A 14907 - Strategic Management Accoun6ng (2018-2019) Session 10 - - PowerPoint PPT Presentation

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 –

Current and Fixed Assets

• 11. Opera4onal Decisions
• 3. Accoun4ng Principles and Valua4on Criteria –

Current and Fixed Assets ..Cont’d

• 12. Exam
• 4. Financial Statement Analysis
• 13. Target Cos4ng and Life Cycle Cos4ng
• 5. Performance Measurement and Cost

Accoun4ng

• 14. Servi4za4on and Cost Management
• 6. Exam
• 15. Performance Measurement, Sustainability and CSR
• 7. Strategic Management Accoun4ng
• 16. Voluntary Disclosure and Balanced Scorecard – Case Study
• 8. Budgets and Performance Management
• 17. Presenta4on and Discussion of Case Study
• 9. Pricing Decisions
• 18. Exam

PT PGS LS PGS A 14907 Strategic Management Accoun6ng 2

RECAP PREVIOUS SESSION

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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.

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SESSION 10 OBJECTIVES

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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

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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

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Investment Appraisal – The Basics

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Why do people and companies/organiza6ons invest?

Why Invest?

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The expecta6on that for a certain outlay today a bigger return will be received tomorrow.

If I deposit €100 with a bank and the market interest rate is 6% p.a. I would expect to receive €106 in 1 years 6me. If I borrowed €100 from a bank and the market interest rate is 6% p.a. I would expect to pay back €106 in 1 years 6me. Therefore, if I invest the borrowed money I will require a higher return

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

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Source: An Insight into Management Accoun6ng – John Sizer

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)

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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

• Simplicity
• Easy to calculate
• Easy to Understand
• Appeals to a basic level of

human psychology – anxiety and risk

• Short-life projects
• Where rapid changes in

technology e.g. IT systems Disadvantages

• Doesn’t measure

profitability

• Doesn’t take into account

the 6ming of cash flows

• Long-life projects

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ACCOUNTING RATE OF RETURN (ARR)

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Accoun4ng rate of return (ARR)

ARR = Average annual profit × 100% Average investment

Average annual profit = Total profit aRer deprecia6on Life of investment Average investment = Ini6al cost + Residual value 2

Where: 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

• Uses profits
• Comparable to ROCE
• Can be compared to a pre-

determined % Disadvantages

• Uses accruals concept
• Doesn’t consider 6ming of

cash flows

• Rela6ve measure: small

projects may have higher ARR but lower absolute profit

• No generally accept basis

for calcula6ng ARR

• Ignores 6ming of profits

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DISCOUNTED CASH FLOW (DCF)

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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

• f zero and can be compared to the rate

required or considered acceptable

Discoun6ng at 15% gave a posi6ve NPV, therefore discount again at a higher discount rate:

Internal rate of return (IRR)

Internal rate of return (IRR)

IRR = 15% + $70,710 × (20% − 15%) = 17.3% ($70,710 + $83,840)

Internal Rate of Return

Advantages

• By using discounted cash

flows takes into account:

– Risk – Timing – Returns

Disadvantages

• Doesn’t work with non-

conven6onal cash flows e.g if there are large decommissioning costs

• Favours investments which
• ffer returns in the shorter-

term-encourages short- termism.

• Can’t evaluate non

quan6fiable issues e.g. new technology investments

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REAL WORLD COMPLEXITIES

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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

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Discount Rate

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• 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

Factors to consider

Cost of Capital

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Weighted average cost of Capital is the sum of Weighted Cost of equity Weighted Cost of debt 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 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 %

Deciding what to count: Relevant cash flows

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Only those costs or revenues affected by the decision should be considered. Costs already incurred or which will be incurred anyway should be excluded. Factory costs, administra6on and head office costs which will not change should be excluded

Opportunity costs

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Used only in decision making and defined as: “The cost of an alterna4ve that must be foregone in order to pursue a certain ac4on”

Measured in terms of the lost contribu6on from the use of a par6cular resource. Contribu6on = Revenue – Variable (direct) cost

Real-world complexi4es: taxa4on

• Income tax paid on profits from an investment

will represent a cash ouqlow.

• Interest on any debt financing is an allowable

expense against income tax.

• Tax losses may give rise to tax relief on other

profits.

• Capital allowances.

Real-world complexi4es: infla4on

• Infla6on decreases the purchasing power of

future cash inflows, making them worth less.

• Therefore infla6on can create distor6ons

when aremp6ng to assess the 6me value of money and in calcula6ng returns from investments.

