SESSION 03 INVESTMENT DECISIONS

0301
OVERVIEW
Objective
To understand the type of investment decisions that will be made by organisations.
To assess an investment using the payback period and the ARR methods.





TYPES OF
EXPENDITURE
PAYBACK
PERIOD
ACCOUNTING
RATE OF RETURN
INVESTMENTS
Capital
Revenue
Investment decisions
Definition
Possible Improvements
Advantages
Disadvantages
EVALUATION
Definition
Calculation
Advantages
Disadvantages


SESSION 03 INVESTMENT DECISIONS
0302
1 TYPES OF EXPENDITURE
1.1 Capital
Capital expenditure (CAPEX) refers to the purchase of non-current (fixed) assets or their
improvement;
1.2 Revenue
Revenue expenditure is incurred to maintain non-current assets e.g. repairs
1.3 Investment decisions
Decisions about which non-current assets should be acquired.
Also referred to as project appraisal, investment appraisal or CAPEX analysis.
2 PAYBACK PERIOD
2.1 Definition

The time it takes for the operating cash flows from a project to pay back the
initial investment.


Decision rule

If payback period < target ACCEPT
If payback period > target REJECT



Illustration 1

Investment $1.4m
Annual cash flows (before depreciation but after tax) $0.3m
Project life 10 yrs


Solution
Payback period =
0.3
1.4
= 4.7 years
(or five years if cash flows are assumed to arise at year ends.)
SESSION 03 INVESTMENT DECISIONS
0303
2.2 Possible Improvements
2.2.1 Discounted payback period
First discount the cash flows to present value and then calculate the payback period
This takes into account the time value of money.
2.2.2 Bail-out factor
This takes into account the estimated scrap/disposal value of the asset if the project is
abandoned early
2.3 Advantages of payback
Simple to calculate.
Easy to understand.
Concentrates on earlier flows:
more certain;
more important if firm has liquidity concerns.
2.4 Disadvantages of payback
Ignores cash flows after payback period;
Target period is subjective;
Gives little information about change in shareholder wealth.
Unless flows are discounted, time value of money is ignored
3 ACCOUNTING RATE OF RETURN (ARR)
3.1 Definition

The earnings of a project expressed as a percentage of the capital outlay or
average investment.


Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI).
3.2 Calculation
This is a financial accounting measure based on the income statement and statement of
financial position.
It includes:
Sunk costs (money already spent);
Net book values of assets;
Depreciation and amortisation ;
Allocated fixed overheads.
SESSION 03 INVESTMENT DECISIONS
0304
Calculated as

investment Initial
profit operating annual Average
100
OR
investment Average
profit operating annual Average
100


Decision rule
If ARR > target ACCEPT
If ARR < target REJECT

Example 1

Initial investment $200m
Scrap value $20m
Operating cash flows:
Year 1 $100m
Year 2 $50m
Year 3 $50m
Year 4 $50m

Required:
Calculate ARR on
(i) Initial investment
(ii) Average investment


SESSION 03 INVESTMENT DECISIONS
0305
3.3 Advantages
Uses readily available accounting information;
Simple to calculate and understand;
Often used by financial analysts to appraise performance.

3.4 Disadvantages
Different methods of calculation may cause confusion;
Based on profits rather than cash. Profits are easily manipulated by accounting policy.
Ignores time value of money;
Target rate is subjective;
A relative measure (%) gives little information about the absolute change in
shareholders wealth.
Example 2

A project being considered would require a machine costing $80,000. Market
research of $8,000 has already been carried out and has been capitalised. The
result is that the project is expected to last for six years and produce net cash
earnings of $20,000 for each of the first three years and then $15,000 for each of
the last three years. The anticipated scrap proceeds of the machine at various
stages in its life are as follows:
After year 1 $40,000
After year 2 $30,000
After year 3 $20,000
After year 4 $13,000
After year 5 $10,000
After year 6 $4,000

Required:
Evaluate the project using
(a) ARR
(b) ARR using the average investment approach
(c) payback period
(d) payback period incorporating the bail-out factor.
You may assume that cash flows arise evenly during the year.

SESSION 03 INVESTMENT DECISIONS
0306
Solution
(a)



(b)


(c)/ (d)
Time Flow Cumulative
flow
Scrap Net cumulative
flow
0
1
2
3
4
5
6
(88,000)
20,000
20,000
20,000
15,000
15,000
15,000








40,000
30,000
20,000
13,000
10,000
4,000








Payback period =
Payback period with bail-out =

SESSION 03 INVESTMENT DECISIONS
0307

Key points

Payback and ARR are commonly used in practice. However neither
method informs management of the absolute change in shareholders
wealth due to a particular project
As well as being able to calculate payback and ARR it is therefore vital that
you can also explain why they are not acceptable methods of project
appraisal





FOCUS
You should now be able to:

define and distinguish between capital and revenue expenditure;
calculate payback and assess its usefulness as a measure of investment worth;
calculate ARR and assess its usefulness as a measure of investment worth.


EXAMPLE SOLUTIONS
Solution 1
Average annual profit
5 . 17
4
180 250
years project of No
on depreciati Total flows cash Total
=

Average investment
110
2
20 200

2
value Scrap + investment Initial
=
+
=
ARR on initial investment % 75 . 8 100
200
5 . 17
=
ARR on average investment % 91 . 15 100
110
5 . 17
=
SESSION 03 INVESTMENT DECISIONS
0308
Solution 2 ARR and Payback
(a) ARR
Average annual earnings =
6
15,000) 3 20,000 (3 +
= $17,500
Average annual depreciation =
6
000 , 4 8,000 + 80,000
= $14,000
ARR =
000 , 88
000 , 14 17,500
= 4%
(b) Average investment =
2
000 , 4 88,000 +
= $46,000
ARR =
000 , 46
000 , 14 17,500
= 7.6%
(c)/ (d)
Time Flow Cumulative
flow
Scrap Net cumulative
flow
0
1
2
3
4
5
6
(88,000)
20,000
20,000
20,000
15,000
15,000
15,000
(88,000)
(68,000)
(48,000)
(28,000)
(13,000)
2,000
17,000

40,000
30,000
20,000
13,000
10,000
4,000
(88,000)
(28,000)
(18,000)
(8,000)

12,000
21,000

Payback period
= 4
15
13
years
Payback period with bail-out = 4 years