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Admin Matters

Seminar 11:
Capital Investment: Analysis &
Project Management

ACCT5996
Management Accounting and Business Analysis

Seminar Objectives
1.
2.

3.
4.
5.
6.

Describe the difference between independent and mutually

exclusive capital investment decisions.
Explain the roles of the payback period and accounting rate
of return in capital investment decisions.
Calculate the net present value (NPV) for independent
projects.
Compute the internal rate of return (IRR) for independent
projects.
Tell why NPV is better than IRR for choosing among
mutually exclusive projects.
Apply techniques for project managing approved capital
investments
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Chapters and Objectives

Textbook CH19, LO1
Textbook CH19, LO2
Textbook CH19, LO3, LO6, LO7
Textbook CH19, LO4
Textbook CH19, LO5
B&V CH 8, pp. 286-306

Mapping Seminar and Text Book Objectives

Seminar Objectives
LO1
LO2
LO3
LO4
LO5
LO6

Capital Investment (CI) Decisions

LO 1

Organisations are faced with opportunity/need to invest

Often because of improvement opportunities identified.

CI concerned with planning, prioritisation, financing,

and applying criteria to decide on investments.
Long-term decisions

Requiring evaluation spanning several years to determine the

acceptability of the project

Commitment of substantial amount of money

Timing difference between investment and benefits

Future uncertainty
Irreversibility of investments
Important to make the right choice

Capital Investment Decisions

Capital budgeting

The process of making capital investment decisions

Types of capital budgeting projects

Independent projects

LO 1

Projects that, if accepted or rejected, will not affect the cash flows of
another project.

Mutually exclusive projects

Projects that, if accepted, preclude the acceptance of competing projects.

Capital budgeting: nondiscounting methods

Payback period

Time required for a firm to recover its original investment

When even cash flows are assumed

Payback period = original investment/annual cash flow

LO 2

However, for uneven cash flows, payback is calculated by

adding back cash flows until original investment is recovered.
Decision rule could be:
To set maximum payback period.
To choose between payback alternatives

Capital budgeting: nondiscounting methods

Payback period
Benefits

Help control the risks associated with the uncertainty of future cash flows.
Help minimize the impact of an investment on a firms liquidity problems.
Help control the risk of obsolescence.
Help control the effect of the investment on performance measures.

Deficiencies:

Ignores the time value of money

Ignores the performance of the investment beyond the payback period

LO 2

Capital budgeting: nondiscounting methods

Accounting rate of return (ARR)

Measure return based on income, not cash flow

ARR = average income/original investment

or
ARR = average income/average investment
Where average invt = (original invt + salvage val)/2

Benefits
Considers profitability
May be consistent with incentive plans

Deficiencies:
Ignores the time value of money
May result in rejecting viable projects

Exercise 19.7 (p.738)

LO 2

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Capital budgeting: discounting methods

Net present value

LO 3

The difference between the present value of the cash inflows

and outflows associated with a project.

i.e. NPV = PV of future cash flows (P) PV of projects cost (I)

Required rate of return/discount rate must be defined corresponds to

cost of capital.

Decision criterion:

If NPV > 0:
Investment is profitable and therefore acceptable
NPV measures the increase in wealth

11

Estimating Cash Flows: Initial Outlay

Estimated cost of the investment

Purchase price
Other costs (freight, installation, training, testing)

Attributable cash inflow or cost savings

Receipts from the disposal of existing investment

Tax effect of profit/loss on disposal (based on NBV)

LO 3

12

Estimating Cash Flows: Annual Cash Flows

Cash inflows
Relevant cost savings
Attributable revenue

Cash outflows
Attributable cash operating expenses

Taxation

Depreciation tax shield tax (cash flow) effect of depreciation

LO 3

13

Estimating Cash Flows: Divestment

Disposal of investment

Profit or loss on disposal

Tax effects of disposal of investment (based on NBV)

LO 3

14

Estimating Cash Flows: Non-relevant items

Allocation of existing fixed costs

Attributable change in fixed cost will be relevant

Sunk cost

E.g. cost of existing investment

Revenue from sale of existing investment is relevant

Financing charges
E.g. interest

Accounting depreciation (without tax effect)

Problem 19.32 (p.748)

LO 3

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Capital budgeting: discounting methods

Internal rate of return

LO 4

The interest rate that sets the net present value of an

investment at zero.
Found through trial and error or software package.

