Welcome to Capital Investment Decision Making!
Hello there! Welcome to one of the most practical parts of the P2 syllabus. In this section, we are looking at Capital Investment Decision Making. Essentially, we are trying to answer one big question: "Should we spend a large amount of money now to gain benefits in the future?"
In this chapter, we focus on the two "traditional" methods of evaluating projects: Payback Period and the Accounting Rate of Return (ARR). These are often called "non-discounted" methods because they don't look at the 'time value of money' (the idea that $1 today is worth more than $1 next year). Don't worry if that sounds technical; we will take it step-by-step!
1. The Payback Period
The Payback Period is exactly what it sounds like: it is the amount of time it takes for a project to generate enough cash to "pay back" the initial cost of the investment.
Think of it like this: If you lend a friend $100 and they promise to pay you back $20 every week, your "payback period" is 5 weeks. Simple, right?
How to Calculate Payback
There are two ways to calculate this, depending on whether the cash coming in is the same every year or different.
Scenario A: Constant Annual Cash Flows
If the project brings in the same amount of cash every year, use this formula:
\( \text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}} \)
Scenario B: Uneven Cash Flows (The Cumulative Method)
If the cash flows change every year, you need to keep a "running total" (cumulative total) until the investment is recovered.
Step-by-Step Process:
1. List the cash flows for each year.
2. Create a "Cumulative Cash Flow" column.
3. Identify the year in which the cumulative total turns from negative to positive.
4. To find the exact month, use this "Mini-Formula":
\( \text{Payback} = \text{Years before full recovery} + \left( \frac{\text{Unrecovered cost at start of year}}{\text{Cash flow during the recovery year}} \right) \)
Example: You invest $1,000. In Year 1 you get $600. In Year 2 you get $800. At the end of Year 1, you still need $400. In Year 2, you earn $800. So, you need half of Year 2. Payback = 1.5 years.
Decision Rule
Companies usually have a target payback period (e.g., "We only accept projects that pay back within 3 years").
- If Payback is less than the target: Accept.
- If Payback is more than the target: Reject.
Advantages and Disadvantages
Pros:
- Very simple to calculate and understand.
- Great for businesses with liquidity (cash flow) problems.
- Minimizes risk by focusing on getting cash back quickly.
Cons:
- Ignores the Time Value of Money: It treats a dollar in year 5 the same as a dollar in year 1.
- Ignores Total Profitability: It doesn't care what happens after the payback date. A project could pay back in 2 years but then never make another cent!
Quick Review: Payback focuses on speed of recovery, not total profit.
2. Accounting Rate of Return (ARR)
While Payback focuses on cash, ARR focuses on Accounting Profit. This is the only method in your exam that uses "Profit" instead of "Cash Flow."
Prerequisite Concept: Profit vs. Cash Flow
Remember from your earlier studies: Cash Flow = Operating Profit + Depreciation. If an exam question gives you cash flows but asks for ARR, you must subtract depreciation to find the profit!
How to Calculate ARR
The most common formula used in the CIMA syllabus is:
\( \text{ARR} = \frac{\text{Average Annual Accounting Profit}}{\text{Average Investment}} \times 100\% \)
Where:
\( \text{Average Profit} = \frac{\text{Total Profit over project life}}{\text{Number of years}} \)
\( \text{Average Investment} = \frac{\text{Initial Investment} + \text{Residual (Scrap) Value}}{2} \)
Decision Rule
Companies set a minimum target ARR % (often based on their current Return on Capital Employed).
- If project ARR is higher than target: Accept.
- If project ARR is lower than target: Reject.
Advantages and Disadvantages
Pros:
- Uses percentages, which makes it easy to compare projects of different sizes.
- Look at the entire life of the project (unlike Payback).
- Links directly to how the company’s performance is reported in financial statements.
Cons:
- Ignores Time Value of Money: Just like Payback, it doesn't discount future values.
- Profits are subjective: Accounting profits can be manipulated by changing depreciation methods or capitalization policies.
Did you know? Many managers prefer ARR because their annual bonuses are often tied to accounting profit targets, not cash flow targets!
Key Takeaway: ARR measures profitability as a percentage, but it ignores the timing of when that profit is earned.
3. Summary Table: Comparison
To help you remember the differences, here is a quick comparison:
Feature: Payback Period
- Basis: Cash Flow
- Objective: Liquidity / Speed
- Time Value of Money? No
- Project Life: Only looks at start of project
Feature: Accounting Rate of Return (ARR)
- Basis: Accounting Profit
- Objective: Profitability %
- Time Value of Money? No
- Project Life: Looks at the whole life
Common Mistakes to Avoid
1. Mixing up Cash and Profit: In ARR, always use Profit. For Payback, always use Cash Flow. If the question gives you one and you need the other, remember: Profit = Cash Flow - Depreciation.
2. Average Investment Error: When calculating the average investment for ARR, don't forget to add the residual value before dividing by 2. Students often subtract it by mistake!
3. Ignoring the Target: In the exam, always compare your answer to the company's "hurdle rate" or "target period" before saying whether the project is good or bad.
Don't worry if these formulas seem a bit dry right now. Once you practice a few cumulative cash flow tables and average profit calculations, they will become second nature! Keep going!