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					Chapter 20: Capital investment appraisal

     On completion of this topic you should be able to
        Explain the purpose of capital investment appraisal
        Calculate and interpret the payback period for an
        investment project
        Calculate and interpret the accounting rate of return for
        an investment project
        Describe the advantages and disadvantages of these two
        techniques
     Independent study
        Study Chapter 20
        Progress test and practice question(s) as set
                             Business Accounting                    1
Capital investment appraisal


   Whilst cost accounting provides information to
    management for making short-term decisions
    about revenue expenditure, this topic provides
    information for long-term decisions about capital
    expenditure
   Capital investment appraisal is ‘the evaluation of
    proposed investment projects, with a view to
    determining which is likely to give the highest
    financial return’ (Collis and Hussey, 2007, p. 335)


                         Business Accounting              2
Characteristics of capital investment decisions

  Time span            2+ years
  Nature               Strategic (eg whether to build or buy a
                       new factory)
  Level of             Medium – high
  expenditure
  External factors     Very important (eg interest rates and
                       rates of inflation)
  Typical techniques   Payback period
                       Accounting rate of return
                       Discounted cash flow techniques
    Adapted from Jones, 2002, p. 452
                           Business Accounting                   3
The capital investment decision

   Capital investment appraisal techniques are used
    for making decisions concerning the investment of
    large amount of capital in a long-term project
   Management needs to know that the investment
    project will be worthwhile
        Either it will generate more cash than the initial amount
        invested or it will provide cost savings over the life of the
        project that will exceed the capital invested
     At the very least, management needs to know that
      the business will get its money back

                              Business Accounting                       4
Exercise 1
Capital investment decisions

   Cotswold Coolers is doing well and has £100,000 to invest in
    new bottling machines
   Ros has a choice of 3 machines. Each will cost £100,000 and
    have an expected life of 3 years, but the net cash inflows vary
            Year Machine 1 Machine 2 Machine 3
                        £            £             £
               1     60,000       20,000        10,000
               2     40,000       40,000        20,000
               3     20,000       60,000        95,000
   Required
     - Complete the pro forma and decide which machine is the
       better investment

                             Business Accounting                      5
Exercise 1
Capital investment decisions

                    Year   Machine 1 Machine 2 Machine 3
                                    £         £         £
 Cash outflow        0      (100,000) (100,000) (100,000)
 Net cash inflows    1         60,000    20,000  10,000?
                     2         40,000    40,000  20,000?
                     3         20,000    60,000  95,000?
 Subtotal                  ________? ________? ________?
 Net cash flow             ________? ________? ________?




                           Business Accounting              6
Solution 1
Capital investment decisions
                         Year Machine 1 Machine 2 Machine 3
                                  £         £         £
  Cash outflow       (A)  0   (100,000) (100,000) (100,000)
  Net cash inflows        1          60,000          20,000    10,000
                          2          40,000          40,000    20,000
                          3          20,000          60,000    95,000
  Subtotal        (B)               120,000         120,000   125,000
  Net cash flow (B-A)                20,000          20,000    25,000

   Is it simply a question of choosing the investment
    that gives the highest positive net cash flow?
   What other factors should be considered?



                              Business Accounting                       7
Solution 1
Capital investment decisions (continued)

     Machine 3 looks best as the net cash inflow is
      £25,000 (£5,000 higher than for Machines 1 or 2)
        But waiting until Year 3 to get most of the cash increases
        risk – the annual net cash flows are estimates and the
        further ahead the forecast, the more unreliable it is
   Machines 1 & 2 both give the same total net cash
    inflow, so either is worth considering, but Machine 1
    is the more favourable because the cash comes in
    sooner
   It’s difficult to decide - we need a technique to help


                             Business Accounting                     8
Capital investment appraisal techniques


                     Capital investment
                          appraisal


                         Accounting            Discounted
    Payback period
                        rate of return          cash flow




                         Business Accounting                9
Payback period

    The payback period is ‘the time required for the
     predicted net cash flows to equal the capital
     invested in a proposed investment project’ (Collis
     and Hussey, 2007, p. 338)
       The project that repays the capital invested in the
       shortest time is considered to be the most favourable
    The following estimates are needed
       The amount of capital required
       The amount and timing of the net cash flows
       generated by the investment project


                            Business Accounting                10
Conventions and assumptions

    Year 0 is a conventional way of referring to the start
     of Year 1
    Year 1, 2, 3 etc means the end of Year 1, 2, 3, etc
    It is assumed that the cash outflow from the initial
     investment of capital will take place at Year 0
    It is assumed that the net cash inflows during a
     year will be received evenly throughout the year
    Negative cash flows are shown in brackets



                          Business Accounting             11
Exercise 2
Mr Cornetto’s ice cream van project
  Mr Cornetto is considering investing in an ice cream van that will
  cost £12,000 and last 4 years. Estimated annual cash flows are:
                                          £          £
                 Cash inflows
                    Sales                      20,000
                 Cash outflows
                    Purchases         5,000
                    Wages             9,000
                    Expenses          2,000 (16,000)
                 Net cash flow                  4,000
   Required
    - Calculate the payback period in years using the formula:
                         Initial capital investment
                           Annual net cash flow

