Week 10-capital investment decisions

Question 1

What is capital budgeting?

Answer 1

How managers plan significant outlays on projects that
have long-term implications such as the purchase of
new equipment and introduction of new products.
• Capital Budgeting decision should be focused on a
firm’s plan to achieve its objectives. E.g. a firm’s
planning to diminish its environmental impact capital
investments in energy infrastructure would be
justifiable than something that negates its long term
strategy

Question 2

Typical Capital Budgeting Decisions (4)

Answer 2

Plant expansion
New Equipment
Equipment replacement
Lease or buy

Question 3

What type of decisions does capital budgeting cover?

Answer 3

Screening decisions. Does a proposed project meet some present standard of acceptance? (may include ethical and quality standards)

 Preference decisions. Selecting from among several competing courses of action.

Question 4

Potential sources for capital investment?

Answer 4

The term capital investment funding implies investment in non-current assets, some of it may be needed for working capital requirements too.

• stock (shares) issue
• regular bank loans
• convertible loan stock

For a new start up: venture capital and angel investors

Question 5

What are the five capital investment appraisal methods?

Answer 5

• payback
• internal rate of return
• discounted payback
• net present value
• accounting rate of return

Question 6

What is the time value of money?

Answer 6

Business investments extend over long periods of
time, so we must recognise the time value of money.
Still you would see later that some methods DO NOT
consider time value of money
• Investments that promise returns earlier in time are
preferable to those that promise returns later in
time.Although it is preferable but not always the
case as we would see later.

Question 7

Present value factor

annuity factor

Answer 7

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Question 8

What is an annuity?

Answer 8

An investment that involves a series of identical cash flows at the end of each year is called an annuity

Question 9

What is the net present vaue method?

Answer 9

1) Calculate the present value of cash inflows,
2) Calculate the present value of cash outflows,
3) Subtract the present value of the outflows from the present value of the inflows.

When positive: Acceptable, since it promises a
return greater than the required rate of return.

When zero: Acceptable, since it promises a return equal to the required rate of return.

When negative: Not acceptable, since it promises a return less than the required rate of return.

Assumptions made:
-All cash flows other than the initial investment occur at the end of a period.
• All cash flows generated by an investment project areimmediately reinvested and the reinvested funds will
yield a rate of return equal to the discount rate.

Question 10

What are typical cashflows?

Answer 10

• repairs and maintenance
• working capital (If the working capital goes up during the life of the investment then there must have been a cash outflow in the period)
• initial investment
• incremental operating costs

Question 11

What are typical cash infloes?

Answer 11

• salvage value
• reduction of costs
• incremental revenues
• release of working capital

Question 12

What are the factors that influence the required return by investors from a project?

Answer 12

• interest foregone
• inflation
• risk premium

Question 13

What are the advantages and disadvantages of NPV?

Answer 13

Advantages
Theoretically the NPV method of investment appraisal is superior to all others. This is because it:
• considers the time value of money
• is an absolute measure of return
• is based on cash flows not profits
• considers the whole life of the project
• should lead to maximisation of shareholder wealth.

Disadvantages
• It requires knowledge of the cost of capital
• It is relatively complex (compared to e.g. payback period or accounting rate of return).

Question 14

What is the internal rate of return?

Answer 14

The internal rate of return is computed by finding the
discount rate that will cause the net present value of a
project to be zero.

If the internal rate of return is equal to or greater
than the company’s required rate of return, the
project is acceptable.

The higher the internal rate of return, the more desirable the project will be.

If future cashflows are the same every year: PV factor for IRR= investment required/ net annual cash flow (then check what % corresponds to that number)

Question 15

What are the problems with IRR?

Answer 15

Technical problems with the mathematics of IRR in some
circumstances mean that it can give misleading signals (and even multiple or no signals). IRR may have multiple values if positive cash flows are followed by negative ones, and then by positive ones again.

• If there are multiple values for IRR, we do not know which value to compare with hurdle rate.
• Size of investment is ignored like in some other methods e.g. ARR 3% on £1m gives a bigger NPV (= £30,000) than 5% on £100,000 (= £5,000))

Question 16

NPV or IRR?

Answer 16

Where independent projects have positive NPV, and
therefore IRR above the cost of capital, they are
acceptable on the assumption that capital markets
are functioning well and liquidity is unlikely to be a
problem. Acceptance should maximise the stock
market wealth of shareholders.

• NPV is the criterion aligned with finance theory in
good capital markets, and on technical grounds it
gives the correct signal for investments of all sizes, as
independent NPVs are additive measures of
shareholder value creation.

