Practical Problems of Theoretically Correct Approaches to Assessing Investment Opportunities

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Capital Investment Opportunities: Introduction.

Capital investment opportunities for profit-making organisations can be assessed using five main methods, as described by John R. Dyson (2010), outlined below. These methods are employed in the construction industry by clients who wish to calculate how financially viable various options are and the amount of time it will take in order to provide them with a return or, at the very least, pay for itself.

 

Payback

Payback is the assessment of how long it will take for a project to pay for itself. For example, if a client wishes to build a supermarket then they will make a calculation as to how long it will take for the revenues generated by sales within the supermarket to cover the cost of the build itself. The calculation is simply performed by working out the difference between income and outgoings as follows:

Cost of the Supermarket Year Anticipated Net Cash Flow Cumulative Net Cash Flow
£600,000
1 £20,000 £20,000
2 £80,000 £100,000
3 £100,000 £200,000
4 £200,000 £400,000
5 £200,000 £600,000

 

We can see that by the end of the fifth year the supermarket has been calculated to have made £600,000 – the same as the initial cost.
As Dyson states, the method requires the following information:

  • Initial cost of the project and all other associated cash payments divided by accounting period.
  • Quantity and accounting period of each return
    Although this method is very simple and fast when compared with other methods of investment appraisal there are numerous disadvantages, some of which are:
  • Because this method deals with net cash flow all none cash elements are excluded from calculations.
  • It is based on an estimate of when the returns on the initial investment will be made – there is no guarantee how long payback will actually take and external effects, such as marked value depreciation and the economy at large, are not taken into account.
  • Because vision is not extended beyond achievement of payback long term profit is not taken into account. It is possible that the project which provides the highest short-term yield may not perform as well as other options in the long term.
  • The timing of the returns has no effect on calculations. The example given above may pose problematic because the majority of the return is later on in the life of the project. Present value deductions would see these sums reduced making payback take longer.

 

Discounted Payback

Much like payback, discounted payback calculates the amount of time it takes for an investment to pay for itself, however it manages to overcome one of the disadvantages of payback by applying appropriate interest rates to make cash received in different accounting periods more comparable. Taking the example used for calculating payback discounted payback would be calculated as follows:

D1 D2 D3 D4 D5
Year Net Cash Flow Discount Factors Present Value at 6% (D2 x D3) Cumulative Present Value
0 (£600,000) 1.000 (£600,000) (£600,000)
1 £20,000 0.943 £18,860 (£581,140)
2 £80,000 0.890 £71,200 (£509,940)
3 £100,000 0.840 £84,000 (£425,940)
4 £200,000 0.792 £158,400 (£267,540)
5 £200,000 0.747 £149,400 (£118,140)
6 £150,000 0.705 £105,750 (£12,390)
7 £100,000 0.665 £66,500 £54,110

 

As can be seen from the discounted payback method, the project would recover its original cost during the seventh year. If we assume that the net cash flows are accrued equally we can calculate the month by dividing the remainder at the end of the sixth year by the present value of the cash flow for the seventh and multiply the result by twelve months: (£12,390 / £66,500) x 12 = 2.2, so by the end of the second month.

Whilst this can be regarded as a more accurate method than standard payback calculation it still carries almost all of the disadvantages.

 

Accounting Rate of Return

The accounting rate of return method takes the profit a project is expected to make and divides it between the capital investment (this is then usually multiplied by 100 in order to express the result as a percentage).
The disadvantages of this method are:

  • As definitions of non-profit vary so too will the results of the calculation. Aspects such as taxation and inflation will be subject to interpretation and may either be left in or taken out of calculations. This, however, is not a common problem because the standard technique involves taking net profit.
  • The definition of capital invested is also contentious – some accountants will use the initial investment, others will take the average investment over the life of the product.

Therefore this may be calculated as either (average annual net profit divided by initial capital investment) multiplied by 100 or (average annual net profit divided by average investment) multiplied by 100.

Using the example of a project as follows:

Project Cost / Residual Value Year Estimated Net Profit
£450,000 (Cost)
1 £100,000
2 £150,000
3 £250,000
4 £225,000
£190,000 (Residual value) 5 £45,000
Total Net Profit £770,000

 

We can calculate the accounting rate of return as (£154,000 / £450,000) x 100 = 34.2% or (£154,000 / £320,000) x 100 = 48.1%



This demonstrates the varying results that can be generated depending on the assumptions made at the start of calculation. There are other disadvantages to this method:

  • There is no adjustment made for the present value of future returns on the investment.
  • Residual value, which is notoriously difficult to calculate (given a number of factors such as future market fluctuations and maintenance of the product), can have a massive bearing on the outcome of the calculation, should the latter method be used.

