SESSION 03 – INVESTMENT DECISIONS OVERVIEW Objective To understand the type of investment decisions that will be made by organisations To assess an investment using the payback period and the ARR methods INVESTMENTS TYPES OF EXPENDITURE EVALUATION Capital Revenue Investment decisions PAYBACK PERIOD Definition Possible Improvements Advantages Disadvantages ACCOUNTING RATE OF RETURN Definition Calculation Advantages Disadvantages 0301 SESSION 03 – INVESTMENT DECISIONS TYPES OF EXPENDITURE 1.1 Capital Capital expenditure (CAPEX) refers to the purchase of non-current (fixed) assets or their improvement; 1.2 Revenue Revenue expenditure is incurred to maintain non-current assets e.g repairs 1.3 Investment decisions Decisions about which non-current assets should be acquired Also referred to as project appraisal, investment appraisal or CAPEX analysis PAYBACK PERIOD 2.1 Definition The time it takes for the operating cash flows from a project to pay back the initial investment Decision rule If payback period < target ACCEPT If payback period > target REJECT Illustration Investment $1.4m Annual cash flows (before depreciation but after tax) $0.3m Project life 10 yrs Solution 1.4 = 4.7 years 0.3 (or five years if cash flows are assumed to arise at year ends.) Payback period = 0302 SESSION 03 – INVESTMENT DECISIONS 2.2 Possible Improvements 2.2.1 Discounted payback period First discount the cash flows to present value and then calculate the payback period This takes into account the time value of money 2.2.2 Bail-out factor This takes into account the estimated scrap/disposal value of the asset if the project is abandoned early 2.3 Advantages of payback Simple to calculate Easy to understand Concentrates on earlier flows: more certain; more important if firm has liquidity concerns 2.4 Disadvantages of payback Ignores cash flows after payback period; Target period is subjective; Gives little information about change in shareholder wealth Unless flows are discounted, time value of money is ignored ACCOUNTING RATE OF RETURN (ARR) 3.1 Definition The earnings of a project expressed as a percentage of the capital outlay or average investment Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI) 3.2 Calculation This is a financial accounting measure based on the income statement and statement of financial position It includes: Sunk costs (money already spent); Net book values of assets; Depreciation and amortisation ; Allocated fixed overheads 0303 SESSION 03 – INVESTMENT DECISIONS Calculated as Average annual operating profit × 100 Initial investment OR Average annual operating profit × 100 Average investment Decision rule If ARR > target ACCEPT If ARR < target REJECT Example Initial investment Scrap value Operating cash flows: Year Year Year Year Required: Calculate ARR on (i) Initial investment (ii) Average investment 0304 $200m $20m $100m $50m $50m $50m SESSION 03 – INVESTMENT DECISIONS 3.3 Advantages Uses readily available accounting information; Simple to calculate and understand; Often used by financial analysts to appraise performance 3.4 Disadvantages Different methods of calculation may cause confusion; Based on profits rather than cash Profits are easily manipulated by accounting policy Ignores time value of money; Target rate is subjective; A relative measure (%) – gives little information about the absolute change in shareholders’ wealth Example A project being considered would require a machine costing $80,000 Market research of $8,000 has already been carried out and has been capitalised The result is that the project is expected to last for six years and produce net cash earnings of $20,000 for each of the first three years and then $15,000 for each of the last three years The anticipated scrap proceeds of the machine at various stages in its life are as follows: After year After year After year After year After year After year $40,000 $30,000 $20,000 $13,000 $10,000 $4,000 Required: Evaluate the project using (a) (b) (c) (d) ARR ARR using the average investment approach payback period payback period incorporating the bail-out factor You may assume that cash flows arise evenly during the year 0305 SESSION 03 – INVESTMENT DECISIONS Solution (a) (b) (c)/ (d) 0306 Time Flow Cumulative flow Scrap (88,000) 20,000 40,000 20,000 30,000 20,000 20,000 15,000 13,000 15,000 10,000 15,000 4,000 Payback period = Payback period with bail-out = Net cumulative flow SESSION 03 – INVESTMENT DECISIONS Key points Payback and ARR are commonly used in practice However neither method informs management of the absolute change in shareholders’ wealth due to a particular project As well as being able to calculate payback and ARR it is therefore vital that you can also explain why they are not acceptable methods of project appraisal FOCUS You should now be able to: define and distinguish between capital and revenue expenditure; calculate payback and assess its usefulness as a measure of investment worth; calculate ARR and assess its usefulness as a measure of investment worth EXAMPLE SOLUTIONS Solution Average annual profit Total cash flows − Total depreciation 250 − 180 = 17.5 = No of project years Average investment Initial investment + Scrap value ARR on initial investment = 200 + 20 = 110 17.5 × 100 = 8.75% 200 ARR on average investment 17.5 × 100 = 15.91% 110 0307 SESSION 03 – INVESTMENT DECISIONS Solution — ARR and Payback (a) (b) ARR Average annual earnings = (3 × 20,000 + × 15,000) = $17,500 Average annual depreciation = 80,000 + 8,000 − ,000 = $14,000 ARR = 17,500 − 14 ,000 = 4% 88 ,000 Average investment = 88,000 + ,000 = $46,000 ARR = 17,500 − 14 ,000 = 7.6% 46 ,000 (c)/ (d) 0308 Time Flow (88,000) 20,000 20,000 20,000 15,000 15,000 15,000 Cumulative flow (88,000) (68,000) (48,000) (28,000) (13,000) 2,000 17,000 Scrap 40,000 30,000 20,000 13,000 10,000 4,000 Payback period 13 = 15 years Payback period with bail-out = years Net cumulative flow (88,000) (28,000) (18,000) (8,000) − 12,000 21,000 ... (ROCE) or Return on Investment (ROI) 3.2 Calculation This is a financial accounting measure based on the income statement and statement of financial position It includes: Sunk costs (money already... Uses readily available accounting information; Simple to calculate and understand; Often used by financial analysts to appraise performance 3.4 Disadvantages Different methods of calculation may... DECISIONS Key points Payback and ARR are commonly used in practice However neither method informs management of the absolute change in shareholders’ wealth due to a particular project As well as