Strategic Management Accounting

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Strategic Management Accounting

• Topic 10
• PROJECT APPRAISAL

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Goals for this topic

• To explain the four investment decision rules
  and their advantages and disadvantages
• To compute incremental cash flows
• To evaluate projects of different lives
• To apply sensitivity analysis to evaluate the
  NPV calculation

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THIS SESSION
AN INTRODUCTION TO CAPITAL BUDGETING
CAPITAL BUDGETING IN CONTEXT
Non - DCF TECHNIQUES
DCF TECHNIQUES

• What is Capital Budgeting?
• How is it used in Project Appraisal?
• On what basis should we evaluate projects?

• What Non-DCF techniques are available?
• What are their strengths limitations?

• What other factors do we need to consider in
  Project Appraisal?
• Why are they important?

• What DCF techniques are available?
• What are their strengths limitations?

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AN INTRODUCTION TO CAPITAL BUDGETING
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What is capital budgeting?

• Term used to describe techniques used by managers
  to assess the financial viability of projects
  (investments) that have long-term implications (gt
  1 year)
• Capital budgeting, capital expenditure capital
  investments
• Typical investments include
• cost reduction, equipment selection, lease v buy,
  equipment replacement and new product decisions

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Why is capital budgeting important?

• Capital investments
• Often involve the commitment of significant
  proportion of organisational resources
• Involve a long-term commitment of organisational
  resources, exposing the organisation to
  uncertainty (ie new competitive products, changes
  in market demand)
• Expose the organisational to technological risk.

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Essential criteria for capital budgeting

• In order for a technique to be useful for
  evaluating capital investment decisions, it must
• have clear guidelines on when to accept reject
  an investment
• be able to be clearly interpreted
• be able to rank alternative investments.

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Types of capital budgeting techniques

• Non-DCF techniques
• does not take into account the time value of
  money
• techniques include payback period, bail-out
  period, accounting rate of return
• DCF techniques
• take into account the time value of money
• techniques include Net present value, internal
  rate of return, present value index, discounted
  payback period, discounted bail-out period

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Non - DCF TECHNIQUES
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EXAMPLE

• New piece of medical Equipment- purchase price
  10,000
• Estimated life Five Years
• Estimated Residual Value 2,000
• Straight line Depreciation is used

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• Annual Net Cash Inflows
• (due to increased patient fees)
• Year 1 3,000
• Year 2 4,000
• Year 3 6,000
• Year 4 2,000
• Year 5 5,000
• Required Rate of Return 10
• Calculate the Payback, ARR,IRR
• NPV associated with this proposed
• Purchase
• Should the purchase proceed?

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PAYBACK PERIOD

• Payback period
• The time taken to recoup, in cash flows, the net
  dollars invested in the project.
• Commonly used in Australia.
• Simple, popular easy
• Formula Original Investment
• Annual Net Cash Inflows

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• Advantages of payback period technique
• simple to calculate and easy to understand
• liquidity is important to most organisations
• Disadvantages of payback period technique
• ignores the time value of money
• takes too short-run a view
• ignores cash flows at the end of the investments
  useful life

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ACCOUNTING RATE OF RETURN

• Accounting rate of return (ARR)
• Based upon accounting data (not predicted cash
  flow information)
• formula
• Average annual net cash inflows - Depreciation
• initial investment

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• Advantages of ARR technique
• simple to calculate and easy to understand
• consistent with financial accounting reports
• Disadvantages of ARR technique
• ignores the time value of money
• in averaging all cash flows, fails to reflect the
  advantages of near as opposed to distant returns
  when comparing projects
• sensitive to methods of depreciation
• may result in the rejection of long-term
  profitable projects

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DCF TECHNIQUES
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Significance of the time value of money concept

• Time value of money concept - money can earn a
  return (bank, sharemarket, other investments)
• Want to ensure that the return from money
  invested gt the return from the other alternatives
• Need to incorporate time value of money concept
  when assessing the cash flows associated with
  various investments

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Example The Time value of money

• Assume a company is obligated to pay a creditor
  150,000 in 5 years time. What amount of cash
  should be invested now at 8 to yield such cash
  in the future?

Initial Investment ???
Future Cash Requirement
150,000
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TABLE Present Value of 1
Number of Periods 5 6
8 10 12 15
Discount Rate
1 .952 .943 .926 .909 .893 .870
5 .784 .747 .681 .621 .567 .497
10 .614 .558 .463 .386 .322 .247
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Revision of the time value of money

• Present Value
• FV
• (1 r)n
• Future Lump Sum x Present Value Factor
• 150,000 x 0.681
• 102,150

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Internal Rate of Return method (IRR)

• Measure of the actual economic return earned by
  the investment over its useful life (The yield
  provided by the Project)
• The IRR is the discount rate at which the present
  value of the cash inflows exactly equals the
  present value of the cash outflows arising from
  the investment
• Acceptable investments where IRR gt COC
• Initial Cash Outlay Sum all future cash inflows
  discounted at the Internal Rate of Return

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• Advantages
• Measure of the actual economic return earned by
  the investment over its useful life
• Disadvantages
• multiple solutions are possible
• trial error to find r can be cumbersome
• limiting assumptions
• hurdle rate firm's cost of capital, projects
  not mutually exclusive, firm's reinvestment rate
  IRR

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Net Present Value method (NPV)

• NPV The sum of the future net cash inflows
  discounted at the required rate of return and
  deducting from the resulting present value, the
  initial cash outlay of the project
• Cost of capital (discount rate, required rate of
  return) is the cost of raising funds to finance
  the project.
• Acceptable investments where NPV gt 0

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• Advantages
• considers quantity, timing risk of cash flows
• results in a dollar answer
• ranks projects correctly
• maximises return to the organisation
• Disadvantages
• difficult to understand communicate

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DCF Techniques Other issues to consider

• Effect of taxation
• cash flow items
• non-cash flow items
• Effect of inflation
• inflation-adjusted cash flows market-based
  discount rate (which includes adjustment for
  inflation)
• real cash flows and real discount rate (which has
  removed adjustment for inflation)
• Calculating the cost of capital (disc. rate)

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CAPITAL BUDGETING IN CONTEXT
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• Strategic factors
• Long-term strategic opportunities
• Employee morale
• Impact upon the environment

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• Behavioural factors
• Problems in identifying potential projects
• Prediction problems caused by human behaviour
• Problems of short-term manager short-term
  performance measures
• Problems caused by self-identification with
  projects
• Personnel development capital projects
• Risk-seeking risk-adverse behaviour