Chapter 10 / Making capital investment
decisions
The nature of investment decisions
The essential feature of investment decisions it time. Investment involves making an outlay of
something of economic value, usually cash, at one point in time, which is expected to yield economic
benefits to the investor at some other point in time. The outlay is typically one large amount and the
beneifts arrive as a series of smaller amounts over a fairly protracted period. Investment decisions
tend to be of profound importance to the business because:
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Large amounts of resources are often involves.
It is often difficult and/or expenseive to bail out of an investment once it has been
undertaken.
Investment appraisal methods
It is essential that there is proper screening of investment proposals. An important part of this
screening process is to ensure that the business uses appropriate methods of evaluation. There are
basically four methods to evaluate investment opportunities:
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Accounting rate of return (ARR)
Payback period (PP)
Net present value (NPV)
Internal rate of return (IRR)
Not every business use these methods, sometimes they use their own method and rely on the ‘gut
feeling’. Most businesses, however, seem to use one (or more) of these four methods.
Accounting rate of return (ARR)
The accounting rate of return (ARR) method takes the average accounting operating profit that the
investment will generate and expresses it as a percentage of the average investment made over the
life of the profit.
Average annual operating profit
ARR =
x 100
Average investment to earn that profit
Average investment = Cost of machine + Disposal value / 2
See p. 249 for example.
Users of ARR should apply the following decision rules:
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For any project to be acceptable it must achieve a target ARR as a minimum.
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Where there are competing projects that all seem capable of exceeding this minimum rate
(that is, where the business must choose between more than one project), the one with the
higher or highest ARR would normally be slected.
ARR and ROCE
We should note that the ARR and the return on capital employed (ROCE) ratio take the same
approach to performacen measurement, in that they both relate accounting profit to the cost of the
assets invested to generate that profit.
ROCE is a popular means of assessing the performance of a business, as a whole, after it has
performed.
ARR is an approach that assesses the potential performance of a particular investment, taking the
same approach as ROCE, but before it has performed.
Managers using ARR will require that any investment undertaken should achieve a target ARR as a
minimum. Perhaps this minimum target would be based on the rate that previous investments had
actually achieved (as measured by ROCE).
Operating profit can be seen as a net increase in wealth over a period, and realing it to the size of
investment made to achieve it seems a logical approach. ARR is said to have a number of advantages
as a method of investment appraisal.
Shareholders seem to use this ratio (ROCE) to evaluate management performance, and sometimes
the financial objective of a business will be expressed in terms of a target ROCE.
ARR is based on the use of accounting profit. When measuring performance over the whole life of a
project, however, it is cash flows rather than accounting profits that are important.
Cash is the ultimate measure of the economic wealth generated by an investment. This is because it
is cash that is used to acquire resources and for distribution to owners.
Accounting profit is more appropriate for reporting achievement on a periodic basis. It is useful
measure of prpductive effort for a relatively short period, such as a year or half-year. Accounting
profit is fine for measuring performance over a short period but cash is the approapriate measure
when considering the performance over the life of a project.
Payback period
The payback period is the length of time it takes for an initial investment to be repaid out of the net
cash inflows from a project. The decision rule for using PP is:
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For a project to be acceptable it would need to have a payback period shorter than a
maximum packback period set by the business.
If there were two (or more) competing projets whose payback periods were all shorter than
the maximum packback period requirement, the decision-maker should select the project
with the shorter (shortest) payback period.
The PP method has vertain advantages. It is quick and easy to calculate, and can be easily understood
by managers. The logic of using PP is that project that can recoup their cost quickly are economically
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more attractive than those with longer payback periods, that is, it emphasises liquidity. PP is
probably an improvement on ARR in respect of the timing of the cash flows. PP is not, however, the
whole answer to the problem.
