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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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Investment appraisal Capital investment or capital expenditure (often abbreviated as ‘cap ex’) means spending money now in the hope of getting it back later through future cash flows.

The process of evaluating or appraising potential investments is to:

ž generate ideas based on opportunities or identifying solutions to problems;

ž research all relevant information;

ž consider possible alternatives;

ž evaluate the financial consequences of each alternative;


ž assess non-financial aspects of each alternative;

ž decide to proceed;

ž determine an implementation plan and implement the proposal;

ž control implementation by monitoring actual results compared to plan.

There are three main types of investment:

ž new facilities for new product/services;

ž expanding capacity to meet demand;

ž replacing assets in order to reduce production costs or improve quality or service.

These are inextricably linked to the implementation of business strategy.

Most investment appraisals consider decisions such as:

ž whether or not to invest;

ž whether to invest in one project or one piece of equipment rather than another;

ž whether to invest now or at a later time.

There are three main methods of evaluating investments:

1 Accounting rate of return.

2 Payback.

3 Discounted cash flow.

While the first is concerned with profits, the second and third are concerned with cash flows from a project. For any project, investment appraisal requires an estimation of future incremental cash flows, i.e. the additional cash flow (net of income less expenses) that will result from the investment, as well as the cash outflow for the initial investment. Depreciation is, of course, an expense in arriving at profit that does not involve any cash flow (see Chapter 6). Cash flow is usually considered to be more important than accounting profit in investment appraisal because it is cash flow that drives shareholder value (see Chapter 2).

It is important to note the following:

1 The financing decision is treated separately to the investment decision. Hence, even though there may be no initial cash outflow for the investment (because it may be wholly financed), all investment appraisal techniques assume an initial cash outflow. If a decision is made to proceed, then the organization is faced with a separate decision about how best to finance the investment.

2 The outflows are not just additional operating costs, as any new investment that generates sales growth is also likely to have an impact on working capital, since inventory, debtors and creditors are also likely to increase (see Chapter 6).

3 Income tax is treated as a cash outflow as it is a consequence of the cash inflows from the new investment.


Table 12.1 Cash flows for investment alternatives

–  –  –

As we consider each method, let us assume three alternative investments.

Table 12.1 shows the estimated cash flows.

For simplicity, we assume that each of the cash flows occurs at the end of each year. Year 0 represents the beginning of the project when the initial funds are paid out. If we add up the cash flows in the above example, Project 1 returns £125,000 (5 @ £25,000), Project 2 returns £175,000 (5 @ £35,000) and Project 3 returns £260,000 (2 @ £60,000 + £80,000 + 2 @ £30,000), although the initial investment in each is different.

Accounting rate of return The accounting rate of return (ARR) is the profit generated as a percentage of the investment. This is equivalent to the return on investment (ROI) that was introduced in Chapter 7. The investment value for ARR is the depreciated value each year. The depreciated value each year, assuming a life of five years with no residual value at the end of that time, is shown in Table 12.2. The accounting rate of return varies annually, as Table 12.3 shows for Project 1.

For the whole investment period, the accounting rate of return is the average annual return divided by the average investment. The average annual return is the total profit divided by the number of years. As we assume that depreciation is spread equally throughout the life of the asset, the average investment is half the initial investment, i.e. half-way through its life.

–  –  –

The average ROI for Project 1 is:

25,000/5 5,000 = = 10% 100,000/2 50,000 The accounting rate of return for Project 2 is shown in Table 12.4.

The average ROI for Project 2 is:

50,000/5 10,000 = = 16% 125,000/2 62,500 The accounting rate of return for Project 3 is shown in Table 12.5.

The average ROI for Project 3 is:

10,000/5 2,000 = = 2% 200,000/2 100,000

–  –  –

Project 3 in particular has substantial fluctuations in ROI from year to year. Using this method, Project 2 shows the highest return. However, it does not take into account either the scale of the investment required or the timing of the cash flows.

Payback This second method calculates how many years it will take – in cash terms – to recover the initial investment, on the assumption that the shorter the payback

period, the better the investment. Based on the cash flows for each project:

ž Project 1 takes four years to recover its £100,000 investment (4 @ £25,000).

ž Project 2 has recovered £105,000 by the end of the third year (3 @ £35,000) and will take less than seven months (20/35 =.57 of 12 months) to recover its £125,000 investment. The payback is therefore 3.57 years.

ž Project 3 recovers its investment of £200,000 by the end of the third year (£60,000 + £60,000 + £80,000).

Based on the payback method, Project 3 is preferred (followed by Projects 2 and

1) as it has the fastest payback. However, the payback method ignores the size of the investment and any cash flows that take place after the investment has been recovered.

Neither the accounting rate of return nor the payback method considers the time value of money, i.e. that £100 is worth more now than in a year’s time, because it can be invested now at a rate of interest that will increase its value. For example, £100 invested today at 10% interest is equivalent to £110 in a year’s time. Conversely, receiving £100 in a year’s time is not worth £100 today. Assuming the same rate of interest it is worth only £91, because the £91, invested at 10%, will be equivalent to £100 in a year’s time.

