You are on page 1of 10

Managing Finance (MNGFIN)

Week 6: Making capital investment decisions


Learning objectives for Week 6
This week you will learn about the following topics:

Accounting rate of return (ARR) and payback period (PP) Net present value (NPV) and internal rate of return (IRR) Appraisal methods in practice Dealing with risk Managing investment projects

Introduction
This week you will be introduced to various methods for evaluating projects and investments. You will examine the accounting rate of return and the payback period, two traditional methods for analysing the profitability of investment decisions. You will also learn about two contemporary methods: net present value and internal rate of return. These two methods are more widely used and accepted, as they overcome the limitations inherent in traditional methods. Finally, you will explore how managers analyse risk and manage investment projects. The recorded lecture begins by examining the accounting rate of return and payback period. The week concludes with a discussion of managing investment projects. You can play each section as many times as you like and also read the text version. The textbook readings and journal article cover the key learning objectives at a reasonably challenging level. The PowerPoint slides at the end provide useful diagrams and summaries to help you review the main points you have covered during the week. For the Assessment, you will discuss a question online. There is no Hand-in Assignment this week, but you should begin working on an outline in preparation for writing your Final Project.

Reading
The journal article prescribed for this week is required reading and can be found in the online library at the University of Liverpool: Langfield-Smith, K. (2008) Strategic management accounting: how far have we come in 25 years?, Accounting, Auditing and Accountability Journal, 21 (2), pp. 204228, Emerald Management Xtra 95 [Online]. DOI: 10.1108/09513570810854400 (Accessed 30 June 2009). Textbook Atrill, P. & McLaney, E. (2009) Management accounting for decision makers. 6th ed. Harlow, England: Financial Times/Prentice Hall. (Please note that the references to these readings can be found in the Lecture Notes text under the headings of the topics to which they relate.) Accounting rate of return (ARR) and payback period (PP)

Pages 257269 in Chapter 8 analyse the use of the accounting rate of return and the payback period methods for evaluating investment projects. These traditional methods are simple in nature; however, they have limitations that must be properly understood and addressed. Net present value (NPV) and internal rate of return (IRR)

Pages 269283 in Chapter 8 describe how to compute and use net present value as a capital investment decision criteria. This method incorporates important elementssuch as timing of cash flows, interest rate, and inflationthat have significant impact on the decisions regarding the viability of projects. This reading also explores how to compute the internal rate of return (IRR) and describes how this rate can be used to make investment decisions. Appraisal methods in practice

Pages 283291 in Chapter 8 explore the trends in use of capital investment decision methods. You will find that contemporary methods, such as NPV and IRR, are more widely used; however, many organisations still use the traditional methodsnamely, ARR and PPbecause of their simplicity. Dealing with risk

Pages 291303 in Chapter 8 examine how managers evaluate the risk involved with projects by using sensitivity analysis and the concept of expected NPV. Managing investment projects

Pages 303308 in Chapter 9 discuss the stages involved with managing projects. Evaluating the profitability of projects is only one step, but it is also vital to further screen projects for quality and monitor them throughout their useful life.

Individual Project For this module, you are required to complete a course project that reveals mastery in application of the management accounting concepts and finance emphasised in the course. This involves reporting on a specific organisation within an industry and the management accounting and finance practices that affect the value of the chosen firm or industry. This project should be a formal business report that provides both specific processes and strategies involving budgeting, costing, capital decision making, capital acquisition, and cost of capital structure of the chosen firm. These processes and strategies are to be supported with management accounting concepts. For this project, you will select a company that you are familiar with or work for. This week you will continue to work on your Final Project for this module. Prepare an annotated outline of your Final Project, briefly indicating the content you plan to include in each section of the report and the concepts and techniques you plan to apply for analysing any data and developing your argument. This is due to be handed in next week. The outline should not include detailed sections of the Final Project. Instead, it should be a specific and crisp overview of the contents that will comprise the final report, which will provide a detailed account of the five tasks listed below. Remember that the tasks required for the Final Project are to: 1. Assess the budgeting process and procedures for the organisation with regards to preparation techniques, uses for evaluation, differences between business units/divisions, etc. 2. Analyse how the organisation collects, stores, and prepares management accounting information, particularly the use of a management accounting system (MAS) and how information is disseminated throughout the organisation. 3. Evaluate the costing process and procedures of the organisation with respect to method or approach utilised. 4. Assess the capital decision making process within the organisation with regards to what methods are utilised, how such methods are chosen, how projects are selected and managed, and what measures are employed to evaluate performance. 5. Evaluate the criteria or mechanisms used by the organisation for deciding how best to acquire capital and analyse the capital structure of the company. The annotated outline should address each of the tasks listed above. You need to briefly describe what information you will include in each section of the report that will satisfy these requirements. The work that will be carried out in the outline should

