Investment decision: determine long term cash flows.

Then: determine mid and long term profitability using absorption costing.

Then: determine short term profitability using direct costing.

Investments are major decisions that have long-term consequences beyond current consumption.

1. The decision commits resources for a lengthy period of time, and this commitment usually prevents taking another future opportunity.
2. Management's flexibility to modify and investment as time and information unfold can affect alternative decisions.

By using:

• Sensitivity analysis
• Scenario analysis
• Expected value analysis

• A method of comparing alternative investments
• Combines estimates of present and future cash outflows and inflows associated with each investment
• Discounts the cash flows to account for the opportunity costs of committing funds
• Differs from payback period methods
• Includes all cash flows throughout the life of the investment
• Always discounts the cash flows

(1) Investment cash flows

• Asset acquisition (and disposal of old asset)
• Tax effect from disposal of old asset
• Tax credit arising from the new acquisiton

(2) Periodic operating cash flows

• Receipts from operators
• Cost savings that occur (incl.tax savings)
• Operating expense

(3) Cash flows from termination of investment

• The discount rate is an estimate of the opportunity cost of making this investment instead of some other
• If the rate chosen is too high, some profitable investments will be rejected
• If the rate chosen is too low, some marginal investment will be approved too easily

Suggested discount rates:

• A risk-free rate (e.g. treasury bond rate)
• Long-term market return on equities
• The rate chosen should allow for price inflation

Cash to be received in the future has a cost. Alternative investments and price inflation reduce the value of those cash flows in current monetary terms (present value). That is why the cash flows are discounted, normally using a constant discount rate.

• Compute the present value of each cash inflow
• Sum all the present values to get the net present value (NPV)
• If the NPV of the investment is greater than zero, the project promises returns greater than the opportunity rate

Managers may want to  know how soon they will recover an intial investment. This method counts the time that will pass before the projected cash inflows equal the initial cash expenditure.

The payback period method complements the discounted cash flow method, though the result may be different.

One of the two discounted cash flow techniques (the other is PV/NPV). IRR is the average annual return earned through the life of an investment. 

Depending on the method used, it can either be the effective rate of interest or the discount rate that reduces to zero the net present value of income inflows and outflows.

If IRR > required rate of return (discount rate), this means the NPV > discount rate --> accept the project

If IRR < required rate of return (discount rate), this means the NPV < discount rate --> reject the project

If IRR = required rate of return (discount rate), this means the NPV = discount rate --> we are indifferent

1. Bias from personal commitment to an investment project.
2. Fear of loss of prestige, position or compensation from a failed investment.
3. Greed and intentional behavior to defraud an organization or its stakeholders.

• Testing practices/Hiring practices
• Most of internal control procedures focus on detecting and preventing errors people did not intent to do
• Investment reporting and reviews- periodic progress reporting to see if the investment is meeting the stated goals
• Codes of ethics-educate and support employees who want to behave ethically
• Internal audits- examinations of operations, programs and financial results performed by independent investigators
• Protect accuracy of accounting