Chapter 15

1. Chapter 15 Capital Investment Decisions

2. Accounting rate of return • Pfeiffer and Schneider (2010, p. 1) propose that the process of capital budgeting ‘defines a set of rules to govern the way in which managers at different levels of the hierarchy produce and share information about investment projects’. • Capital budgeting provides not only a way of analysing a project/investment but also a shared language which can be used to explain the possible outcomes.  

3. Accounting rate of return • Stages of investment appraisal When making investment decisions the management accountant or manager needs to go through a staged process to ensure they have gathered all the relevant information and performed the relevant financial calculations.  

4. Accounting rate of return • What techniques and tools are available to analyse capital investments? There has been significant research conducted to find out what techniques are used in industry. A CIMA (2009) report found that the most popular technique in use was NPV. Net present value was used in around 60 per cent of the companies surveyed, followed by the payback method at around 55 per cent, IRR at around 43 per cent, ARR at around 18 per cent and real options being used by around 5 per cent. However, when analysing only the larger companies the use of all techniques increases.

5. Stages of the investment appraisal process • Gather all relevant information • Once all the future investments are identified the work now begins to gather all the relevant information, this includes relevant cash flows and the risks involved. This sounds much easier than it is in practice. Gathering information on prices and demand curves can be very difficult especially when you are analysing a project within a volatile market. • A full financial analysis will now take place to model all investments based upon the information gathered in the previous section; using techniques such as NPV, IRR, payback and ARR. • Most organizations require all models to be presented as part of a business proposal where the financial data will be presented along with strategic fit. The report will include a full risk analysis, feasibility test and acceptability test, and any additional benefits which cannot be quantified.

6. Stages of the investment appraisal process • The financial models will not be the only factor in determining the outcomes of which investments are chosen. The board will examine the business proposal and determine which one(s) gain their approval. • Following approval, the implementation process will follow requiring key performing indicators (KPIs) to be established and monitored. Following a relevant period of time the proposal should, in theory, be subject to audit. Before any analysis is performed the organization must start with their strategy, what do they want to achieve? • From there they can search for opportunities that will add value to their organization and fit with the strategic direction of the company. Of course, not all investments will be strategy led because some investments will be required through legal or regulatory requirements.

7. Stages of the investment appraisal process • Most organizations will not simply accept all projects, even when they are not mutually exclusive. Although the NPV or IRR analysis may suggest the investment should be accepted the company will have capital restrictions. A full screening analysis is required to filter those that have a strategic fit with the organization. • Identify all investment possibilities and screen them Implementation of investment and post-audit • Selection and approval of business proposal • Present information into a business proposal • Performing a financial analysis of all appropriate investments

8. Stages of the investment appraisal process • Accounting rate of return The accounting rate of return (ARR) is a financial ratio which uses ‘profits after depreciation’, in other words your operating profit, to calculate the return an investment provides. The formula is: ARR = Average profits ÷ Average investment × 100% • Companies always want to know how long it will take to recover the capital they investment in any project. When the economic climate is on a downturn this is even more important. Payback is a calculation which is measured in time. 

9. Time value of money • Both the ARR and payback calculation, have one big criticism; they do not consider the time value of money. The time value of money relates to how the value of money reduces over a given period of time.   In theory the discount rate should include: 1) The risk-free rate of investing (the rate set for government bonds and so on) 2) The risk of inflation 3) The risk of other uncertainties

10. Time value of money • If you have studied corporate finance, you will know it offers models such as the capital asset pricing model (CAPM) to calculate the ‘rate of return’. The CAPM model examines a company’s performance against the stock market, the risk-free rate and the required additional return based upon the risks for the investment. The rate of return a company uses is also known as the ‘cost of capital’.   • Once you have your rate of return you can calculate how much your cash flow needs to be discounted, this is known as the present value (PV) rate: PV = 1/(1 + r)n Where: r = cost of capital (this must always be placed into the formula as a decimal) n = the number of compound years the cash flow is considering  

11. Net present value • A technique which considers the cash flows of a project and incorporates the time value of money is called net present value (NPV). • The basic concept behind this technique is to compare the investment of the project against the discounted annual cash flows. When you have calculated the NPV you must then examine the value   • When analysing investments it is important to understand whether the investments you are analysing are mutually exclusive or not. Mutually exclusive means that the company will only invest in one of the options because the investments you are analysing cannot be taken at the same time.

12. Net present value • If the answer is positiveYou accept the project because you have recovered your required rate of return, plus more. If the answer is zero You accept the project because you have recovered your required rate of return (remember your cost of capital included the additional return you want for the risk you are taking). If the answer is negative You typically do not go ahead with the project because you are receiving less than you are willing to accept for the risk you are taking on your investment. Note this is using financial data only, there are often many other factors involved when making these decisions.

13. Cash Flows Present value calculations are performed using cash flows. This means you must not include any accounting concepts that are not cash flows. Common problems are as follows: 1. Depreciation is not a cash flow it is an accounting concept to reduce the value of an asset. 2. Working capital is considered an out-flow at the beginning of the project and an in-flow at the end of the project. 3. Cash flows should be future incremental cash flows; you should not include any sunk costs or allocated fixed costs. 4. Any costs that relate to financing of the project should not be included as they are already included in the cost of capital used in the NPV calculation.

