17. Decision Making and Project Appraisal

Question 1

What do capital investment decisions consider?

Answer 1

Future cash flows

Question 2

What are the main cash based measures of investment decisions?

Answer 2

• Payback period
• Discounted payback period
• Net present value (NPV)
• Internal rate of return (IRR)

Question 3

What does payback period calculate?

Answer 3

How long it takes for the net cash flows from an investment to repay the initial investment

Question 4

What is the discounted payback period?

Answer 4

The payback period, with time value of money taken into consideration

Question 5

What are the 5 main benefits of payback as an investment appraisal method?

Answer 5

1. Simple to calculate
2. Easy to understand
3. Uses relevant cash flows
4. Good initial screening tool
5. Allows for risk in timing of cash flows

Question 6

What are the 4 main drawbacks of payback as an investment appraisal method?

Answer 6

1. Ignores time value of money (unless DPP)
2. Only considers flows up to payback date
3. May lead to short term decision making
4. No clear decision rule

Question 7

What is the NPV of an investment?

Answer 7

The discounted present value of all cash inflows and outflows of an investment

Question 8

Considering NPV, when should a project be undertaken?

Answer 8

If NPV is positive

Question 9

What discount rate do we use when calculating NPV?

Answer 9

Cost of capital

Question 10

What are the 4 main benefits of NPV as an investment appraisal method?

Answer 10

1. Allows for time value of money
2. Shows change in shareholders wealth
3. Can allow for risk
4. Looks at entire project

Question 11

What are the 2 main drawbacks of NPV as an investment appraisal method?

Answer 11

1. Requires cost of capital to be estimated

2. Calculations can be time consuming and not easily understood

Question 12

What is the internal rate of return?

Answer 12

The discount factor that would give an NPV of zero - the actual % return that the project generates

Question 13

What is the relationship between discount factor and NPV?

Answer 13

As discount factor increases, NPV decreases - project becomes less attractive as cost of financing increases

Question 14

How do we estimate the IRR?

Answer 14

Calculate NPV at discount rate given, and a second discount rate (higher if NPV negative). Estimate the IRR by L + (NPVl)/(NPVl - NPVh) *(H-L)

Question 15

When do we accept a project using IRR?

Answer 15

If IRR> cost of capital

Question 16

What are the 4 main benefits of IRR as an investment appraisal method?

Answer 16

1. It allows for time value of money
2. Does not require an exact cost of funds to be known
3. As a % measure it is familiar to non accountants
4. Looks at the entire project

Question 17

What are the 2 main drawbacks of IRR as an investment appraisal method?

Answer 17

1. It does not tell you whether to accept or reject

2. Possible to have more than one IRR