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[Solved] describe the importance of the investment decision

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[Solved] describe the importance of the investment decision

Session 11

Making capital investment decisions

11.1  Introduction

In this session we will explore how organisations use financial information when they are making investment decisions. This is known as capital budgeting. There are a number of different appraisal tools that are currently used by managers. Some of these methods are more helpful than others and you will have the opportunity to use and evaluate them all within this session.

 

Topics covered in this session

  • Key concepts in capital budgeting
  • Capital budgeting tools
  • Tax, inflation and other considerations

 

Learning objectives

By the end of this session you should be able to:

 

  • describe the importance of the investment decision

 

  • describe the various techniques and methods for assessing and appraising investment projects.

 

  • explain the failure of accounts-based management to guide value maximising decisions in many circumstances

 

  • use and critically appraise the methods, in order to control capital expenditure projects

 

 

Resources you will need

Dyson Chapter 19

 

11.2 Capital budgeting

Organisations have developed specific tools to control the acquisition and use of long-term assets. This is because:

  • The amount of money committed to the acquisition of capital assets is usually quite large.
  • The commitment to long-term assets for an extended time creates the potential for
    • excess capacity that creates excess costs
    • scarce capacity that creates lost opportunities.
  • The long-term nature of capital assets creates technological risk

 

Read Dyson pages 419 - 421.

 

Capital budgeting is a systematic approach to evaluating an investment where the fundamental evaluation issue in dealing with a long-term asset is whether its future benefits justify its initial cost.

Key concepts

Before we consider some of the appraisal methods used in capital budgeting, it is useful to introduce and define some key concepts.

Investment and return

Investment is the monetary value of the assets the organisation gives up to acquire a long-term asset.

 

Return is the increased future cash inflows attributable to the long-term asset.

Investment and return form the foundation of capital budgeting analysis, which focuses on whether the expected increased cash flows (return) will justify the investment in the long-term asset.

Time value of money (TVM) is a central concept in capital budgeting. Since money can earn a return its value depends on when it is received. Using money has a cost which is the lost opportunity to invest the money in another investment alternative.

In making investment decisions, the problem is that investment cash is paid out now, but the cash return is received in the future. We therefore need an equivalent basis to compare the cash flows that occur at different points in time.

 

Future value

Since money has time value, it is better to have money now than in the future

Having £1.00 today is more valuable than receiving £1.00 in the future because the £1.00 on hand today can be invested to grow to more than £1.00.

The future value (FV) is the amount that today’s investment will be after earning a stated periodic rate of return for a stated number of periods:

                                    For one period: FV=PV x (1+r)

 

Since investment opportunities usually extend over multiple periods, we need to compute future value over several periods :

FV with Multiple Periods

An initial amount of £1.00 accumulates to £1.2763 over five years if the annual rate of return is 5%:         The formula for a future value is FV=PV x (1+r)n

Very few people actually use the formula, preferring calculators, published tables  (see Dyson Appendix 2 P478 ), and in business, spreadsheets.

Choosing a common date

An investment’s cash flows must be converted to their equivalent value at some common date in order to make meaningful comparisons between the project’s cash inflows and outflows. The conventional choice is the point when the investment is undertaken. Analysts call this time zero, or period zero

 

Therefore, conventional capital budgeting analysis converts all future cash flows to their equivalent value at time zero. Analysts call a future cash flow’s value at time zero its present value. The process of computing present value is called discounting

We can rearrange the FV formula to compute the present value:

                                                FV = PV x (1 + r)n

                                                PV = FV/(1 + r)n or PV = FV x (1 + r)-n

 

Decay of a present value

A fixed amount of cash to be received at some future time becomes less valuable as interest rates increase and as the time period before receipt of the cash increases. One consequence of this decay is that large benefits expected far in the future will have relatively little current value, especially when interest rates exceed 10%. Arbitrarily high interest rates will result in projects (especially long-term ones) being inappropriately turned down.

Cost of capital

The cost of capital is the interest rate used for discounting future cash flows. It is also known as the risk-adjusted discount rate. The cost of capital is the return the organisation must earn on its investment to meet its investors’ return requirements. The organisation’s cost of capital reflects the amount and cost of debt and equity in its financial structure and the financial market’s perception of the financial risk of the organisation’s activities.

 

 

11.3 Capital budgeting tools

Capital budgeting is the collection of tools that planners use to evaluate the desirability of acquiring long-term assets. There are five popular approaches:

  • Accounting rate of return
  • Payback
  • Net Present Value
  • Internal Rate of Return
  • Profitability Index

We will examine each of these approaches in turn. To show how each methods works, and alternative perspectives, we will apply each to The Doughnut Cafe as it considers the purchase of a new automatic doughnut cooker:

  • Cost: £70,000
  • Life: five years
  • Benefit: expanded capacity and reduced operating costs would increase  profits by £20,000 per year
  • Cost of capital is 10%
  • The new cooker would be sold for £10,000 at the end of five years

At the end of this section you will be asked to apply these methods to another investment decision.

