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Finance > Appraisal of Capital Projects > Flashcards

Appraisal of Capital Projects Flashcards

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1
Q

What is financial management?

A
  • Concerned with firm’s investment and financing decisions

- Firm-level economics of time and risk

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2
Q

What does financial strategy comprise of?

A
  • Financing strategy

- Investment strategy

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3
Q

What is financing strategy?

A

Raising the funds needed by an organisation in the most appropriate manner

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4
Q

What is investment strategy?

A

Managing the employment of those funds within the organisation, including the decision to reinvest or distribute any subsequent profits generated by the organisation

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5
Q

What are capital investment decisions?

A

Decisions that usually involve a relatively long horizon and substantial capital investment

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6
Q

What are examples of decision problems?

A
  • Whether or not to invest in a new production plan
  • Whether or not to acquire a rival company
  • Whether or not to develop and launch a new product
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7
Q

Which techniques for investment appraisal ignore the time value of money and risk?

A
  • ARR

- PBP

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8
Q

Which techniques for investment appraisal consider the time value and money and risk?

A
  • NPV

- IRR

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9
Q

What is the accounting rate of return?

A
  • Based on accounting profit

- It doesn’t take into account the time value of money

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10
Q

Why is it better for techniques to be focused on cash flows rather than accounting profit?

A

Cash flows are less manipulatable than profits

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11
Q

What is the formula for ARR?

A

Average annual profit/average investment x 100

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12
Q

How is average annual profit calculated?

A

Total profit/number of years

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13
Q

How is average investment calculated?

A

(Initial investment/residual value)/2

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14
Q

What is the decision rule for ARR?

A
  • Accept project if ARR is equal to or greater than company’s target ARR
  • Accept the profit with the highest ARR
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15
Q

What is the payback period?

A
  • Cash flow based method

- The length of time it will take for cash inflows to cover initial investment

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16
Q

How is payback period calculated?

A

By working out the cumulative net cash flows for each project. The method can be modified to accept discounted cash flows to give the discounted payback period.

17
Q

What is the decision for for PBP?

A
  • Accept project if the PBP is within the company’s target PBP
  • Choose project with the shortest PBP
18
Q

What is the time value of money?

A

The idea that £1 today will grow to be worth more than £1 in the future.

19
Q

What is the formula for the time value of money?

A

FV = PV x (1+r)^n

FV = future value 
PV = present value
r = interest rate per period
n = number of goods
20
Q

What is the formula for discounting?

A

PV = FV x 1/(1+r)^n

21
Q

Why do future cash flows need to be discounted?

A

In order to take into account the opportunity cost of investment (OCI). Funds tied up in investment projects could have been used elsewhere to earn a profit. Funds tied up in investment are costly.

22
Q

When should firms invest in capital projects?

A

Only if they yield a return in excess of the OCI. The OCI is also known as the ‘minimum required rate of return’ or ‘project cost of capital’ or ‘discount rate’

23
Q

What is the net present value?

A
  • Discounted cash flow method of investment appraisal
  • It involves discounting all relevant cash flows to their present value
  • The sum of all present values less the initial costs gives the NPV
24
Q

What is the formula for NPV?

A

ΣCFi/(1+R)I - investment costs

25
Q

What is the decision rule?

A
  • Accept project if NPV is greater than 0

- Accept project with the highest NPV

26
Q

How can NPV be used when dealing with capital rationing?

A

Capital rationing is limitations on funding that prevent all positive NPV projects, NPV can be used to calculate profitability index - NPV per £ of initial capital outlay

27
Q

How is NPV used to calculate profitability index?

A

PI = NPV/Initial Investment

28
Q

How should a value maximising company choose its projects?

A

In order of the PI, provided the projects are divisible, otherwise pick the combination which maximises weighted average PI on the funds available

Finance (6 decks)

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