9 Capital Investment Appraisal Flashcards
What is Accounting rate of return (ARR)?
This method takes the average accounting operating profit that an investment will generate and expresses it as a percentage of the average investment made over the life of the project.
ARR = average expected return(accounting profit) x 100 /average capital employed or investment
How does ARR compare with ROCE?
The accounting rate of return is very similar to the return on capital employed ROCE which investors use to interpret company performance. This is an advantage as it ensures individual projects investments are internally assessed in the same way that they are assessed externally by investors. The only difference is that with ARR the profit is calculated before depreciation. This is because the most appropriate way to make long term decisions is to use cash flows rather than accounting profit based on arbitrary allocations.
What should be considered when deciding on an investment?
- risk and uncertainty
- monetary returns
- non-monetary business objectives
What are the advantages of ARR?
Simple and easy to calculate. Easy to understand.
Very similar to Return on capital employed- seen as key ratio by investors
Projects judged by ARR are assessed internally in the same way as assessed externally.
What are the disadvantages of ARR?
attaches same value to cash flows whether received in year 1 or year 5
Should ARR be calculated before or after depreciation.
Doesn’t consider size of investment. An investment of £40,000 with ARR of 10% generates £4,000. An investment of £400,000 with ARR of 10% generates £40,000.
What is the payback period?
length of time it takes for an initial investment to be repaid out of the net cash inflows from a project
What are the strengths of payback period?
Minimises impact of long term risk – like change of government, Chances of competitors producing copy products
Quick and simple to calculate and managers easily understand it.
Avoids obvious difficulties in projecting cash flow several years from hence.
What are the weaknesses of payback period?
Difficulties in predicting what expenditure has to be paid – Especially when large negative cashflow at the end of the project is present.
Ignores time value of money.
Favours short term projects over long term projects .
What is discounting?
With investment appraisal we use the reverse of compounding.
We estimate cash flows we expect in future years and discount them at an appropriate rate.
The rate used for discounting takes into account inflation but also the firm’s required rate of return.
The required rate of return on a project depends on the risk involved and the opportunity cost of not investing the funds elsewhere.
The discount rate a business uses for investment appraisal is known as its cost of capital.
What is net present value (NPV)?
The total of the present values
If the net present value is positive the project should be accepted.
If the net present value is negative the project should be rejected
If NPV is Zero, investor is indifferent as to whether to invest
What are the strengths of NPV?
It Recognises the Time Value of Money
It recognises the difference in size of investment
It allows for additivity – So projects whose success depends upon the introduction of subsequent projects , may be added together to find out their combined NPV.
What are the weaknesses of NPV?
Difficult to explain to people not formally trained in Finance
Provides answers in monetary terms, so does not allow comparison for profitability of the project.
What is the internal rate of return (IRR)?
of a particular investment is the discount rate that, when applied to its future cash flows, will produce an NPV of zero
- represents the return from an investment opportunity.
Is NPV or IRR preferred?
The NPV is preferred to IRR
Where net cash flows are both positive and negative there can be more than one IRR
IRR is a percentage. A business might be concerned with value of cash flow
What are the problems with IRR compared with NPV?
- If cash flows are erratic some years positive some years negative more than one IRR would be produced
- It is just a percentage no account is taken of the size of the investment
