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1FE105 M ANAGEMENT A CCOUNTING C APITAL I NVESTMENT D ECISIONS Elin K. Funck

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T ODAYS AGENDA What is Capital Investments and Capital Budgeting? The Capital Investment model Payback - a simple method of capital investment appraisal Discounting - the time of value of money Net Present Value – a more advanced method of capital investment appraisal Investment appraisals in practice

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W HAT IS C APITAL I NVESTMENTS ? ”Capital Investment decisions concerns decisions which consequences range over a long time.” Involves large sums and the appraisals of profits and cash- flows that will be generated in the future, usually over a relatively long time period. Product costing – short-term decisions about production Capital investments – long-term decisions.

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C APITAL I NVESTMENTS Capital investments can be divided into: Real investments: investments in physical objects Financial investments: investments in stocks, bonds, securities Intellectual/strategic investments: investments in markets, research, product development, education etc. The purpose with the investment can be: Replacements investmentsExpansion investments New investmentsRationalization investments Environment investments

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C APITAL BUDGETING ”Capital budgeting is the process of decision-making in respect of selecting investment projects, and the amount of capital expenditure to be committed.” o Does it pay off to expand the production by purchase of one or more machines? o Which type of machine should be chosen? o Do the machines have to be replaced, if so, when is the best time, now or in a few years?

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W HY C APITAL BUDGETING ? The aim with capital budgeting is: o Calculate profitability/return on investments in different capital investments. o Rank different capital investments, concerning their profitability. o Function as a support for decision-making when allocating resources. and… o Show the capital investments effect on cash flow o Base for assess the risk of capital investments

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F OCUS IN C APITAL I NVESTMENTS Capital investments ≈ long-term cost-volume- proft analysis Focus is on: Costs and revenues over a life-time In other words payment or net cash inflow

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T HE C APITAL I NVESTMENT MODEL Time Cash inflow Cash outflow G = Capital outlay /Original investment cost I = Cash inflow per year U = Cash outflow per year R = Residual value n = expected life time of the investment t = Time 0 (beginning of year one) a = I – U = net cash inflow

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S HORT GLOSSARY Original investment : covers all cash inflow and outflow initially caused by the investment. Can be determined relatively easily. It is assumed that the cash is spent now (year 0). Cash inflow : A capital investment can lead to inflow of capital by increased production and sales and as a result increased cash inflow. Cash outflow : A capital investment can lead to future outflow of capital by for example operating costs. Time period : The time period of the capital investment is the assumed period that it is economic defensible to keep the investment. Residual value : At the end of the time of the investment the investment may still have a certain value, it may be possible to sell it (cash inflow) or it may have a scrap value (cash outflow). That residual value has to be considered in the investment calculation.

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A SIMPLE APPRAISAL TECHNIQUE - P AYBACK Estimates the length of time it will take for cash flows to cover the initial investment outflow. A useful technique when the management principle criteria is the ability for the project to ’pay for itself’ quickly. Decision criteria: An investment is profitable if the payback time is shorter than expected. If we have to chose between several investments, payback will point towards the choice that is refunded fastest. Decision criteria: An investment is profitable if the payback time is shorter than expected. If we have to chose between several investments, payback will point towards the choice that is refunded fastest.

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P AYBACK – HOW TO CALCULATE Take cumulative cash flow into account and identify the point at which the net cumulative cash flow reaches zero. If cash flow is the same amount every year the payback is calculated as: Original investment Annual cash flows If the amount of the cash flow are different every year the payback is calculated as summarize the cash flow for each year until it reach the cash flow for the original investment.

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E XAMPLE - P AYBACK A company is discussing if they should go into the Chinese market or not. They calculate with that launching their products in China would initially cost them 700 000 SEK. However, the investment would also increase the profit with 140 000 SEK per year. How fast would an investment in China pay back? Total cash flowAccumulative cash flow Year 0- 700’ Year 1 +140’-560’ Year 2+140’-420’ Year 3+140’-280’ Year 4+140’-140’ Year 5+140’ 0’ Original investment700 000 Annual cashflows 140 000 = = 5 years

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E XAMPLE – P AYBACK A company has developed two new products ‘Trivial’ and ‘Great’. Costs for R&D is amount to 20’ SEK and 60’ SEK respectively. The company calculate with that launching the two products will result in increased profit of 5’ SEK and 20’ SEK annually. Which product is most profitable? === TrivialGreat Total CF Acc CFTotal CFAcc CF Year 0 -20-60 Year 1 +5-15+20-40 Year 2 +5-10+20-20 Year 3 +5 -5+20 0 Year 4 +5 0 Original investment20 4 years60 3 years Annual cash flow520

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P ROS AND CONS WITH P AYBACK PROS: + simple and common method + can be used as a first screening method CONS: - Concentrate attention on only one aspect – the ability of an investment to pay back quickly - Cash flows beyond the point of payback is ignored - Does not take into consideration that the value of a payment is getting lower the later in time the payment occur.

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T HE PRINCIPLE OF THE TIME VALUE OF MONEY Because of interest, 100 SEK now is not the same as 100 SEK in a month’s time or a year’s time, or ten year’s time. Compounding interest (we calculate with 10 per cent interest) End of yearInterest earned (SEK)Total investment (SEK) 0 0,1*100 100 10 1 0,1*110 110 11 2 0,1*121 121 12,1 3 0,1*133,1 133,1 13,3 4 0,1*146,4 146,4 14,6 5161

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C OMPOUNDING INTEREST ; C APITAL VALUE OVER TIME The value of 100 SEK invested at 10% compound annually, for five years. We calculate future value. = 100 x 1,1 5 100 kr 110 kr 121 kr 133 kr 146 kr 161 kr * 1,1 1

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D ISCOUNTED CASH FLOW (DCF) 161 SEK 100 SEK 161 (1,10) 5 = 100 SEK The opposite of the concept of compounding interest. We calculate present value.