Problems with PP
We can see that the PP method is not concerned with the profability of projects; it is concerned
simply with their payback period. Thus cash flows arising beyond the payback period are ignored. PP
takes some note of the timing of the costs and benefits from the project. Its key deficiency, however,
is that it is not linked to promoting increases in the wealth of the business and its owners. PP will
tend to recommend undertaking projects that pay for themselves quickly.
The PP method requires the manger sof a business to select a maximum acceptable payback period.
This maximum period, in practice, will vary from one business to the next.
Net present value (NPV)
The net present value (NPV) provides us with:
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Consider all of the costs and benefits of each investment opportunity; and
Makes a logical allowance for the timing of those costs and benefits
Interest lost
If we are to be deprived of the opportunity to spend our money for a year, we could equally well be
deprived of its use by placing it on deposit in a bank or building society. By investing the funds in
some other way, we shall be incurring an opportunity costs.
- an opportunity cost occurs where one course of action, for example making an investment,
deprives us of the opportunity to derive some benefit from an alternative action, for example putting
the money in the bank and earning interest.
From this we can see that any investment opportunity must, if it is to make us wealthier, do better
than the returns that are available from the next best opportunity.
Risk
Buying a machine to manufacture a product, or to provide a service, to be sold in the market, on the
strength of various estimates made in advance of buying the machine exposes the business to risk.
Things may not turn out as expected.
It is important to remember that the decision whether to invest in the machine must be taken before
any of these things are known. It is only after the machine has been purchased that we could
discover that the level of sales, which had been estimated before the event, is not going to be
achieved.
In practice, we tend to expect a higher rate of return from investment projects where the risk is
perceived as being higher. How risky a particular project is, and therefore how large this risk
premium should be, are matter that are difficult to handle.
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Inflation
Inflation is los the loss in the purchasing power of money which occurs over time. The investor needs
compensating for this loss of purchasing power if the investment is to be made. This compensation is
on top of return that takes account of what could have been gained from an alternative investment
of similar risk. In practice, interst rates observable in the market tend to take inflation into account.
Rates that are offered to potential building society and bank depostitors include an allowance for the
rate of inflation that is expected in the future.
What will a logical investor do?
A logical investor who is seeking to increase his or her wealth will only be prepared to make
invsetments that will compensate for the loss of interest and purchasing power of the money
invested and for the fact that returns expected may not materialise (risk). This is usually assessed by
seeing whether the proposed investment will yield a return that is greater than the basic rate of
interesest plus a risk minimum.
Naturally, investors need at least the minimum returns before they are prepared to invest. Usually it
is the investment with the highest percentage return that will make the investor most wealthy.
We can make a more general statement about the PV of a particular cash flow.
PV of the cash flow of year n = actual cash flow of year n divided by (1+r)
Where n is the year of cash flow (that is, how many years into the future) and r is the opportunity
investing rate expressed as a decimal (instead of as a percentage).
See p. 363 for example.
The decision rule for NPV is simple:
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If the NPV is positive the project should be accepted; if it is negative the project should be
rejected.
If there are two (or more) competing projects that have positive NPV’s, the decision-maker
should select the project with the higher (or highest) NPV.
Using discount tables
Deducing the present values of the various cash flows is a little laborious using the approach that we
have just taken. To deduce each PV we took the relevant cash flow and multiplied it by 1/(1 + r).
Tables exist that show values of this discount factor for range of values of r and n. (appendix E).
Look at the column of 20% and the row of one year. We find that the factor is 0.833. this means that
the PV of a cash flow of €1 receivable in one year is €0.833. so the present value of a cash flow of
€20.000 receivable in one year’s time is €16,660 (that is 0.833x20.000), the same result as we found
doing it in longhand.
We have seen that the appropriate discount rate to use in NPV assessments is the opportunity cost
of finance. This is often known as the cost of capital.
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Why NPV is better
NPV is a better method dan ARR or PP because it fully takes account of each of the following:
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The timing of the cash flows
The whole of the relevant cash flows. NPV includes all of the relevant cash flows irrespective
of when they are expected to occur.
