Slide 10.1 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Part Three

Slide 10.1

Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015

Part ThreeFINANCE

Chapter 10MAKING CAPITAL

INVESTMENT DECISIONS

Slide 10.2


LEARNING OUTCOMES

You should be able to:

Identify and discuss the four main investment appraisal methods found in practice

Explain the nature and importance of investment decision making

Explain the methods used to monitor and control investment projects

Discuss the strengths and weaknesses of various techniques for dealing with risk in investment appraisal

Slide 10.3


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 10.4


The scale of investment by UK businesses

Source: Annual reports of the businesses concerned for the financial years ending in 2013

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

Annual sales End-of-year revenue non-current assets

Wm Morrison Supermarkets plc 5.6 11.1

Vodafone plc 32.4 12.0

Marks and Spencer plc 8.3 13.2

Severn Trent Water Ltd 24.4 6.3

Go-Ahead Group plc 2.3 10.6

J D Wetherspoon plc 7.9 10.2

British Sky Broadcasting plc 9.0 17.8

Ryanair Holdings plc 6.4 6.0

Slide 10.5


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 10.6


Average annual profit Average investment to earn that profit

ARR =

Accounting rate of return (ARR)

× 100%

Slide 10.7


ARR decision rule

Where competing projects exceed the minimum rate, the one with the highest ARR

should be selected

For a project to be acceptable, it must achieve at least a minimum target ARR

Slide 10.8


Problems with ARR

Ignores the timing of cash flows

Use of average investment

Use of accounting profit

Competing investments

Slide 10.9


Payback period (PP)

Payback period (PP)

Time taken for initial investment to be

repaid out of project net cash inflows

Slide 10.10


PP decision rule

If competing projects have payback periods shorter than maximum payback period, the one

with the shortest payback period is selected

Project should have a shorter payback period than the required maximum payback period

Slide 10.11


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 10.12


The cumulative cash flows of each project in Activity 10.6

Project 1

Project 3

Project 2Yr 1

Cash flows (£000)

200 800600400 9000 500300100 700

Y 2

Yr 3

Yr 1

Yr 2

Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Y1

Payback period

Initial outlay

Yr 3

Yr 4

Yr 5

Y 5

Y4

Figure 10.1 Cumulative cash flows for each project in Activity 10.6

Slide 10.13


Interest foregone

InflationRequired return

Risk premium

The factors influencing the returns required by investors from a project

Slide 10.14


NPV decision rule

If competing projects have positive NPVs, the one with the highest NPV is selected

If project NPV is positive, it should be accepted; if it is negative it should be rejected

Slide 10.15


Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent

0 654321 7 8 9 10

Years into the future

10

20

30

40

50

60

70

80

90

100P

ence

£1

Figure 10.2 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent

Slide 10.16


Why NPV is better than ARR and PP

The whole of the relevant cash flows

The objectives of the business

The timing of the cash flows

NPV fully addresses each of the following:

Slide 10.17




The discount rate, which, when applied to the future

project cash flows, produces a zero NPV

Slide 10.18


IRR decision rule

If competing projects exceed minimum IRR requirement, the one

with the highest IRR is selected

Project must meet a minimum IRR requirement.

(The opportunity cost of finance)

Slide 10.19


The relationship between the NPV and IRR methods

NPV (£000)

Cost of capital (%)

10

20

30

40

50

60

70

0 10 20 30 40

IRR

−10

0

Figure 10.3 The relationship between the NPV and IRR methods

Slide 10.20


Problems with IRR

Does not directly address wealth maximisation

Ignores the scale of investment

Has difficulty with unconventional cash flows

Slide 10.21


Some practical points related to investment appraisal

Past costs

Common future costs

Opportunity costs

Taxation

Year-end assumption

Cash flows not profit flows

Interest payments

Other factors

Slide 10.22


The main investment appraisal methods

Investment appraisal methods

Discountedcash flow methods

Net present value

Internal rate

of return

Accounting rate

of return

Payback period

Non-discountedcash flow methods

Figure 10.4 The main investment appraisal methods

Slide 10.23


Investment appraisal in practice

Many surveys have shown the following features:

NPV and IRR have become increasingly popular

Continued popularity of the PP and ARR methods

Businesses tend to use more than one method

Larger businesses rely more heavily on NPV and IRR than smaller businesses

Slide 10.24


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 period

3.46 3.89 3.33 3.57 3.52 3.55

Response scale: 1 = Never 5 = Always

Documents

Slide 10.1 Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9 th edition © Pearson Education Limited 2015 Part Three