520 Accounting: Business Reporting for Decision Making
Summary of learning objectives
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 entities’ asset bases or turnover
- involve risk and uncertainty
- usually 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.
12.2 Describe and apply the concept of the accounting rate of return (ARR).
The accounting rate of return is a simple measure which expresses the average profit over the
period of the investment as a percentage of the average investment. Decision makers may accept
projects where the ARR exceeds a required minimum level.12.3 Explain and use the payback period (PP) method.
Having sufficient cash is important to entities that want to survive. Thus, the time it takes to recoup
cash is important. The payback period is the period of time necessary to recoup the initial outlay
with net cash inflows. Investors favour projects with short PPs.12.4 Discuss and calculate net present values (NPV) and apply the decision rule.
Discounted cash-flow techniques overcome the problem of the time value of money by specifically
recognising that $1 received sometime in the future is worth less than $1 received now. The NPV
measure compares the sum of the present values (PVs) of all of the expected cash inflows from the
project with the PVs of the expected cash outflows. The NPV is the net outcome. Positive NPVs
indicate that projects are acceptable. Negative NPVs indicate that projects will not increase wealth.12.5 Discuss and calculate internal rates of return (IRR) and apply the decision rule.
The IRR is the rate of return, which discounts the cash flows of a project so that the PV of the
cash inflows equals the PV of the cash outflows. The equation used to find the IRR is similar to
the NPV equation, except that the left-hand side equals zero when the IRR is found. Investors may
accept projects where the IRR exceeds a required rate of return.12.6 Explain some of the practical issues in making investment decisions.
The tools outlined cause decision making to appear relatively easy. In practice, there may be diffi-
culties with the following issues:- collecting data
- taxation effects
- finance
- human resources
- goodwill and future opportunities
- social responsibility and care of the natural environment.
Key terms
Accounting rate of return (ARR) Average profit over the period of the investment as a percentage of
the average investment.
Deflation Decrease in the prices of goods and services.
Discount rate Interest rate at which a future cash flow is converted to a present value.
Dividend imputation scheme Scheme that allows investors (in companies that pay income tax) credits
for their share of the tax already paid by companies.