Payback period

The payback period (PP) is the number of periods needed to recover a project’s initial investment. In this case £70,000 is recovered midway between years 3 and 4 and so the payback period for this project is 3.5 years.  Many people consider the payback period to be a measure of the project’s risk as the organisation has unrecovered investment during the payback period. The longer the payback period, the higher is the risk. Organisations compare a project’s payback period with a target that reflects the organisation’s acceptable level of risk.

The payback criterion has two problems. Firstly it ignores the time value of money and secondly it ignores the cash outflows that occur after the initial investment and the cash inflows that occur after the payback period. Nevertheless. some surveys show that the payback calculation is the most used approach by organisations for capital budgeting.  This popularity may reflect other considerations, such as bonuses that reward managers based on current profits, that create a preoccupation with short-run performance.

Read about payback period on pages 422 – 424 of Dyson

Accounting rate of return

Analysts compute the accounting rate of return (ARR) by dividing the profit by the average level of investment.

The increased annual income related to the new cooker will be £8000

(£20,000 - £12,000 of depreciation). The average income will equal the annual income since the annual income is equal each year.

The average investment is £40,000 = (£70,000 + 10,000) / 2

The accounting rate of return for the cooker investment is computed as:

£8,000 / £40,000 = 20%

If the accounting rate of return exceeds the target rate of return, then the project is acceptable. However by averaging, it does not consider the timing of cash flows. This method is an improvement over the payback method in that it considers cash flows in all periods

Read about ARR on pages 426 to 428.

Net present value

The net present value (NPV) is the sum of the present values of a project’s cash flows.

It incorporates the time value of money.

The steps used to compute an investment’s net present value are as follows:

Step 1: Choose the appropriate period length to evaluate the investment proposal.

The most common period used in practice is one year (one year).

Step 2: Identify the organisation’s cost of capital, and convert it to an appropriate rate of return. (10%)

Step 3: Identify the incremental cash flow in each period of the project’s life.

(£70,000 outflow immediately

£20,000 inflow at the end of each year for five years

£10,000 inflow from salvage at the end of five years)

(It is useful to organize the cash flows associated with a project on a timeline to help identify and consider all the project’s cash flows systematically.)

Step 4: Compute the present value of each period’s cash flow using the organisation’s cost of capital for the discount rate.

(The present value of the cash flows when the organisation’s cost of capital is 10% are:

For a five-year annuity of £20,000, PV = £75,816

For the £10,000 salvage in five years, PV = £6,209)

Step 5: Sum the present values of all the periodic cash inflows and outflows to determine net present value.

(The PV of the cash inflows (from step 4) is £82,025

Because the investment of £70,000 takes place at time zero, the PV of the total outflows is £(70,000)

The NPV of this investment project is £12,025)

Step 6: If the project’s net present value is positive, the project is acceptable from an economic perspective. Purchase the cooker!

Read about NPV in pages 428 to 430

Internal rate of return

 

The internal rate of return (IRR) is the actual rate of return expected from an investment. The IRR is the discount rate that makes the investment’s net present value equal to zero. If an investment’s NPV is positive, then its IRR exceeds its cost of capital. If an investment’s NPV is negative, then it’s IRR is less than its cost of capital. By trial and error, or the use of a financial calculator or spreadsheet software, we find that the IRR in our example is 16.14% > 10% cost of capital, so the project is desirable.

IRR has some disadvantages:

  • It assumes that a project’s intermediate cash flows can be reinvested at the project’s IRR - and this is frequently an invalid assumption.
  • It can create ambiguous results, particularly:
    • when evaluating competing projects in situations where capital shortages prevent the organisation from investing in all positive NPV projects
    • when projects require significant outflows at different times during their lives.

Moreover, because a project’s NPV summarizes all its financial elements, using the IRR criterion is unnecessary when preparing capital budgets, but it remains a widely used capital budgeting tool.

Read about IRR on pages 430 to 433.

Profitability index

The profitability index (PI) is a variation of the net present value method and is used to make comparisons of mutually exclusive projects of different sizes. It is computed by dividing the present value of the cash inflows by the present value of the cash outflows. A profitability index of 1 or greater is required for the project to be acceptable.

In the case of the Doughnut Cafe, the present value of the cash inflows was £82,025 and the present value of the cash outflows was £70,000.

Therefore, the profitability index for that project was 1.17 (£82,025/£70,000)

When two projects are being compared, it is possible for project A to have a higher profitability index while project B has a higher NPV. An organisation must determine how to choose when the criteria give conflicting results.

The effect of taxes

Capital budgeting must consider the tax effects of potential investments as, firstly, organisations must pay taxes on any net benefits provided by an investment and, secondly, they can use the depreciation associated with a capital investment to reduce income and offset some of their taxes.

 

Assume for The Doughnut café that profit is taxed at a rate of 40%.

