Appraisal of Capital Projects Flashcards
What is financial management?
- Concerned with firm’s investment and financing decisions
- Firm-level economics of time and risk
What does financial strategy comprise of?
- Financing strategy
- Investment strategy
What is financing strategy?
Raising the funds needed by an organisation in the most appropriate manner
What is investment strategy?
Managing the employment of those funds within the organisation, including the decision to reinvest or distribute any subsequent profits generated by the organisation
What are capital investment decisions?
Decisions that usually involve a relatively long horizon and substantial capital investment
What are examples of decision problems?
- 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
Which techniques for investment appraisal ignore the time value of money and risk?
- ARR
- PBP
Which techniques for investment appraisal consider the time value and money and risk?
- NPV
- IRR
What is the accounting rate of return?
- Based on accounting profit
- It doesn’t take into account the time value of money
Why is it better for techniques to be focused on cash flows rather than accounting profit?
Cash flows are less manipulatable than profits
What is the formula for ARR?
Average annual profit/average investment x 100
How is average annual profit calculated?
Total profit/number of years
How is average investment calculated?
(Initial investment/residual value)/2
What is the decision rule for ARR?
- Accept project if ARR is equal to or greater than company’s target ARR
- Accept the profit with the highest ARR
What is the payback period?
- Cash flow based method
- The length of time it will take for cash inflows to cover initial investment
How is payback period calculated?
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.
What is the decision for for PBP?
- Accept project if the PBP is within the company’s target PBP
- Choose project with the shortest PBP
What is the time value of money?
The idea that £1 today will grow to be worth more than £1 in the future.
What is the formula for the time value of money?
FV = PV x (1+r)^n
FV = future value PV = present value r = interest rate per period n = number of goods
What is the formula for discounting?
PV = FV x 1/(1+r)^n
Why do future cash flows need to be discounted?
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.
When should firms invest in capital projects?
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’
What is the net present value?
- 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
What is the formula for NPV?
ΣCFi/(1+R)I - investment costs
What is the decision rule?
- Accept project if NPV is greater than 0
- Accept project with the highest NPV
How can NPV be used when dealing with capital rationing?
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
How is NPV used to calculate profitability index?
PI = NPV/Initial Investment
How should a value maximising company choose its projects?
In order of the PI, provided the projects are divisible, otherwise pick the combination which maximises weighted average PI on the funds available
