30 views

Uploaded by Seethalakshmy Nagarajan

capital investment decisions

- 11_mini case
- Financial Management 11e Ch13
- Fundamentals of Petroleum Economics
- FINAL-Gracie Evans Farm
- Net Present Value and Other Investment Criteria
- Study Quest and Problem Bab 11
- Effective Business Presentations With PowerPoint Data Analysis Chicago to Atlanta Route
- Lesson-18 CAPITAL BUDGETING
- Project Cost Management Formulae
- Cost Benefit Analysis
- NPV model
- Groupe Ariel Assignment Instructions and Rubric 1121
- Topic 11 - Long-Term Decision Making
- Excel Functions (Ism)
- pfi_internalratesguidance1_210307
- 04HDM 4EconomicAnalysisConcepts2008!10!22
- Chapter 08 Net Present Value and Other Investment Criteria
- B102121.edited
- Chapter_6
- PRESTON UNIVERSITY.docx

You are on page 1of 36

18 CAPITAL INVESTMENT

(Contributed by Deryl Northcott)

Introduction

Capital Investment Defined

Who is Involved in Making CI Decisions?

Why Are Capital Investment Decisions Important?

Types of Capital Investments

The Capital Investment Process

What Information is Relevant to a CI Decision?

Financial Analysis of Capital Investment Projects

Accounting Concepts

- Payback Period

- Accounting Rate of Return

Economics and Finance Concepts

- The Net Present Value Method

- A Variation on NPV - Profitability Index

- Internal Rate of Return

- Discounted Payback Period

- The Winner - NPV

Issues in Using NPV Correctly

- The Timing of Cashflows

- Taxation

- Depreciation

- Taxation Investment Incentives

- Taxation Effects - Summary

- Inflation

- Capital Rationing

Using NPV - Summary

Using NPV - An Extended Example

People Are Important Too!

Summary

Introduction

It is an unfortunate requirement that to make money, an organisation usually has to

spend money - the trick is always in spending it wisely. Making decisions about

what is and isn’t worth spending money on is never easy, especially where the

- .

expenditure is large and the returns risky, as is generally the case with capital

investment.

Capital investment (CI) can be seen as a sub-set of capital budgeting. Capital

budgeting refers to both the selection of long-term investments, and planning for

their financing. The Fisher Separation Theorem states that, in theory at least, the

investment decision is separate from the financial decision. There are special

circumstances when the investment and financial decisions are inter-related.

However, deciding which projects should be undertaken is sufficiently problematic

to warrant consideration on its own, and so forms the focus of this chapter.

acceptance of decisions about investment in long-term, risky capital

assets.

These decisions take place within the organisational context and impact upon the

strategic and operating position of the organisation, and also upon those people who

constitute the organisation. Therefore, we would expect CI decisions to take into

account the strategic and behavioural implications of the proposed investment, as

well as some rigorous examination of its financial effects.

There is no one answer to this question. Evidence from practice suggests that a

variety of people may participate in CI decisions (Bower, 1970; Mukherjee &

Henderson, 1987), even though much of the prescriptive literature suggest that these

decisions are the domain of the accountant. It is common in practice to see any or

all of the following personnel contributing:

- operational managers

- line staff (who work with the capital assets)

- production personnel

- engineers

- specialist capital investment officers / committees

- general managers and boards of directors (who are often responsible for the

final decision to commit to large items of expenditure).

It is therefore rare for CI decisions to be made behind the closed doors of the

accountant’s office. Although accountants have a role in providing financial

analyses and advice, specialist technical expertise is often required to assess

potential investments.

- .

Capital investment decisions are significant at two levels: for the future operability

of the organisation making the investment, and for the economy of a nation as a

whole. Capital investment directs significant resources towards particular areas of

economic activity. So collectively, CI decisions made by individual organisations

impact upon the future economic position of a nation.

has implications for many aspects of operations. Capital investment may concern

the purchase or modification of plant and machinery, so the cost, range, quality,

innovation and leadership of products are all affected by CI decisions.

Capital investment projects can take many forms. Generally, they involve:

2. Expansion of existing operations,

3. Strategic expenditure to develop new types of production technologies or

product lines, perhaps re-positioning the organisation in the market place, or

responding to some change in the operating environment, or

4. Non-financially motivated expenditures, e.g. safety, environmental or

legislatively required expenditures.

Depending on what the purpose of a CI is, the criteria for approving the project may

differ. For example, a risky, innovative project which launches the organisation

into a new area of operations will generally be expected to show a good financial

return. In comparison, a plant alteration required to meet health or safety

regulations may not be expected to achieve any financial return - it is a necessity,

and the focus will be on minimising the cost of achieving the legal requirements.

It is important to recognise that there are several ‘phases’ involved in making CI

decisions. The nature and relationship of these phases is shown in Exhibit 18.1.

- .

Strategic Planning

Formal CI Systems

Indentification of Project

Analysis and Monitoring and

potential definition and Implementation

acceptance post-audit

investments screening

Feedback

Organisational personnel

generating investment ideas, and judgement in being able to recognise a good idea

when it appears! Once the initial idea has been identified, the project needs to be

defined and detailed. Here, it is important to consider all the implications of the

project, for example: How much will it cost? What are its financial and strategic

advantages? How will it affect the organisation’s operations? At this stage, it is

usually possible to ‘screen out’those CI ideas which are clearly infeasible, or which

may not be as good as was first thought.

Once CI ideas have been formulated and screened, the promising projects continue

on to the ‘analysis and acceptance’stage. Here, rigorous financial analyses are used

to assess the financial implications of a CI project (later in this chapter we will look

at the kinds of financial analysis which can be used). Normally, if a project meets

the requirements of financial analysis, it will be accepted, and then implemented.

Once the project is up and running, it may be monitored so that a ‘post audit’can be

conducted, looking at how successful the investment has been.

Exhibit 18.1 shows that this decision process has links to the strategic planning

function in an organisation, and to the personnel who make CI decisions, implement

the projects and work with the capital assets. Finally, it is important to recognise

that this decision making process takes place within the organisational environment,

and so is subject to the objectives, traditions and culture of the organisation.

All of this looks simple. However, practice rarely reflects tidy, structured ‘models’.

The phases of this process may, in practice, be interactive and iterative and may

occur out of order or not at all! However, this model presents a useful starting point

for considering the facets of CI decision making. Each of the phases is important,

and a successful programme of CI decision making should include elements of them

- .

all.

The short answer to this question is: anything that changes as a result of a CI

decision will be relevant to assessing the viability of that investment. That is, the CI

decision maker must identify relationships between the decision made, and the costs

and benefits which accrue from it either immediately or in the future.

- changes in revenues or costs,

- required increases in working capital items (e.g. inventory).

Getting this information is often more difficult than it would first appear. For

example, the purchase price of a fixed asset is often the only explicit component of

the initial outlay cost. Other less obvious costs might include installation, legal

costs, re-training of employees, redundancy payments associated with the

discontinuation of present employees and production set-up costs. Capital

investment decision makers must be careful that they have considered all the effects

of implementing a CI project.

A number of irrelevant factors are often incorrectly included in the analysis of

proposed CIs. Examples include:

- sunk costs (costs already incurred which cannot now be changed, no matter

what decision is made),

- future costs and revenues which would have accrued regardless of the

current CI decision,

- allocations of fixed costs (where the total cost to the organisation will not

change, even though the way it is allocated for reporting purposes may), and

- financing costs (already taken into account in the required rate of return

imposed on a CI proposal).