Where independent projects have positive NPV, and
therefore IRR above the cost of capital, they are
acceptable on the assumption that capital markets
are functioning well and liquidity is unlikely to be a
problem. Acceptance should maximise the stock
market wealth of shareholders.

• NPV is the criterion aligned with finance theory in
good capital markets, and on technical grounds it
gives the correct signal for investments of all sizes, as
independent NPVs are additive measures of
shareholder value creation.

Question 17

Least cost decision

Answer 17

In decisions where revenues are not directly involved,
managers should choose the alternative that has the least total
cost from a present value perspective.

Question 18

Accounting Rate of Return

Answer 18

ARR is a simple rate of how much profit
can be made on average, out of an
investment outlay

see FM sheet

ARR takes the average accounting operating profit that the investment will generate and expresses it as a percentage of the average investment made over the life of the project

• In calculating the annual operating profit we need to
deduct the annual depreciation charge from the annual cash flow

• The estimated residual value for the asset of investment at the end of its useful life is part of capital employed hence we need to add it to the initial investment cost
when computing the average capital employed

Decision rule
– Must be more than the target ARR for the company
(normally>Cost of capital)

– Among competing projects one with highest ARR is considered more desirable

– ROCE serves as a good benchmark on ARR for the
company/industry

Question 19

What are the advantages of ARR?

Answer 19

-Seems logical and a consistent method of measuring business performance e.g. used internally in comparing divisions (as ‘ROI’).

• May be important to consider as ARRs are also used by external users of the company’s published
accounts (e.g. as ‘ROCE’)

• ARR provides a percentage return which can be compared with a target return

• Focuses on profitability – an important consideration
for shareholders

• Relatively easy to understand and compute
• Draws attention to the notion of overall profit

Question 20

Disadvantages of ARR?

Answer 20

-Completely ignores the length of time during which the investment outlay is recovered

• It depends on the depreciation policy (and other accounting policies)
adopted (prone to manipulation?).

• It also ignores the Time Value of Money i.e. ignores that £1 received
now is preferable to £1 received in five years.

• Does not take into account cash flows – only profits (they may not
be the same thing)

• Treats profits arising late in the project in the same way as those
which might arise early, especially when calculating average ARR

Question 21

Payback period

Answer 21

Measures the length of time for capital investment recovery

Attempts to estimate the length of time it would
take before the initial project’s outlay is paid back
in cash.

Those projects which repay (recoup) the original
investment the earliest are deemed most
favourable and economically more attractive for
investment

Payback measures the rate of recovery in terms
of net cash flows.

Decision rule:

Payback period for an investment should be
shorter than minimum payback period set by the
company.

Among competing projects one with the shortest
payback period is considered more desirable

-Helps manage liquidity constraints which may be
especially important for small businesses that have
difficulty in accessing finance (exacerbated by GFC and banks’ continuing reluctance to lend….)

• ‘Cash is king’

• But danger of ignoring valuable potential cash flows after
payback period……

Question 22

Payback period advantages

Answer 22

Advantages

• it is useful when the technology is changing rapidly and
returns are needed quicker before demand of the product
recedes.
• it focuses on quick returns and minimising risk.
• it uses cash flows, not accounting profit.
• An easily understood technique
• Suitable for a business that is short on liquidity

Question 23

Payback period disadvantages?

Answer 23

Disadvantages:

• it ignores returns after the payback period
• it ignores the timings of the cash flows. This can
be resolved using the discounted payback
period.
• Ignores profit.
• It does not separate the projects that pay back
significant amount earlier from the other
projects that have similar payback period i.e.
Time value of money is ignored
• Maximum acceptable payback period could be
an arbitrary and subjective figure.

Question 24

Investment appraisal in practice?

Answer 24

• businesses tend to use more than one method
• NPV and IRR have become increasingly popular
• continued popularity of the PP and ARR methods
• larger businesses rely more heavily on NPV and IRR than smaller businesses

Question 25

Two alternative projects have their NPV quite
small in an uncertain climate. What would you
be assessing/doing as the management
accountant?

Answer 25

In such case even small errors in the estimates could change the recommended
decision.

Alternative technical approaches to allowing for uncertainty include:
calculating probability weighted expected cash flows and doing ‘sensitivity
analysis’ to estimate the robustness of the results to changes in the estimates
(e.g. the IRR calculation shows by how far the cost of capital could rise before
the NPV becomes negative—not much here; a ‘PV’ payback could show how much the useful life of each machine could fall before its NPV becomes
negative).

However sensitivity analysis only varies one assumption at a time.

Allowing for multiple or interacting variations requires more complex ‘scenario
building’ or probabilistic ‘Monte Carlo simulation’.