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D ISCOUNTED CASH FLOW ( SEQUENCE ) Assume we have a sequence of the same amount cash (100 000 SEK) received for 4 years. How do we calculate the net present value? 100’ 100’100’100’100’ (1,10)¹(1,10)²(1,10)³(1,10) 4 + + + = 317’ SEK

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T IME VALUE OF MONEY IN INVESTMENT APPRAISALS Most methods/techniques for capital investment rests, in different ways, on the observation that cash inflow and outflow are taking place in different period of times. Capital investment methods/techniques are thus trying to make cash inflows and outflows comparable, in the same point of time. A cash flow now is made equivalent to cash flow in the end of for example year five by ”discounting” the cash flow.

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T HE C APITAL I NVESTMENT MODEL Time Cash inflow Cash outflow G = Capital outlay /Original investment cost I = Cash inflow per year U = Cash outflow per year R = Residual value n = expected life time of the investment t = Time 0 (beginning of year one) a = I – U = net cash inflow

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A MORE ADVANCED APPRAISAL TECHNIQUE – N ET P RESENT V ALUE (NPV) Net present value (NPV) uses the technique of discounting in order to express all future estimated cash flows in the same time. A useful method when we want to compare payments which occur in different times. Payments are returned to beginning of year 0. Decision criteria: Profitable if the net present value is positive, i.e. larger than 0. The capital investment with greatest net present value is most profitable. Decision criteria: Profitable if the net present value is positive, i.e. larger than 0. The capital investment with greatest net present value is most profitable.

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N ET P RESENT V ALUE – HOW TO CALCULATE df = discount factor R = residual value Tables of the discount factor is used to ease the calculation. Note! On p 174-175 in course book you have a table that gives the present value of a single payment received a number of years in the future discounted at x% per year. Original investment + cash flow *df (rate % ;year) + R * df (rate %; year)

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D ISCOUNT FACTORS

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E XAMPLE – N ET P RESENT V ALUE +30´ +30´ +30´ +30´ +30´ Year1 Year 2 Year 3 Year 4 Year 5 G= -100 000 Assume an investment in a new machine will cost 100 000 SEK. The company calculate with that the investment will result in a profit of 30 000 SEK per year and with that the discount rate is 10 per cent. Is the investment profitable?

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N ET PRESENT VALUE – AN EXAMPLE Year Payment receivedPresent value (SEK) 130’30’/1,1 1 = 27,2727 230’30’/1,1 2 = 24,79 330’30’/1,1 3 =22,539 430’30’/1,1 4 =20,49 530’30’/1,1 5 =18,6276 Net present value 113,7 SEK Payment received less original investment: 113,7-100= 13,7’ SEK. The investment is profitable since the net present value is positive.

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N ET PRESENT VALUE – AN EXAMPLE YearPayment receivedPresent value 130’0.9091= 27,2727 230’0.8264= 24,79 330’0.7513=22,539 430’0.6830=20,49 530’0.6209=18,6276 Net present value 113,7 SEK Payment received less original investment: 113,7-100= 13,7’ SEK. The investment is profitable since the net present value is positive. When we use discount factor

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N ET PRESENT VALUE – AN EXAMPLE When the payments received are of the same size it is possible to calculate: 1 – (1+0,1) -5 = 3,7908 30*3,7908=113 723 SEK 0,10 113,7-100= 13,7 SEK.

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P ROS AND CONS WITH N ET P RESENT V ALUE PROS: + NPV builds the time value of money into calculations + Unlike Payback, NPV takes all of the future projected cash flows into account + NPV is very useful for ranking different projects as it deals in absolute value CONS: - It can be difficult to explain NPV to non-financial managers - There are significant practical difficulties in determining an appropriate discount rate

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E STABLISHING A DISCOUNT RATE Note! The discount rate that is applicable for investment appraisal is likely to be different from the interest rate payable by, for example, banks. Why? Because the interest rate should express the expected return on the investment and compensate for waiting (postponed consumption), lost purchasing power and risk. Note! If there is an alternative use for the funds (alternative investment), the appropriate discount rate must be at least this rate. The cost to borrow capital, the interest rate for the money borrowed in banks (bank rate) + the owners demand on return of the investment = Cost of capital The cost to borrow capital, the interest rate for the money borrowed in banks (bank rate) + the owners demand on return of the investment = Cost of capital

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E XAMPLE - E STABLISHING THE C OST OF C APITAL The bank interest rate is at present 2 per cent. The owner of a company have expressed that they demand 6 per cent return on investments. The company is considering going into the Asian market. An alternative would be to solely go into the Chinese market. The company has calculated with that the latter will yield 10 per cent return. Which is the lowest discount rate the company should calculate with when investigating the decision of going into the Asian market? The appropriate discount rate to calculate with is 10 per cent. In this case calculate with the opportunity cost of investment/ alternative investment.

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I NVESTMENT APPRAISAL IN PRACTICE UK1975198119861992 Payback73%81%92%94% Net Present Value32%39%68%74% UKAll org Small orgLarge org Payback63% 56%55% Net Present Value43% 23%80% Large organizations tent to use more formal capital budgeting techniques. Many organizations use multiple appraisal techniques. Payback is often used for screening.

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