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Accounting and Finance: An Introduction - McLaney and Atrill (2018) - Chapter 14 (Summary)
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Week 11 – Accounting and FinanceChapter 14 – Making capital investment decisions
THE NAURE OF INVESTMENT DECISIONS
- Essential feature of investment decisions is time
- Investment decisions tend to be of profound importance of the business because:
o Large amounts of resources are often involved
o Relatively long timescales are involved
o It is often difficult and/or expensive to bail out of an investment once it has
been undertaken
INVESTMENT APPRAISAL METHODS
- Proper screening; important part of this screening process is to ensure that
appropriate methods of evaluation are used
- Possible to find businesses that use variants of the methods (IRR, NPV,…)
- Smaller business often do not use any formal appraisal method
- Only NPV is wholly logical approach
ACCOUNTING RATE OF RETURN (ARR)
- This method takes the average accounting operating profit that the investment will
generate and expresses it as a percentage of the average investment made over the
life of the project
- ARR = (Avrg annual operating profit/ avrg investment to earn that profit) * 100%
- Decision rules:
ARR and ROCE
- Return on capital employed (ROCE) is a widely-used measure of economic
performance; expresses the business’s operating profit as a percentage of the value
of the assets used to generate it
- Both ROCE AND ARR take the same approach to measuring business performance;
both related operating profit to the cost of assets used to generate that profit
- However, ROCE assesses the performance of the entire business after it has
performed, whole ARR assesses the performance of a particular investment before it
has performed
- Given the link between the two measures, the target ARR could be based on overall
ROCE previously achieved
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