MANAGEMENT

ACCOUNTING

Lecture 6

DECISION MAKING
Strategic Decision Making

Dr. Abdullah Hamoud

Main source: Hansen & Mowen (2007). Managerial Accounting (8th ed.). Thomson.

1-1
 Types of Decisions

Strategic Decision Making

Is selecting among alternative

strategies so that long term
competitive advantage is
established.

1-2
 Strategic Decision Making

▪ Strategic Decisions are relating to

Capital Investment Decisions.

▪ Capital Investment Decision is:

➢ Concerned with the process of planning,
setting goals & priorities, arranging
financing, & using certain criteria to select
long–term assets.
➢ The process of making capital investment
decisions is often referred to as capital
budgeting.
1-3
 Strategic Decision Making

Types of capital
budgeting projects

Mutually exclusive
Independent projects
projects

1-4
 Strategic Decision Making

How do the 2 types of

capital budgeting differ?

In capital budgeting, decisions to

accept/reject an independent project
does not affect decisions about another
project whereas acceptance of a
mutually exclusive project precludes
other projects.
1-5
 Strategic Decision Making

What is a “reasonable
return” on a capital
investment?

A capital investment must earn

back its original cost and cover
opportunity cost of funds invested.

1-6
 Strategic Decision Making

Capital investment
decision models

Non-discounting Discounting
models models
Ignore the time value of Explicitly consider the
money time value of money

1-7
 Strategic Decision Making

Capital Investment Decisions Methods

Methods used to guide managers’

investment decisions are:
⚫ Non-discounting
⚫ Payback period
⚫ Accounting rate of return

⚫ Discounting
⚫ Net present value (NPV)
⚫ Internal rate of return (IRR)
1-8
 Strategic Decision Making

Non-discounting

Payback period

▪ Is the time required for a firm to recover its

original investment.
▪ It is the length of time an investment reaches a
breakeven point.

Payback period tells how long it will take a

project to break even.
1-9
 Strategic Decision Making

What Is a Good Payback Period?

▪ The best payback period is the shortest

one possible.
▪ Getting repaid or recovering the initial
cost of a project or investment should be
achieved as quickly as it allows.
▪ However, not all projects and
investments have the same time horizon.
1-10
 Strategic Decision Making

Payback Period uses:

❖ Sets maximum payback period for all

projects; rejects any that exceed
payback period

❖ Measures of risk
▪ Riskier firms use shorter payback period
▪ In liquidity problems, use shorter
payback period

❖ Avoids obsolescence
1-11
 Strategic Decision Making

Payback Period provides information that can

be used to help:
➢ Control risks of uncertain future cash flows
➢ Minimize impact of investment on liquidity
problems
➢ Control risk of obsolescence
➢ Control effects of investment on performance
measures

1-12
 Strategic Decision Making

Payback Period Deficiencies:

❖ Ignores performance of investment

beyond payback period

❖ Ignores time value of money

1-13
 Payback period Example-1

Honley Medical invests $1,000,000 in a new RV

generator. The investment is expected to generate
net cash flows of $500,000 per year.

How long will it take for the project to break even?

1-14 Continued
 Payback period Example-1

Payback period = Original investment ÷ Annual cash flows

= $1,000,000 ÷ $500,000
= 2 years

1-15
 Payback Period Example-2

The engineering department of Honley Medical’s

Specialty Products Division is considering two different
types of computer-aided-design (CAD) systems: CAD-A
and CAD-B. Each system requires an initial outlay of
$150,000, has a five-year life, and displays the
following annual cash flows:

Will using payback period help make the right choice?

1-16 Continued
 Payback Period Example-2

Payback period
Investment Year 1 Year 2 Year 3 Year 4 Year 5
CAD – A $ 90,000 $ 60,000 $ 50,000 $ 50,000 $ 50,000
CAD - B }40,000 110,000 25,000 25,000 25,000

Payback period does not

distinguish between the 2
investments because the
payback periods are equal
but the return after payback
is different.

1-17
 Payback Period Example-3

Suppose that the investment in RV generators is

1,000,000 and has a life of five years with the
following expected annual cash flows: $300,000,
$400,000, $500,000, $600,000, and $700,000.

The payback period for the project is 2.6 years,

computed as follows:
$300,000 (1 year) + $400,000 (1 year) + $300,000
(0.6 year).

1-18 Continued
 Payback Period Example-3

*In the third year, when only $300,000 is needed and $500,000 is available, the
amount of time required to earn the $300,000 is found by dividing the amount
needed by the annual cash flow ($300,000/$500,000).

Thus, the payback is 2.6 years (2.0 + 0.6).

1-19
 Payback Period Example-4

The Delta company is planning to purchase a

machine known as machine X. Machine X would
cost $25,000 and would have a useful life of 10
years with zero salvage value. The expected
annual cash inflow of the machine is $10,000.

