Making Capital Investment Decisions

Slide 10.
IS5303 Finance Management

(GE)
Saman Rasaputhra
Director
KPMG
srasaputhra@kpmg.com
samanrasaputhrauoc@gmail.com
+ 94 77 727 6433, + 94 77 003 1731
1
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Slide 10.2
Part Three
FINANCE
Chapter 10
MAKING CAPITAL
INVESTMENT DECISIONS
Slide 10.3
LEARNING OUTCOMES
You should be able to:
Explain the nature and importance of investment decision

making
Identify and discuss the four main investment appraisal

methods found in practice
Discuss the strengths and weaknesses of various techniques for

dealing with risk in investment appraisal
Explain the methods used to monitor and control investment

projects
Slide 10.4
The nature of investment

decisions
• The essential feature of investment decisions is
time. Investment involves making an outlay of
something of economic value, usually cash, at
one point in time, which is expected to yield
economic benefits to the investor at some other
point in time.
• Usually, the outlay precedes the benefits. Also,
the outlay is typically one large amount and the
benefits arrive as a series of smaller amounts
over a fairly protracted period.
Slide 10.5
The nature of investment decisions
Large amounts of resources are

often involved
It is often difficult and/or expensive to bail out of

an investment once undertaken
Slide 10.6
The scale of investment by UK businesses

Business Expenditure on additional non-current (fixed)
assets as a percentage of:
Annual sales End-of-year

revenue non-current assets
British Sky Broadcasting plc 9.0 17.8
Ryanair Holdings plc 6.4 6.0
Go-Ahead Group plc 2.3 10.6
J D Wetherspoon plc 7.9 10.2
Marks and Spencer plc 8.3 13.2
Severn Trent Water Ltd 24.4 6.3
Vodafone plc 32.4 12.0
Wm Morrison Supermarkets plc 5.6 11.1
Source: Annual reports of the businesses concerned for the financial years ending in 2013
Slide 10.7
Slide 10.8
Methods of investment
appraisal
• Given the importance of investment
decisions to investors, it is essential that
proper screening of investment proposals
takes place. An important part of this
screening process is to ensure that the
business uses appropriate methods of
evaluation.
Slide 10.9
Investment appraisal methods

Four methods of
evaluation
Accounting rate of return

(ARR)
Payback period (PP)
Net present value

(NPV)
Internal rate of return

(IRR)
Slide 10.10
Use variants of these four

methods
• It is possible to find businesses that use
variants of these four methods. It is also
possible to find businesses, particularly
smaller ones, that do not use any formal
appraisal method, but rely more on the
‘gut feeling’ of their managers. Most
businesses, however, seem to use one (or
more) of these four methods.
Slide 10.11
Example 10.1
• Billingsgate Battery Company has carried out
some research that shows that the business
could provide a standard service that it has
recently developed. Provision of the service
would require investment in a machine that
would cost £100,000, payable immediately.
Sales of the service would take place throughout
the next five years. At the end of that time, it is
estimated that the machine could be sold for
£20,000.
Slide 10.12
• Sales of the service would be expected to

occur as follows:
Number of units
Next year 5,000
Second year 10,000
Third year 15,000
Fourth year 15,000
Fifth year 5,000
It is estimated that the new service can be sold for
£12 a unit, and that the relevant (variable) costs
will total £8 a unit.
Slide 10.13
• To simplify matters, we shall assume that the cash from

sales and for the costs of providing the service are paid
and received, respectively, at the end of each year. (This
is clearly unlikely to be true in real life. Money will have
to be paid to employees (for salaries and wages) on a
weekly or a monthly basis. Customers will pay within a
month or two of buying the service. On the other hand,
making the assumption probably does not lead to a
serious distortion. It is a simplifying assumption that is
often made in real life, and it will make things more
straightforward for us now.
• We should be clear, however, that there is nothing about
any of the four approaches that demands this
assumption being made.)
Slide 10.14
Slide 10.15
Accounting rate of return (ARR)

• The accounting rate of return (ARR)
method takes the average accounting
profit that the investment will generate and
expresses it as a percentage of the
average investment made over the life of
the project.
Slide 10.16
Accounting rate of return (ARR)
Average annual profit

ARR = × 100%
Average investment to earn that profit
Slide 10.17
Billingsgate Battery example