represent a higher-level view than the contents of the Final Project. As such, you must remain at this level to avoid reusing the same wording in the final document. There is NO submission this week.

Accounting rate of return (ARR) and payback period (PP) Textbook reading (Atrill & McLaney: Ch. 8, pp. 257269) With the goal of maximising wealth to shareholders, management in general and financial managers in particular have a substantial responsibility in determining what courses of action an organisation will undertake. Compounding the complexity of this responsibility is the likelihood that companies will be faced with various options and decisions in terms of the projects that may be pursued. The focus for this week is the examination of techniques that help financial managers analyse and evaluate such possibilities, allowing them to discern which projects will increase wealth and which will not, as well as the priority that each project should receive. In order to properly address these investment appraisal decisions, you will focus on two traditional evaluation methods: the accounting rate of return (ARR) and the payback period (PP). One of the more traditional methods of evaluating capital investment decisions is the ARR, which expresses the average accounting profit generated by an investment as a percentage of the average investment made to earn that profit over the life of the project. To better understand how the ARR is computed and utilised, carefully examine the formula (p. 248) and example (Activity 8.2) that are provided in your reading. While the computation for the ARR is rather straightforward, it is important to understand what the final percentage provides for the financial manager. The percentage derived indicates how much the potential investment will increase or return to the organisation in terms of accounting profit. For example, in Activity 8.2, the investment decision in question would have an ARR of 11.1%, meaning that the accounting profit expected is approximately 11% more than it costs to invest in the project. Does this mean the company should pursue the project? It is impossible to tell from the information provided, because each organisation will have different percentage thresholds with regards to ARR that will support any decision to pursue the investment. The target ARR set by an organisation is the minimum rate that an investment must return before it can be deemed as acceptable, and this rate will vary depending on the specific requirements for each organisation. While the ARR is rather simple to use, it has some serious shortcomings that may hinder its widespread use. First, when expressing values in percentage form, the total amounts are ignored. So a project with a higher ARR than another may seem like the better choice, but such a project may actually create a substantially lower amount of wealth for the organisation. Also, using the ARR to compare projects falls short with regards to the timing of profits because it is only based on the accounting profit rather than cash flows. Two projects may be comparable with regards to the ARR, yet one project may return more profit in early years while the other returns a larger amount in later years. Another traditionaland rather simplemethod for evaluating capital investment decisions is the payback period (PP). By determining the length of time that it will

take the original investment to be repaid, use of the PP helps to make up for one of the limitations of the ARR. Two projects that have comparable ARRs can be further examined by the PP method to determine which one will repay its investment sooner. The project with a smaller payback period would be deemed to be more attractive, as the costs will be recouped more quickly. This tool helps to incorporate the timing of cash flows between projects. As with the ARR, an organisation must have an acceptable threshold against which to compare the calculated PP. Although the PP method helps to account for some timing of cash flows, it still ignores the overall profitability of projects, thus limiting its use. Simply using the PP as the sole criterion could possibly eliminate projects that would create more wealth than others or those that would return a higher percentage. As you make your way through this section, you will become better acquainted with the limitations of both ARR and PP and find that these two methods are best used in tandem. However, even when using both methods, there are still limitations, as neither accounts for risk, interest, or inflation. In the next topic, you will examine two contemporary methods for analysing capital investment decisions.