Again, asking the simple question: "Will these costs or revenues change as a result

of the decision made?" is usually enough to reveal their relevance (or irrelevance)

to the decision. Remember though - it can be difficult to predict what might happen

if the CI is not undertaken, so working out the changes caused by a project may not

be easy!

important factor in deciding whether or not to accept proposed investments in many

organisations. However, there are many more organisations for which profit results

and wealth generation are not of primary importance, but are merely means to an

end. Such organisations include central and local Government bodies and not-for-

profit organisations such as clubs, social services and charities. For these

organisations, the financial viability of a CI may not be a relevant criterion in

establishing its desirability. Investment decisions may be based on criteria which

are difficult to quantify, thus making CI decision making an especially challenging

- .

instances financial analyses can be a helpful input to their CI decisions. For

example, financial considerations may be relevant where more than one alternative

way of achieving a goal is identified and a choice must be made about which option

to pursue. Where financial analysis has utility, CI decision makers in all types of

organisations need to be aware of the range of decision support techniques available

for considering financial aspects of investments.

In the next part of this chapter, this range of financial analysis techniques is

presented after looking at the different theoretical perspectives of the alternative

approaches.

There are two main views of financial performance measurement which form the

theoretical underpinnings of CI analysis techniques: accounting concepts and

economics or finance concepts.

conventions, have given financial accounting a particular ‘view of the world’. From

an accounting perspective, long-term financial success is measured by profitability,

while short-term success places greater emphasis on liquidity.

These concerns of liquidity and profitability have formed the basis of two CI

analysis techniques: ‘payback period’ and ‘accounting rate of return’. These

accounting-based methods are popular in practice, especially among CI decision

makers in small and medium sized firms, and are often referred to as ‘traditional’

methods.

concerned with the maximisation of shareholder wealth and the consideration of

risk. As CI decision making is concerned with effective resource allocation, it

follows that successful CI projects are those which add to the value of the firm, thus

increasing shareholder wealth. Following from this, a CI is acceptable if its

expected cash returns exceed its expected cash costs, so liquidity (the timing of

these cashflows) and profitability (determined for the financial reporting of these

cashflows) become less important.

considerations has led to the development of CI analysis techniques quite different

from the ‘traditional’ accounting-based methods. These techniques are the ‘net

present value’, ‘profitability index’, ‘internal rate of return’ and ‘discounted

payback period’approaches.

How each of the alternative analysis techniques is used, and the strengths and

weaknesses of each approach will now be discussed.

- .

Accounting Concepts

Payback Payback period (PP) is concerned with liquidity. It is a short-term oriented method

Period which asks, "How soon will the CI project pay itself back?" The faster a CI project

can recoup its initial cost, the better. Payback period focuses on the cashflows from

a CI project, and the speed at which they are received, rather than on any measure

of profitability or overall return.

horizon as a yardstick for assessing CI proposals. The greater the liquidity needs of

the investor, the shorter may be the acceptable PP time period. The selection of a

PP ‘cut-off point’is therefore arbitrary.

and installing the system is $6,000. The expected cost savings associated with the

computer system will improve as staff become more familiar with using it. The

pattern of expected cash benefits is:

($)

1 500 500

2 800 1,300

3 1,000 2,300

4 1,200 3,500

5 1,500 5,000

6 2,000 7,000

7 2,000 9,000

8 2,000 11,000

From the cumulative cashflows, we can see that the computer system’s payback

period is between five and six years. If we assume that cashflows accrue evenly

throughout the year, then the payback period is 5.5 years. Should the firm purchase

the computer system? The answer depends on the PP criterion they use. If the firm

has established a cut-off point of four years, then they would not purchase the

computer system. If, however, their cut-off was six years, then the computer system

is acceptable.

The PP analysis method has two major deficiencies. First, it ignores any cashflows

which occur after the project’s payback period. The benefits accruing from the

computer system in the previous example in years seven and eight could have been

- .

enormous, yet the PP calculation would have taken no account of them. This

deficiency reflects the short-term orientation of the PP technique. Therefore, the

use of PP as a decision making tool penalises those projects with inherently long

lives and promotes projects which produce rapid returns, even though those returns

may be modest and short-lived.

The second major deficiency of the PP technique is that it ignores the time value of

money. A modified version of the PP analysis method, called ‘Discounted Payback

Period’(DPP) has been proposed as a means of overcoming this problem, and will

be discussed later in this chapter.

Despite its deficiencies, payback period is often used in practice. PP analysis may

be useful as a first screening device where an organisation is concerned with

liquidity. However, PP should not be used as the sole basis for CI decisions, if the

intention is to maximise shareholder wealth.

Accounting The second of the accounting-based CI analysis methods is the accounting rate of

Rate of return (AROR). This method compares a CI project’s ‘profitability’ to the capital

Return employed in the investment. One of the difficulties of this method is that there are

several ways of representing ‘profit’ and ‘capital employed’. Alternative profit

measures can include or omit financing expenses, depreciation and tax. ‘Capital

employed’ can be either initial capital (i.e. the historic cost of the organisation’s

assets) or average capital employed.

However, the most common definition of AROR uses the ‘earnings before interest

and tax’ (EBIT) profit figure (which includes the effects of depreciation), and the

average capital employed. The ‘average capital employed’concept requires that we

know how much is invested in an asset at the beginning and end of its useful life.

This investment comprises both the value of the asset itself, and the value of any

working capital which is held in association with this asset (often this working

capital component is constant over the asset’s life). The concept of ‘capital

employed’is illustrated in Exhibit 18.2.

- .

$ invested

Where:

wc + pp sv = salvage value

pp = purchase price

n = the life of the investment

wc + sv

wc

Time

year n

AROR =

average capital employed

i. e

(initial outlay + residual value) ÷ 2

and residual value = sv + wc

An asset costs $12,000 to purchase, and has an expected life of five years with a

salvage value of $2,000. Additional inventories costing $1,000 are required at the

time the asset is commissioned, but can be liquidated for $1,000 at the end of the

asset’s life. It is estimated that the asset will increase annual revenues by $5,000,

although it will create a straight-line annual depreciation expense of $2,000.

The annual pre-tax profit generated by this asset is ($5,000 - $2,000) = $3,000 for

- .

= (Initial capital + terminal capital) ) 2

= [$13,000 + ($2,000 + $1,000)] ) 2

= ($13,000 + $3.000) ) 2

= $8,000

AROR:

= $3,000 ) $8,000

= 0.375 or 37.5%

Like the payback period method, AROR is not without substantial flaws. This

method uses accounting profit, rather than cashflows, as a measure of return on an

investment. Inconsistencies in the derivation of profit figures (perhaps due to

changing accounting policies) can produce widely differing AROR results. Also,

accounting profits suffer from ‘distortions’such as depreciation expenses and gains

and losses on the sale of fixed assets. Although these items feature in the

determination of ‘profit’, they do not result in the actual payment or receipt of cash

by the organisation. And, since they are not actual cashflows, they have no impact

on the wealth of the investors.

The second major flaw of the AROR method is shared with the PP method - it does

not take account of the time value of money. The return on a CI is deemed to be its

average accounting profits, even though these profits occur in different time periods

and may change from year to year .

It may be that some CI decision makers prefer to analyse investments using a profit-

based measure. Often such an approach is consistent with the profit performance

measures to which managers are themselves subjected. Whatever the reason for its

use, the AROR approach is inappropriate for those organisations seeking to

maximise shareholder wealth.

So, it can be seen that the two main ‘traditional’ analysis methods are not ideal.

Although both are used in practice, they have serious shortcomings, and can lead to

incorrect CI decisions. These techniques have largely fallen from favour in the

normative CI literature, and have been replaced with the ‘sophisticated’ techniques

which find their roots in economic theory.

The Net The net present value (NPV) analysis method discounts all future cashflows from a

Present CI back to their present value, and compares them with the present value ‘cost’ of

Value entering into the investment. Hence, the ‘net’ present value is the difference

Method between the present values of the investment’s inflows and outflows.