• In our example, the average annual profit before
depreciation over the five years is £40,000 [that
is, £000(20 + 40 + 60 + 60 + 20)/5].
• Assuming ‘straight-line’ depreciation (that is,
equal annual amounts), the annual depreciation
charge will be £16,000 [that is, £(100,000 −
20,000)/5].
• Thus the average annual profit after depreciation
is £24,000 (that is, £40,000 − £16,000).
Slide 10.18
Billingsgate Battery example contd…/-
Slide 10.19
ARR decision rule
For a project to be acceptable, it must achieve

at least a minimum target ARR
Where competing projects exceed the

minimum rate, the one with the highest ARR
should be selected
Slide 10.20
Problems with ARR
Ignores the timing of

cash flows
Use of average investment
Use of accounting profit
Competing investments
Slide 10.21
Payback period (PP)

• The payback period (PP) is the length of
time it takes for an initial investment to be
repaid out of the net cash inflows from a
project. Since it takes time into account,
the PP method seems to go some way to
overcoming the timing problem of ARR –
or at least at first glance it does.
Slide 10.22
Payback period (PP)
Time taken for initial

investment to be repaid out
of project net cash inflows
Payback period (PP)
Slide 10.23

• The project’s costs and benefits can be summarised as:
Slide 10.24
Billingsgate Battery example Contd…/-

• The payback period can be derived by calculating the
cumulative cash flows as follows:
Slide 10.25
Billingsgate Battery example Contd…/-

• We can see that the cumulative cash flows become
positive at the end of the third year.
• Had we assumed that the cash flows arise evenly over
the year, the precise payback period would be:
• 2 years + (40/60) = 2 2/3 years
• where 40 represents the cash flow still required at the
beginning of the third year to repay the initial outlay, and
60 is the projected cash flow during the third year.
• Again we must ask how to decide whether 2 2/3 years is
acceptable.
Slide 10.26
PP decision rule
Project should have a shorter payback period than

the required maximum payback period
If competing projects have payback periods shorter

than maximum payback period, the one with the
shortest payback period is selected
Slide 10.27
Problems with PP
Does not take timing of cash

flows fully into account
Ignores cash flows after PP
Does not take risk fully

into account
Not related to wealth

maximisation objective
Arbitrarily determined
target payback period
Slide 10.28
The cumulative cash flows of three projects

Initial outlay
Payback
period
Yr Yr Yr Yr Yr
Project 1
1 2 3 4 5
YrY
Y Yr Y Y
Project 2 1
12 3 4 5
Project 3 Yr Yr Yr Yr Yr
1 2 3 4 5
0 100 200 300 400 500 600 700 800 900

Cash flows (£000)
Slide 10.29
Net present value (NPV)

• To make sensible investment decisions,
we need a method of appraisal that:
– considers all of the costs and benefits of each
investment opportunity; and
– makes a logical allowance for the timing of
those costs and benefits.
• The net present value (NPV) method
provides us with this.
Slide 10.30
To summarise, we can say that the logical investor, who is seeking to

increase his or her wealth, will only be prepared to make investments
that will compensate for the loss of interest and purchasing power of
the money invested and for the fact that the returns expected may not
materialise (risk). This is usually assessed by seeing whether
the proposed investment will yield a return that is greater than the basic
rate of interest (which would include an allowance for inflation) plus a
risk premium.
Slide 10.31
The factors influencing the returns required by

investors from a project
Interest Required Inflation

foregone return
Risk
premium
Slide 10.32

• The project’s costs and benefits can be summarised as:
Slide 10.33
Slide 10.34
NPV decision rule
If project NPV is positive, it should be

accepted; if it is negative it should be rejected
If competing projects have positive NPVs,

the one with the highest NPV is selected
Slide 10.35
Slide 10.36
Using discount tables
Slide 10.37
• The fact that the project has a negative

NPV means that the present values of the
benefits from the investment are worth
less than the cost of entering into it.
• Any cost up to £126,510 (the present
value of the benefits) would be worth
paying, but not £150,000.
Slide 10.38
Present value of £1 receivable at various times in the

future, assuming an annual financing cost of 20 per cent
100
£1
90
80
70
60
Pence
50
40
30
20
10
0 1 2 3 4 5 6 7 8 9 10
Years into the future
Present value of £1 receivable at various times in the future, assuming

