OVERVIEW
Objective
¾
To understand the type of investment decisions that will be made by organisations.¾
To assess an investment using the payback period and the ARR methods.TYPES OF EXPENDITURE
PAYBACK
PERIOD RATE OF RETURN ACCOUNTING
INVESTMENTS
¾ Capital
¾ Revenue
¾ Investment decisions
¾ Definition
¾ Possible Improvements
¾ Advantages
¾ Disadvantages
EVALUATION
¾ Definition
¾ Calculation
¾ Advantages
1
TYPES OF EXPENDITURE
1.1
Capital
¾
Capital expenditure (CAPEX) refers to the purchase of non-current (fixed) assets or their improvement;1.2
Revenue
¾
Revenue expenditure is incurred to maintain non-current assets e.g. repairs1.3
Investment decisions
¾
Decisions about which non-current assets should be acquired.¾
Also referred to as project appraisal, investment appraisal or CAPEX analysis.2
PAYBACK PERIOD
2.1
Definition
The time it takes for the operating cash flows from a project to pay back the initial investment.
Decision rule
If payback period < target ACCEPT If payback period > target REJECT
Illustration 1
Investment $1.4m
Annual cash flows (before depreciation but after tax) $0.3m
Project life 10 yrs
Solution
Payback period = 0.3
1.4 = 4.7 years
2.2
Possible Improvements
2.2.1
Discounted payback period
¾
First discount the cash flows to present value and then calculate the payback period¾
This takes into account the time value of money.2.2.2
Bail-out factor
¾
This takes into account the estimated scrap/disposal value of the asset if the project is abandoned early2.3
Advantages of payback
9
Simple to calculate.9
Easy to understand.9
Concentrates on earlier flows: more certain; more important if firm has liquidity concerns.
2.4
Disadvantages of payback
8
Ignores cash flows after payback period;8
Target period is subjective;8
Gives little information about change in shareholder wealth.8
Unless flows are discounted, time value of money is ignored3
ACCOUNTING RATE OF RETURN (ARR)
3.1
Definition
The earnings of a project expressed as a percentage of the capital outlay or average investment.
¾
Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI).3.2
Calculation
¾
This is a financial accounting measure based on the income statement and statement of financial position.¾
It includes:¾
Calculated asinvestment Initial
profit operating annual
Average ×
100
OR
investment Average
profit operating annual
Average × 100
Decision rule
If ARR > target ACCEPT If ARR < target REJECT
Example 1
Initial investment $200m
Scrap value $20m
Operating cash flows:
Year 1 $100m
Year 2 $50m
Year 3 $50m
Year 4 $50m
Required:
3.3
Advantages
9
Uses readily available accounting information;9
Simple to calculate and understand;9
Often used by financial analysts to appraise performance.3.4
Disadvantages
8
Different methods of calculation may cause confusion;8
Based on profits rather than cash. Profits are easily manipulated by accounting policy.8
Ignores time value of money;8
Target rate is subjective;8
A relative measure (%) – gives little information about the absolute change in shareholders’ wealth.Example 2
A project being considered would require a machine costing $80,000. Market research of $8,000 has already been carried out and has been capitalised. The result is that the project is expected to last for six years and produce net cash earnings of $20,000 for each of the first three years and then $15,000 for each of the last three years. The anticipated scrap proceeds of the machine at various stages in its life are as follows:
After year 1 $40,000 After year 2 $30,000 After year 3 $20,000 After year 4 $13,000 After year 5 $10,000 After year 6 $4,000
Required:
Evaluate the project using (a) ARR
(b) ARR using the average investment approach (c) payback period
(d) payback period incorporating the bail-out factor.
Solution
(a)
(b)
(c)/ (d)
Time Flow Cumulative
flow Scrap Net cumulative flow
0 1 2 3 4 5 6
(88,000) 20,000 20,000 20,000 15,000 15,000 15,000
40,000 30,000 20,000 13,000 10,000 4,000
Payback period =
Key points
³
Payback and ARR are commonly used in practice. However neither method informs management of the absolute change in shareholders’ wealth due to a particular project³
As well as being able to calculate payback and ARR it is therefore vital that you can also explain why they are not acceptable methods of project appraisal
FOCUS
You should now be able to:
¾
define and distinguish between capital and revenue expenditure;¾
calculate payback and assess its usefulness as a measure of investment worth;¾
calculate ARR and assess its usefulness as a measure of investment worth.EXAMPLE SOLUTIONS
Solution 1
Average annual profit
5
Average investment
Solution 2 — ARR and Payback
(a) ARR
Average annual earnings =
6
Average annual depreciation =
6
Time Flow Cumulative
flow Scrap Net cumulative flow
