubjective

See textbook & further reading

Cashisrequiredtopaydividends

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MBA7001 Accounting for Decision-Makers

Week 6 Lecture Capital Investment Appraisal

ComparingPBPwithARR
ThecashflowsforprojectsZandSareasfollowsandthere
isnoresidualvalueforeitherinvestment:
Z
Year
0(20,000)
14,000
26,000
36,000
47,000
56,000
AnticipatedPBP3years7months

(25,000)
8,000
8,000
6,000
6,000
5,000
3years6months

Figure 5.1 Payback period for the Zenith machine

19

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Objectives(2)

ComparingPBPwithARR

Discountedcashflow(DCF)techniques

UsingARR:
ProjectZ:
[(4000+6000+6000+7000+6000)20000]/5 =18.0%
10,000

a)Explainandapplyconceptsrelatingtointerest
anddiscounting,including:

ProjectS:
[(8000+6000+5000+6000+8000)25000]/5
12,500

ii)thecalculationofpresentvalues,andtheuseof
discountandannuitytables;

i)thetimevalueofmoneyandtheroleofcostof
capitalinappraisinginvestments;

=12.8%

b)Calculatenetpresentvalueanddiscussits
usefulnessasaninvestmentappraisalmethod.
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DiscountedCashFlowTechniques
DCFisaninvestmentappraisaltechnique

Time value
Money has a time value i.e. the timing of a cash flow
affects how much it is really worth to us.
For example, if offered 100 now or 100 in one years
time, most people would choose the money now.

whichtakesintoaccountboththetimings
ofcashflowsandalsototalreturnsovera
projectslife.

The main reasons for this time value are as follows:

Inflation time erodes the purchasing power of the money.

TwoDCFmethodstoevaluatecapital

Investment opportunities the money now can be invested

to grow into more than 100 in one year.

investments:

(i)
(ii)

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Net Present Value (NPV)

Internal Rate of Return (IRR)

Cost of finance the receipt now could be used to repay a

loan, say, and save/ reduce interest charges.
Risk the earlier cash flow is less risky than the promise
of cash in the future.
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MBA7001 Accounting for Decision-Makers

Week 6 Lecture Capital Investment Appraisal

Compounding & Discounting

Compounding = multiplying a present sum by a
return % to give a future value of an investment,

DCFAssumptions timing!

i.e. FV = PV (1 + r)n

Cashflowsincurredatthebeginningof
projectoccurinyear0.

Discounting = dividing the future value of an

investment by a return % to give the present
value,

Cashflowsoccurringduringtimeperiod
assumedtooccuratperiodend.

i.e. PV = FV
1
(1 + r)n

Cashflowsoccurringatbeginningofperiod
assumedtooccuratendofpreviousperiod.
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Net Present Value

NPVExample

NPV = the sum of the discounted (present)

values of the cash flows from the investment.
If the discounted future cash flows >
cost of setting up the project today
The project has a + net present value (NPV)

Decision rule Accept all positive NPV

investments as they enhance shareholders
wealth; the greater the NPV, the greater the
enhancement and the more desirable.

SagaCo.estimatestherelevantcashflowofprojectAasfollows:

YearCashflow

0(100,000)
160,000
280,000
340,000
430,000
IfDiscountrate=15%, isprojectAacceptableforthecompany?

Homework

Net Present Value

InternalRateofReturn(IRR)
IRR =thediscountratethatcausesaprojectto

haveazeroNPV.

Advantages?

Disadvantages?

Over non-discounted techniques studied earlier

Itrepresentstheaveragepercentagereturnon

theinvestment,takingaccountofthefactthat
cashmaybeflowinginandoutoftheprojectat
variouspointsinitslife.
Decisionrule projectsthathaveanIRR

greaterthanthecostofcapitalareacceptable;
thegreatertheIRR,themoredesirable.

MBA7001 Accounting for Decision-Makers

Week 6 Lecture Capital Investment Appraisal

IRR

InternalRateofReturn

Example Singlecashinflow

The rate of interest (discount) at which the NPV = 0

Year

Cashflow Discountrate
PV

0(120)1.00 (120)
1

138?
120
NPV=0

IRR=?

IRR decision rule

IRR = The % return given by a project
As the IRR gives the discount rate at which the
NPV is zero, it follows that:
If IRR > Cost of capital, ACCEPT project;
(because project is bound to have a + NPV at
the cost of capital)
If IRR < Cost of capital, REJECT project
This rule is valid for all CONVENTIONAL cash flows
(ie a cash outflow followed by a series of inflows)

IRR
Example Unevencashflows
Time
Y0
Y1-5
Y5

CF
10% Discount
PV
12% Discount
PV

factor

factor

(80,000)
1.000
(80,000)
1.000
(80,000)
20,000
3.791
75,820
3.605
72,100
10,000
0.621
6,210
0.567
5,670
NPV = 2,030
NPV = (2,230)

IRR=
= 10.95%

IRR graphical illustration

IRR
NPV

Itdoesnotrelatedirectlytoshareholderswealth.
+VE

Takesaccountofthetimingofcashflow.

ACCEPT
11%
IRR
0
10%
CoC

12%

Takesallrelevantinformationintoaccount.
Cost of capital %

Doesnotalwaysprovideclearsignalsandcanbe

impracticaltouse.
REJECT

-VE

MBA7001 Accounting for Decision-Makers

Week 6 Lecture Capital Investment Appraisal

NPVandIRRcompared
WillNPVandIRRalwayscometosimilarconclusions?
TimeProjectAProjectB

Year0(10,000)(6,000)
16,0003,650
26,0003,650
NPV@10%413334
IRR13%14%
Figure9.1GraphoftheNPVagainstthediscountratefortwoproject(AandB)

NPVandIRRcompared
Unconventionalcashflows MultipleIRRsandNoIRRs

TimeProjectCProjectD

Year0(10,000)10,000
133,000(16,000)
2(24,000)12,000
Figure9.2 GraphoftheNPVagainstthediscountrateforProjectC

Homework

Internal Rate of Return

Advantages?

Disadvantages?

Over non-discounted techniques studied earlier

Figure9.3 GraphoftheNPVagainstthediscountrateforProjectD