Figure 10.2
an annual financing cost of 20 per cent
Slide 10.39
Why NPV is better than ARR and PP
NPV fully addresses each of the following:
The timing of the cash flows
The whole of the relevant cash flows
The objectives of the business
Slide 10.40
Internal rate of return (IRR)

• This is the last of the four major methods of
investment appraisal that are found in practice. It
is quite closely related to the NPV method in
that, like NPV, it also involves discounting future
cash flows.
• The internal rate of return (IRR) of a particular
investment is the discount rate that, when
applied to its future cash flows, will produce an
NPV of precisely zero. In essence, it represents
the yield from an investment opportunity.
Slide 10.41
Internal rate of return (IRR)
The discount rate, which, when

applied to the future project cash
flows, produces a zero NPV
Internal rate of
return (IRR)
Slide 10.42
Slide 10.43
Slide 10.44
Slide 10.45
How to calculate IRR
Slide 10.46
IRR decision rule
Project must meet a minimum IRR requirement.

(The opportunity cost of finance)
If competing projects exceed minimum IRR

requirement, the one with the highest IRR is
selected
Slide 10.47
The relationship between the NPV and IRR methods

70
60
50
NPV 40
(£000)
30
20
IRR
10
0 30
0 10 20 40
−10 Cost of capital (%)
Figure 10.3 The relationship between the NPV and IRR methods
Slide 10.48
Problems with IRR
Does not directly address wealth

maximisation
Ignores the scale of investment
Has difficulty with unconventional cash

flows
Slide 10.49
Some practical points related to investment appraisal
Cash flows not

Past costs
profit flows
Common Year-end
future costs assumption
Opportunity Interest
costs payments
Other factors
Taxation
Slide 10.50
The main investment appraisal methods
Investment appraisal methods
Discounted Non-discounted
cash flow methods cash flow methods
Net Internal Accounting

Payback
present rate rate
period
value of return of return
Figure 10.4 The main investment appraisal methods

Slide 10.51
Investment appraisal in practice
Many surveys have shown the following

features:
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
Slide 10.52
A multinational survey of business practice
US UK Germany Canada Japan Average
IRR 4.00 4.16 4.08 4.15 3.29 3.93
NPV 3.88 4.00 3.50 4.09 3.57 3.80
Payback 3.46 3.89 3.33 3.57 3.52 3.55

period
Response scale: 1 = Never 5 = Always
Slide 10.53
53
53

Making Capital Investment Decisions

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Slide 10.

IS5303 Finance Management

You should be able to:

Explain the nature and importance of investment decision

Identify and discuss the four main investment appraisal

Discuss the strengths and weaknesses of various techniques for

Explain the methods used to monitor and control investment

The nature of investment

The nature of investment decisions

Large amounts of resources are

It is often difficult and/or expensive to bail out of

The scale of investment by UK businesses

Annual sales End-of-year

Investment appraisal methods

Accounting rate of return

Payback period (PP)

Net present value

Internal rate of return

Use variants of these four

• Sales of the service would be expected to

• To simplify matters, we shall assume that the cash from

Accounting rate of return (ARR)

Accounting rate of return (ARR)

Average annual profit

Billingsgate Battery example

Billingsgate Battery example contd…/-

ARR decision rule

For a project to be acceptable, it must achieve

Where competing projects exceed the

Problems with ARR

Ignores the timing of

Use of average investment

Use of accounting profit

Payback period (PP)

Payback period (PP)

Time taken for initial

Billingsgate Battery example

Billingsgate Battery example Contd…/-

Billingsgate Battery example Contd…/-

Project should have a shorter payback period than

If competing projects have payback periods shorter

Does not take timing of cash

Ignores cash flows after PP

Does not take risk fully

Not related to wealth

The cumulative cash flows of three projects

0 100 200 300 400 500 600 700 800 900

Net present value (NPV)

To summarise, we can say that the logical investor, who is seeking to

The factors influencing the returns required by

Interest Required Inflation

Billingsgate Battery example

NPV decision rule

If project NPV is positive, it should be

If competing projects have positive NPVs,

Using discount tables

• The fact that the project has a negative

Present value of £1 receivable at various times in the

Present value of £1 receivable at various times in the future, assuming

Why NPV is better than ARR and PP

NPV fully addresses each of the following:

The timing of the cash flows

The whole of the relevant cash flows