Decision criterion:

IRR compared with required rate of return

IRR > required rate, investment deemed acceptable.

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Capital budgeting: discounting methods

NPV, IRR and mutually exclusive projects

LO 5

NPV and IRR both yield the same decision for indepednent
projects.
For mutually exclusive projects NPV and IRR can produce
different outcomes

NPV assumes that cash flows are reinvested at required rate of return,
IRR assumes they are reinvested at the IRR rate
The first is the more reasonable assumption
NPV provides an absolute measure, IRR provides a relative measure
Can at times provide different outcomes (competing projects).
It is believed that NPV provides a more consistently correct signal of
wealth maximisation.
For these reasons, NPV is preferred over IRR for mutually exclusive
projects.

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Keeping it Real: Capital budgeting in Aust

2008 survey conducted on capital
budgeting practices of Australian
businesses. (See Article)
Findings
NPV most popular. IRR and payback also
used.
CAPM is the most popular asset pricing
model for discount rate, despite heavy
criticism.
Newer approaches (e.g. Real Options),
not that popular.

LO 5

18

Project managing approved capital investments

Gantt chart

A horizontal bar chart that displays the project shcedule

Shows beginning and end times for each activity
Can be used to track progress

LO 6

At end of week 5
Green = completed
Blue = in progress
Red = behind
schedule

19

Project managing approved capital investments

Network diagram

LO 6

Used to show precedence relationships among different

project activities

We will follow the activity on node (AON) convention for drawing network
diagrams.
Shows each activity as a circle (or node) and connects activities with
arrows.

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Project managing approved capital investments

AON diagram
conventions

LO 6

21

Project managing approved capital investments

Critical path method (CPM)

Approach for scheduling activities within a project for the

fastest and most efficient execution

CPM terminology

Critical path method: an algorithm for scheduling activities

within a project for the fastest and most efficient execution
Critical path: the path within a project that takes the longest
time to complete
Dictates the project completion time

Slack: the amount of flexibility in scheduling an activity within a

project
No slack time for activities on critical path

LO 6

B&V CH8, Problem 1

(p.320)

22

Project managing approved capital investments

CPM: cost and time tradeoff analysis

LO 6

Sometimes the most efficient schedule is not sufficient for

meeting customer needs.
The scope of the project may need to be changed or additional
resources may need to be assigned to speed up the project.

If the scope of the project is changed, the project team can reevaluate the
schedule based on the new guidelines using the critical path method.
If additional resources are assigned to speed up the project schedule, a
cost and time tradeoff analysis (crashing) is conducted.

Crashing: an approach for identifying the lowest-cost

approach for reducing the project duration

23

Project managing approved capital investments

Project crashing procedure

LO 6

Crash the project one period at a time

Select the activity on the critical path with the lowest crash cost
per period.

Crash this activity to the maximum extent possible or to the extent where
desired deadlines are met

When there are multiple critical paths, crash activities on all

the critical paths.

Find the sum of crashing the least expensive activities on each path
Consider crashing common activities or a combination of activities

B&V CH8, Problem 2 (p.320)

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Project managing approved capital investments

PERT

LO 6

Technique for addressing the impact of uncertainties in activity

time estimates on the duration of the entire project.
Uses probability analysis to estimate three values for
time:optimistic (to), most likely (tm) and pessimistic (tp) values

to

tp

(t p
6

to )

Determines expected activity duration (te) and their

variance (2)
t
e

4tm
6

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Project managing approved capital investments

PERT

LO 6

PERT is useful for determining probability of timely project

completion
2 of critical path = sum of 2 for critical path activities
Use z value to detemine probability of completion by a certain
time
x

Apply z to statistical table to find probability

Hamilton Company Case

26

Next Week
Quiz 3: covers Seminars 8 - 11 inclusive

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