The time value of money needs to be recognized in investment appraisals in order to compare investment alternatives with different cash flows over different time periods. The third method of investment appraisal therefore involves discounted cash flow (DCF), i.e. it discounts the future cash flows to present values using a discount rate (or interest rate) that is usually the firm’s cost of capital (the risk-adjusted cost of borrowing for the investment).

There are two discounted cash flow techniques: net present value and internal rate of return.

Net present value The net present value (NPV) method discounts future cash flows to their present value and compares the present value of future cash flows to the initial capital investment.

–  –  –

The discount rates to be applied are based on the company’s cost of capital.

The cost of capital (see Chapter 2) represents the weighted average of the cost of debt and equity and takes into account the riskiness of a project. As the cost of borrowing has been taken into account, an investment makes sense if the NPV is positive. The discount rate can be obtained from net present value tables (see Appendix to this chapter for an example). More commonly, spreadsheet software (e.g. Excel or Lotus) is used as this contains an NPV function.

Using the same example, the NPV for Project 1 is shown in Table 12.6. As the net present value is negative, Project 1 should not be accepted since the present value of future cash flows does not cover the initial investment.

The NPV for Project 2 is shown in Table 12.7. Project 2 can be accepted because it has a positive net present value. However, we need to compare this with Project 3 to see if that alternative yields a higher net present value. The NPV for Project 3 is shown in Table 12.8.

Despite the faster payback for Project 3, the application of the net present value technique to the timing of the cash flows reveals that the net present value of Project 3 is lower than that for Project 2, and therefore Project 2 – which also showed the highest accounting rate of return – is the recommended investment.

However, using the NPV method it is difficult to determine how much better Project 2 (with an NPV of £7,650) is than Project 3 (with an NPV of £3,300) because each has a different initial investment.

One way of ranking projects with different NPVs is cash value added (CVA) or

profitability index, which is a ratio of the NPV to the initial capital investment:

NPV cash value added = initial capital investment In the above example, Project 2 returns a CVA of 6.12% (7,650/125,000) while Project 3 returns a CVA of 1.165% (3,300/200,000). Companies may have a target

–  –  –

CVA, such that, for example, to be approved a project must have a CVA of 10% (i.e. the NPV is at least 10% of the initial capital investment).

The second DCF technique is the internal rate of return.

Internal rate of return The internal rate of return (IRR) method determines, by trial and error, the discount rate that produces a net present value of zero. This involves repeated calculations from the discount tables on a trial-and-error basis using different discount rates until an NPV of 0 is reached. The discount rate may need to be interpolated between whole numbers. Spreadsheet software also contains an IRR

function. The IRR for each project, using the spreadsheet function, is:

Project 1 7.9% Project 2 12.4% Project 3 10.7%


This is a more informative presentation of the comparison because it presents the cash flows as an effective interest rate. The project with the highest internal rate of return would be preferred, provided that the rate exceeds the cost of capital (i.e.

the borrowing cost).

Comparison of techniques While the accounting rate of return method provides an average return on investment and a business may select the highest return, it ignores the timing of cash flows. Sometimes where there are high short-term ROIs, managers may prefer those investments even though the longer-term impact is detrimental to the organization. This is because managers may be evaluated and rewarded on their short-term performance (see Chapter 13). Payback measures the number of years it will take to recover the capital investment and while this takes timing into account, it ignores cash flows after the payback period. Both methods ignore the time value of money.

Discounted cash flow techniques take account of the time value of money and discount future cash flows to their present value. This is a more reliable method of investment appraisal. Discounted cash flow is similar to the method of calculating shareholder value proposed by Rappaport and described in Chapter 2.

However, for investment evaluation, while all projects with a positive net present value are beneficial, a business will usually select the project with the highest net present value, or in other words the highest internal rate of return, sometimes using the initial cash investment (CVA) or the cost of capital (IRR) as a benchmark for the return.

Because of rapid change in markets and increased demands for shareholder value, the use of discounted cash flow techniques has declined in many businesses.

Boards of directors typically set quite high ‘hurdle’ rates for investing in new assets. These are commonly in terms of payback periods of two to four years or ROI rates of 25–50%. This approach reduces the importance of discounted cash flow techniques.

However, for larger investments where returns are expected over many years, discounted cash flow techniques are still important. Investments in buildings, major items of plant, mining exploration and so on etc. commonly use NPV and IRR as methods of capital investment appraisal.

The following case study provides an example of investment appraisal.

Case study: Goliath Co. – investment evaluation

Goliath Co. is considering investing in a project involving an initial cash outlay for an asset of £200,000. The asset is depreciated over five years at 20% p.a. Goliath’s

cost of capital is 10%. The cash flows from the project are expected to be as follows:


–  –  –

The company wishes to consider the return on investment (each year and average), payback and net present value as methods of evaluating the proposal.

The depreciation expense is £40,000 per year. Net cash flows and profits are

as follows:

–  –  –

Using the spreadsheet NPV function, the answer is calculated in Table 12.9 (the difference is due to rounding).

Although the ROI is 7% and the payback is four years, the discounted cash flow shows that the net present value is negative. Therefore the project should be rejected, as the returns are insufficient to recover the company’s cost of capital.

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