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12 Strategic Investment Decisions We introduced strategy in Chapter 2 to explain its link with achieving shareholder value. In this chapter we are more concerned with strategy implementation through capital investment decisions and the tools used to evaluate those decisions. Strategy Ansoff (1988) provided a typical description of strategy formulation: objectives and goals were established; then an internal appraisal of strengths and weaknesses and an external appraisal of opportunities and threats led to strategic decisions such as diversification or the formulation of competitive strategy. He established a hierarchy of objectives that were centred on performance measures such as return on investment (see Chapter 7, later in this chapter and Chapter 13). A contrasting approach was developed by Quinn (1980), which he called logical incrementalism. Quinn argued against formal planning systems, which he believed had become ‘costly paper-shuffling exercises’, observing that ‘most major strategic decisions seemed to be made outside the formal planning structure’ (p. 2). Quinn further argued that: the real strategy tends to evolve as internal decisions and external events flow together to create a new, widely shared consensus for action among key members of the top management team. (p. 15) Logical incrementalism is similar to work by Mintzberg and Waters (1985), which defined strategy as a pattern in a stream of decisions. Mintzberg and Waters separated the intended from the realized strategy, arguing that deliberate strategies provided only a partial explanation, as some intended strategies were unable to be realized while other strategies emerged over time. The difficulty for businesses in the twenty-first century is that they must continually adapt to technological and market change, making long-term strategy problematic. However, to give the external appearance of being well managed they need to develop strategies, even if only to legitimize what senior managers are doing. Nevertheless, strategy can be crucial in enabling a business to be proactive in increasingly competitive and turbulent business conditions. The absence of strategy can lead to reactivity and a steady erosion of market share. 182 ACCOUNTING FOR MANAGERS As we saw in Chapter 8, Porter (1980) developed his ‘five forces’ model for analysing an industry. This focused on the effects of rivalry among existing firms, the threat of new entrants, the bargaining power of suppliers and customers, and the threat of substitute products and services. Porter also identified three ‘generic strategies’ for competitive advantage: cost leadership, differentiation and focus. Cost leadership requires efficiency, tight cost control and the avoidance of unprofitable work, with low cost a defence against competition. Differentiation can be achieved through, for example, brand image, technology or a unique distribution channel. These factors insulate against price competition because of brand loyalty and lower customer sensitivity to pricing differences. Focus emphasizes servicing a particular market segment (whether customer, territory or product/service) better than competitors who may be competing more broadly. In his second book, Porter (1985) introduced the ‘value chain’ as a tool to help create and sustain competitive advantage (see Chapter 9). However, the formulation of strategy is frequently divorced from the annual budgeting cycle (see Chapter 14), as organizations produce strategic planning documents separately from the annual budget based on last year plus or minus a percentage in order to achieve short-term financial targets. Consequently, the issue of translating strategy formulation into implementation is problematic unless resource allocations follow strategy. In their most recent addition to the strategy literature, Kaplan and Norton (2001) built on the success of their Balanced Scorecard approach (see Chapter 4) to emphasize the ‘strategy-focused organization’ that links financial performance with non-financial measures. Non-financial measures in the Balanced Scorecard measure how well the organization is meeting the targets established in its strategy. Kaplan and Norton use ‘strategy maps’ to identify cause–effect relationships, although these should be modified over time as a result of experience gained within organizations. They also argued that budgetary allocations and incentives need to be consistent with strategy, while reflecting the importance of continual learning and improvement. One of the most important elements of strategy implementation is capital investment decision-making, because investment decisions provide the physical and human infrastructure through which businesses produce and sell goods and services. This is the topic of this chapter. Investment appraisal Capital investment or capital expenditure (often abbreviated as ‘cap ex’) means spending money now in the hope of getting it back later through future cash flows. The process of evaluating or appraising potential investments is to: ž ž ž ž generate ideas