 

Net Present Value (NPV)

Like the discounted payback method of investment appraisal, net present value involves adjustments for the current value of expected future income and starts with the calculation of expected annual cash flow and the selection of a relevant interest rate.
Once the interest rate has been selected, the discount factors can be obtained and the cash flow multiplied by these factors. Unlike the discounted payback method, these annual present values are then added together to give the net present value, which may be negative (for example if a product with a high outlay projected a short lifespan with low cash flow). The project with the highest net present value should be selected.
A product costing £175,000 with an estimated life of four years and an expected return rate of 7% would be calculated as follows:

NP1 NP2 NP3 NP4
Year Net Cash Flow Discount Factor 7% Present Value

(NP2 x NP3)

1 £40,000 0.935 £37,400
2 £85,000 0.873 £74,205
3 £70,000 0.816 £57,120
4 £65,000 0.763 £49,595
Total Present Value £218,320
Deduct Initial Outlay £175,000
Net Present Value £43,320

 

Again, this method of appraisal is not without disadvantages, however no disadvantage is exclusive to this method which makes it one of the most widely used and regarded methods.

 

Internal Rate of Return

Internal rate of return works on the same principal as net present value, but where net present value uses a presumed return rate, internal rate of return works around that to calculate the required rate of return in order that the total present value balances with the initial investment.
The method works as follows:

For this example we will take a project requiring an initial investment of £200,000 with the following projected net cash flow:

NP1 NP2
Year Net Cash Flow
1 £50,000
2 £80,000
3 £75,000
4 £65,000

 

The net present values are then calculated using two differing discount factors. These should not span a vast range as we are looking to come as close to balancing the net present value as possible, ideally the results will be one negative and one positive so we can then identify a value in-between to return our desired result:

IR1 IR2 IR3 IR4 IR5 IR6
Year Net Cash Flow Discount Factor A 9% Discount Factor B 15% Present Value A (IR2 x IR3) Present Value B (IR2 x IR4)
1 £50,000 0.917 0.870 £45,850 £43,500
2 £80,000 0.842 0.756 £67,360 £60,480
3 £75,000 0.772 0.658 £57,900 £49,350
4 £65,000 0.708 0.572 £46,020 £37,180
Total Present Values £217,130 £190,510
Deduct Initial Outlay £200,000 £200,000
Net Present Value £17,130 (£9,490)

 

We can now find the interest rate between 9% and 15% at which the total present value balances with the initial outlay.



We do this by performing the calculation positive factor + (positive net present value divided by (positive NPV + negative NPV)) multiplied by rate range to arrive at an internal rate of return of 11.58%
With the complexity that the internal rate of return method presents us comes disadvantages. Not only is it a difficult system to use, but there is a certain element of trial and error involved in finding the two discount factors to define the required range.

All methods of appraisal carry their problems and disadvantages, some which are inherent to the process and present in all methods of calculation, such as:

  • The requirement to predict certain future elements such as interest rates, rates of return or the life span of the product itself.
  • Estimation of the initial cost of a project. It is almost inevitable that elements out of our control will be encountered in a construction project causing costs to go up.

For a playoff between complexity and accuracy the generally preferred method of capital investment assessment is net present value.

 

References

Dyson, J. R. (2010) Accounting for non-accounting students. 8th ed. Essex, Pearson Education Limited.

Hannagan, T. (2008) Management Concepts and Practices. 5th ed. Essex, Pearson Education Limited.

Kajanová, J. (2006) ‘The Relationship Between Business Finance and Accounting’. Vadyba/Accounting, 2(11), pp. 58 – 64.

Kirkham, R. (2007) Ferry and Brandon’s Cost Planning of Buildings. 8th ed. Oxford, Blackwell Publishing Limited.

McLaney, E. (2005) Business Finance: Theory and Practice. 7th ed. Essex, Pearson Education Limited.

Smith, C. (2003) ‘Corporate social responsibility: whether or how?’. California Management Review, 45 (4).

Torrington, D. Hall, L. & Taylor, S. (2008) Human Resource Management. 7th ed. Essex, Pearson Education Limited.

Anon. (No date) ‘About Us’. Public Concern At Work, [online] 1 November 2010. Available at http://pcaw.co.uk/aboutus/aboutus.htm

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