CAPITAL INVESTMENT

Question 1

The objective of Capital Investment Appraisal

Answer 1

is to enable a business to decide whether or not to invest in a particular capital investment project and, where there are a number of viable alternatives, to decide in which of them to invest.

Question 2

OBJECTIVE

Answer 2

In all cases it is necessary to evaluate whether the benefits obtained from the initial investment are sufficient to justify the original capital outlay.

Question 3

How much should a project earn?

Answer 3

Capital is not Free.
Providers of capital expect a return from their investment.
Share capital - dividends and/or growth in share value
Loan capital - paying interest

Question 4


How much should 
a project earn?

Answer 4

A project needs to earn a rate of return at least equal to the rewards that will satisfy the mix of providers. Otherwise raising capital in the future will be even more difficult.

Question 5



How do you find 
the Cost of Capital?

Answer 5

All organisations have to make decisions, the benefit of which, are in the future.
The future is uncertain, and the longer that future period is, the more uncertain.

Question 6

Typical decisions are:-

Answer 6

Having say to invest in the new staging equipment for your events , or lease it, or do nothing and fall behind your competitors.

Question 7

Considerations in making the investment decisions

Answer 7

Long-term outcomes are more difficult to predict than short-term ones.
Investment involves the immediate risk of funds in the hope of securing returns later.

Question 8

Considerations in making the investment decisions

Answer 8

Long-term decisions have to fit in with the strategy of the organisation.
Risk occurs where the outcomes of current actions are unknown.
Wherever there are risks there is a need to compensate those who are taking the risks.

Question 9

Business Risk and Financial Risk

Answer 9

A company’s business risk is determined by what projects it undertakes, it influences market share and competitive position.
A company’s financial risk is determined by how it finances these projects, it may be influenced by the level of gearing and liquidity ratios.

Question 10

There are four different ways of appraising projects for capital investments

Answer 10

ARR- Accounting Rate of Return
PAYBACK
Net Present Value
Internal Rate of Return

Question 11


Lecture example ARR

Answer 11

Project X- 4 year project
Cost £80,000 Resale value £8,000
Cost of Capital 12%.

Project X- 4 year project
Net Cash flows Year 1 £20,000
Year 2 £30,000
Year 3 £40,000
Year 4 £40,000

Question 12

FORMULA ARR

Answer 12

Formula:-

ARR = Average Profit x 100
Average Investment

Step 1 Calculate the Average Profit

Step 2 Calculate the Average Investment

Step 3 Use in formula

Question 13

EXAMPLE OF ARR FORMULA

Answer 13

£
Net cash flow years 1-4 = 130,000
Depreciation (72,000)
Profit over 4 years = 58,000
Average profit = 58,000 = £14,500
4

                                             £ Value at start (year 0)        80,000 Add Value at end  year 4     8,000 Total                                     88,000 Average =   88,000   = £44,000
                     2

ARR = Average Profit x 100
Average Investment

ARR = 14,500 x 100 = 32.95%
44,000

ARR = 14,500 x 100 = 32.95%
44,000
For Accept/ reject decisions you would be given a percentage figure acceptable to the Company termed the Return on Capital Employed (ROCE). – see the Ratios Hanbook from Week 1 and 2.

Question 14

PAYBACK

Answer 14

Step 1 The initial cash payment (outflow) enter in year 0- enter as a minus
Step 2 List in year order the cash receipts (inflow) – enter as pluses
Step 3 Accumulate the net outflow/ inflow in a second column
Step 4 When the figure becomes positive this is the year of the Payback
Step 5 If months/ or days are required use the formula shown.

Question 15

EXAMPLE PAYBACK

Answer 15

Year net cash Cumul
Step 1 Year 0 - £80,000 -£80,000
Step 2 Year 1 + £20,000 -£60,000
Step 2 Year 2 + £30,000 -£30,000
Step 2 Year 3 + £40,000 +£10,000 XX
Step 2 Year 4 + £40,000 +£50,000
resale value Y 4 + £8,000 + £58,000
2 years (30000/40000 x 12) = 9 months

Question 16

PAYBACK TIP EXAM

Answer 16

For accept/reject decisions in an exam you would be given the number of years the company would normally consider. The shorter the period the better.

Question 17

Net Present Value

Answer 17

Step 1 The initial cash payment (outflow) enter in year 0- enter as a minus
Step 2 List in year order the cash receipts (inflow) – enter as pluses- if there is a resale value make sure you include it as a receipt in the last year.
Step 3 Enter the discount in a second column.
Step 4 Multiply the figures into a third column and add them up.
Step 5 You arrive at the answer

Question 18

NET PRESENT VALUE EXAMPLE

Answer 18

net cash dcf 12% npv
(A) (B) (A x B )
Year 0 - £80,000 1 -80,000
Year 1 + £20,000 0.893 +17,860
Year 2 + £30,000 0.797 +23,910
Year 3 + £40,000 0.712 +28,480
Year 4 + £48,000 0.636 +30,528
total NPV +£20,778

total NPV +£20,778
For accept/reject decisions in an exam a positive NPV means accept.
A positive NPV is the amount in present value that the project will contribute after paying interest on the investment at the Cost of Capital.

Question 19



Internal Rate of Return TIP

Answer 19

Choose a discount rate – given in your exam

You will arrive at a different answer and the figure will be different in + or -.

Question 20

FORMULA FOR INTERNAL RATE OF RETURN

Answer 20

Formula

IRR =
LDR + (HDR – LDR x PNPV )
PNPV + NNPV

Question 21

INTERNAL RATE STEPS

Answer 21

Step 1 The answer of the NPV and IRR are called Lower Discount Rate and Higher Discount Rate (LDR & HDR)
Step 2 The positive figure is called the Positive Net Present Value (PNPV)
Step 3 The negative figure is called the Negative Net Present Value (NNPV)
Step 4 Add the PNPV to the NNPV ignoring the minus sign.

Question 22

Internal Rate of Return-page 6 - CHOOSE SAY 27%

Answer 22

(A) (B) (A x B )
Year 0 - £80,000 1 -80,000
Year 1 + £20,000 0.787 +15,740
Year 2 + £30,000 0.620 +18,600
Year 3 + £40,000 0.488 +19,520
Year 4 + £48,000 0.384 +18,432
total NPV -7,708

Formula
IRR = LDR + (HDR – LDR x PNPV )
PNPV + NNPV

 = 12 +   (27-12   X          20,778                  )
                                      20,778 + 7,708
    = 12 + (        15     X                            0.729)

   = 12 + 10.94 = 22.94% ANSWER