WEEK 10: INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

WEEK 10&11: INTRODUCTION TO INVESTMENT

DECISIONS (Part 2)

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 Week 10&11: Introduction to Investment Decisions
Investment
Investment is an expenditure with expected returns. This expenditure can either be
capital or revenue expenditure. The latter refers to recurring expenses that expires
within one accounting year. Capital expenditure on the other hand is the
expenditure on non-current asset. Non-current assets are assets which are non-
recurring and last more than one accounting year. Capital expenditure investment is
the focus of investment appraisal techniques. As a result, investment appraisal is
also called capital budgeting.

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 Week 10&11: Introduction to Investment Decisions
Investment decision processes
Investment decision process or capital budgeting process is the process of
identifying investment opportunities, screening the projects, selecting the best
option, implementing and evaluating the project. Proper capital budgeting process
improves project efficiency and minimizes the likelihood of projects becoming
unprofitable. A typical investment appraisal processes are outline below:
• Soliciting for project proposals. This is the first stage where the firm hunt for
ideas by asking the investment management department or relevant departments
to come out with proposals.

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 Week 10&11: Introduction to Investment Decisions
• Project screening: all projects are screened after a careful analysis. The screening
process should ensure that high risk projects are eliminated. Adequate
information is key to successful project screening; therefore, using appropriate
investment appraisal techniques can provide sufficient information to aid the
process.
• Selection and implementation. After screening, projects pass through the ‘go’ or
‘no go decision’. ‘Go’ decision means the project will be viable and hence should
be implemented. A ‘no go decision’ are made on projects with potential failure.

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 Week 10&11: Introduction to Investment Decisions
• Monitoring and evaluation. Long term projects are bound to be influence by
volatility in economic factors therefore, close monitoring and review help to
identity and minimize potential risk factors and ensure that projects achieve
intended purposes.
• Investment appraisal techniques
• There several types of tools use in evaluating capital investments. The most
commonly use ones are:
• Discounted cash flows method
• Net Present Value
• Internal Rate of Return

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 Week 10&11: Introduction to Investment Decisions
• Duration method
• Payback period
• Discounted Payback period
• Macaulay Duration
• Return on capital employ/ ARR/ROI

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 •Payback period
• •
 The payback period of a project is the
number of years it takes before the
cumulative forecasted cash flow equals
the initial outlay’.
 Decision rule: The payback rule says only
accept projects that “payback” in the
desired time frame.
 Major weaknesses: it ignores
 later year cash flows
 present value of future cash
flows.
 Example 8
(500) 150 150 150 150 150 150 150 150
0 1 2 3 4 5 6 7
•Payback period
• How long will take for the project to generate
enough cash flows to pay for itself?
Payback period = 3.33 years
• Merits:
(a) It is simple to calculate and understand.
(b) uses cash flows rather than accounting profits.
• (c) It is often used as a 'first screening method
• prior to more detailed evaluation.
• (d) The fact that it tends to bias in favor of
• short-term projects means that it tends
• to minimize both financial and business
risk.
8 • (e) Appropriate for capital rationing
 •Discounted Payback period
•
•Return on Capital Employed
•

 measures the length of time before the discounted

cash returns from a project cover the initial  Also known as Accounting Rate of Return (ARR)
investment.
or Return on Investment (ROI) is measured as;

 Decision rule:
The shorter the discounted payback period, the mo
re attractive the project  • OR
is. A long discounted payback period indicates tha
t the project is a high risk  project.

 Major weaknesses: it ignores • Where;

 later year cash flows

• Decision rule:
 Example 9
 Single project: estimate the accounting rate of
• A project with the following cash flows is  return that the project should yield. If it exceeds a
under consideration: target rate of return, the project will be
• Y0 Y1 Y2 Y3 Y4 undertaken.
(20000) 8000 12000 4000 2000
• Cost of capital 8%
 Multiple/mutually exclusive projects: The
• project with the highest ROCE would be selected
Required: (provided that the expected ROCE is higher than
Calculate the Discounted Payback Period. the company's target ROCE)
 •Return on Capital Employed
•
•Return on Capital Employed
•

 Example 10
• Merits:
• A company has a target return on capital
employed of 20% (using the first 1. quick and simple calculation.
definition from the paragraph above), and
is now considering the following project. 2. It involves the familiar concept of a
percentage return.