Required:
Compute payback period of machine X and
conclude whether or not the machine would be
purchased if the maximum desired payback period
of Delta company is 3 years.
1-20 Continued
 Payback Period Example-4

Solution:
Since the annual cash inflow is even in this project,
we can simply divide the initial investment by the
annual cash inflow to compute the payback period.
It is shown below:
Payback period = $25,000/$10,000
= 2.5 years
According to payback period analysis, the purchase
of machine X is desirable because its payback
period is 2.5 years which is shorter than the
maximum payback period of the company.
1-21
 Payback Period Example-5

Due to increased demand, the management of Rani

Beverage Company is considering to purchase a new
equipment to increase the production and revenues. The
useful life of the equipment is 10 years and the company’s
maximum desired payback period is 4 years. The inflow
and outflow of cash associated with the new equipment is
given below:
Initial cost of equipment: $37,500
Annual cash inflows:
Sales: $75,000

1-22 Continued
 Payback Period Example-5

Annual cash Outflows:

Cost of ingredients: $45,000
Salaries expenses: $13,500
Maintenance expenses: $1,500
Non cash expenses:
Depreciation expense: $5,000

Required:
Should Rani Beverage Company purchase the new
equipment? Use payback method for your answer.

1-23 Continued
 Payback Period Example-5

Solution:
Step 1: In order to compute the payback period of the
equipment, we need to workout the net annual cash inflow
by deducting the total of cash outflow from the total of cash
inflow associated with the equipment.
Computation of net annual cash inflow:
$75,000 – ($45,000 + $13,500 + $1,500) = $15,000

1-24
 Payback Period Example-5

Solution:
Step 2: Now, the amount of investment required to purchase
the equipment would be divided by the amount of net annual
cash inflow (computed in step 1) to find the payback period
of the equipment.
= $37,500/$15,000 = 2.5 years
* Depreciation is a non-cash expense and therefore has
been ignored while calculating the payback period of the
project.
According to payback method, the equipment should be
purchased because the payback period of the equipment is
2.5 years which is shorter than the maximum desired
payback period of 4 years.
1-25
 Payback Period Example-6

An investment of $200,000 is expected to generate the

following cash inflows in six years:
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000
Required:
Compute payback period of the investment. Should the
investment be made if management wants to recover the
initial investment in 3 years or less?
1-26 Continued
 Payback Period Example-6

Solution:
Because the cash inflow is uneven, the payback period
formula cannot be used to compute the payback
period.
We can compute the payback period by computing the
cumulative net cash flow as follows:

1-27
 Payback Period Example-6

Solution:
❑ Because the cash inflow is uneven, the payback period formula
cannot be used to compute the payback period.
❑ We can compute the payback period by computing the
cumulative net cash flow as follows:
Payback period = 3 + (15,000*/40,000)
= 3 + 0.375
= 3.375 Years

*Unrecovered investment at start of 4th year:

= Initial cost – Cumulative cash inflow at the
end of 3rd year
= $200,000 – $185,000
= $15,000

The payback period for this project is 3.375 years which is longer than
the maximum desired payback period of the management (3 years).
The investment in this project is therefore not desirable.
1-28
 Strategic Decision Making

Non-discounting

Accounting rate of return

▪ Accounting rate of return is a non-discounting model of

return on a project.
▪ Accounting rate of return measures the return on a
project in terms of income,
as opposed to using a project’s cash flow.

Accounting rate of return = Average income

1-29
Original investment (or Average investment)
 Accounting Rate of Return Example-1

Honley Medical’s IV Division is considering investing in a

special tooling that requires an initial outlay of $100,000.
The life of the investment is five years with the following
cash flows: $30,000, $30,000, $40,000, $30,000, and
$50,000.
Assume that the tooling has no salvage value after the five
years and that all revenues earned within a year are
collected in that year, and depreciation is $20,000.

Will the investment earn an acceptable accounting rate of

return?
1-30 Continued
 Accounting Rate of Return Example-1

Solution:
Accounting rate of return =
Average income ÷ Original investment (or Average investment)

Average cash flow is $36,000

So,

ARR = ($36,000 - $20,000) / $100,000 = 16%

or
= ($36,000 - $20,000) / $50,000 = 32%

1-31
 Accounting Rate of Return Example-1

Solution:
Accounting rate of return =
Average income ÷ Original investment (or Average investment)

Average cash flow is $36,000

So,

ARR = ($36,000 - $20,000) / $100,000 = 16%

or
= ($36,000 - $20,000) / $50,000 = 32%

1-32
 Accounting Rate of Return Example-1

Notes:

• The total cash flow for the five years is $180,000, making the
average cash flow $36,000 ($180,000/5).

• Average depreciation is $20,000 ($100,000/5).

• The average net income is the difference between these two

figures: $16,000 ($36,000 -$20,000).

• Using the average net income and original investment, the

accounting rate of return is 16 percent ($16,000/$100,000).

• If average investment is used instead of original investment, then

the accounting rate of return would be 32 percent
1-33($16,000/$50,000).