The objectives of the business. NPV is the only method of appraisal in which the output of
the analysis has a direct bearing on the wealth of the owners of the business. Positive NPVs
enhance wealth; negative ones reduce it.
Economic value is a value that hase been derived by adding together the discounted (present) values
of all future cash flows from the asset concerned.
Internal rate on return (IRR)
This is quite closely related to the NPV method in that, like NPV, it also involves discounting future
cash flows.
The internal rate on return (IRR) of a particular investment is the discount rate that, when applied to
its future cash flows, will produce an NPV or precisely zero. In essence, it represents the yield from
an investment opportunity. It is somewhat laborious to reduce the IRR by hand, sicne it cannot
usually be calculated directly. Iteration (trial and error) is the approach that must usually be
adopted.
Read pages 369, 370 enz.
Users of the IRR method should apply the following decision rules:
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for any project to be acceptable, it must meet a minimum IRR requirement. This is often
referred to as the hurdle rate and, logically, this should be the opportunity cost of finance.
Where there are competing projects (that is, the business can choose only one of two or
more viable projects), the one with the higher (or highest) IRR would be selected.
IRR has certain attributes in common with NPV. All cash flows are taking into account, and their
timing is logically handled.
Problems with /IRR
The main disadvantage of IRR, relative to NPV, is the fact that it does not correctly address the
question of wealth generation. It could therefore lead to the wrong decision being made. This is
because IRR would, for example, always see an IRR of 25% as being preferable to a 20 % IRR,
assuming an opportunity cost of finance of say, 15%/ although accepting the project with higher
percentage return will often generate more wealth, this may not always be the case. This is because
IRR completely ignores the scale of investment.
A further problem with the IRR method is that it has difficulty handling projects with unconventional
cash flows.
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Some practical points
There are several practical points that we should bear in mind when undertaking an investment
appraisal:
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Past costs; we should take account only of relevant costs in our analysis. This means that only
costs that vary with the decision should be considered.
Common future costs; some future costs ma also be the same. For example, the cost of raw
materials may not vary with the decision whether to invest in a new piece of manufacturing
plant or to continue to use existing plant.
Opportunity costs; for example, when considering a decision concerning whether or not to
continue to use a miche already owned by the business, the realisable value of the machine
might be an important opportunity cost.
Taxation; owners will be itnersted in the after-tax returns generated from the business, and
so taxation will usually be an important consideration when making an investment decision.
Cash flows not profit flows;
Year-end assumption; this is a simplifying assumption that is used to make the calculations
easier. The assumption is clearly unrealistic, as money will have to be paid to emplyees on a
weekly or montly basis and credit customers will pay within a month or two of buying the
product or service.
Interest payments when using discounted cash flow techniques (NPC and IRR), interest
payments should not be taken into account in deriving the cash flows for the period. The
discount factor already takes account of the costs of financing, and so to take account of
interst charges in deriving cash flows for the period would be double counting.
Other factors. Investment decision-making must not be viewed as simply a mechanical
exercise. The results derived from a particular investment appraisal method will be only one
input to the decision-making process.
Investment appraisal in practice
Many surveys have been conducted in the UK into methods of investment appraisal used by
businesses. They have shown the following features:
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Businesses tend to use more than one method to assess each investment decision,
increasingly so over time.
The discounting methods (NPV and IRR) have become increasingly popular over time, with
these two becoming the most popular in recent years.
ARR and PP continue to be popular despite their theorectical shortcoming and the rise in
popularity of the discounting methods.
Larger businesses tend to use the discounting methods and to use more than one method in
respect of each decision.
PP can provide a convenient, though rough and ready, assessment of the profitability of a project.
The popularity of PP may suggest a lack of sophistication by managers concerning investment
appraisal. This criticism is most often made against managers of smaller businesses.
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IRR may be as popular as NPV, despite its shortcomings, because it expresses outcomes in
percentage terms rather than in absolute terms. This form of expression appears to be more
acceptable to managers, despite the problems of percentage measures.
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