Net present value (NPV) and internal rate of return (IRR) Textbook reading (Atrill & McLaney: Ch. 8, pp. 269283) While the ARR is helpful, it stops short of fully evaluating the profitability and suitability of a project from a financial perspective. Financial managers are not only concerned with accounting profits, as the ARR utilises, but also cash flows that result from projects. It is these cash flows that are used to cover costs and pay back investors. The two evaluation methods discussed in the previous section fail to incorporate the time value of money; as you well know, money received today is worth more than the same amount received at some time in the future. The use of net present value (NPV) incorporates the dimensions and timing of cash flow, as well as inflation and risk, and has become one of the most widely used and acceptable techniques for evaluating capital investment decisions. To best understand the concept of NPV, you should pay careful attention to the methods of calculating the present values of cash flows and examples provided in the reading. As you will see, this technique reduces, or discounts, the cash flows for each time period based on some rate of interest, known as the opportunity investment rate. This calculation is necessary to perform because it is possible to invest a certain amount of money with a financial institution and receive a return in subsequent time periods. By discounting the cash flows for each time period, it is possible to determine the amount of investment that would be presently required to achieve a future return. Once a present value for each time period has been determined, these amounts are then summed and compared to the total investment required for the project. To be acceptable, the project must show that the sum of the amounts is greater than amount of initial investment. The difference that is thus

calculated is the NPV of the investment. A positive NPV means that the project returns are better than those of the financial institution for the same investment, and, as such, the decision to undertake the project is the correct decision. A negative NPV depicts the opposite scenario. An important variable within the NPV evaluation method is the rate of interest used to discount the cash flows. (Note: Discounting tables are available in your text in Appendix E that can be used to calculate the present values of cash flows, for a series of different interest rates.) We can deduce that when the NPV of a project is positive, the rate of return for the project is higher than the interest rate used in the calculation. What interest rate to use in the calculation is an important consideration for the organisation, as this rate sets a minimum value that projects must return. As noted above, it is possible to place an investment with a financial institution and receive a return on the investment. So, it is important that the interest rate used in the NPV calculation at least incorporates the interest rate that can be achieved through safer investments, such as banks or government securities. However, organisations would desire a higher rate of return than those just mentioned, in part to account for the risk involved with undertaking projects and also to account for inflation. Therefore, the interest rate used to discount the cash flows generated by the project would most likely incorporate a premium for risk and inflation, known as the risk premium. Organisations are also able to adjust this risk premium for different projects based on the amount of risk perceived. The rate most often used in NPV computation is the cost of capital for the organisation. This represents the average cost of acquiring funds, either through issuing bonds or stock. While you will examine the cost of capital later in this module, it is important to realise that it is this cost, represented as a rate of interest, which must be considered when evaluating projects. In determining the interest rate to be used when calculating the NPV, you may begin to see how this rate is being developed as the minimum rate of return that is acceptable for a project. For example, if a company uses 20% as the interest rate for its NPV calculations and the NPV of the project is exactly 0.00, we are able to determine that the rate of return for the project is also 20%. Thus, the project meets the threshold and can be considered acceptable. However, the organisation may desire that projects not only have a positive NPV, but also meet a predetermined rate of return, such as the internal rate of return (IRR). More specifically, IRR is the interest rate that would create indifference between making an investment or not; this metric is calculated for a value of the NPV equal to zero.The IRR is determined by backing into it through an examination of NPV. As you will see, and as the authors state, this process can be very time consuming if completed by hand, so the use of computer software is often employed. This process is accomplished by calculating the NPV of projects using different rates and eliminating them until one gives an NPV equal to zero. For evaluation purposes, the IRR serves both as a threshold rate for individual projects and as a comparison rate