• Capital cost of asset $80,000 3. It looks at the entire project life

Estimated life 4 years
Estimated profit before depreciation; • Major weaknesses:  
Year 1 $20,000
Year 2 $25,000 1. Uses accounting profit whch may suffer
Year 3 $35,000 from creative accounting techniques
Year 4 $25,000
2. Project life span is ignored
The capital asset would be depreciated by
25% of its cost each year, and will have no 3. Ignores the time value of money
residual value.
• Required:
• You are required to assess whether the
project should be undertaken
 •Discounted Cash Flows •Discounted Cash Flows
• •

• Example 11:
 is an investment appraisal technique which takes
into account both the timings of cash flows and • The executor of your father’s Will has
also total profitability over a project's life. It offered you the following options’
seeks to improve shareholders’ wealth by taking
on projects that yield higher returns i. GH¢ 50 million now
ii. GH¢ 120 million in 8 years time
 Techniques iii. GH¢ 10 million at the end of each year for
 Compounding (computing Terminal the next 8 years
values or Future Value)
 Discounting: iv. GH¢ 5 million forever
1. PV of a single sum v. GH¢ 10 million at the beginning of each
2. PV of Perpetuity year for the next 8 years.
3. PV of Annuity (either annuity
due or ordinary annuity)
• If the existing discount rate is 10% which of
the options will you accept.
• NOTE: Annuity is a constant cash flows for a
number of years.
• Perpetuity is a constant cash flow forever
 Week 8: Introduction to Investment Decisions
• Net Present Value
NPV is the difference between present value of cash inflows and the present value of
cash outflows. Decision Rules:
• If the NPV is positive, accept the project
• If the NPV is negative, reject the project
• If the NPV is zero, acceptance or rejection depends on qualitative or non-financial
factors. If the qualitative factors are favorable, the project will be accepted and vice
versa. However, from management accounting and economics perspective Zero NPV
means the firm will break-even and at the break-even it is prudent for the firm to
undertake the project unless there are alternative projects that can offer positive NPV.

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 Week 8: Introduction to Investment Decisions
Example 12
Apitoro has won lottery and intends to buy a corn milling machine to use in his village, Avalavagi. He
anticipates that the village folks will patronize his business. He claims that he will be able to make a
profit of GHS 28,360 within five years of operation based on the following cash flows projection:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
GHS GHS GHS GHS GHS GHS
Cash Flows(120,000) 31,210 55,200 27,500 19,200 15,250

His calculations did not take into account the time value of money.
Required:
You are required to reassess the cash flows of the business if the project risk is expected to be 12% per
annum.

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 Week 8: Introduction to Investment Decisions
Example 13
A business needs GHS13,216 to buy an equipment which will generate a cost
savings of GHS4,000 per annum for the first three years and GHS3,000 per annum
for the subsequent two years.
Assume a discount rate of 12% per annum.

Required:
Evaluate the equipment should be purchased or not?

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 Week 8: Introduction to Investment Decisions
• QUESTION 1
• Global Consult is considering two capital expenditure Projects: Agriculture and Baking.
Both proposals are for similar products and both are expected to operate for four
years. The company anticipates a cost of capital of 22%. Only one proposal can be
accepted.
• The net after tax cash flows of the projects are as follows;
• Agriculture (GH¢) Baking (GH¢)
• Initial Investment (50,000) (45000)
• Year 1 25,500 12,500
• Year 2 24,500 15,500
• Year 3 17,000 21,000
• Year 4 19,000 42,000
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 Week 8: Introduction to Investment Decisions
You are required to calculate:
• Net Present Value (NPV) for each project. 5 marks
• Internal Rate of Return (IRR) of each project. Use 28% as the alternative rate for
the IRR. 5 marks
• The Payback period for each project. 5 marks
[Total marks 15]

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