The decision criterion used in conjunction with the NPV method is the same for all

- .

investments and all organisations: if the NPV is positive (i.e. greater than zero),

then the investment should be accepted. Conversely, if the NPV is negative the

investment should be rejected. A positive NPV indicates that an addition to the

wealth of the investors is expected. Theoretically, a decision maker would be

indifferent about a CI with a NPV of exactly zero. However, intuitively, a zero

increase in wealth is usually insufficient reward for the effort of pursuing the

investment, and so a zero NPV project would rarely be attractive.

In order to use the NPV analysis method, there are several inputs which must be

determined. Broadly the required information includes:

- the relevant future cash flows associated with the CI,

- the anticipated life of the CI, and

- the appropriate discount rate to be used.

As noted earlier, determining the initial outlay and future cashflows associated with

a CI is rarely straight-forward. Similarly, uncertain effects such as wear and tear,

obsolescence and changes in the activities of the organisation can render asset life

estimates incorrect. Perhaps the most problematic input is the determination of an

appropriate risk-adjusted discount rate - the choice of discount rate is crucial to the

outcome of the NPV analysis.

Vehicle Purchase Proposal

employee will be trained to obtain a Heavy Transport Licence at a cost of $100.

Vehicle running costs are estimated at $3,000 p.a., but Porter Co.will save $7,000

p.a. in contract delivery charges. The vehicle will have a useful life of six years, to

be sold for $3,000 at the end of year six. Porter Co. requires a 12% rate of return

on this type of investment (tax and depreciation are ignored until later in this

chapter).

Cashflows Time 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6

($00s) (now)

HTL training -1 -30 -30 -30 -30 -30 -30

Running costs

Savings on

delivery costs +70 +70 +70 +70 +70 +70

- .

Total annual

cashflows -161 +40 +40 +40 +40 +40 +70

All initial outlay costs are said to occur in ‘time 0’ - i.e. now. Note that running

costs and savings on delivery contract charges are annuities continuing for the life

of the investment. Note also the implicit assumption that cashflows occur at the end

of each year. For example, the first year’s running costs are assumed to occur in

one year’s time, and will be discounted by one year to obtain their present value.

This assumption facilitates simple illustrations, and in practice, where it is difficult

to ascertain the exact timing of cashflows, such simplifying assumptions may be

used.

+ (PV of a sum of $3,000 received in 6 years’time, at 12%)

= -$16,100 + ($4,000 x 4.1114) + ($3,000 x 0.5066)

= -$16,100 + $16,446 + $1,520

= + $1,866

So, the vehicle purchase opportunity has a positive NPV, and should be accepted.

A Variation The Profitability Index (PI) measure uses exactly the same discounted cashflow

on NPV - information as the NPV method. However, instead of finding the difference

Profitability between initial outlay and the present value of future cashflows, the PI approach

Index finds the ratio of these two values. A generalised formula for PI is:

PI = Initial Outlay

For example, if we calculated the PI of the delivery vehicle proposal in the previous

example, it would be:

$17,966

PI = $16,100

= 1.116

than 1 should be rejected. The PI approach will always produce the same accept or

reject decision as the NPV approach, as it is simply a re-ordering of the same

information. However, PI has advantages over NPV where a firm is subject to

capital rationing, as will be noted later.

Internal Rate Internal rate of return (IRR) is another major CI analysis method derived from the

of Return theoretical perspective of economics. The IRR approach focuses on finding the

discount rate at which the NPV of a project would be zero. That is, the ‘IRR’is the

- .

rate of return earned by the project itself, and equates the present value of future

cashflows to the initial outlay. Simple examples illustrate this approach.

1. Simple returns:

You invest $1,000, and at the end of the year you receive an interest cheque for

$120. The IRR of this investment is easily found:

$120

IRR =

$1,000

= 12%

2. Compound returns:

You invest $1000 in Municorp. shares. After holding these shares for four

years, you sell them and receive $1,810.60. The IRR of this investment can be

found by solving the following equation:

$1,810.60 ÷ $1,000 = (1 + IRR ) 4

18106

. = (1 + IRR ) 4

At this point there are two choices: you can consult a table of compound interest

factors to find the four year rate which has a factor of 1.8106 (16%), or you can

solve the equation algebraically:

4

1.8106 = (1 + IRR)

(1 + IRR) = 1.16

IRR = 16%

In practice, finding the IRR of a project involves complex calculations. Now that

computers are widely available, IRRs can be automatically computed for a series of

cashflows. However, it aids our understanding of how IRR works to consider a

‘trial and error’ approach to finding the IRR of a CI project. Let us reconsider the

delivery vehicle purchase example. We can restate the problem in terms of the

IRR. To find the IRR, we set the NPV at zero and solve for the discount rate, that

is:

(PV of a sum of $3,000 received in 6 years’time, at IRR%)

Without the help of a computer, there is no quick way to solve this equation. The

simplest manual approach is to repeatedly guess at the IRR until answers are

obtained which are close to the required zero. Once we have obtained a discount

rate which produces a slightly positive NPV, and a discount rate which produces a

- .

slightly negative NPV, then we can use linear interpolation between the two points

to find an estimate of the IRR which will give an NPV of zero.

(Based on example of vehicle purchase proposal)

The IRR of the vehicle purchase opportunity is the discount rate at which the NPV

equals zero, i.e.:

(PV of a sum of $3,000 received in 6 years’time, at IRR%)

The NPV of this project has already been calculated at 12% as +$1,866. Since this

result is positive, raising the discount rate will reduce the NPV. Re-calculating the

NPV using a 16% discount rate:

+ (PV of a sum of $3,000 received in 6 years’time, at 16%)

= -$16,100 + ($4,000 x 3.6847) + ($3,000 x 0.4014)

= -$16,100 + $14,739 + $1,204

= -$157

With one positive NPV result and one negative NPV result, linear interpolation is

used to estimate the IRR. This can be represented graphically:

NPV

+$1866

16%

Discount rate

12%

-$157

(i) the distances between the two observed NPVs and the zero NPV point

- .

(ii) the distances between the two trial discount rates and the IRR

1866

IRR = 12% + × (16% - 12%)

1866 - (-157)

= 12% + (0.922 × 4%)

= 15.69%

The IRR of 15.69% is much closer to 16% than to 12%, and this was obvious from

the NPV results. The 12% calculation produced an answer that deviated by $1866

from the desired zero point, while the 16% answer was only $157 off target.

‘Linear’ interpolation assumes that the relationship between the two data points is

that of a straight line. This is rarely true. So, the closer are the two discount rates

used, the more accurate will be the answer, as a straight line will better approximate

the relationship over a shorter distance.

It can be seen that the IRR method, while using the same cashflow information as

the NPV method, presents a percentage return on the investment, rather than

measuring the investment’s net contribution to wealth. Research evidence suggests

that many practitioners favour the percentage expression of IRR (Pike, 1982).

However, it is thought that this preference is due to the mistaken belief that using

IRR removes the need to determine a discount rate. Of course, when considering

the acceptability of a CI project, its IRR must be compared to some pre-determined

required rate of return. So, even using IRR, the need to work out an appropriate

discount rate is not escaped!

There are also some weaknesses associated with IRR, arising both from its

mathematical formulation, and from the model’s inherent assumptions. The IRR

equation requires that a polynomial root (or solution) can be found which makes the

NPV equal to zero. However, there are cases where a series of cashflows has no

root, or multiple roots, as demonstrated in the following examples:

Time 0 Yr 1 Yr 2

discount rate which will produce a zero NPV for this series of cashflows.

- .

Time 0 Yr 1 Yr 2

This set of cashflows has IRR solutions at 25% and 400%, and would produce a

positive NPV at any discount rate between these two values.

In such cases, the use of IRR as a decision-support tool is problematic. Which IRR

is the correct one? A necessary (but not sufficient) condition for multiple IRR

solutions is that there is more than one change in the sign of the cashflows.

