A 14907 - Strategic Management Accoun6ng (2018-2019) Session 10 Investment Decisions Paul G. Smith B.A., F.C.A
Course Overview 1. Financial Vs Management Accoun4ng 10. Investment Decisions 2. Accoun4ng Principles and Valua4on Criteria – 11. Opera4onal Decisions PGS Current and Fixed Assets 3. Accoun4ng Principles and Valua4on Criteria – 12. Exam Current and Fixed Assets ..Cont’d PT 4. Financial Statement Analysis 13. Target Cos4ng and Life Cycle Cos4ng 5. Performance Measurement and Cost 14. Servi4za4on and Cost Management Accoun4ng 6. Exam 15. Performance Measurement, Sustainability and CSR LS 7. Strategic Management Accoun4ng 16. Voluntary Disclosure and Balanced Scorecard – Case Study 8. Budgets and Performance Management 17. Presenta4on and Discussion of Case Study PGS 9. Pricing Decisions 18. Exam A 14907 Strategic Management Accoun6ng 2
RECAP PREVIOUS SESSION A 14907 Strategic Management Accoun6ng 3
Summary Session 9 • Cos6ng and pricing – different approaches to cos6ng. • Consumer behaviour and pricing. • Compe6tor behaviour and pricing. • Pricing new products or services. • Product life cycle and pricing. • Special pricing strategies. A 14907 Strategic Management Accoun6ng 4
SESSION 10 OBJECTIVES A 14907 Strategic Management Accoun6ng
Session 10 Objec4ves • ARer studying this topic, the students will be able to: – Assess the financial impact of an investment using tradi6onal techniques. – Evaluate the strengths and weaknesses of the above techniques. – Demonstrate an awareness of alterna6ve techniques. – Explain the role of financial assessment within the wider strategic assessment of investment decisions.
OVERVIEW SESSION 10 A 14907 Strategic Management Accoun6ng 7
Overview Session 10 • Tradi6onal investment appraisal techniques. • The strengths and weaknesses of individual appraisal techniques. • The use and abuse of investment appraisal techniques. • Financial analysis within the overall context of investment planning. • Non-financial factors in investment appraisal. • Alterna6ve strategic approaches to investment appraisal.
INVESTMENT APPRAISAL – THE BASICS A 14907 Strategic Management Accoun6ng
Investment Appraisal – The Basics Why do people and companies/organiza6ons invest? A 14907 Strategic Management Accoun6ng
Why Invest? The expecta6on that for a certain outlay today a bigger return will be received tomorrow. If I deposit €100 with a If I borrowed €100 from a bank and the bank and the market market interest rate is 6% p.a. I would interest rate is 6% p.a. I expect to pay back €106 in 1 years 6me. would expect to receive Therefore, if I invest the borrowed €106 in 1 years 6me. money I will require a higher return A 14907 Strategic Management Accoun6ng
Investment appraisal – the basics • What does an investor need to know? – Return – Timing – Risks The importance of the 4me value of money At an interest rate of 7% money loses half its value every decade. The promise of €1 in 10 years is worth but 50 cents today.
Components of Capital Budge6ng 1. A crea6ve search for investment opportuni6es 2. Long-range plans and projec6ons of the company’s future development 3. A short-range budget of supply of funds and demanded capital 4. A correct yards6ck of the economic worth 5. Realis6c es4ma4on of the economic worth of individual projects 6. Standards for the screening of investment proposals that are geared to the company’s economic circumstances 7. Expenditure controls of outlays for facili6es by comparison of authoriza6ons and expenditures 8. Candid and economically realis6c post-comple4on audits of project earnings 9. Investment analysis of facili6es that are candidates for disposal 10. Forms and procedures to insure smooth workings of the system Source: An Insight into Management Accoun6ng – John Sizer A 14907 Strategic Management Accoun6ng
Tradi4onal evalua4on techniques • Payback period (PP) • Accoun6ng rate of return (ARR) • Discounted cash flow (DCF): – Net present value (NPV) – Internal rate of return (IRR)
Worked example 9.1
Worked example 9.1
Worked example 9.1
PAYBACK PERIOD (PP) A 14907 Strategic Management Accoun6ng
Payback period (PP)
Payback period (PP) Ini6al cost s6ll not paid back aRer three years = $140,000 Net cash inflow in year 4 = $350,000 Therefore the remaining balance of $140,000 would be paid back in $140,000 / $350,000 = 0.4 of a year. The payback period is therefore 3.4 years.