                               Business Accounting                     12
Solution 2
Mr Cornetto’s ice cream van project

     The payback period for the ice cream van project is

         Initial capital investment = £12,000
           Annual net cash flow       £4,000
                                    = 3 years exactly

     We have been able to use this formula because Mr
      Cornetto expects the net cash flows to be the same
      every year over the life of the project, but we can’t
      use it if the projected annual net cash flows are
      expected to differ…
                           Business Accounting                13
Exercise 3
Mr Cornetto’s pasta van project

   An alternative project is to invest in a pasta van that
    will also cost £12,000 and last 4 years
   Because take-away pasta may take some time to
    catch on, the annual net cash flows are expected to
    be £2,000 in year 1, rising to £3,000 in year 2,
    £5,000 in year 3 and £6,000 in year 4
   Required
       Using the pro forma, calculate the payback period in
       years and months for the pasta van project



                            Business Accounting               14
Pro forma
Mr Cornetto’s pasta van project

       Year   Net cash flow Cumulative net cash flow
                          £                        £
        0          (12,000)                 (12,000)
        1             2,000                        ?
        2             3,000                        ?
        3             5,000                        ?
        4             6,000                        ?




  Payback period …………………………? (years and months)

                        Business Accounting            15
Solution 3
Mr Cornetto’s pasta van project
        Year     Net cash flow          Cumulative net cash flow
                             £                                 £
          0           (12,000)                          (12,000)
          1              2,000                          (10,000)
          2              3,000                           (7,000)
          3              5,000                           (2,000)
          4              6,000                             4,000
  The payback period is somewhere between 3 - 4 years where
   the cumulative net cash flow changes from a deficit to a surplus
  3 years +         Deficit £2,000            = 0.33 = 3 yrs 4 mths
            Deficit £2,000 + Surplus £4,000
  So Mr Cornetto should choose the ice cream van project, as it
   takes only 3 years to pay back the initial investment
                             Business Accounting                   16
Advantages and disadvantages of payback period

    Advantages
        Simple to calculate and easy to understand
        Useful for risky projects where prediction of future cash
        flows beyond first few years is difficult (eg IT)
        Useful if short-term cash flows are more important to
        survival of the business than long-term cash flows
        Useful if borrowing or gearing is a concern
    Disadvantages
        Does not take account of the time value of money (cash
        now is worth more than cash received later)
        Ignores cash flows after the payback period

                             Business Accounting                    17
Accounting rate of return

   The payback period focuses on cash flows, but the
    accounting rate of return (ARR) focuses on profit
   The accounting rate of return ‘measures the
    predicted average profit before interest and tax as
    a percentage of the average capital employed in a
    proposed investment project’ (Collis and Hussey,
    2007, p. 342)
   When comparing ratios from different sources, care
    must be taken that the same definition of profit and
    capital employed have been used

                         Business Accounting               18
Exercise 4
Fresh Farm Foods ARR
  The owners of Fresh Farm Foods are planning to open either
   a farm shop or a café. Estimates for the two projects are:
                                        Farm shop        Café
                                                 £          £
      Average sales                         62,000 109,000
      Average costs and expenses            43,400 82,000
      Average capital employed             100,000 180,000
  Required
  - Using the pro forma, calculate the average profit for each
    project and the ARR using the following formula and decide
    which is the better of the two investments
                     Average profit      100
               Average capital employed
                           Business Accounting                   19
Pro forma
Fresh Farm Foods ARR

                                       Farm shop                Café
                                                £                  £
 Average sales                                  ?                  ?
 Average costs and expenses          (         )?        (        )?
 Average profit                                 ?                  ?

 Average PBIT  100                            ?  100       ?  100
 Average CE                                    ?             ?

                      ARR =                       ?%            ?%




                         Business Accounting                       20
Solution 4
Fresh Farm Foods ARR

                                      Farm shop         Café
                                                £          £
 Average sales                             62,000   109,000
 Average costs and expenses              (43,400)   (82,000)
 Therefore, average profit                 18,600     27,000

 Average PBIT  100               8,600  100 27,000  100
 Average CE                     100,000         180,000
                        ARR =           18.6%             15%
  The Farm Shop gives a higher ARR than the Café, but should
   the owners base their decision purely on this?
  If we had more information, we could calculate the payback
   period as well
                           Business Accounting                  21
Conclusions
Advantages and disadvantages of ARR

  Advantages
      Simple to calculate and easy to understand
      Takes account of the entire life of the project
      Compatible with the performance ratio, ROCE
  Disadvantages
      Does not take account of the time value of money
      Ignores the timing of profits (eg benefit of earning a larger
      proportion of profit in early years) and timing of cash flows
      No standard definition of terms (limits comparisons)
      Averages can be misleading (actual figure may be ↑ or ↓)
      No guidance on what is an acceptable rate of return
                            Business Accounting                   22

				
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