Typically, we see an initial cash outflow followed by a series of inflows over the life

of the CI. However, where there are further changes in the sign of the cashflows,

the multiple solution problem can occur. The possibility of multiple IRRs makes

this method less attractive as a CI analysis tool.

The second main problem with the IRR approach is that it can produce rankings of

CI projects which conflict with those obtained using NPV. This becomes a

problem where a firm must select between mutually exclusive CI projects, as

illustrated in the following example.

to that factory, and must choose between two options with the following cashflows:

(ii) spend $40,000 now and receive $46,000 in 1 year’s time.

This factory modification is a one-off expenditure for Ratima Co. and no further

investment opportunities are expected for at least four years. Ratima Co. has a

required rate of return of 10%.

(i) + $3,576 13.19%

(ii) + $1,818 15.00%

Therefore, using the NPV rule we would accept option (i) as it has the greater NPV.

However, using the IRR rule (where both options exceed the RRR), we would be

inclined to select option (ii) as it has the greater IRR.

The different rankings result from the differing assumptions of the NPV and IRR

approaches, in this case best referred to as ‘opportunity cost’ assumptions. If

Project (i) is foregone, the investor forfeits a return (for three years) of 13.19%. If

- .

Project (ii) is forgone, the investor forfeits a return (for one year) of 15%. While

the IRR of project (ii) appears more appealing, the NPV shows that on an

investment of $40,000, a 15% return for one year is worth less than a 13.19% return

for three years.

It is not appropriate to use the IRR approach for ranking mutually exclusive

projects. Clearly project (i) should be accepted, as it will make the larger

contribution to the wealth of the investor. Reliance on the IRR rankings would

lead to an incorrect decision in this instance.

The re-investment assumption of the IRR model causes problems where cashflows

accrue over the life of an investment. The IRR model assumes that all cashflows

produced by a CI can be re-invested at the IRR. This is often unrealistic. If a

project has an IRR of 20%, but market rates for investment are only 14%, then we

cannot expect to re-invest cashflows arising from the CI at the 20% rate. So, the

IRR method has overstated the return which will realistically be generated by the

CI. Using NPV no such assumption is required, as it is possible to vary discount

rates to reflect changing investment possibilities over the life of the project. Here

again, NPV is preferred over the IRR method.

Discounted When the payback period (PP) method was considered earlier, it was noted that a

Payback variation called the discounted payback period (DPP) improved this approach. The

Period DPP approach has all the perceived advantages of PP - it is easy to understand and

compute, and it allows the investor to focus on liquidity where this is appropriate.

But, unlike PP, DPP takes into account the time value of money. Therefore, the

DPP approach is a useful step towards the theoretically superior method of NPV,

particularly for smaller business managers who find the PP approach attractive.

The DPP method discounts each year’s net cash flow by the appropriate discount

rate and determines the number of years it takes for these discounted cashflows to

recoup the CI’s initial outlay. Because DPP recognises the time value of money, it

produces a longer payback period than does the non-discounted PP approach, and

takes into account more of the CI’s cashflows.

Another advantage of DPP over the traditional PP method is that it has a clear

‘accept or reject’criterion. Using DPP, a project is acceptable if it pays back within

its lifetime. An example illustrates the difference between the PP and DPP

approaches.

$7,000 p.a. for six years.

($) (@15%) ($)

- .

1 +7,000 +6,087 -13,913

2 +7,000 +5,293 -8,620

3 +7,000 +4,603 -4,017

4 +7,000 +4,002 -15

5 +7,000 +3,480 +3,465

6 +7,000 +3,026 +6,491

The PP is just under three years ($20,000 ÷ $7,000). Acceptance depends on

the chosen cut-off time: if cut-off is two years, would reject, if three years would

accept.

The discounted payback period is just over four years. The investment would

be accepted, as it pays back within its six year lifetime.

Discounted payback period still does share one limitation with PP - cashflows

which occur after the payback period are ignored. However, since the DPP is

always longer than the PP, the DPP method ignores fewer of these cashflows. DPP

also conveys a sense of liquidity measurement which is not achieved using the NPV

method. Since PP is often the only CI analysis undertaken in smaller businesses,

switching to DPP is a step in the right direction for many CI decision makers.

The Winner- Financial analysis techniques do not provide all the answers in CI decision making.

NPV Organisations may have objectives which cannot be reflected in quantitative

financial analyses. However, where it is relevant to consider the financial

performance of a CI, there are several reasons why NPV provides the best means

for doing so.

Payback period is a useful first screening device, and AROR has some strength in

facilitating comparison of CI outcomes with profit performance measures. But,

only the discounted cashflow methods focus, as the name suggests, on cash (the

source of wealth) and the time value of money (the value of that cash).

NPV has none of the computational problems of IRR, and a combination of NPV

and PI can tell us both the value of the CI, and the significance of that return

relative to the size of the investment (which is useful when limited funds are

available for investment). The NPV also allows for additivity of CI values, whereas

IRRs cannot be added to achieve a sense of the total return to the organisation.

So, IRR can work, (but sometimes doesn’t and is complex), DPP is a step in the

right direction, and NPV is best! Since NPV is preferred, there are some issues that

must be addressed to ensure that it is used correctly.

- .

The Timing A key aspect of using NPV is the recognition of the different timing of cashflows

of Cashflows from a CI project. In practice, cashflows may occur at any time throughout the

year, but for simplicity we assume that all cashflows occur at the end of the year.

For example, if considering a CI investment on 1 January 1993, and the first

running cost is to be incurred in July 1993, we would assume that this running cost

cashflow occurs on 31 December 1993, and discount it by one year to find its

present value. Such assumptions will, of course, slightly distort NPV results. For

major projects where the amount of the cash flow is significant it is, of course,

important to discount the cash flows by the exact number of days required.

However, it should be recognised that NPV can only ever be a decision support

tool. It can never provide an exact answer, as many of the cashflows are themselves

uncertain and must be estimated. The effect of simplifying assumptions about

cashflows usually has limited impact on the analysis.

Taxation Up until now the effects of taxation have been ignored, for simplicity. However, in

reality, tax has a significant impact on the cashflows of CIs. Where cashflows from

a CI change the amount of tax payable, then this is itself a real cashflow effect.

There are a number of ways in which these tax effects occur:

- when costs (or reduced revenues) of a CI decrease profit,

- when a gain or loss is made on the sale of a fixed asset,

- when a CI is depreciated or written down, and

- when special taxation relief is provided as an investment incentive.

The first of these taxation effects is perhaps the most obvious. It is unrealistic to

consider only pre-tax cash revenues from a CI, as revenues which change reported

profits also change tax liabilities, and produce taxation cashflows. It is important

also to consider the timing of these tax cashflows. Most businesses pay tax one year

after the end of each financial year. So for example, a cost or revenue which occurs

in three years’ time will normally produce a taxation effect in four years’ time,

assuming (for simplicity) that all cashflows occur at the end of the year.

Hall Co. is considering purchasing a new packaging machine. The machine will

cost $52,000, plus installation costs will be $4,000. A $2,000 increase in inventory

will be required, which can be liquidated for $2,000 at the end of the machine’s 5

year life. The machine is expected to cost $26,000 per year to run, but will reduce

packaging costs by an estimated $60,000 per year. It will have a zero salvage value

in five years’time. Hall Co.is subject to a 35% tax rate.

- .

Only the increased costs and revenues appear in the income statement, affecting

profit and therefore tax. Both the asset price and installation cost are capitalised to

the asset account, and the increased inventory is a current asset rather than an

expense.

Cashflows Time 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6

($000s)

Purchase price -52

Installation -4

Inventory -2 +2

Running Costs -26 -26 -26 -26 -26

Cost Savings +60 +60 +60 +60 +60

Increased tax* -11.9 -11.9 -11.9 -11.9 -11.9

= ($60,000 - $26,000) x 0.35

= $11,900

and as profit has increased, so will the tax liability, producing a cash outflow,

assumed to occur one year after the costs and revenues themselves.

