03. Investment Decisions

Question 1

Differentiate between capital expenditure and revenue expenditure.

Answer 1

Capital expenditure - the acquisition of non-current assets or their improvement.

Revenue expenditure - incurred to maintain non-current assets (e.g. repairs).

Question 2

What is the role of investment appraisal?

Answer 2

1. If the company’s main financial objective is to maximise (or at least produce satisfactory) shareholder wealth, the key investment appraisal technique should be net present value (NPV). This is because NPV shows the theoretical absolute change in shareholder wealth due to a project.
2. Managers may also require other measures as part of their decision-making process (e.g. payback as a liquidity measure and return on capital employed (ROCE) to judge the effect on published financial statements).
3. Providers of finance may wish to know the project’s internal rate of return (IRR). In particular, banks compare project IRR to the interest rate on proposed loans in order to measure the headroom in the project and the consequential risk of default on the debt; the higher the project IRR over the proposed loan interest rate, the lower the risk of default.

Question 3

Outline the payback period and the decision rule for it.

Answer 3

Payback period is the amount of time it takes for the undiscounted operating cash flows from a project to pay back the initial investment.

The decision rule for payback period is:
- if payback period < target ACCEPT
- if payback period > target REJECT

Question 4

What are three advantages of the payback period?

Answer 4

1. Simple to calculate.
2. Easy to understand.
3. Concentrates on earlier flows, which are:
   - more certain; and
   - more important if the organization has liquidity concerns.

Question 5

What are four disadvantages of payback period?

Answer 5

1. Ignores cash flows after payback period.
2. Target period is subjective.
3. Ignores time value of money.
4. Gives no information about the change in shareholder wealth.

Question 6

The discounted payback is considered an improvement to the payback period. Outline the discounted payback.

Answer 6

Discounted method - this method requires that cash flows first be discounted to present value and then a discounted payback period is calculated. This approach takes into account the time value of money.

Question 7

Outline the return on capital employed and state the decision rule for it.

Answer 7

Return on capital employed (ROCE) is the average annual operating profit expressed as a percentage of the initial (or average) investment.

ROCE is also referred to as accounting rate of return (ARR) or return on investment (ROI).

The decision rule for ROCE is:
If ROCE > target ACCEPT
If ROCE < target REJECT

Question 8

Suggest two formulas for ROCE.

Answer 8

ROCE = (average annual operating profit/initial investment) * 100

Or

ROCE = (average annual operating profit/average investment) * 100

Where average investment = (initial investment + scrap value) / 2

And

average annual profit = (total cash flows - total depreciation) / number of project years

Question 9

What are three advantages of ROCE?

Answer 9

1. Uses readily available accounting information.
2. Simple to calculate and understand.
3. Often used by financial analysts to appraise performance.

Question 10

What are six disadvantages of ROCE?

Answer 10

1. Different methods of calculation may cause confusion.
2. Based on profits rather than cash flow. Profits are easily manipulated by accounting policy.
3. Ignores time value of money.
4. Target rate is subjective.
5. As a relative (percentage) measure, it gives no information about the absolute dollar charge he in shareholders’ wealth.
6. It does not give a clear decision rule.