Management Accounting - Capital investment decisions
1.
Capital Investment Decisions
(Project Appraisal)
Capital investment decisions are those decisions
that involve current outlays (costs) in return for a
stream of benefits in future years.
The
distinguishing
decisions
and
feature
capital
between
investment
short-term
(long-term)
decisions is time.
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3.
Appraisal methods
The concept of Net Present Value (NPV)
• By using discounted cash flow techniques we can
calculate Net Present Value.
• Present value is the today’s value (year 0) of any future
cash flow after discounting it by an appropriate discount
rate.
• The process of converting cash to be received in the
future into a value at the present time by the use of an
interest rate is called as discounting.
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4.
Present value =
FV
(1 + K)^
• Compounding is the opposite of discounting, since it is
the future value of present cash flows.
Future Value = PV (1 + K)^
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5.
• Calculation of Net Present Value,
– Example:
The Master company is evaluating a project with an
expected life of three (3) years and investment outlay of
Rs. 10 million. The estimated net cash inflows are as
follows.
– Year 1 3 million
– Year 2 6 million
– Year 3 4 million
The opportunity cost of capital is 10%. You are required to
calculate the net present value of the project.
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6.
The Internal Rate of Return (IRR)
This is the discount rate that will cause the net
present value of an investment to be zero.
That is, IRR is the Effective Interest Rate (EIR) of
the project.
IRR is also known as Discounted Rate of Return.
IRR is the “maximum cost of capital” that can be
allowed to finance a project. If your cost of capital
is greater than IRR , then you are incurring
losses.
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7.
The IRR can be found by trial and error by using a number
of discount factors until the NPV equals zero.
However, we can use Interpolation method to calculate IRR.
This method gives an approximation of the IRR.
IRR = LR +
LR NPV
x (HR – LR)
LR NPV – HR NPV
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8.
• Calculate the IRR of the previous example…
• IRR has a technical shortcoming. That is, when
cash flows of the project are unconventional
multiple IRRs are possible for a project. But,
only one IRR is economically significant in
determining whether or not the investment is
possible.
• Therefore, when unconventional cash flows
involve, NPV method is more appropriate to
decide whether project is accepted or not.
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9.
Timing of cash flows
To simplify the presentation, our calculations have been
based on the assumption that any cash flows in future
years will occur in one lump sum at the year end.
Both NPV and IRR methods take into account the time
value of money.
Techniques that ignore the time value of
money
Payback Method
Accounting rate of return (ARR)
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10.
Payback Method
• The payback method is defined as the length of
time that is required for a stream of cash inflows
from an investment to recover the original cash
outlay of the investment.
• Payback period is a simple method but could result
in selecting a wrong project since it does not
consider time value of money.
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11.
• However, to minimize the problems with payback
period, it can be adjusted to show the time value
of money and discounted payback method is
used.
• Calculate
the
payback
discounted payback period
period
and
for previous
example.
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12.
Accounting rate of return (ARR)
The Accounting rate of return (ARR) , also known as the
return on investment and return on capital employed .
This method differs from other methods in that profits
rather than cash flows are used.
ARR = average annual profits
average investments
x 100
However, ARR method ignores the time value
of money.
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13.
Example ….
A project has an initial outlay of Rs. 20 million. It is
assumed that project will have an scrap value of Rs.5
million. Average annual profit expected from the project
is Rs. 3 million.
ARR = average annual profits
average investments
3
(20+5)/2
x 100
X 100
24%
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14.
Decision criteria
• Accept the project if NPV is positive.
• Accept the project if Discount rate < IRR
• Accept the project if payback is comparatively
shorter.
• Accept the project if ARR > expected rate of
return
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15.
Mutually exclusive projects
Mutually exclusive projects exist where the acceptance
of one project excludes the acceptance of another
project .
It is recommended to use NPV method to rank
mutually exclusive projects.
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16.
Qualitative factors
Not all investment projects can be described
completely in terms of monetary costs and benefits.
Therefore, even if some costs and benefits cannot be
quantified they should be considered in investment
decisions.
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17.
Capital rationing
Situations may occur where there are
insufficient funds available to a firm to
undertake all those projects that yield a
positive net present value. This situation is
described as capital rationing.
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18.
The term “soft capital rationing” is often used to
refer to situations where, for various reasons the firm
internally imposes a budget ceiling on the amount
of capital expenditure.
Where the amount of capital investment is restricted
because of external constraints such as the inability
to obtain funds from the financial markets, the term
“hard capital rationing” is used.
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19.
Whenever
capital
rationing
exists, management should allocate the
limited available capital in a way that
maximizes the NPVs of the firm.
For ranking projects “profitability index”
is used.
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20.
Profitability index = PV of cash inflows
investment
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21.
Example………
Sade company operates under the constraint of capital
rationing has identified four (4) independent investments
from which to choose. The company has Rs. 10 million
available for capital investment during the current period.
Which projects should the company choose?
Projects
P
Q
R
S
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Investment
required
Rs. Mn
Present
value of
Inflows
Rs. Mn
5
3
6
2
5.6
3.5
6.2
2.4
Net
Present
value
0.6
0.5
0.2
0.4
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Profitability
Index (PI)
Ranking as
per PI
1.12
1.17
1.03
1.20
3
2
4
1
21
22.
Weighted average cost of capital (WACC)
Most companies are likely to be financed by a
combination of debt and equity capital. The overall
cost of capital is also called as weighted average
cost of capital.
WACC =
(% of Debt capital x cost of debt)
+
(% of Equity capital x cost of equity)
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23.
Example…..
Assume that after tax cost of debt capital is 8% and
the required rate of return on equity capital is 12%
and the company intends to maintain a capital
structure of 40% debt and 60% equity. The overall
cost of capital for the company is calculated as ,
(8% x 40%) + (12% x 60%) = 10.4%
Can we use the WACC as the discount rate to
calculate a project’s NPV ?
Yes , provided that the project is of equivalent risk
to the firm’s existing assets and firm intends to
maintain its target capital structure.
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