Capital Budgeting

Question 1

What is a capital investment and give 2 examples

Answer 1

• A capital investment is defined as the spending of a large amount of money by a business with the intention of making an acceptable future return. Examples include:
  
  • The commencement of a new business
  • The replacement of old plant and equipment
  • The opening of a new shop
  • The manufacture of a new product

Question 2

4 Characteristics of a Capital Investment

Answer 2

• Cannot turn back decisions
• Uses considerable cash resources
• Owners and investors expect a return on the investment
• Committed for many years
• High risk Investment

Question 3

3 Factors affecting Capital Investment Decisions

Answer 3

• Customer Preferences: a business that wants to develop a new product should ensure that it understands the needs of the intended consumer of this product before proceeding with this investment
  - Understanding your selected target audience and what the customers actually want to buy
• Competitors - A business should understand the strengths and weaknesses of its competitors - being able to consider the likely reaction of its competitors to any investment that it makes
  - New fast food restaurants competing with McDonalds, KFC etc
• Government Regulation - A business must ensure that any investment proposal takes into account the cost of complying with government regulations
  - Laws limiting amount of pollution that factories can emit

Question 4

Define the concept of time value of money

Answer 4

One dollar today is worth more than one dollar received on a future date due to factors such as inflation

Question 5

What is a payback period and what does it allow

Answer 5

length of time a proposal is expected to take to repay the initial cash outlay
Allows business to choose investments with shorter payback periods

Question 6

3 Advantages of payback period

Answer 6

• Simple to calculate
• Easy to understand
• A good indicator of the risk of an investment

Question 7

3 Disadvantages of Payback Period

Answer 7

• Payback period doesn’t account for the time value of money
• Payback period cannot determine if a proposed investment is likely to generate an acceptable rate of return - can’t determine percentage returns
• Payback period ignores cashflows after payback period is reached
• Payback period makes assumptions about future cash flows that may not be accurate, particularly for latter years of a project

Question 8

What is Net Present Value

Answer 8

determines if the expected rate of return of an investment proposal is above, equal to or below the rate of return required by a business

Question 9

How is NPV calculated

Answer 9

calculates the present value of the future net cash inflows of an investment - it then compares present values with initial cash outlay

Question 10

What is discount rate or cost of capital

Answer 10

the rate of interest that is used in present value calculations

Question 11

Advantages of NPV

Answer 11

• Takes into account the time value of money
• Has a simple decision rule
  
  • If NPV is positive, investment is good to go
  • If NPV is negative, investment shouldn’t happen
• Establishes if a required rate of return should be achieved

Question 12

Disadvantages of NPV

Answer 12

• NPV makes assumptions about future cash flows that may not be accurate - particularly latter project years
• More complex to calculate than the payback period
• Less easy to understand than the payback period