1 Capital Investment Appraisal February 20 th 2007

2 Learning Objectives To understand the nature and importance of investment decision-making in organisations To understand the concept of the time value of money and how to calculate discount factors To identify the four investment appraisal methods and how to evaluate investment proposals using these methods *** To summarise advantages and disadvantages of these methods both in theory and practice To make recommendations based on your analyses

3 Recommended Readings Drury C (2001) Management Accounting for Business Decisions 2nd Edition. Thomson. (Chapter 9) Gowthorpe C (2003) Business Accounting and Finance for Non-Specialists. Thomson. (Chapter 21) McLaney E and Atrill P (2002) Accounting: An Introduction, 2nd edition. Prentice Hall: Europe. (Chapter 14) Cashmore C (2002) Cut to the Chase, CIMA Insider, September. Dugdale D & Jones C (1991) Discordant voices: accountants views of investment appraisal Management Accounting, November. Dugdale D (1992) Is there a correct method of investment appraisal? Management Accounting, May. Scarlett B (2002) That Sinking Feeling, CIMA Insider, September.

4 Nature & Importance Nature –Long-term rather than short-term –Large investment rather than small investment –More complicated from concerns of future cash flows and/or time value of money Importance –Large amounts of resources are often involved: business strategy, profitability, and survive –Difficult to bail out, once an investment made –Close relationship with shareholders: wealth maximisation

5 Methods of Investment Appraisal Payback period –The length of time: cash proceeds recover the initial capital expenditure Accounting Rate of Return (ARR) –A return measurement by using average annual profits Net Present Value (NPV) –The present value of the net cash inflows less the initial investment Internal Rate of Return (IRR) –A return measurement takes into account the time value of money

6 Example There are two optional projects for your company to choose. However, you can only choose one of them. The data for the initial investments are in the following table. You are required to calculate: –Payback period –ARR –NPV –IRR, and –Your recommendation

7 Data for the Projects Project AProject B Initial investment£100,000 Cash inflows Year 1£45,000£30,000 Year 2£40,000£30,000 Year 3£35,000£44,000 Year 4£30,000£46,000 The depreciation is £20,000 per year. The residual value for both projects is the same, £20,000.

8 Payback Period The Payback period = the point in time at which cash flows turn from negative to positive Project ACash flowsCumulated cash flow Year 0-100,000 Year 145,000-55,000 Year 240,000-15,000 Year 335,000+20,000 Year 450,000+70,000

9 Payback Period Payback period (A) = change in cash flow required to reach zero/total cash flow in year =15,000/35,000 = years = 2.43 years Payback period (B) = 40,000/44,000 = years = 2.91 years Which project is the better one based on payback period?

10 Payback Period Project BCash flowsCumulated cash flow Year 0-100,000 Year 130,000-70,000 Year 230,000-40,000 Year 344,000+4,000 Year 466,000+70,000

11 ARR Step 1: calculate annual profit –Annual profit = net cash inflow - depreciation Step 2: calculate average profit –Average profit = total profits / number of years Step 3: calculate average capital invested –Average capital invested = (initial cost + residual value) /2 Step 4: calculate ARR –ARR = average profit/average capital invested x 100

12 ARR Project A –Average profit = (25, , , ,000)/4 = 70,000/4 = 17,500 –Average capital invested = (100,000+20,000) /2 = 60,000 –ARR = 17,500/60,000 x 100 = 29% Project B –Average profit = (10, , , ,000)/4 = 17,500 –Average capital invested = (100, ,000)/2 = 60,000 –ARR = 17,500/60,000 x 100 = 29% Which project is the better one?

13 The Time Value of Money What a difference between £1 now and £1 in a years time? Factors change the value of money –Interest cost –Inflation –Other risks to materialise the money For example: the annual interest rate is 10%, I lend you £1 now and will get back after 1 year, how much worth of that £1 in a years time? –? x (1+10%) = £1 –? = £ % is called cost of capital; ? is called the discount factor

14 NPV Assume that your companys cost of capital is 10% Discount factors at 10% are: –Year –Year –Year –Year

15 NPV Project ACash flowDiscount factorDis.d cash flow Year 0-100, (100,000) Year 145, ,905 Year 240, ,040 Year 335, ,285 Year 450, ,150 NPV£34,380

16 NPV Project BCash flowDiscount factorDis.d cash flow Year 0-100, (100,000) Year 130, ,270 Year 230, ,780 Year 344, ,044 Year 466, ,078 NPV£30,172 Which project is the better one based on NPV?

17 IRR IRR: the discount rate when the net present value is zero Project A –NPV = £34,380 when the discount rate is 10% –NPV = ? When the discount rate is 25% Project ACash flowDiscount factorDis.d cash flow Year 0-100, (100,000) Year 145, ,000 Year 240, ,600 Year 335, ,920 Year 450, ,500 NPV£20

18 IRR Project B –NPV = £30,172 when the discount rate is 10% –NPV = ? When the discount rate is 25% Project BCash flowDiscount factorDis.d cash flow Year 0-100, (100,000) Year 130, ,000 Year 230, ,200 Year 344, ,258 Year 466, ,060 NPV-7,482

19 IRR Project A: IRR = 25% Project B –Total change in NPV = 30, ,482 = 37,654 –Total change in discount rate = 25% - 10% = 15% –IRR = 10% + 30,172/37,654 x15 = 22% Which project is better?

20 Project Selection MethodsSingle projectChoice of projectsA or B? Paybackless than the target period Shortest payback period A ARRAbove the target rate With the highest ARR N/A NPVA positive NPVWith the highest NPV A IRRHigher than the target rate (cost of capital) With the highest IRRA

21 Advantages & Disadvantages MethodAdvantagesDisadvantages Payback simple and easy to understand and use objective – using cash flows liquidity – commercially realistic cautious & risk averse – ignores later cash flows ignores the time value of money ignores cash flows after the payback period ARR simple and easy to understand and use aids internal and external comparisons looks at the whole life of the project A useful tool to measure divisional managerial performance subjective – profit, not cash flows ignores the time value of money difficulty in use when with same ARR and various project sizes

22 Advantages & Disadvantages MethodAdvantagesDisadvantages NPV takes account of the time value of money concerns of shareholder wealth takes account of risk looks at the whole life of the project difficult to be understood by managers adverse effects on accounting profits in the short run how to choose discount rate? IRR takes account of the time value of money easy to be understood by managers difficult to use in choosing projects of varying sizes difficult to choose when have the same IRR

23 Tips of Exam Question How to use four methods based on examples How to interpret and compare your calculations How to select the best choice How to distinguish advantages and disadvantages of four methods