based on opportunities or identifying solutions to problems; research all relevant information; consider possible alternatives; evaluate the financial consequences of each alternative; STRATEGIC INVESTMENT DECISIONS ž ž ž ž 183 assess non-financial aspects of each alternative; decide to proceed; determine an implementation plan and implement the proposal; control implementation by monitoring actual results compared to plan. There are three main types of investment: ž ž ž new facilities for new product/services; expanding capacity to meet demand; replacing assets in order to reduce production costs or improve quality or service. These are inextricably linked to the implementation of business strategy. Most investment appraisals consider decisions such as: ž ž ž whether or not to invest; whether to invest in one project or one piece of equipment rather than another; whether to invest now or at a later time. There are three main methods of evaluating investments: 1 Accounting rate of return. 2 Payback. 3 Discounted cash flow. While the first is concerned with profits, the second and third are concerned with cash flows from a project. For any project, investment appraisal requires an estimation of future incremental cash flows, i.e. the additional cash flow (net of income less expenses) that will result from the investment, as well as the cash outflow for the initial investment. Depreciation is, of course, an expense in arriving at profit that does not involve any cash flow (see Chapter 6). Cash flow is usually considered to be more important than accounting profit in investment appraisal because it is cash flow that drives shareholder value (see Chapter 2). It is important to note the following: 1 The financing decision is treated separately to the investment decision. Hence, even though there may be no initial cash outflow for the investment (because it may be wholly financed), all investment appraisal techniques assume an initial cash outflow. If a decision is made to proceed, then the organization is faced with a separate decision about how best to finance the investment. 2 The outflows are not just additional operating costs, as any new investment that generates sales growth is also likely to have an impact on working capital, since inventory, debtors and creditors are also likely to increase (see Chapter 6). 3 Income tax is treated as a cash outflow as it is a consequence of the cash inflows from the new investment. 184 ACCOUNTING FOR MANAGERS Table 12.1 Cash flows for investment alternatives Year Project 1 Project 2 Project 3 0 initial investment 1 inflows 2 inflows 3 inflows 4 inflows 5 inflows −100,000 25,000 25,000 25,000 25,000 25,000 −125,000 35,000 35,000 35,000 35,000 35,000 −200,000 60,000 60,000 80,000 30,000 30,000 As we consider each method, let us assume three alternative investments. Table 12.1 shows the estimated cash flows. For simplicity, we assume that each of the cash flows occurs at the end of each year. Year 0 represents the beginning of the project when the initial funds are paid out. If we add up the cash flows in the above example, Project 1 returns £125,000 (5 @ £25,000), Project 2 returns £175,000 (5 @ £35,000) and Project 3 returns £260,000 (2 @ £60,000 + £80,000 + 2 @ £30,000), although the initial investment in each is different. Accounting rate of return The accounting rate of return (ARR) is the profit generated as a percentage of the investment. This is equivalent to the return on investment (ROI) that was introduced in Chapter 7. The investment value for ARR is the depreciated value each year. The depreciated value each year, assuming a life of five years with no residual value at the end of that time, is shown in Table 12.2. The accounting rate of return varies annually, as Table 12.3 shows for Project 1. For the whole investment period, the accounting rate of return is the average annual return divided by the average investment. The average annual return is the total profit divided by the number of years. As we assume that depreciation is spread equally throughout the life of the asset, the average investment is half the initial investment, i.e. half-way through its life. total profits/no. of years initial investment/2 Table 12.2 Depreciated value of alternative investments End of year Project 1 Project 2 Project 3 1 2 3 4 5 80,000 60,000 40,000 20,000 0 100,000 75,000 50,000 25,000 0 160,000 120,000 80,000 40,000 0 STRATEGIC INVESTMENT DECISIONS Table 12.3 ARR/ROI for Project 1 Year Cash flow Depreciation Profit Investment ROI 1 2 3 4 5 25,000 25,000 25,000 25,000 25,000 20,000 20,000 20,000 20,000 20,000 5,000 5,000 5,000 5,000 5,000 80,000 60,000 40,000 20,000 0 6.25% 8.3% 12.5% 25% The average ROI for Project 1 is: 5,000 25,000/5 = = 10% 100,000/2 50,000 The accounting rate of return for Project 2 is shown in Table 12.4. The average ROI for Project 2 is: 10,000 50,000/5 = = 16% 125,000/2 62,500 The accounting rate of return for Project 3 is shown in Table 12.5. The average ROI for Project 3 is: 10,000/5 2,000 = = 2% 200,000/2 100,000 Table 12.4 ARR/ROI for Project 2 Year Cash flow Depreciation Profit