ACCT 5011

Accounting for Management M

Topic 9
Capital Investment Decisions

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 Learning Objectives
1. Understand the features of investment
decisions;
2. Apply accounting rate of return;
3. Apply payback period method;
4. Calculate net present values and
understand the role of discount rate;
5. Apply internal rate of return;
6. Understand some practical issues in
making decisions.

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 Features of investments
 often involve large amounts of resources
 involve risk and uncertainty
 often span long periods of time
 normally require a relatively large cash
outlay
 returns are received over a long period
 are often difficult to reverse
 are made based on available data only

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 Features of investment
 In Nov. 2012, Bunnings announced it would open
12 new stores in NSW during 2013-2015, an
investment involving over $420 million.

 Discuss:
What resources may be involved?
What are potential risks and rewards?
What data Bunnings may have used for such
investment decision?
Can this investment reverse if it is not successful?

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 1. Accounting Rate of Return(ARR)

ARR expresses the average net profit over the

period of the investment as a percentage of the
average investment as shown:
ARR = Average net profit / Average investment

Similar to ROA, but ARR involves expected

values

Note: Average Investment

= Opening + Closing Value/2

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 Decision rule for ARR
Varies between entities;

The ARR which is the highest or is

greater than a required rate of return
(RRR) is usually chosen.

Note: RRR would normally be the cost of

capital or finance for the entity, although
some entities may have arbitrary RRRs
which they have set for various reasons.

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Advantages & Disadvantages of ARR

Advantages:

 simple to calculate
 easy to understand
 consistent with the ROA measure

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Advantages & Disadvantages of ARR
Disadvantages:
 the time value of money is ignored
Therefore, ARR cannot differentiate
between two equally profitable projects but
with unequal timing of the profits.

 the importance of cash is ignored (the

ultimate resource without which businesses
cannot survive)

 Profits and costs may be measured in

different ways for different projects
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 2. Payback Period (PP)
 The payback period is the period of time necessary
to recoup the initial outlay with net cash inflows.
e.g. 1. if an initial investment of $10,000 creates a net
cash inflow of $2,000 per year then we say the payback
period for this investment is 5 years ($10,000/$2,000).
2. if an initial investment of $10,000 creates a net
cash inflow of $4,400 per year then pp is 2.27 years
($10,000/$4,400).
3. if an initial investment of $10,000 creates a net
cash inflow of $2,000, $4,400, $5,000, $8,000 in four
years, then pp is 2.72 years, i.e.
Calculation: 2 years recover ($2,000 + $4,400) =$6,400
remaining is ($10,000-$6,400)/$5,000 = 0.72 year

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 Decision rule for PP
This varies between entities, but most have
maximum periods beyond which they would not
invest.

Obviously the quicker the PP the better!!

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Advantages & Disadvantages of PP
Advantages:
 simple to calculate
 easy to understand
 crude measure of risk in the decision
because projects with high early cash
inflows will have smaller PPs.
Disadvantages:
 time value of money is ignored as it treats
all cash inflows equally
 it ignores all cash inflows after payback has
occurred (so less-profitable short-term
investments may get the nod !)
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 3. Net Present Value (NPV)
 NPV specifically recognises that if you
received $1 sometime in the future from an
investment then it is worth less than if you
received that same $1 now !
 Time value of money. e.g. If you lent $100 to
a friend at the beginning of the year, and your
friend repaid $100 at the end of the year, the
$100 received was worth less because of the
change in prices (e.g. inflation) and
opportunity cost (e.g. interest or other
returns if you invest your $100).

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 NPV
The NPV measure compares the sum of the present
values (PVs) of all of the expected cash inflows,
including scrap value, from the project with the PVs
of the expected cash outflows.