14. Net present value • The impact of the capital allowances and calculation of taxable profits are usually performed before they are incorporated into your NPV model. Rules: 1) Use the present value factor discount tables when the cash flows are not the same every year. 2) Use the cumulative present value factor discount tables when the cash flows are the same every year. 

15. Net present value • Common multiple method The first method uses the lowest common multiple of the lives of the projects involved. When this is established you simply analyse the project for this period. This can be observed in the example below:

16. Net present value • You will note this simple calculation is similar to calculating a depreciation charge using the reducing balancing method. The only part of the calculation you have to consider carefully is when a residual value is given. Residual value is simply the value that you can sell the asset for at the end of its useful life and then the remaining balance is your WDA for the final year. Once you have calculated the WDAs you then need to calculate the tax payable.

17. Net present value • In this NPV calculation it is assumed that there is a one year time lag in paying the taxation. • So the taxation calculated at the end of year 1 would be paid in year 2. • Once you have reached this stage you are ready to perform a normal NPV calculation with the taxation included.

18. Net present value Equivalent annual cost method • To overcome the problem of analysing projects over very long time periods, equivalent annual cost method, continues to examine all projects over the same time period, however, instead of extending the investment time period it actually reduces it by examining all projects using the yearly annuity that would be received. • The yearly annuity simply means the average annual cash flow that would be received from this project

19. Internal rate of return • There is another measure which can be used, namely the internal rate of return (IRR). • The IRR is a calculation that measures the efficiency or yield of a project, whereas, in contrast the NPV measures the value of the return. • The NPV is measured in currency and the IRR is measured as a percentage.  

20. Internal rate of return • Calculating the IRR can be a lengthy process, the following formula shows you what you are looking for: Where:  C = cash flows  n = number of years r = cost of capital (in decimals)  So in this case you need to looking for r, the unknown variable. Calculating r is a process of testing different possibilities. Testing involves guess work and you need to keep testing different rates until you get to where the NPV equals zero.

21. Disadvantages of IRR Although IRR has many advantages – the main ones being that managers like percentages and everyone understands them – it has some disadvantages that you need to be aware of: • If a project is being considered which is set within an uncertain market where conditions change regularly, this can create problems for the IRR technique. • When a project has many positive and negative cash flows because the project has to be updated on a regular basis due to market conditions, this can lead to more than one possible IRR. • However, the IRR technique cannot handle this type of scenario, it can only work on the basis that there is one IRR. The NPV calculation can accommodate changing discounts rates because each year can be discounted separately.

22. Do all companies use capital budgeting techniques to determine their investment? • Ekanem (2007) argued that smaller firms will use intuition in their investment decisions – called the ‘bootstrapping’ techniques – where they use past experience to determine what is best for their companies.  • Miller and O’Leary (2007) argue that capital budgeting techniques are more than financial evaluations and state that they are ‘mediating instruments’ that can help organizations manage and co-ordinate investments in both intra-organizational and inter-organizational investment decisions. Miller and O’Leary (2007) found that capital budgeting instruments helped to shape the future of the technology industry. 

23. Do all companies use capital budgeting techniques to determine their investment? • Warren (2012) found that capital budgeting techniques were also used as ‘mediating instruments’ within the UK generation electricity market. • The study found that capital budgeting techniques were use as: • An international language across different markets within the same sector • A source of power by modelling current regulation to mobilizing resources which would create the need for consultation of the future of the market • A legitimizing tool which could be used to justify a lack of investment, using real options theory

24. Strategic investment decisions • Modelling the future involves strategy. • Management accountants have many financial techniques that can help to determine suitable investments in addition to these tools, they also need to appreciate that not all projects are driven by financial considerations alone. 

25. Real options   • Increasingly, real options analysis (ROA) is used within investment analysis. This is a theory borrowed from corporate finance and embedded within the decision-making process. • A financial option provides the investor the right (but does not obligate them) to sell or buy an asset in the future at a set price. • The company is making an initial investment with the knowledge that this offers the possibility to change direction in the future, but is not an obligation to do so. If a decision is taken later in the process, to expand for example, further capital will be deployed at this point 

26. Real options   • Worked Example 15.9 Real options Imagine you are offered the opportunity to invest in a project where market research shows there is an equal chance of the investment being successful; if successful you will receive £10,000 in return and if unsuccessful you will lose £12,000. There is an option available to invest in this project and the price of this option is £1,000. Would you purchase this option?

27. Real options   • Solution Step 1: Assume there is no option: (0.5 × £10,000) – (0.5 × £12,000) = £5,000 - £6,000 = -£1,000 Step 2: Calculate the value of the investment if the option is available: [(0.5 × £10,000) – (0.5 × 0)] - £1,000 = £4,000 You can see that by investing in the option and waiting to see, the value of the project is much higher because you have the right to not complete the full investment.