If a CI project involves the sale of a currently held asset, further taxation effects can

occur. If the selling price differs from the asset’s net book value then a gain or loss

on sale occurs. Although not actual cashflows in themselves, gains will increase

profit thus increasing tax, and losses will decrease profit and reduce tax payable.

Again, it is normally assumed that such tax effects produce cashflows one year after

the sale of the asset, when the tax liability is payable.

Angle Co. is considering replacing an old forklift purchased six years ago for

$50,000 with an estimated useful life of ten years. It has been depreciated on a

straight-line basis to a salvage value of $10,000. Angle Co. has a 35% tax rate.

$50,000 − $10,000

= $50,000 − 6 ×

10

= $26,000

- .

(i) The old forklift is sold for $30,000 (cash received now):

= $4,000

⇒ Tax payable = $4,000 x 0.35

= $1,400 (payable in 1 year’s time)

(ii) The old forklift is sold for $15,000 (cash received now):

= $11,000

⇒ Tax break received = $11,000 x 0.35

= $3,850 (received in 1 year’s time)

When the sale of an existing asset forms part of a CI proposal, both the cash

received for the asset (i.e. its selling price) and the taxation implications of any gain

or loss on sale must be taken into account in analysing the cashflows.

Depreciation Although the purchase price of a CI is incurred at the outset of the investment,

financial accounting practice is to spread this initial cost over the life of an asset via

depreciation. When conducting NPV analysis, depreciation itself is meaningless.

The initial cash outlay occurs when the asset is purchased in ‘time 0’, and the

accounting treatment of the asset does not change that. However, as an asset is

depreciated over its life, that depreciation is recognised as an expense in the income

statement each year, thus reducing profit. And as we know, a reduction in profit,

though looking bad from an accounting point of view, is good from a cashflow

perspective as it means less tax!

Different countries have different ways of allowing asset depreciation for taxation

purposes. Some countries (like the UK) use ‘writing down allowances’ which are

established at a fixed rate. Other countries (including New Zealand) prescribe

allowable depreciation rates which a business can use to expense different assets in

the income statement. The following example shows an illustration of how

depreciation allowances affect taxation cashflows.

An asset is purchased by Taylor Co. for $100,000, and has a useful life of four

years. It is subject to a depreciation allowance of 25% on its diminishing value.

Taylor Co. is subject to a 35% tax rate.

Depreciation allowances:

Tax effect (cash inflow)

2nd year $75,000 x 0.25 = $18,750 $18,750 x 0.35 = $6,563

3rd year $56,250 x 0.25 = $14,063 $14,063 x 0.35 = $4,922

- .

The taxation cashflows resulting from the depreciation allowances would normally

occur one year after the depreciation expense is recognised. So, if the first

depreciation allowance occurs at the end of the first year of the asset’s life, the

timing of the taxation cashflows would be as follows:

Time 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Cashflows:

Initial outlay -$100,000

the change in depreciation is relevant to the NPV analysis. For example, if an

existing asset depreciated at $3,000 per year, is to be replaced with a new asset

having annual depreciation of $5,000, then only the increase in depreciation of

$2,000 per year is relevant to calculating taxation effects.

significant impact on the NPV of a CI project. Therefore, it is important to identify

any changes in depreciation allowances so that the amount and timing of tax

payments can be correctly incorporated into the NPV analysis.

Investment in particular types of capital assets. In these cases, depreciation allowances may be

Incentives accelerated, or there may be special ‘one-off’ tax credits in the year of the asset’s

purchase. It is in the interests of the CI decision maker to be aware of such

incentives, as they could impact on the viability of a CI project.

Taxation Taxation affects the NPV of a CI by changing its cashflows. This occurs because

Effects - real cash effects of a CI (e.g. revenues and costs) and the accounting treatment of

Summary CI effects (e.g. gains and losses on asset sale and depreciation) all impact on

reported profit and therefore change tax liabilities. A CI proposal cannot be

correctly analysed without taking these taxation issues into account.

Inflation Inflation affects the value of cashflows by eroding their purchasing power. Investors

want to be compensated for this reduced purchasing power of future cashflows, so

inflation is built into the discount rate used in NPV analyses.

A rate of return which includes an inflation component is a nominal rate. The real

rate of return removes the inflation component. It is important to distinguish

between real and nominal rates of return when discounting cashflows for NPV

analysis. Both the rate and the cashflows used must be consistent. Therefore, if a

- .

nominal rate of return is used as the discount rate, then it should be recognised that

inflation will increase the nominal size of the cashflows over the life of the CI.

Alternatively, if cashflows are assumed to stay constant over the life of the asset,

then a real rate of return should be used. It is a common mistake to use inconsistent

combinations of rates of return and cashflows, resulting in incorrect NPV analyses.

If done properly, both approaches will provide the same result.

Capital It has been assumed up to this point that a firm will have sufficient funds available

Rationing to invest in any available project which has a positive NPV. However, due to

externally imposed restrictions, (e.g. hard capital rationing) or internally imposed

budgets (e.g. soft capital rationing) there may be only limited funds available to the

firm for investment. Where this is the case, a choice must be made between

positive NPV projects.

Here, the profitability index (PI) is more useful than NPV. While NPV shows the

value of an investment, PI expresses that value as a proportion of the initial outlay

funds required. Therefore, where funds are scarce, a higher PI project would be

preferred as it returns more per scarce dollar than a project with a lower PI.

or multi period capital rationing is the use of Linear Programming (LP). Linear

programming is a (usually) computerised mathematical technique. It calculates

‘optimal’ solutions where an objective (e.g. maximising NPV) is pursued under

constrained conditions (e.g. capital rationing), and can in its more sophisticated

forms, cope with probabilistic outcomes, multiple objectives and multiple

constraints. Linear programming is also useful where minimum liquidity and

profitability constraints must be met by a CI investment programme.

‘Real world’ complications make the financial analysis of CI projects difficult.

However, once the impact of these factors is assessed the NPV analysis method

(together with PI) can accommodate the effects of tax, depreciation and inflation

and lead to correct decision making where mutually exclusive projects exist. As

with most financial decision making, the hard part is predicting what the future

holds, but no CI analysis method alone can address this problem!

how to conduct an NPV analysis on a CI proposal, may now be helpful.

In this example, there are two machines: an existing machine, and a new machine

which could be purchased as a replacement. In approaching the information, it is

helpful to consider a CI project as having three types of cashflows:

- .

2. Annual incremental cashflows (occurring over the life of the investment), and

3. Terminal cashflows (occurring at the end of the investment’s life).

about the CI proposal assists in discounting these cashflows in order to find the

project’s NPV. The construction of a time-line makes the analysis easier to follow.

Purchase price $200,000 $320,000

Expected useful life 8 years 5 years

Current age 3 years not applicable

Expected salvage value $0 $20,000

Depreciation straight-line straight-line

Pre-tax annual revenue generated $80,000 $180,000

Pre-tax annual running costs $20,000 $20,000

Inventory required $15,000 $25,000

Current resale value $100,000 not applicable

Note that inventory can be sold at the end of the assets’lives for its current value.

Discount rate 10% (real, ie no inflation considered)

Timing of tax payments 1 year after the current operating year

Cost of rent for the machine site $27,000 p.a.