Investment ROI 1 2 3 4 5 35,000 35,000 35,000 35,000 35,000 25,000 25,000 25,000 25,000 25,000 10,000 10,000 10,000 10,000 10,000 100,000 75,000 50,000 25,000 0 10% 13.3% 20% 40% Table 12.5 ARR/ROI for Project 3 Year Cash flow Depreciation Profit Investment ROI 1 2 3 4 5 60,000 60,000 80,000 30,000 30,000 50,000 50,000 50,000 50,000 50,000 10,000 10,000 30,000 −20,000 −20,000 160,000 120,000 80,000 40,000 0 6.25% 8.3% 37.5% −50% 185 186 ACCOUNTING FOR MANAGERS Project 3 in particular has substantial fluctuations in ROI from year to year. Using this method, Project 2 shows the highest return. However, it does not take into account either the scale of the investment required or the timing of the cash flows. Payback This second method calculates how many years it will take – in cash terms – to recover the initial investment, on the assumption that the shorter the payback period, the better the investment. Based on the cash flows for each project: ž ž ž Project 1 takes four years to recover its £100,000 investment (4 @ £25,000). Project 2 has recovered £105,000 by the end of the third year (3 @ £35,000) and will take less than seven months (20/35 = .57 of 12 months) to recover its £125,000 investment. The payback is therefore 3.57 years. Project 3 recovers its investment of £200,000 by the end of the third year (£60,000 + £60,000 + £80,000). Based on the payback method, Project 3 is preferred (followed by Projects 2 and 1) as it has the fastest payback. However, the payback method ignores the size of the investment and any cash flows that take place after the investment has been recovered. Neither the accounting rate of return nor the payback method considers the time value of money, i.e. that £100 is worth more now than in a year’s time, because it can be invested now at a rate of interest that will increase its value. For example, £100 invested today at 10% interest is equivalent to £110 in a year’s time. Conversely, receiving £100 in a year’s time is not worth £100 today. Assuming the same rate of interest it is worth only £91, because the £91, invested at 10%, will be equivalent to £100 in a year’s time. The time value of money needs to be recognized in investment appraisals in order to compare investment alternatives with different cash flows over different time periods. The third method of investment appraisal therefore involves discounted cash flow (DCF), i.e. it discounts the future cash flows to present values using a discount rate (or interest rate) that is usually the firm’s cost of capital (the risk-adjusted cost of borrowing for the investment). There are two discounted cash flow techniques: net present value and internal rate of return. Net present value The net present value (NPV) method discounts future cash flows to their present value and compares the present value of future cash flows to the initial capital investment. present value (PV) of cash flows = cash flow × discount factor (based on number of years in the future and the cost of capital) STRATEGIC INVESTMENT DECISIONS 187 net present value (NPV) = present value of future cash flows − initial capital investment The discount rates to be applied are based on the company’s cost of capital. The cost of capital (see Chapter 2) represents the weighted average of the cost of debt and equity and takes into account the riskiness of a project. As the cost of borrowing has been taken into account, an investment makes sense if the NPV is positive. The discount rate can be obtained from net present value tables (see Appendix to this chapter for an example). More commonly, spreadsheet software (e.g. Excel or Lotus) is used as this contains an NPV function. Using the same example, the NPV for Project 1 is shown in Table 12.6. As the net present value is negative, Project 1 should not be accepted since the present value of future cash flows does not cover the initial investment. The NPV for Project 2 is shown in Table 12.7. Project 2 can be accepted because it has a positive net present value. However, we need to compare this with Project 3 to see if that alternative yields a higher net present value. The NPV for Project 3 is shown in Table 12.8. Despite the faster payback for Project 3, the application of the net present value technique to the timing of the cash flows reveals that the net present value of Project 3 is lower than that for Project 2, and therefore Project 2 – which also showed the highest accounting rate of return – is the recommended investment. However, using the NPV method it is difficult to determine how much better Project 2 (with an NPV of £7,650) is than Project 3 (with an NPV of £3,300) because each has a different initial investment. One way of ranking projects with different NPVs is cash value added (CVA) or profitability index, which is a ratio of the NPV to the initial capital investment: cash value added = NPV initial capital investment In the above example, Project 2 returns a CVA of 6.12% (7,650/125,000) while Project 3 returns a CVA of 1.165% (3,300/200,000). Companies may have a target Table 12.6 NPV for Project 1 Year 1 2 3 4 5 Project 1 cash flows