For simplicity, assume that the relevant tax law requires straight-line depreciation to be claimed as a tax-deductible expense.

Convert pretax cash flows to after-tax cash flows:

Using straight-line depreciation, £12,000 depreciation will be claimed each year

Taxable income of £8,000 will result in £3,200 in taxes being paid each year

The annual after-tax cash flow will be £16,800

 

The investment provides two after-tax benefits:

Five-year annuity of £16,800

Lump-sum payment of £10,000 at the end of five years

 

Because book value after five years is £10,000, there is no gain in selling it for £10,000 and, therefore, no tax

 

The present value of the five-year annuity of £16,800 discounted at 10% is £63,685

The present value of the payment of £10,000 is £6,209

The net present value of this investment project is £(106)

(£63,685 + 6,209 - 70,000)

 

Because the project’s net present value is negative, it is not economically desirable.

 

Use the following activity to practise applying the appraisal methods we have discussed.

 

Activity 12.1

 

The directors of Expansion Ltd are currently considering two mutually exclusive investment projects.  Both projects are concerned with the purchase of new plant and machinery.

 

                                                            Project 1                      Project 2

                                                                 £                             £

 

Cost (immediate outlay)                     100,000                       60,000

 

Expected annual net

Profit/Loss

            Year 1                                     30,000                         18,000

            Year 2                                      (1,000)                        (2,000)

            Year 3                                     4,000                           6,000

Year 3 Estimated residual value         7,000                           6,000

 

The company has an estimated cost of capital of 10% and utilises the straight line method of depreciation for all fixed assets when calculating net profit.

 

Use ARR, PB, NPV and IRR to compare the two projects.

 

Make notes for a report for the management of Expansion Ltd outlining which project should be undertaken.

 

You should include a discussion of which method of investment appraisal you consider to be most appropriate and why.

 

11.4  Capital budgeting – other considerations          

 

 

Effect of inflation

 

To account for inflation we adjust future cash flows so that we can compare pounds of similar purchasing power. Similarly, we discounted future cash flows to the present using an appropriate discount rate to account for the time value of money. We discount each cash flow by the appropriate discount rate and the expected inflation rate.

 

If expected inflation is 2.5%, the combined discount rate would be 1.1275% (1.10 x 1.025)

 

Uncertainty in cash flows

Due to the long term nature of capital budgeting projections, the cash flows are more uncertain, the more into the future they are. There are a number of techniques that can be used to overcome this, some of which you have encountered earlier in this module:

  • High – Low estimates
  • Expected values and probabilities
  • A wait and see approach – test-market a prototype first
  • Sensitivity analysis  - at what level of the various data does the project become unviable (% change) ?
  • What-if analysis – e.g. what if my sales are 90% of the plan?

Strategic considerations

Capital budgeting is primarily a financial exercise and there is no doubt that it forces financial discipline on what might be a speculative exercise. However, there may be strategic benefits to be gained from an investment and these benefits may often be very hard to quantify. For example, an investment could:

  • allow an organisation to make goods or deliver a service that competitors cannot, e.g. by developing a patented process to make a product that competitors cannot replicate
  • support improving product quality by reducing the potential to make mistakes, e.g. by improving machining tolerances or reducing reliance on operator settings
  • help shorten the production cycle time, e.g., by implementing one-hour photo developing.

Thinking again about the Doughnut Café, they may consider investing in a cooker that senses when a doughnut is cooked and ejects it automatically because:

  • It may allow the hiring of less-skilled, and lower-paid employees.
  • The cooker may improve the consistency of cooking and the quality of the doughnuts so that customers find the doughnuts more desirable.
  • There are likely to be increased sales if the competitors do not have this cooker.
  • The automatic cooker can prevent an erosion of sales if competitors also purchase it.

Post-implementation audits

Post-implementation audits (PIAs) can provide an important discipline to capital budgeting. When estimates are used to support proposals, recognising the behavioural implications is important.  This behaviour is mitigated if people understand that, once equipment is acquired, the company will compare results with the claims made in support of the equipment’s acquisition.

Budgeting - other spending proposals

Organisations develop spending proposals for discretionary items other than capital expenditures, for example, for research and development, advertising, and training. Such items can provide benefits that will be realised for many periods into the future. Their magnitude suggests that they should be evaluated like capital spending projects when possible.

Summary           

We began this session with an introduction to the key concepts involved in capital budgeting. Money has a time value, and this needs to be taken into account when appraising new investments. An organisation must also be aware of its cost of capital. We then used five different appraisal methods: Accounting rate of return, payback, net present value, internal rate of return and profitability interest. Although NPV is one of the more complex methods, and hence is not in universal use, it is generally considered to be superior to the others. We also discussed other considerations that need to be taken into account in capital budgeting, including  the effect of taxes and inflation and uncertainty in cash flows.  As always, it is important to view financial information in the wider context of organisational strategy.


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