Accounting Business Reporting for Decision Making

CHAPTER 12 Capital investment 501

Chapter 12 preview

In this chapter, we examine how entities make decisions to invest in new assets or new projects. An

Australian listed company such as JB Hi-Fi Ltd regularly makes decisions about investments in new

product markets, new concept stores and new retailing outlets in shopping centres. The Qantas Group

makes decisions about investments in aircraft for its passengers and air cargo operations by asking ques-

tions such as, ‘Should we lease an aircraft or buy an aircraft? What size aircraft do we require for

our Jetstar and Qantas passengers?’ BMW (the German motor cycle and vehicle manufacturer) makes

decisions about which models of vehicles and motor cycles to produce each year and the types of inves-

tors to target. Managers of small stores such as convenience stores face decisions such as the type of

newspapers, magazines and confectionary to sell and whether to update the store with new fixtures

and fittings. The investments may be small or large, but the principles that underlie the decisions about

whether to make the investments are the same, no matter the absolute size of the investment or the type

of entity investing.

Four principal methods are discussed in this chapter to evaluate whether an investment in assets or

projects should proceed. They are the accounting rate of return (ARR), payback period (PP), net present

value (NPV) and internal rate of return (IRR). Finally, sometimes there are practical difficulties and

complications in calculating and applying numerical decision-support tools. In the last section of the

chapter, we discuss some of the issues that might arise.

12.1 The nature and scope of investment decisions

LEARNING OBJECTIVE 12.1 Explain the nature and scope of investment decisions.

Investment decisions are made by managers in all sorts of entities, large and small. Some of the most

common features of investments are that they:

• often involve large amounts of resources in relation to entity asset bases or turnover


• involve risk and uncertainty that stem from the inability to cost projects accurately and to foresee

operating revenues and costs

• often span long periods of time


• normally require a relatively large initial cash outlay, and returns are received over a long period into

the future

• are often difficult to reverse without the loss of substantial funds


• must be made on the basis of best available data, and the values factored into the initial decision may

not prove to be correct due to the effects of unexpected external influences.

Let us look at each of these features in turn. Investments in projects, property, plant and equipment

often involve large amounts of resources (staff time and funds) in relation to some other measure of the

entity’s size. JB Hi-Fi Ltd, for example, on its 2015 balance sheet had more than $176 million of plant

and equipment and the Qantas Group had $10.7 billion. The Qantas Group’s property, plant and equip-

ment includes land, aircraft and engines, buildings, aircraft spare parts and leasehold improvements. For

both JB Hi-Fi Ltd and the Qantas Group, the amounts of investments involved are very large and need to

be made with the help of appropriate decision-support tools.

Investment decisions normally involve risk and uncertainty, with managers expected to also bear the

responsibility for ‘bad investments’. Risk in finance is defined as measurable variation in outcomes.

Uncertainty, on the other hand, is the unmeasurable variation in outcomes. Risk can be measured with

some degree of confidence when the same decision is taken many times and the varying outcomes can

be analysed, so that a measure of the variation can be made. Thereafter, the decision maker will have a

better understanding of how expected outcomes may vary. BMW Group spends large amounts of funds

on research and development activities. The company employs approximately 11 800 employees in its

global research and innovation network situated in 12 locations across five countries. The company

expenses research costs as they are incurred. Costs on development projects are recognised as intangible