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Chapter 20: Capital investment appraisal On completion of this topic you should be able to Explain the purpose of capital investment appraisal Calculate and interpret the payback period for an investment project Calculate and interpret the accounting rate of return for an investment project Describe the advantages and disadvantages of these two techniques Independent study Study Chapter 20 Progress test and practice question(s) as set Business Accounting 1 Capital investment appraisal Whilst cost accounting provides information to management for making short-term decisions about revenue expenditure, this topic provides information for long-term decisions about capital expenditure Capital investment appraisal is ‘the evaluation of proposed investment projects, with a view to determining which is likely to give the highest financial return’ (Collis and Hussey, 2007, p. 335) Business Accounting 2 Characteristics of capital investment decisions Time span 2+ years Nature Strategic (eg whether to build or buy a new factory) Level of expenditure Medium – high External factors Very important (eg interest rates and rates of inflation) Typical techniques Payback period Accounting rate of return Discounted cash flow techniques Adapted from Jones, 2002, p. 452 Business Accounting 3 The capital investment decision Capital investment appraisal techniques are used for making decisions concerning the investment of large amount of capital in a long-term project Management needs to know that the investment project will be worthwhile Either it will generate more cash than the initial amount invested or it will provide cost savings over the life of the project that will exceed the capital invested At the very least, management needs to know that the business will get its money back Business Accounting 4 Exercise 1 Capital investment decisions Business Accounting 5 Exercise 1 Capital investment decisions Business Accounting 6 Solution 1 Capital investment decisions Business Accounting 7 Solution 1 Capital investment decisions (continued) Machine 3 looks best as the net cash inflow is £25,000 (£5,000 higher than for Machines 1 or 2) But waiting until Year 3 to get most of the cash increases risk – the annual net cash flows are estimates and the further ahead the forecast, the more unreliable it is Machines 1 & 2 both give the same total net cash inflow, so either is worth considering, but Machine 1 is the more favourable because the cash comes in sooner It’s difficult to decide - we need a technique to help Business Accounting 8 Capital investment appraisal techniques Capital investment appraisal Payback period Accounting rate of return Business Accounting Discounted cash flow 9 Payback period The payback period is ‘the time required for the predicted net cash flows to equal the capital invested in a proposed investment project’ (Collis and Hussey, 2007, p. 338) The project that repays the capital invested in the shortest time is considered to be the most favourable The following estimates are needed The amount of capital required The amount and timing of the net cash flows generated by the investment project Business Accounting 10 Conventions and assumptions Year 0 is a conventional way of referring to the start of Year 1 Year 1, 2, 3 etc means the end of Year 1, 2, 3, etc It is assumed that the cash outflow from the initial investment of capital will take place at Year 0 It is assumed that the net cash inflows during a year will be received evenly throughout the year Negative cash flows are shown in brackets Business Accounting 11 Exercise 2 Mr Cornetto’s ice cream van project Business Accounting 12 Solution 2 Mr Cornetto’s ice cream van project The payback period for the ice cream van project is Initial capital investment = £12,000 Annual net cash flow £4,000 = 3 years exactly We have been able to use this formula because Mr Cornetto expects the net cash flows to be the same every year over the life of the project, but we can’t use it if the projected annual net cash flows are expected to differ… Business Accounting 13 Exercise 3 Mr Cornetto’s pasta van project An alternative project is to invest in a pasta van that will also cost £12,000 and last 4 years Because take-away pasta may take some time to catch on, the annual net cash flows are expected to be £2,000 in year 1, rising to £3,000 in year 2, £5,000 in year 3 and £6,000 in year 4 Required Using the pro forma, calculate the payback period in years and months for the pasta van project Business Accounting 14 Pro forma Mr Cornetto’s pasta van project Business Accounting 15 Solution 