Purchase of new machine ($320,000)

Required increase in inventories (10,000)

Sale of old machine* 100,000

INITIAL OUTLAY (cash outflow) ($230,000)

Current book value = Historic cost - accumulated depreciation

= $200,000 - [ 3 x (200,000 - 0)/8 ]

= $200,000 - $75,000

= $125,000

= $125,000 - $100,000

= $25,000

= $25,000 x 0.30

= $7,500 (cash inflow one year after sale of machine)

- .

running cost)

= ($100,000 - 0)

= $100,000 (cash inflow in years 1 to 5)

= $100,000 x 0.30

= $30,000 (cash outflow in years 2 to 6)

x tax rate

= [ (320,000 - 20,000)/5 -

(200,000 - 0)/8 ] x 0.30

= ($60,000 - $25,000) x 0.30

= $10,500 (cash inflow in years 2 to 6)

Note that the cost of rent for the machine site is not included - it is irrelevant as

it will not change if the new machine is purchased.

Liquidation of increased inventory $10,000

TERMINAL CASHFLOW (cash inflow) $30,000

Year 0 1 2 3 4 5 6

Tax: sale of old machine +7.5

Increased profits +100 +100 +100 +100 +100

Tax: increased profits -30 -30 -30 -30 -30

Depn. tax shield +10.5 +10.5 +10.5 +10.5 +10.5

Terminal cashflow +30

($)

Discounted @ 10% -230000 +97727 +66529 +60481 +54983 +68612 -11007

(Σ) NPV = +$107,325

The opportunity to replace the old machine with a new machine has a substantial,

positive NPV. This financial analysis result can now be used as part of the

information (together with considerations such as strategy, market factors,

technology etc.) to arrive at an investment decision.

- .

It is often forgotten that CI decision making is a human activity rather than an

objective, mechanical procedure. There are people behind the ‘process’. Capital

investment theory has tended to reflect an image of economically rational, profit

maximising decision makers with perfect knowledge and few emotions. Such

people can correctly use and interpret the sophisticated CI techniques proposed in

the literature, and will never make a bad decision simply because they are having a

bad day! A hopeful, but somewhat unrealistic scenario. Behavioural factors, both

at an individual and organisational level, impact on decision making practice. These

factors must be considered so that a complete, rich picture of CI decision making

can be achieved.

For example, it is usually assumed that the results of NPV analyses are used as an

economic input into CI decisions, reflecting projects’ financial viability.

Alternatively, a positive NPV result may be seen as a political bargaining tool.

Divisional managers who want to secure organisational resources (and political

influence) for their own division might point to a positive NPV project as an

example of the lucrative investment opportunities available to that division. Then,

not only are the analysis results assisting an economic decision, they are also being

used as ammunition in a resource bargaining situation which may produce a

political advantage for the division manager. In such cases, there may be a

temptation to make the NPV results look good, as a lack of attractive investment

opportunities would reflect poorly on a division’s future success. Which objective

then takes precedence? This becomes a function of the organisational climate and

of the individual decision maker’s preferences, and there may be no one right

answer.

understood without considering the organisational and political contexts within

which it occurs. CI decisions influence, and are influenced by, other aspects of

organisational activity. For example, there can be conflicts between ‘rational’ CI

decisions and performance evaluation systems. It is difficult in practice to ensure

that CI decision makers will aim to maximize shareholder’s wealth, unless they are

somehow motivated to do so. Therefore, performance evaluation systems need to

reward behaviour which promotes the economic goals of the organisation. This

means that performance evaluation of CI decision makers should take a long-term

orientation, and should focus on the criteria by which CI decisions are made (e.g.

NPV) rather than accounting performance measures. Also, people should be held

responsible for only those outcomes over which they have control. This can be

difficult where CI project implementation is removed from the initial decision

makers, or where decisions are made by groups of people rather than individuals.

It is also important that the CI decision making activity be integrated with the

organisation’s strategic planning. Capital investment decisions are long-term,

dictating major resource allocations which will affect the future direction and

activities of the organisation. Like other strategic decisions, CI decisions must be

responsive to the firm’s technology, goals and environment. These factors are often

uncertain and difficult to incorporate within quantitative decision models. So, it is

- .

financial tools used in CI analysis. The strategic success of CI decision making

requires a much broader focus.

When we look back at the model of the CI decision making process presented

earlier, it is clear that such a model can only be a simplistic representation of

practice. The model has no iterative loops, no intervention of external or political

factors in the process, and no recognition of the un-programmed ‘chaos’ which

often characterises decision making practice. This model does, however, provide a

starting point for considering the factors which contribute to effective CI decision

making.

Summary

In the overall scheme of the CI decision making activity, the information provider is

both master and servant. Servant, because information must be provided which is

useful to those people who are charged with making the CI decision. Master,

because the information presented, and the way in which it is presented, can

significantly shape the final decision! In the end, it is people who will take action

based on the numbers. Both people and process are important, as both determine

success or failure in the CI decision making activity.

Key Terms The rate that is applied to future cash flows to restate them in year zero dollars.

An approach to capital investment decision making that expresses future cash flows

in current dollar values. The two most common forms of DCF are Internal Rate of

Return and Net Present Value.

The discount rate that adjusts the sum of all cash flows associated with the analysis

to zero.

A method of evaluating future cash flows by adjusting the future dollars to year zero

dollars via a discount rate.

Payback Period

The period required for future cash inflows to equal the initial cash investment.

Present Value

The value in year zero dollars of a future cash flow.

Tax Effect

The reduction of revenue and expense items due to the tax rate, frequently used to

refer to the effect of non cash items such as depreciation on the annual cash flows.

- .

References Bower, J.L., Managing the Resource Allocation Process: A study of Corporate

Planning and Investment, Richard D. Irwin Inc., Homewood, Illinois, 1970.

Correlational Analysis’, Accounting, Organizations and Society, Vol. 12(1), 1987,

pp. 31-48.

Horngren, C.T. & Foster, G., Cost Accounting: A Managerial Emphasis, 6th

Edition, Prentice-Hall Inc., Englewood Cliffs, New Jersey, 1987.

March, J.G. & Olsen, J.P., Ambiguity and Choice in Organizations, Bergen,

Universitetsforlaget, 1976.

Mukherjee, T.K. & Henderson, G.V., ‘The Capital Budgeting Process: Theory and

practice’, Interfaces, Vol. 17 (2), March-April, 1987, pp. 78-90.

Northcott, D., Capital Investment Decision Making, Academic Press Ltd, London,

1992.

Pike, R.H., Capital Budgeting in the 1980s: A Major Survey of the Investment

Practices in Large Companies, The Chartered Institute of Management

Accountants (CIMA), U.K., 1982.

Selected Klammer, T.P. & Walker, M.C., ‘The continuing increase in the use of

Readings sophisticated capital budgeting techniques’, California Management Review, 1984,

pp. 135-148.

companies’, Accounting and Finance, Vol. 29 (2), November, 1989, pp. 73-89.

Pike, R.H. & Wolfe, M.B., Capital Budgeting for the 1990s: A Review of Capital

Investment Trends in Larger Companies, The Chartered Institute of Management

Accountants (Occasional Paper Series), London, 1988.

- .

Questions

18.1

Firm X is replacing an old machine. The new machine costs $120,000, will incur $500 installation

costs and will operate in a workshop which currently costs $1,500 per annum to rent. The old machine

has an original purchase price of $80,000 and a current book value of $40,000. However, Firm X can

sell it for $65,000. The firm’s tax rate is 50% and tax is payable in the year that profits are reported.

Required:

Assuming that Wooltrue Company has a tax rate of 50%, and that tax is payable in the year profits are

reported, what is the ‘initial outlay’involved in the purchase of the new machine?

18.2

Wooltrue Company operates a knitting machine which cost $70,000 and has accumulated depreciation

of $45,000. The company intends to replace this machine with a modern version costing $120,000

plus $200 installation charge. With the new machine, wool inventories will have to be increased by

$4,000, but an immediate overhaul planned for the old machine (at $2,500) will no longer be required.

The old machine can instead be sold for $30,000.

