Management Accounting - Capital investment decisions


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Management Accounting - Capital investment decisions

  1. 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. 4/29/2011 COM 4310 1
  2. 2. Appraisal methods • NPV • IRR • Payback / Discounted payback • ARR 4/29/2011 COM 4310 2
  3. 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. 4/29/2011 COM 4310 3
  4. 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)^ 4/29/2011 COM 4310 4
  5. 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. 4/29/2011 COM 4310 5
  6. 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. 4/29/2011 COM 4310 6
  7. 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 4/29/2011 COM 4310 7
  8. 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. 4/29/2011 COM 4310 8
  9. 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) 4/29/2011 COM 4310 9
  10. 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. 4/29/2011 COM 4310 10
  11. 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. 4/29/2011 COM 4310 11
  12. 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. 4/29/2011 COM 4310 12
  13. 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% 4/29/2011 COM 4310 13
  14. 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 4/29/2011 COM 4310 14
  15. 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. 4/29/2011 COM 4310 15
  16. 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. 4/29/2011 COM 4310 16
  17. 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. 4/29/2011 COM 4310 17
  18. 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. 4/29/2011 COM 4310 18
  19. 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. 4/29/2011 COM 4310 19
  20. 20. Profitability index = PV of cash inflows investment 4/29/2011 COM 4310 20
  21. 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 4/29/2011 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 COM 4310 Profitability Index (PI) Ranking as per PI 1.12 1.17 1.03 1.20 3 2 4 1 21
  22. 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) 4/29/2011 COM 4310 22
  23. 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. 4/29/2011 COM 4310 23