Payback Period Advantages Disadvantages • Simplicity • Doesn’t measure profitability • Easy to calculate • Doesn’t take into account • Easy to Understand the 6ming of cash flows • Appeals to a basic level of • Long-life projects human psychology – anxiety and risk • Short-life projects • Where rapid changes in technology e.g. IT systems A 14907 Strategic Management Accoun6ng
ACCOUNTING RATE OF RETURN (ARR) A 14907 Strategic Management Accoun6ng
Accoun4ng rate of return (ARR) ARR = Average annual profit × 100% Average investment Where: Average annual profit = Total profit aRer deprecia6on Life of investment Average investment = Ini6al cost + Residual value 2 Some6mes also referred to as Return on investment (ROI)
Accoun4ng rate of return (ARR) Average annual profit: The total profit before deduc6ng deprecia6on = $1,860,000 ($280,000 + $390,000 + $390,000 + $350,000 + $250,000 + $200,000) The total deprecia6on can be calculated as the ini6al cost less the residual value of the investment = $1,200,000 − $150,000 = $1,050,000 The average annual profit = ($1,860,000 − $1,050,000) = $135,000 6 years
Accoun4ng rate of return (ARR) Average investment: Because the company charges deprecia6on on a straight-line basis, the average investment will be the value halfway between the ini6al cost and the residual value: Average investment = $1,200,000 + $150,000 = $675,000 2
Accoun4ng rate of return (ARR) ARR = $135,000 × 100% = 20.0% $675,000
Accoun6ng Rate of Return Advantages Disadvantages • Uses accruals concept • Uses profits • Doesn’t consider 6ming of • Comparable to ROCE cash flows • Can be compared to a pre- • Rela6ve measure: small determined % projects may have higher ARR but lower absolute profit • No generally accept basis for calcula6ng ARR • Ignores 6ming of profits A 14907 Strategic Management Accoun6ng
DISCOUNTED CASH FLOW (DCF) A 14907 Strategic Management Accoun6ng
Net present value (NPV) The NPV of an investment is the sum of the present values of all cash flows which arise as a result of undertaking that investment. The present value (P) of a single sum, A, receivable in n years’ 6me, given an interest rate (discount rate) of r, is given by:
Net present value (NPV)
Internal rate of return (IRR) IRR = A% + NPV at A% x (B% − A%) (NPV at A% − NPV at B%) Where: A% = the lower discount rate B% = the higher discount rate The IRR is the discount rate which gives a NPV of zero and can be compared to the rate required or considered acceptable
Internal rate of return (IRR) Discoun6ng at 15% gave a posi6ve NPV, therefore discount again at a higher discount rate:
Internal rate of return (IRR) IRR = 15% + $70,710 × (20% − 15%) = 17.3% ($70,710 + $83,840)
Internal Rate of Return Advantages Disadvantages • Doesn’t work with non- • By using discounted cash conven6onal cash flows e.g flows takes into account: if there are large – Risk decommissioning costs – Timing • Favours investments which – Returns offer returns in the shorter- term-encourages short- termism. • Can’t evaluate non quan6fiable issues e.g. new technology investments A 14907 Strategic Management Accoun6ng
REAL WORLD COMPLEXITIES A 14907 Strategic Management Accoun6ng
Real-world complexi4es • Establishing an appropriate discount rate • Deciding what to count: relevant cash flows • Opportunity costs • Taxa6on • Infla6on • Annui6es • Capital ra6oning: the profitability index • Replacement decisions • Lease or buy
DETERMINING AN APPROPRIATE DISCOUNT RATE A 14907 Strategic Management Accoun6ng
Discount Rate Factors to consider 1. The firm’s cost of capital 2. The opportunity cost of inves6ng the capital outside the firm 3. The return on alterna6ve projects available A 14907 Strategic Management Accoun6ng
Cost of Capital The minimum acceptable return from any project is the rate of interest which the firm is paying for the capital invested in the firm. i.e. its cost of capital Weighted average cost of Capital is the sum of Weighted Cost of equity Weighted Cost of debt A company is financed partly by equity and partly by debt. The company’s current gearing is 30% (i.e. Debt is 30% of total capital therefore equity is 70%). The cost of equity is 16% and the cost of debt is 10%. The weighted average cost of capital can be calculated as: WACC = (16% x 70%) + (10% x 30%) = 14.2 % A 14907 Strategic Management Accoun6ng
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