capital Flashcards
What is capital investing
Capital investing is measuring the returns from an investment in capital in terms of time and value of return.
Important as it involves large amounts of money, so we want to make sure we are making the right decision for the business.
Benefits do not remain constant. The return will depreciate over time, as the older the car, the more work it has done, the less appeal of the car.
Payback period
The time it takes to recover the cash outflows on an initial capital investment (to repay the initial cash outlay).
Value of time
The value of $10,000 today does not have the same value of $10,000 in 2 years time.
Instead of asking what is the value of an investment two years down the track, it is how much is it worth now if I receive it two years later?
Net present value
The amount resulting from discounting the net cash flows (cash inflows - cash outflows) at the minimum discount rate to their present values, and then subtracting the present value cost of the Capital Investment.
Factors affecting capital investment decisions
Customer preferences, competitors, government regulation.
Customer preferences
A business that wants to develop a new product should ensure that it understands the needs of the intended consumers of this product before proceeding with the investment.
Competitors
A business should understand the strengths and weaknesses of its competitors. A business should consider the likely reaction of its competitors to any investment it makes.
Government regulation
A business should ensure that any investment proposal takes into account the cost of complying with government regulations.
Advantage of the payback period
Simple to calculate.
Easy to understand.
A good indicator of the risk of an investment.
Disadvantages of the payback period
Doesn’t take into account the time value of money.
Cannot determine if a proposed investment is likely to generate an acceptable rate of return.
Ignores cash inflows after the payback period is reached.
Makes assumptions about future cash flows that may not be accurate, especially for later years.
Advantage of the net present value method
Takes into account the time value of money.
Has a simple decision rule (positive = good).
Establishes if a required rate of return should be achieved.
Disadvantage of the net present value method
Makes assumptions about future cash flows that may not be accurate, especially about later years.
More complex to calculate than payback period.
Less easy to understand than payback period.
Based on your quantitative calculations, would you recommend the owners to invest in option 1 or option 2? Justify.
Option 2, Both options are over the benchmark 5 yaer payback period, however, option 2 will be paid back more quickly so is the less risky option.
Even though the payback period has not been reached, NPV takes into account the time value of money so is a better capital budgeting technique to investigate further.
Option B has a positive NPV and is returns above the 9% required rate so should be chosen based on the calculations.
Explain, using your workings, how NPV assists management in deciding which machinery should be purchased.
NPV is an analysis of discounted cash flows. These cash flows take into consideration the time value of money to estimate if a project is viable in the long term.
Describe the nature of capital investment decisions.
The nature of capital investment includes:
- the investment or purchase of assets for a long-term involve a significant sum of money relative to the business size.
- cannot be easily reversed due to the long-term commitment of business resources.