NPV = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 +…+ CFn/(1+r)n – INV

 Where
 CF = the net cash flow at the end of period n
 r= the selected discount rate per period
 n=the number of periods, and
 INV = the initial investment

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 Present value table
Present value of $1.00
years 12% 14% 16%
1 0.893 0.877 0.862
2 0.797 0.769 0.743
3 0.712 0.675 0.641
4 0.636 0.592 0.552

e.g. if you receive $2,000 cash inflow in year 3, and you apply 14% discount
rate, then PV of this $2,000 future cash flow = $2,000x0.675 = $1,350

Present value of a series of $1.00

years 12% 14% 16%
1 0.893 0.877 0.862
2 1.690 1.647 1.605
3 2.402 2.322 2.246
4 3.037 2.914 2.798

e.g. if you receive an annual cash inflow of $2,000 for 3 years, and you apply
14% discount rate, then PV of annual $2,000 future cash flow = $2,000x2.322
= $4,644 (this equals $2000x0.877+ $2,000x0.769 + $2,000x0.675)

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 Decision rule for NPV

Invest in projects that have a

positive NPV (i.e. where the present
value of net cash flows > initial
investment)

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Factors that affect the discount rate r
Inflation
  Invested funds will lose purchasing power
 However, most of time interest rates offered in
financial markets have already incorporated the
inflation effect
Risk
 Investment that involves more risk demand higher
returns
 Therefore, more risky investments have a risk
margin added to interest rate
Opportunity cost
 benefit foregone if the alternative investment is
selected
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The relationship between r and NPV
When the risk or the opportunity cost of an
investment increases, r increases, but NPV
decreases, meaning the NPV result is less likely
to be positive or attractive.

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 Advantages of NPV
NPV takes into account:
 All of the expected cash flows
 Timing of expected cash flows (with cash

flows received sooner given more weight)

 Cash flows only, (so not subject to changing

accounting rules and standards as profit

figures are).
 That the decision rule is explicit, i.e.

positive NPVs will increase business wealth

(assuming data is correct).

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 Disadvantages of NPV
 The method relies on the use of an
appropriate discount factor
 The actual return in terms of the %

investment outlay is not revealed

 Ranking of projects in terms of highest NPVs

may not lead to optimum outcomes

e.g. if projects A, B & C’s initial costs are $60m, $35m,
$25m, and NPV of each project is $2.7m, $1.5m and
$1.3m. The NPV results support project A (highest
NPV), However, project B&C together will have higher
NPV ($1.5m+$1.3m=$2.8m) with same investment
($35m+$25m=$60m)

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4. Internal Rate of Return (IRR)
 The IRR is the rate of return, which discounts
the cash flows of a project so that the PV of
the cash inflows just equals the PV of the cash
outflows, (i.e. the difference between the PV of
the cash inflows and the PV of the cash
outflows is zero).
 i.e. if PV = INV, then r= ? %

CF1 /(1+r) + CF2 /(1+r)2 + CF3 /(1+r)3 + … + CFn /(1+r)n = INV

 With a scientific calculator or the use of

discount tables, solving for r is a trial and
error problem.
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 Decision rule for IRR

Accept projects where the IRR exceeds

the entity’s RRR

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Advantages & disadvantages of IRR
Advantages:
IRR takes into account:
 all of the expected cash flows
 the timing of expected cash flows (and cash flows

received sooner are given higher weight)

 a concept (rate of return) familiar to managers.

Disadvantages:
 Ignores the scale of projects, so it does not

focus on the generation of absolute wealth

 In some cases produces two IRR values (and

sometimes no IRR)
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Investment decisions influenced by
other practical considerations

Decision making is not as simple as inputting

numbers into a calculator and coming up with an
investment decision. There are a number of
other issues that may complicate decision-
making

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Other issues to be considered
 Datacollection – costs and revenues may not
be easy to determine

 Impact of taxation – company tax rate

currently 30%. The impact of tax is to reduce
net cash annual returns by 30%. Also non-cash
costs such as depreciation may complicate the
tax effect.

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Other issues to be considered
 Opportunity costs — the cost of foregoing
benefits that would be available if the
resources had been used for the next best
alternative

 Risklevels — data collected may be

inaccurate or incomplete. External factors
which have been built into the project
analysis may change (unexpectedly): e.g.
suppliers fail to supply materials, legislation
change, resource availability, etc.
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Other issues to be considered
 Obtainingfinance — some investments look
good on paper but may have trouble
attracting finance

 Human resources — will there be employees

or consultants available with the required
skills available when required?

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Other issues to be considered
 retaininggoodwill and future opportunities —
goodwill takes time as does customer loyalty
that assists in a mutually-satisfactory
business deal.

 socialresponsibility — social responsibility

and care of the natural environment is now
becoming more pronounced with investors and
can also affect business decisions (e.g.
pollution responsibilities, saving our forests)

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