Accounting Business Reporting for Decision Making

CHAPTER 12 Capital investment 521

Inflation Increase in the prices of goods and services.

Internal rate of return (IRR) Rate of return that discounts the cash flows of a project so that the

present value (PV) of the cash inflows equals the PV of the cash outflows.

Net present value (NPV) Sum of the present values of the expected cash inflows from the project less

the PVs of the expected cash outflows.

Opportunity cost Cost of forgoing benefits that would be available if the resources had been used for

the next best alternative.

Payback period (PP) Time necessary to recoup with net cash inflows the initial outlay.

Risk Measurable variation in outcomes.

Time value of money Notion that a dollar is worth more the sooner it is received, all other things

being equal.

Uncertainty Unmeasurable variation in outcomes.

APPLY YOUR KNOWLEDGE 42 marks

PART A

a. Explain the method of using the trial and error approach for calculating IRR. 4 marks

b. Discuss the advantages and disadvantages of both the ARR and the payback period. 4 marks

c. Examine the practical issues in making capital investment decisions. 4 marks

d. Distinguish between the net present value (NPV) of an investment and its future

value (FV). Provide an example to explain the difference between the two amounts. 4 marks

PART B

Chang De Silva Ltd, an Australian entity, is offered three projects for which the cash flows are as follows

in thousands of dollars. The directors work on 14 per cent as their required rate of return (RRR). Assume

all cash flows occur at the end of the relevant year. No scrap values are expected for any of the projects.

Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

X – 390 70 90 95 100 60

Y – 310 80 100 140 150 80

Z – 250 130 70 60 40 30

Required

a. Calculate ARR and PP for each project. 6 marks

b. Rank the projects and advise Chang De Silva which projects, if any, to accept.

Give your reasons. 2 marks

c. What other information would be useful to consider as part of your investment decision? 4 marks

PART C

Eloise Tan (a student) recently received a digital SLR camera for her 18th birthday. Over the summer

months she has been busy experimenting with the lenses and taking photos of Brisbane attractions such

as the Brisbane River, the Gabba, Southbank, Suncorp Stadium and the Brisbane CBD. A friend has

recommended that with a little more work on her technique perhaps she could sell her photos. She has

decided that the best idea and location would be the Sunday market at Southbank. She has set herself

a goal of saving $30 000 over a five-year period. To improve her technique, Eloise feels she needs to

do a course at a local TAFE which will cost $3000. She also will need to purchase a new ultrawide

12–35 mm lens costing $2000 and a tripod costing $1500. She thinks she can make $25 000 each year

after all costs (e.g. rent of stall, materials, transport, printing and framing) are paid. After five years of

selling photos, she hopes to go overseas with her savings of $30 000 and sell all her photography equip-

ment for about $2000.