Corporate Finance- Accounting Rate of Return and Payback Period PDF

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Download Corporate Finance- Accounting Rate of Return and Payback Period PDF

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Accounting Rate of Return and Payback Period The Accounting Rate of Return and Payback Period use different types of financial reporting in their calculations. Accounting Rate of Return uses account profit whereas Payback uses Cash Flow. First, a comparison between these two financial reporting methods will be made.

Accounting Profit Vs Cash Flows •

Cash flows are an objective measure of corporate performance

•

Accounting profit is calculated by applying the accruals concept and thus: •

•

Includes certain subjective non-cash flows i.e. •

Depreciation

•

Change in provisions

Excludes certain cash flows i.e.: •

Changes in working capital

•

Capital costs and proceeds

Depreciation •

Depreciation is an accounting estimate to spread the initial cost of a non-current asset over several accounting periods

•

Choice of methods:

•

•

Straight line

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Reducing balance

E.g. an asset costs £200k, has an expected life of 3 years & an expected residual value of £50k •

Annual expense using the straight-line method:

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(200 cost – 50 residual) ÷ 3 years = £50k per annum

Working Capital •

•

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Components: •

Inventories (stock)

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Trade receivables (debtors)

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Trade payables (creditors)

At the start of a project: •

Purchase inventories- cash outflow

•

Pay suppliers before paid by customers- cash outflow

At the end of a project: •

Net working capital investment is released- cash outflow

Converting Accounting Profits to Cash Flows

Relevant Cash Flows •

•

Relevant cash flows: •

Incremental (change as a result of the decision to accept or reject a project)

•

Included in all investment appraisal methods

Irrelevant cash flows: •

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Non-incremental (do not change as a result of the decision to accept or reject a project) i.e. •

Sunk or committed costs

•

Arbitrary overhead allocations

Only included in the ARR investment appraisal method and excluded from all other methods



Other irrelevant items: •

Depreciation- non cash flow

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Changes in provisions- non cash flow

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Interest- financing item

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Debt capital repayments- financing item

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Dividends- financing item



Incremental (relevant) cash flow = cash flow if the project is accepted minus the cash flow if the project is rejected

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E.g. a company is contemplating launching a new product, which is expected to generate cash flows of £100k. This new product will replace an existing product which is expected to generate a cash inflow of £20k.

•

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Cash flow if the project is accepted:

+£100k

•

Cash flow if the project is rejected:

+£20k

•

Incremental (relevant) cash flow: 100 - +20 =

+£80k

The foregone cash flow from an existing project is also known as an associated cash flow

Incremental (relevant) cash flow = cash flow if the project is accepted minus the cash flow if the project is rejected •

E.g. a company is contemplating launching a new product, which is expected to generate cash flows of £100k. This new product will replace an existing product which is expected to generate a cash outflow of £20k. •

Cash flow if the project is accepted:

•

Cash flow if the project is rejected:

•

Incremental (relevant) cash flow: 100 - -20 =

+£100k -£20k +£120k

An example

Example Investment Project The directors of a company are considering whether or not to proceed with the following capital investment project: •

Cost of equipment to start project £200,000

•

Forecast profit in first year £25,000

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Forecast profit in second year £50,000

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Forecast profit in third and final year £75,000

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Estimated disposal proceeds of equipment (residual) at end of third year £50,000

ARR Two Approaches: Initial Investment ApproachAvg Accounting Profit of Project ARR = ×100 Initial Investment

(25,000+50,000+75,000 )÷ 3 ×100=25 % 200,000

Average Investment ApproachAvg Accounting Profit of Project ARR = ×100 (Initial Investment +Residual)÷ 2

( 25,000+ 50,000 + 75,000 ) ÷ 3 ×100=40 % ( 200,000+50,000) ÷ 2

Decision Rules when Accepting Projects

Select project with highest ARR.



Select projects above hurdle rate which will be given in question.

Advantages•

Simple calculation

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Easily understood by (non-finance) managers as: •

Uses accounting profits

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Shows a percentage return on a project

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Similar to return on capital employed

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Still widely used

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Better than no appraisal or using forecast profits only

Drawbacks•

Subjective choice of approaches and profit

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Profit is a subjective measure of corporate performance

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Ignores: •

project size

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risk of project

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timing of profits

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Hurdle rates are often arbitrary

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Does not align with shareholder wealth creation

Payback Period The PBP is the length of time it takes a project to pay back its initial investment plus start-up working capital. (End of) Year

0

1

2

3

Relevant cash flow

-225

+75

+100

+200

Cumulative cash flow

-225

-150

-50

+150

Payback Period=Year before Cumulative ≥ 0+

2 years+

Last Negative Cumulative Figure Relevant Cashflow Figure whenCumulative ≥0

50 =2.25 years 200

Decision Rules• Select the project with the shortest payback •

Select projects witch shorter payback than a hurdle period

Advantages• Uses objective, relevant cash flows •

Easily understood by (non-finance) managers

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Favours less risky projects

Disadvantages• Ignores size of the project (large projects often take longer to payback their initial investment)

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Ignores cash flows after the payback period

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Assumes cash flows are spread evenly during each year

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Hurdle periods are often arbitrary

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Ignores the time value of money

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Does not align with shareholder wealth creation...