3 Mr Cornetto’s pasta van project Business Accounting 16 Advantages and disadvantages of payback period Advantages Simple to calculate and easy to understand Useful for risky projects where prediction of future cash flows beyond first few years is difficult (eg IT) Useful if short-term cash flows are more important to survival of the business than long-term cash flows Useful if borrowing or gearing is a concern Disadvantages Does not take account of the time value of money (cash now is worth more than cash received later) Ignores cash flows after the payback period Business Accounting 17 Accounting rate of return The payback period focuses on cash flows, but the accounting rate of return (ARR) focuses on profit The accounting rate of return ‘measures the predicted average profit before interest and tax as a percentage of the average capital employed in a proposed investment project’ (Collis and Hussey, 2007, p. 342) When comparing ratios from different sources, care must be taken that the same definition of profit and capital employed have been used Business Accounting 18 Exercise 4 Fresh Farm Foods ARR Business Accounting 19 Pro forma Fresh Farm Foods ARR Business Accounting 20 Solution 4 Fresh Farm Foods ARR Business Accounting 21 Conclusions Advantages and disadvantages of ARR Advantages Simple to calculate and easy to understand Takes account of the entire life of the project Compatible with the performance ratio, ROCE Disadvantages Does not take account of the time value of money Ignores the timing of profits (eg benefit of earning a larger proportion of profit in early years) and timing of cash flows No standard definition of terms (limits comparisons) Averages can be misleading (actual figure may be ↑ or ↓) No guidance on what is an acceptable rate of return Business Accounting 22 [...]... Year 1, 2, 3 etc means the end of Year 1, 2, 3, etc It is assumed that the cash outflow from the initial investment of capital will take place at Year 0 It is assumed that the net cash inflows during a year will be received evenly throughout the year Negative cash flows are shown in brackets Business Accounting 11 Exercise 2 Mr Cornetto’s ice cream van project Business Accounting 12 Solution 2 Mr... percentage of the average capital employed in a proposed investment project’ (Collis and Hussey, 20 07, p 3 42) When comparing ratios from different sources, care must be taken that the same definition of profit and capital employed have been used Business Accounting 18 Exercise 4 Fresh Farm Foods ARR Business Accounting 19 Pro forma Fresh Farm Foods ARR Business Accounting 20 Solution 4 Fresh Farm... Exercise 3 Mr Cornetto’s pasta van project An alternative project is to invest in a pasta van that will also cost £ 12, 000 and last 4 years Because take-away pasta may take some time to catch on, the annual net cash flows are expected to be 2, 000 in year 1, rising to £3,000 in year 2, £5,000 in year 3 and £6,000 in year 4 Required Using the pro forma, calculate the payback period in years and... Accounting 11 Exercise 2 Mr Cornetto’s ice cream van project Business Accounting 12 Solution 2 Mr Cornetto’s ice cream van project The payback period for the ice cream van project is Initial capital investment = £ 12, 000 Annual net cash flow £4,000 = 3 years exactly We have been able to use this formula because Mr Cornetto expects the net cash flows to be the same every year over the life of the project,... of cash flows No standard definition of terms (limits comparisons) Averages can be misleading (actual figure may be ↑ or ↓) No guidance on what is an acceptable rate of return Business Accounting 22 ... employed have been used Business Accounting 18 Exercise 4 Fresh Farm Foods ARR Business Accounting 19 Pro forma Fresh Farm Foods ARR Business Accounting 20 Solution 4 Fresh Farm Foods ARR Business Accounting 21 Conclusions Advantages and disadvantages of ARR Advantages Simple to calculate and easy to understand Takes account of the entire life of the project Compatible with the performance ratio, ... Exercise Capital investment decisions Business Accounting Exercise Capital investment decisions Business Accounting Solution Capital investment decisions Business Accounting Solution Capital investment. .. Business Accounting The capital investment decision Capital investment appraisal techniques are used for making decisions concerning the investment of large amount of capital in a long-term... difficult to decide - we need a technique to help Business Accounting Capital investment appraisal techniques Capital investment appraisal Payback period Accounting rate of return Business Accounting