between projects. However, IRR does very little for evaluating wealth generation, making NPV a superior measure. The examples provided throughout this reading will help to illustrate how each method is computed as well as how each is used for evaluation. Appraisal methods in practice Textbook reading (Atrill & McLaney: Ch. 8, pp. 283291) Now that you have examined some of the techniques used for analysing capital investment decisions, it is important to consider their actual use in the current business environment. After reviewing the advantages and disadvantages of each method, it would be easy to assume that most organisations would choose to utilise the NPV and IRR methods as their primary evaluators of projects. However, as the statistics show, many organisations still rely on the traditional ARR and PP methods. Quite simply, these methods are less complex in terms of calculating, but that does not make them less useful. The PP method, even in spite of its limitations, is still very popular due to its simplicity. The trends also show that organisations are utilising combinations of these techniques more often, rather than relying on one entirely. Nevertheless, the NPV and IRR methods have become the most popular ones utilised by many CFOs, as these techniques provide a greater amount of useful information for making investment decisions, and they account for such variables as the timing of cash flows, risk, and inflation. The reading examines the real-world use of the methods covered as well as some practical considerations that must be recalled when evaluating investment decisions. Dealing with risk Textbook reading (Atrill & McLaney: Ch. 8, pp. 291303) In computing NPV, organisations are able to account for some risk by adding a risk premium onto the interest rate used to discount the cash flows. As projects differ, different risk premiums can be used. However, this method still falls short of accounting for and dealing with the risk involved with projects. NPV is still based on projections of cash flows, sales revenues, cost savings, etc., which are likely to vary to some degree. Also, projects often span a considerable amount of time, which increases the likelihood of inaccurate cash flows (especially those closer to long term) as well as adverse conditions that might impact the project as a whole. One method that financial managers use to help analyse the risk involved with a project is sensitivity analysis. This technique requires a careful examination of the key variables affecting the project, such as sales volume, sales price, operating costs, initial outlay, financing costs, and project life. Each variable is examined to see how changes to it might ultimately affect the viability of the project. Example 8.3 in your reading demonstrates how such analysis is conducted. While this technique is

insightful, it does have its limitations. It takes advanced methods, such as linear programmingwhich are beyond the scope of this moduleto permit a simultaneous sensitivity analysis to be performed. Also, it leaves decision making subjective, as no clear decision rules are present. Another method for analysing risk is to develop an expected NPV of a project with the use of probabilities, which act as weights. Cash flows for each period are adjusted by the probability of that amount actually occurring; expected present value for each period is discounted using the chosen discount rate. The sum of the discounted expected values of cash flows will be the expected NPV. While the decision-making criteria are the same, a positive expected NPV indicates a viable project. This alternative method, which includes the notion of uncertainty associated with each option or alternativeand as such uses probabilities to gauge the value of the expected cash flowsmust be used with caution. The calculation risk involved with the use of this method stems from the determination of the probabilities. These are, for most cases, subjective assessments of the likelihood that each of the options will occur. The assessments, albeit subjective, are functions of the experience level of the managers involved in the investment decision. Carefully review the examples provided in the reading to better understand how expected NPV is derived as well as its limitations. Managing investment projects Textbook reading (Atrill & McLaney: Ch. 9, pp. 303308) Even with the use of appropriate evaluation methods, such as NPV and IRR, organisations and financial managers still have much to consider with regards to choosing and managing investment projects. Managers must consider the amount of investment funds that are available to them as well as the source of these funds. Determining the most viable projects is an exercise in futility if the amount of funds available is unknown. Managers will know how best to allocate the funds once the most profitable projects have been identified. The reading for this topic outlines the five stages of managing investment projects and discusses important considerations at each stage. We have already mentioned two of these stages, determination of investment funds available and identification of profitable projects. After these stages comes a more thorough evaluation of the selected projects that helps to determine the quality of each proposal and the ability of the managers who will be in charge. After projects have been approved, it is vital that they be continually monitored through consistent and timely reporting, which will help managers to detect any variations. This enables the project to be better controlled while providing managers the opportunity to develop corrective courses of action if needed.