07. Capital Investment

Question 1

What is the nature and importance of Capital Investment decisions?

Answer 1

• the investment or purchase of non-assets
• involve a significant sum of money
• expected to generate future cash flows and create value for the business
• cannot be easily reversed due to the long-term commitment of business resources

Question 2

Explain the concept of the time value of money

Answer 2

• it recognises that a dollar received today is worth more than a dollar received in the future due to the opportunity cost of waiting for future payment
• must consider the present value of future cash flows when evaluating investment opportunities and determining their potential return
• money value changes as a result of inflation or interest able to be earned on the original money value

Question 3

What are the three factors affecting Capital Investment decisions?

Answer 3

• consumer preferences
• competition
• government regulation

Question 4

Explain how consumer preferences affect Capital Investments

Answer 4

Consumer preferences, such as changes in consumer behaviour, can impact the demand for a company’s profit + loss and thus influence investment decisions.

Question 5

Explain how competition affects Capital Investments

Answer 5

Competitors can also affect investment decisions as they may introduce new profit + loss that could reduce demand for the company’s offerings. A business should consider the likely reaction of its competitors to any investment that it makes.

Question 6

Explain how government regulation can affect Capital Investments

Answer 6

Government regulation can impact the feasibility of an investment opportunity, such as changes in tax laws or environmental regulations.

Question 7

Explain the Payback Period Method

Answer 7

• calculation of the time required for revenue produced by an investment to reimburse its cost
• payback compared to the entity’s benchmark payback period (i.e. investments must be repaid within 3 years or less)
• if not within the benchmark, it is not accepted
• if within the benchmark, it is accepted
• as the payback period decreases, risk decreases
• when comparing two investments, the investment paid back sooner is better

Question 8

What are some Advantages of the Payback Period Method?

Answer 8

• simple calculation
• does not require calculation of target rate of return

Question 9

What are some Disadvantages of the Payback Period Method?

Answer 9

• less accurate than the NPV method
• time value of money not considered
• cash flows are not evaluated once payback achieved

Question 10

Explain the Net Present Value Method

Answer 10

• calculation of net cash flows for each year of the useful life of an investment with consideration of discounted cash flows (time value of money)
• net flows are added together and the result is the NPV of the investment
• NPV compared to the entity’s expected investment return
• if the value is negative, it is not accepted
• if the value is positive, it is accepted
• as NPV increases, the investment risk decreases
• when comparing two investments, the higher the NPV the better

Question 11

What are some Advantages of the Net Present Value Method?

Answer 11

• more accurate
• considers time value money
• takes into account cash flows for the entire lifetime of the proposal and not just during the payback period

Question 12

What are some Disadvantages of the Net Present Value Method?

Answer 12

• complex to understand in comparison to the payback period method
• difficult to calculate target rate of return and discount rate
• method is sensitive to discount rate used (a small change in chosen discount rate can have a big impact on the final output)