Discount factor (10%) 25,000 25,000 25,000 25,000 25,000 .909 .826 .751 .683 .621 Present value of cash flows 22,725 20,650 18,775 17,075 15,525 Total Less: Initial investment 94,750 100,000 Net present value −5,250 188 ACCOUNTING FOR MANAGERS Table 12.7 NPV for Project 2 Year 1 2 3 4 5 Project 2 cash flows Discount factor (10%) 35,000 35,000 35,000 35,000 35,000 .909 .826 .751 .683 .621 Total Less: Initial investment Present value of cash flows 31,815 28,910 26,285 23,905 21,735 132,650 125,000 Net present value 7,650 Table 12.8 NPV for Project 3 Year 1 2 3 4 5 Project 3 cash flows Discount factor (10%) 60,000 60,000 80,000 30,000 30,000 .909 .826 .751 .683 .621 Total Less: Initial investment Present value of cash flows 54,540 49,560 60,080 20,490 18,630 203,300 200,000 Net present value 3,300 CVA, such that, for example, to be approved a project must have a CVA of 10% (i.e. the NPV is at least 10% of the initial capital investment). The second DCF technique is the internal rate of return. Internal rate of return The internal rate of return (IRR) method determines, by trial and error, the discount rate that produces a net present value of zero. This involves repeated calculations from the discount tables on a trial-and-error basis using different discount rates until an NPV of 0 is reached. The discount rate may need to be interpolated between whole numbers. Spreadsheet software also contains an IRR function. The IRR for each project, using the spreadsheet function, is: Project 1 Project 2 Project 3 7.9% 12.4% 10.7% STRATEGIC INVESTMENT DECISIONS 189 This is a more informative presentation of the comparison because it presents the cash flows as an effective interest rate. The project with the highest internal rate of return would be preferred, provided that the rate exceeds the cost of capital (i.e. the borrowing cost). Comparison of techniques While the accounting rate of return method provides an average return on investment and a business may select the highest return, it ignores the timing of cash flows. Sometimes where there are high short-term ROIs, managers may prefer those investments even though the longer-term impact is detrimental to the organization. This is because managers may be evaluated and rewarded on their short-term performance (see Chapter 13). Payback measures the number of years it will take to recover the capital investment and while this takes timing into account, it ignores cash flows after the payback period. Both methods ignore the time value of money. Discounted cash flow techniques take account of the time value of money and discount future cash flows to their present value. This is a more reliable method of investment appraisal. Discounted cash flow is similar to the method of calculating shareholder value proposed by Rappaport and described in Chapter 2. However, for investment evaluation, while all projects with a positive net present value are beneficial, a business will usually select the project with the highest net present value, or in other words the highest internal rate of return, sometimes using the initial cash investment (CVA) or the cost of capital (IRR) as a benchmark for the return. Because of rapid change in markets and increased demands for shareholder value, the use of discounted cash flow techniques has declined in many businesses. Boards of directors typically set quite high ‘hurdle’ rates for investing in new assets. These are commonly in terms of payback periods of two to four years or ROI rates of 25–50%. This approach reduces the importance of discounted cash flow techniques. However, for larger investments where returns are expected over many years, discounted cash flow techniques are still important. Investments in buildings, major items of plant, mining exploration and so on etc. commonly use NPV and IRR as methods of capital investment appraisal. The following case study provides an example of investment appraisal. Case study: Goliath Co. – investment evaluation Goliath Co. is considering investing in a project involving an initial cash outlay for an asset of £200,000. The asset is depreciated over five years at 20% p.a. Goliath’s cost of capital is 10%. The cash flows from the project are expected to be as follows: 190 ACCOUNTING FOR MANAGERS Year 1 2 3 4 5 Inflow 75,000 90,000 100,000 100,000 75,000 Outflow 30,000 40,000 45,000 50,000 40,000 The company wishes to consider the return on investment (each year and average), payback and net present value as methods of evaluating the proposal. The depreciation expense is £40,000 per year. Net cash flows and profits are as follows: Year 1 2 3 4 5 Inflow 75,000 90,000 100,000 100,000 75,000 Outflow 30,000 40,000 45,000 50,000 40,000 Net cash flow 45,000 50,000 55,000 50,000 35,000 Depreciation 40,000 40,000 40,000 40,000 40,000 Profit 5,000 10,000 15,000 10,000 −5,000 Return on investment: 1 Investment Profit ROI 2 160 5 3.125% 120 10 8.33% 3 80 15 18.75% 4 40 10 25% Over the five years: Profit £35/5 = £7 ROI 7/100 = 7% Investment £200/2 = £100 Cumulative cash flows are: Year 1 2 3 4 Cash flow 45 50 55 50 Cumulative 45 95 150 200 5 0 −5 –