Required:

Assuming that Wooltrue Company has a tax rate of 50%, what is the ‘initial outlay’ involved in the

purchase of the new machine?

18.3

Company Y intends to replace an old plant item. The old asset has an original purchase price of

$1,700, with accumulated depreciation of $1,100, but can only be sold for $400. If the replacement

plant item has a purchase price of $1,900, what is the total initial outlay in replacing the machine?

(Company Y is taxed at 50%, payable in the year profits are reported.)

18.4

A company purchases a new asset for $21,000 plus $250 installation costs. The expected useful life of

this asset is five years, with a $2,000 maintenance programme in year three. It is estimated that the

asset can be sold for $5,000 at the end of year five.

Expected after tax cash savings from use of the asset are $5,000 per annum for the five years. The

asset is to be depreciated at 20% straight line, and the company’s tax rate is 50%. Assume that tax is

payable in the same year that profits are reported.

Required:

a. Construct a ‘time line’ of the cash flows associated with the purchase and operation of the new

machine.

b. From your time line, what is the net present value of purchasing this asset, given a required rate of

return of 15%? Should the asset be purchased?

- .

18.5

Define ‘payback period’.

18.6

Using the payback period decision criterion, which of the following would be accepted, given a

payback cutoff of four years?

$ Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

B 17,000 1,000 1,000 2,000 5,000 35,000

C 3,000 2,000 2,000 - - -

18.7

Name two limitations of payback period as an investment decision criterion.

18.8

Name two positive features of payback period as an investment decision criterion.

18.9

Describe the accounting rate of return (AROR) technique.

18.10

Calculate the AROR of project B:

Expected salvage value $2,500 after 5 years

Cash flows per annum $3,000 for 5 years

Pre-tax accounting profits p.a. $2,800 for 5 years

Company taxation rate 48%

18.11

Firm X uses AROR as an investment decision criterion, with a minimum acceptable rate of 25%. If a

proposed investment has an initial outlay of $15,000, expected life of six years and salvage value of

$400, what must be the TOTAL net profit before tax earned over the life of the asset to meet the

AROR selection criterion? (The tax rate is 50%).

18.12

What are the main disadvantages of Accounting Rate of Return as an investment decision criterion?

18.13

- .

18.14

Using a net present value (NPV) decision criterion, would you accept an investment project with a

negative, positive or zero NPV?

18.15

Calculate the NPV of the following investment, given a required rate of return of 22%:

Inflow year 1 $7,000

Inflow year 2 $8,000

Inflow year 3 $14,000

Outflow year 4 $1,400

18.16

A firm is considering the purchase of a new word processor system, at a cost of $4,000 plus $600

installation costs. It is estimated that such a system will produce administrative cost savings of $600

per annum (after tax and other effects taken into account) with an expected useful life of eight years.

In addition, existing typewriters with a nil book value can be sold for $300. Depreciation on the new

word processor system is allowable at a rate of 12.5% per annum straight line with an expected nil

salvage value. The firm’s tax rate is 50%. Assume that tax is payable in the same year that profits are

reported.

Required:

a. Using a six year maximum payback period criterion, would you advise the firm to purchase the

new system?

b. Given a 20% AROR as a sole investment requirement, should the firm purchase the system?

c. What is the NPV of this investment given a 20% required rate of return? Should it be accepted on

the basis of its NPV?

18.17

What is the definition of ‘Internal Rate of Return’?

18.18

a. Would you expect net present value, internal rate of return and profitability index to produce the

same ‘accept/reject’decision in evaluating a potential investment project?

b. Would you expect the three methods to produce the same rankings for acceptable projects?

18.19

a. Calculate the IRR for a project having the following cash flows:

- .

Inflow in year two $4,600

Terminal flow year four $1,500

b. If the firm had a required rate of return of 15%, would such a project be accepted (assuming the

firm had no other investment opportunities)?

18.20

Consider two mutually exclusive investment opportunities, in a firm whose required rate of return is

15%.

Project A:

Initial outlay $21,696

Cashflow yr 1 $12,000

Cashflow yr 2 $10,000

Cashflow yr 3 $8,000

Project B:

Initial outlay $10,000

Receive cashflow of 2,000 for the next 60 years

Required:

a. What are the IRRs of projects A and B?

b. What are the NPVs of projects A and B?

c. What can you say about the project you would prefer to accept, given that both cannot be

accepted?

18.21

What is a ‘sunk cost’? How should sunk costs be treated in the analysis of CI projects?

18.22

Outline the main differences between the ‘accounting’perspective on CI analysis, and the ‘economics’

type approach. Comment on the relevance of these two perspectives for CI decision making.

18.23

The managers of O’Flannigan Co. have traditionally used payback period and accounting rate of

return criteria for assessing CI projects. They consider a project to be acceptable if it pays back

within four years, and has an AROR of at least 18%. The following information relates to a CI

opportunity currently under consideration. O’Flannigan Co. is subject to a 30% taxation rate.

Assume that tax is payable in the same year that profits are reported.

produced

0 -$20,000 nil

1 +$10,000 $3,000

- .

2 +$8,000 $3,000

3 +$7,000 $3,000

4 +$3,000 $3,000

5 +$2,000 $3,000

The project will have a salvage value of $1,000 at the end of year 5.

b. Calculate the project’s accounting rate of return.

c. Would this project be acceptable to O’Flannigan Co?

d. You suggest to the manager of O’Flannigan Co. that the discounted payback period method would

produce an improved analysis. On the basis of this criterion, (using a 14% required rate of return)

would you recommend that the CI project be undertaken? Show your calculations.

18.24

Yeo Fragrance Co. is considering signing a contract with an advertising agency to promote one of its

products, Scented Body Lotion. The advertising agency requires immediate payment of $6,000, plus

an annual payment of $2,000 at the end of each of the next three years. The advertising agency

predicts that the Scented Body Lotion campaign will increase sales of this product by 3000 units per

annum for the next three years (while the campaign continues). Also, long-term effects from

improved consumer awareness are expected to produce increased sales of 2000 units per annum for

the following two years. Each unit of Scented Body Lotion sold contributes a positive cashflow of

$1.50, and it is assumed that these cashflows accrue at the end of each year of sales. Yeo Fragrance

Co. has a 14% required rate of return for its cosmetic products, and is subject to a 30% taxation rate

payable one year after each financial period.

b. Its payback period

c. Its discounted payback period

d. Its net present value, and

e. Its profitability index.

f. Would you recommend signing the advertising contract? Why or why not?

g. What other uncertain factors might you wish to investigate before making such an investment

decision?

18.25

The Arawa Meat Co. is required by new hygiene regulations to install stainless steel flooring in its

processing area. It is considering three options, all of which have an expected useful life of ten years

in meeting required hygiene standards:

Annual maintenance costs = $3,000

Annual cleaning costs = $4,000

Option 2: Medium grade flooring: Initial cost = $18,000

Annual maintenance costs = $2,000

Annual cleaning costs = $2,000

Option 3: High grade flooring: Initial cost = $24,000

- .

Annual cleaning costs = $2,000

Using an NPV analysis with a 15% discount rate, which option would you recommend to the Arawa

Meat Co? (Ignore taxation and depreciation.)

18.26

Miller Industries Ltd. bought a lathe for $8,000 five years ago. The lathe has been subject to an annual

depreciation allowance of 25% on its diminishing value. If the lathe is now to be sold for $3,000 and

the company’s tax rate is 33%, what cashflows will be associated with the asset sale?

18.27

Belcher Co. owns a disused machine which was purchased ten years ago for $45,000 and has a current

written-down value of $8,000. There are two options available for this machine:

2. it can be modified at an immediate cost of $14,000.

If the machine is modified, it is expected to become productive immediately and will generate a pre-

tax cashflow of +$6,000 per annum for the next four years. The cost of modifying the machine would

be capitalised and added on to its current written-down value. Depreciation allowances of 25%

(straight line) would then apply for the remaining four years of the modified machine’s life, at the end

of which the machine would have zero resale value.

