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Slide 10.1
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Part ThreeFINANCE
Chapter 10MAKING CAPITAL
INVESTMENT DECISIONS
Slide 10.2
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
LEARNING OUTCOMES
You should be able to:
Identify and discuss the four main investment appraisal methods found in practice
Explain the nature and importance of investment decision making
Explain the methods used to monitor and control investment projects
Discuss the strengths and weaknesses of various techniques for dealing with risk in investment appraisal
Slide 10.3
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
The nature of investment decisions
Large amounts of resources are often involved
It is often difficult and/or expensive to bail out of an investment once undertaken
Slide 10.4
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
The scale of investment by UK businesses
Source: Annual reports of the businesses concerned for the financial years ending in 2013
Business Expenditure on additional non-current (fixed) assets as a percentage of:
Annual sales End-of-year revenue non-current assets
Wm Morrison Supermarkets plc 5.6 11.1
Vodafone plc 32.4 12.0
Marks and Spencer plc 8.3 13.2
Severn Trent Water Ltd 24.4 6.3
Go-Ahead Group plc 2.3 10.6
J D Wetherspoon plc 7.9 10.2
British Sky Broadcasting plc 9.0 17.8
Ryanair Holdings plc 6.4 6.0
Slide 10.5
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Investment appraisal methods
Four methods of evaluation
Accounting rate of return (ARR)
Payback period (PP)
Net present value (NPV)
Internal rate of return (IRR)
Slide 10.6
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Average annual profit Average investment to earn that profit
ARR =
Accounting rate of return (ARR)
× 100%
Slide 10.7
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
ARR decision rule
Where competing projects exceed the minimum rate, the one with the highest ARR
should be selected
For a project to be acceptable, it must achieve at least a minimum target ARR
Slide 10.8
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Problems with ARR
Ignores the timing of cash flows
Use of average investment
Use of accounting profit
Competing investments
Slide 10.9
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Payback period (PP)
Payback period (PP)
Time taken for initial investment to be
repaid out of project net cash inflows
Slide 10.10
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
PP decision rule
If competing projects have payback periods shorter than maximum payback period, the one
with the shortest payback period is selected
Project should have a shorter payback period than the required maximum payback period
Slide 10.11
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Problems with PP
Does not take timing of cash flows fully into account
Ignores cash flows after PP
Does not take risk fully into account
Not related to wealth maximisation objective
Arbitrarily determined target payback period
Slide 10.12
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
The cumulative cash flows of each project in Activity 10.6
Project 1
Project 3
Project 2Yr 1
Cash flows (£000)
200 800600400 9000 500300100 700
Y 2
Yr 3
Yr 1
Yr 2
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Y1
Payback period
Initial outlay
Yr 3
Yr 4
Yr 5
Y 5
Y4
Figure 10.1 Cumulative cash flows for each project in Activity 10.6
Slide 10.13
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Interest foregone
InflationRequired return
Risk premium
The factors influencing the returns required by investors from a project
Slide 10.14
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
NPV decision rule
If competing projects have positive NPVs, the one with the highest NPV is selected
If project NPV is positive, it should be accepted; if it is negative it should be rejected
Slide 10.15
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent
0 654321 7 8 9 10
Years into the future
10
20
30
40
50
60
70
80
90
100P
ence
£1
Figure 10.2 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent
Slide 10.16
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Why NPV is better than ARR and PP
The whole of the relevant cash flows
The objectives of the business
The timing of the cash flows
NPV fully addresses each of the following:
Slide 10.17
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Internal rate of return (IRR)
Internal rate of return (IRR)
The discount rate, which, when applied to the future
project cash flows, produces a zero NPV
Slide 10.18
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
IRR decision rule
If competing projects exceed minimum IRR requirement, the one
with the highest IRR is selected
Project must meet a minimum IRR requirement.
(The opportunity cost of finance)
Slide 10.19
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
The relationship between the NPV and IRR methods
NPV (£000)
Cost of capital (%)
10
20
30
40
50
60
70
0 10 20 30 40
IRR
−10
0
Figure 10.3 The relationship between the NPV and IRR methods
Slide 10.20
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Problems with IRR
Does not directly address wealth maximisation
Ignores the scale of investment
Has difficulty with unconventional cash flows
Slide 10.21
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Some practical points related to investment appraisal
Past costs
Common future costs
Opportunity costs
Taxation
Year-end assumption
Cash flows not profit flows
Interest payments
Other factors
Slide 10.22
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
The main investment appraisal methods
Investment appraisal methods
Discountedcash flow methods
Net present value
Internal rate
of return
Accounting rate
of return
Payback period
Non-discountedcash flow methods
Figure 10.4 The main investment appraisal methods
Slide 10.23
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
Investment appraisal in practice
Many surveys have shown the following features:
NPV and IRR have become increasingly popular
Continued popularity of the PP and ARR methods
Businesses tend to use more than one method
Larger businesses rely more heavily on NPV and IRR than smaller businesses
Slide 10.24
Atrill and McLaney, Accounting and Finance for Non-Specialists PowerPoints on the Web, 9th edition © Pearson Education Limited 2015
A multinational survey of business practice
US UK Germany Canada Japan Average
IRR 4.00 4.16 4.08 4.15 3.29 3.93
NPV 3.88 4.00 3.50 4.09 3.57 3.80
Payback period
3.46 3.89 3.33 3.57 3.52 3.55
Response scale: 1 = Never 5 = Always