Real-world complexi4es: infla4on

• If an interest rate includes infla6on, it is

referred to as the ‘money rate’.

• If an interest rate excludes infla6on, it is

referred to as the ‘real rate’.

(1 + real rate) × (1 + rate of infla4on) = (1 + money rate)

Note that the real rate is mul4plied by infla4on, not added, to give the money rate.

Dealing with infla4on in investment appraisal calcula4ons

• Money method: use ‘money’ cash flows (ie those

cash flows which include infla6on) and discount these using the ‘money’ discount rate (ie the discount rate which incorporates the effect of infla6on).

• Real method: use cash flows which exclude the

impact of infla6on and apply the ‘real’ discount rate.

Annui4es

• If the level of cash flow from an investment is

the same from year to year, it is referred to as an annuity.

• The NPV can be calculated by using annuity
• tables. Annuity tables show the present value
• f $1 received every year, star6ng one year

from now and going on for n years.

Capital ra4oning

• Hard ra4oning: capital markets will always

supply a limited amount of capital. A company therefore may not be able to raise sufficient capital to finance all available projects.

• Sol ra4oning: the company may have

sufficient funds available but has chosen to restrict its capital investment for strategic reasons.

INVESTMENT APPRAISAL WITHIN CONTEXT

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Investment Appraisal Within Context

• Integra6ng Qualita6ve Factors
• Assessing Risk: The variable outcomes

– Sensi6vity analysis – Scenario analysis – Probabili6es and expected values – Other methods

• Monte Carlo simula6on
• Markov chain theory
• Fuzzy set theory

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Integra4ng qualita4ve factors

Financial benefits:

• Net present value $x

Non-financial benefits:

• x% of users happy with quality
• x% of users happy with scope
• x hours saved per month

Risk: the variability in

• utcomes
• Sensi6vity analysis
• Scenario analysis
• Probabili6es and expected values

TAKING A BROADER STRATEGIC VIEW

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Taking a broader strategic view

• Real op6ons
• Value chain analysis
• Cost-driver analysis
• Compe66ve advantage analysis

MCKINSEY ARTICLES

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Why Capital Expenditures Need More CFO Aren6on

• CFO Major stakeholder in CAPEX Process
• Consistency with overall cash strategy
• Standard comparable model needed

– Sources of value – Assump6ons (exchange rates, infla6on, costs) – Metrics (NPV, IRR)

• Eliminate engineers’ bias,
• Mul6disciplinary teams – “scrubbing”
• Improved “postmortem” process

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Preparing to make big-6cket investment decisions

• Complex mul6billion dollar projects with long

payback period:

– Start with swing factors (Where uncertainty greatest) – Quan6fy and qualify (determina6on of risk) – Keep decision biases in check (evalua6on processes)

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Nine prac6ces for berer capital investment management

• 1. Make the capital porqolio a priority
• 2. Tap the organiza6on’s collec6ve wisdom
• 3. Set clear investment objec6ves and compare even

seemingly disparate projects

• 4. Scrub the business case for each project mul6ple 6mes

throughout the life cycle

• 5. Use ROI throughout the investment life cycle
• 6. Streamline approvals and make contextually informed

decisions

• 7. Forecast more frequently to enable tac6cal shiRs
• 8. Implement a unified cross-plaqorm approach
• 9. Adopt a culture of con6nuous improvement

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REQUIRED READING AND RESEARCH

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Required reading and research

• Reading – required

– Accoun6ng and Finance for Managers – Chapter 9 Investment Decisions

• Reading – Op6onal
• Exercises

– Comprehension ques6ons 1 – 8 – Exercises 9.1 - 9.3

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SESSION SUMMARY, VALIDATION AND OVERVIEW SESSION 11

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Summary 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.

Overview Session 11

• Seyng sales targets
• Predic6ng the impact of price changes
• Outsourcing vs in-house opera6on/produc6on
• Opera6onal restructuring/automa6on of

business processes

• Closing a business segment
• Dropping a product/service line

Session Valida6on

• What are the main elements of a Capital Budge6ng System?
• What are the three main tradi6onal investment evalua6on techniques?
• What are the advantages and disadvantages of these?
• What real world complexi6es need to be taken into account in performing

these calcula6ons?

• What is the appropriate discount rate to use in DCF calcula6ons?
• How is the WACC determined?
• What are the relevant cash flows that need to be considered in

investment decisions?

• What do we mean by opportunity cost?
• In what ways can we deal with the risk associated with investment

decisions?

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