ACCOUNTING FOR

MANAGEMENT DECISIONS
WEEK 11
CAPITAL INVESTMENT DECISIONS
READING: TEXT CHAPTER 11
PAGES 548 TO 572

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Learning Objectives
Identify the essential features of investment
decisions
State the four common capital investment appraisal
methods
Demonstrate an understanding of the accounting
rate of return method
Demonstrate an understanding of the payback
method
Demonstrate an understanding of the net present
value method
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Learning Objectives contd

Demonstrate an understanding of the
internal rate of return method
Explain the notion of present values
and identify alternative means of
determining present values
Convert forecast profit flows into cash
flows
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Nature of Investment Decisions

The essential feature of investment decisions is the
time factor
Making an outlay of cash which is expected to yield
economic benefits to the investor at some other point
in time
Investment decisions are of crucial importance for
the following reasons:
Large amounts of resources are often involved, therefore if
mistakes are made, the effect can be catastrophic
It is often difficult and expensive to bail out of an
investment once it has been made
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Methods of Investment Appraisal

There are four main methods used in practice to
evaluate investment opportunities:
1.

accounting rate of return (ARR)

2.

payback period (PP)

3.

net present value (NPV)

4.

internal rate of return (IRR)

Some smaller businesses may use informal methods

such as managers instincts

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Accounting Rate of Return (ARR)

ARR takes the average accounting profit the investment
will generate, and expresses it as a percentage of the
average investment in the project as measured in
accounting terms:
Average annual profit
ARR =
x 100%
Average investment to earn that profit

The calculation requires two figures:

The annual average profit
The average investment for the particular project
Note that this method uses profit not cash

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Accounting Rate of Return contd

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

Accounting Rate of Return contd

Problems with ARR:
ARR uses accounting profit, however over the life of
a project, cash flows matter more than accounting
profits
ARR fails to take into consideration the time value of
money
The ARR method presents averaging difficulties
when considering competing projects of different size

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Payback Period (PP)

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

Payback
Advantages of PP:
Quick and easy to calculate,
emphasises the short term
Disadvantages of PP:
Disregards timing of cash flows,
excludes post payback period cash
flows
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Net Present Value (NPV)

NPV Method:
NPV = PVinflows PVoutflows
Net present Value is the sum of the cash flows
associated with a project, after discounting at an
appropriate rate, reflecting the time value of money
Time value of money - $1 received today is worth
more than $1 received in 10 years time
NPV Decision Rules:
Accept the highest positive NPV, reject all negative
NPVs
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Net present value

Advantages of NPV:
Considers all of the costs and benefits of each investment
opportunity
Makes allowance for the timing of these costs and benefits

Considers the time value of money

Disadvantages of NPV
More difficult to calculate, less easily understood

Does not determine actual rate of return or a relative measure

of return

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

NPV contd - 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
A quicker method is to refer to a table of discount factors
(see appendix at end of chapter 11) for a range of values
of r and n
A discount factor is a rate applied to future cash flows to
derive the present value of those cash flows
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Capital investment decisions

11.1 Self assessment question
Beacon Chemicals Ltd is considering the erection of a new plant to
produce a chemical named X14. the new plants capital cost is
estimated at $100,000 and if its construction is approved now the
plant can be erected and commence production by the end of
2008. $50,000 has alread been spent on research and
development work.
Estimates of revenues and costs arising from the operation of the
new plant appear below:
2009

2010

2011

2012

2013

Sales price ($ per unit)

100

120

120

100

80

Sales volume (units)

800

1,000 1,200

1,000

800

Variable costs ($ per unit)

50

50

40

30

40

Fixed costs ($000)

30

30

30

30

30

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Capital investment decisions

If the new plant is erected, sales of some current products will be
lost and this will result in a loss of contribution of $15,000 per
year over its life.
The accountant has informed you that the fixed costs include
depreciation of 420,000 per annum 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 depreciation, of $8,000
per year, and it would require additional working capital of
$30,000. for the purposes of your initial calculations ignore
taxation.
Required:
a) Deduce the relevant annual cash flows associated with building
and operating the plant.
b) Deduce the payback period
c) Calculate the net present value using a discount rate of 8%

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Capital Investment Decisions

a)Relevant cash flows
2008

2009

2010

2011

2012

2013

Sales

80

120

144

100

64

Loss of
contribution

(15)

(15)

(15)

(15)

(15)

Variable costs

(40)

(50)

(48)

(30)

(32)

Fixed costs

(8)

(8)

(8)

(8)

(8)

Operating cash
flows

17

47

73

47

Working capital

(30)

Capital cost

(100)

Net relevant cash

flows

(130)

30

17

47

73

47

39

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Capital Investment decisions

b) Payback
Initial investment 130
Cumulative cash flows
Year 1
17
Year 2
47 64, 66 remaining
Year 3
77
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.
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Capital investment decisions

c)Net present value
Discount
factor

1.00

.926

.857

.794

.735

.681

Present
Value

(130)

15.74

40.28

57.96

34.55

26.56

Net present
Value

45.09

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Net Present Value (NPV) contd

The discount rate and the cost of capital

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
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
It would also be inappropriate to use different discount
rates for different projects
The overall weighted average cost of capital (WACC)
should be used as the discount rate
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Net Present Value (NPV) contd

Why NPV is superior to ARR and PP
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
The whole of the relevant cash flows - NPV includes
all of the relevant cash flows irrespective of when
they are expected to occur
The objectives of the business - NPV is the only
method in which the output bears directly on the
wealth of the business
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Net Present Value (NPV) contd

Two potential limitations with NPV:
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
Ranking of alternative projects - NPV does not
enable ranking of positive projects and therefore the
best investment strategy may not be determined

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Discounted Payback

Whereas the payback period (PP) method does not

take into consideration the time value of money,
discounted payback compares the initial cost with
the cash inflows after discounting

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Internal Rate of Return (IRR)

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

Internal Rate of Return (IRR) contd

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Some Practical Points

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

Investment Appraisal in Practice

Research shows that businesses tend to use more
than one method to assess each investment decision
NPV and IRR seem to be the more popular methods
used in practice
ARR and PP continue to be popular despite their
shortcomings and the rise of popularity of the DCF
methods
Large businesses tend to use the discounting
methods and apply multiple methods for each
decision

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Investment Appraisal and Planning

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