Belcher Co. is subject to a 35% taxation rate payable one year after each financial year, and uses a

required rate of return of 12%.

Required:

a. Identify the relevant cashflows for each of the alternative machine options.

b. Calculate the NPV of each option.

c. What course of action would you recommend?

18.28

You overhear a senior manager say to her management accountant:

"You’ll just have to take those numbers away and do them again. The boss really wants

to go ahead with this project, and he’s not going to appreciate me presenting him with a

financial analysis which indicates a no-go decision!"

Discuss the way(s) in which accounting information is being used in this situation.

18.29

Suggest ways in which a performance evaluation system can incorporate the objectives of CI decision

making. Discuss approaches to, and problems of, measuring:

a. The ‘effectiveness’of CI decisions.

b. The contribution of individual decision makers to these decisions.

- .

18.30

Discuss the role of effective post audit.

18.31

What do you think might be the practical difficulties of incorporating a strategic focus within CI

decision making?

- .

- 11_mini caseUploaded bymayk1234
- Financial Management 11e Ch13Uploaded bywhoismonir
- Fundamentals of Petroleum EconomicsUploaded byfavou5
- FINAL-Gracie Evans FarmUploaded byDaniel Evans
- Net Present Value and Other Investment CriteriaUploaded byDanzyll John Quiogue
- Study Quest and Problem Bab 11Uploaded byVina Deviana R
- Effective Business Presentations With PowerPoint Data Analysis Chicago to Atlanta RouteUploaded byIgnacio
- Lesson-18 CAPITAL BUDGETINGUploaded byTrupti Borikar
- Project Cost Management FormulaeUploaded byupendras
- Cost Benefit AnalysisUploaded byAditya Anwar
- NPV modelUploaded byRachita Jolly
- Groupe Ariel Assignment Instructions and Rubric 1121Uploaded bygadisika
- Topic 11 - Long-Term Decision MakingUploaded byمسعود محمّد
- Excel Functions (Ism)Uploaded bySyril Thomas
- pfi_internalratesguidance1_210307Uploaded byEunice Yew
- 04HDM 4EconomicAnalysisConcepts2008!10!22Uploaded byGopalan Kathiravan
- Chapter 08 Net Present Value and Other Investment CriteriaUploaded byhjbjflaefaifnaerf
- B102121.editedUploaded byNik Marina
- Chapter_6Uploaded byKazi Hasan
- PRESTON UNIVERSITY.docxUploaded byAnonymous JZlybX890T
- 02 - Project Appraisal & AnalysisUploaded byHamza Khwaja
- SONA RAI_1116484_ACC511_TASK2Week10.docxUploaded bySyed Bilal Ali
- 7 Financial Analysis.docxUploaded bysultan
- PM FinalUploaded byshaim mahamud
- Pitt.edu Schlinge Fall99 l7docUploaded byCheryl Ganit
- 1.2 Discounted cash flow.pptxUploaded byMario
- Sample Questions 3Uploaded bydarkhuman343
- chap 16aUploaded byfa2heem
- Lecture 01Uploaded bySangVo
- energystar_buildingupgrademanual_1Uploaded by88san

- Case AnalysisUploaded byPrem Kumar G
- Understanding_motivations_for_entrepreneurship BIS research paper.pdfUploaded bySeethalakshmy Nagarajan
- interaction between culture and entrepreneurship in londons immigrant businesses.pdfUploaded bySeethalakshmy Nagarajan
- Managerial-Accounting-For-managers Noreen Brewer and GarrisonUploaded bySeethalakshmy Nagarajan
- Love J.F. McDonald's. Behind the ArchesUploaded byGregPOM
- Liquidity Analysis of a CompanyUploaded byDhiraj Mehta
- 6-The-Roles-and-Responsibilities-of-Management-Accountants-in.pdfUploaded bySiing Liing
- ____managerial_accounting__an_introduction_to_concepts__methods_and_uses.pdfUploaded byLeojelaineIgcoy
- approaches to change article.pdfUploaded bySeethalakshmy Nagarajan
- Strategic Planning handbookUploaded byFred Chukwu
- us-aers-crisis-leadership - leading the organisation through crisis and uncertainty.pdfUploaded bySeethalakshmy Nagarajan
- 7_Bowman and Moskowitz (2001)Uploaded byShreyash Lavangale
- Action Research HandoutUploaded bygeethamadhu
- tabbu management in global context.docUploaded bySeethalakshmy Nagarajan
- Acas-How-to-manage-change-advisory-booklet.pdfUploaded byBara Bedu
- Buchanan Huczynski_Power and PoliticsUploaded bySeethalakshmy Nagarajan
- JMD-09-2015-0125Uploaded bySeethalakshmy Nagarajan
- 12 828 Make Business Your Business Guide to StartingUploaded byMoybul Ali
- Case Study Practice in CrisisUploaded bySeethalakshmy Nagarajan
- 48 Change ManagementUploaded byVARBAL
- A Framework for Transformational Change in OrganisationsUploaded bySeethalakshmy Nagarajan
- Using aims and objectives to create a business strategy - A Kellogg's Case Study.pdfUploaded bySeethalakshmy Nagarajan
- ch10Uploaded bySeethalakshmy Nagarajan
- Strategy and Structure reexamined.pdfUploaded bySeethalakshmy Nagarajan
- Flexibility - What Happens to CommitmentUploaded bySeethalakshmy Nagarajan
- Green, K., López, M., Wysocki, A., Kepner,K., Farnsworth, D. & and Clark, J. L.Uploaded bysharrelcl
- Hierarchy of Effects ModelUploaded bySeethalakshmy Nagarajan

- cpfrUploaded byahmed_iag
- 0910 MC answersUploaded byPaul Burgess
- MV 3000 Getting Started ManualUploaded byC Walker
- EC qg18deUploaded byGabriel Balcazar
- Prony Method of IIR Filter DesignUploaded byKarim Shahbaz
- Slides 17Uploaded bytegegn mogessie
- 16431 Quality AssuranceUploaded bySachin Kumar
- Electrical & Electronics Measurement Lab ManualUploaded byHari Krish
- Stainless Steel UsesUploaded byDanny See
- Anselme O. Connor v. Commissioner of Internal Revenue, 770 F.2d 17, 2d Cir. (1985)Uploaded byScribd Government Docs
- Performance Improvements Study of Steam Turbine Exhaust HoodsUploaded byCenk Yağız Özçelik
- TB746-93-1 Color, Markings and Camouflage 1964Uploaded bydieudecafe
- Jan to Dec 2015Uploaded byNdokwa
- International Financial Markets FinalUploaded byReshma Mali
- datasheetEldarStormSerpentUploaded byALPolley
- FTCTraining ManualUploaded byShashank Sharma
- Medical PowerPoint TemplateUploaded byakred
- 1 PROBLEM Cost Concept & Cost BehaviourUploaded bybena889
- Three Phase Reactive Power Control Using LabVIEWUploaded byeditor3854
- jqueryUploaded byvictor othugadi
- CRM_wordUploaded byArvind Rewansidha Mane
- op ed globalizationUploaded byapi-217629023
- Elementary Surveying Lecture Part 1Uploaded bysoontobengineer
- City of Lincoln Park Financial & Operating PlanUploaded byAnneHooperRunkle
- Linde Forklift Maintenance ManualUploaded byFelipe Carranza
- Glorious Morning-Score and PartsUploaded byNeo
- rb1Uploaded bysanjittuku
- Risks Associated With Crisis and Disaster Situation in TourismUploaded byAustralian Assignment Help
- E 3031 - 15Uploaded byruben carcamo
- Varroa Treatment OptionsUploaded byrhinorod