Capital investment appraisal Flashcards
Why are non-current assets purchased?
With the intention that they will generate profits for the business for some years into the future as they will be used by the business for more then one financial period
What are some examples of NCA?
Land
Buildings
Machinery
Plant
Vehicles
Office equipment
Why must capital expenditure be very carefully planned?
Cash is a limited resource so they must get the best value from it with maximum benefits
How are capital investment projects appraised?
according to potential earning power
Why must care be taken with capital investment decisions?
Large sums of money generally involved
Money may be tied up for considerable length
Decisions cannot generally be reversed easily
Money committed usually non-returnable
What might be some of the sources of information for a capital investment project?
Human resources
Sales
Finance
Production
Purchasing
Why might investment appraisal need to be done with machines?
Different prices
Different qualities
Produce different quantities and qualities of goods
Different lifespans
Different rates of obsolescence (outdated)
What are the 2 main methods of evaluating a capital project?
Payback methods
Net present value method (NPV)
What are opportunity costs?
the benefit from the alternative use of resources that is forgone when a new project is undertaken
What are sunk costs?
unrecovered expenditures already incurred before a project is undertaken (paid anyway)
What is disregarded when a new project is taken on?
Sunk costs with no influence on new project
What is the payback period with capital investment?
length of time required for total for the total net cash flows to equal the initial capital investment
Why is risk an important factor when considering a long term project?
As the sooner capital expenditure recouped the better the payback method
Why is payback method widely used?
as most businesses are concerned with short term horizons especially in fast moving markets or when liquidity is poor
What does a long payback period mean for the business?
increases the possibility that the original cost will not be recouped
Longer periods may mean cash inflows will be less reliable
How is the payback period measured?
Years and months (weeks or days)
How do you calculate payback period?
work out years first, using cumulative net cashflow, then work the month for the final payback year
What is the formula for payback?
(Amount needed from that year/ amount available that year) X 12 or 52 or 365
Why do you multiply by different numbers for payback?
X12= months
X52= weeks
X365= days
What are the 2 types of investment appraisal when cash flow is not given?
Adding back depreciation
Deducting cash outflow from cash in flow
What are the advantages of the payback method?
Simple to calculate
Fairly easy for non-accountants to understand
Use of cash more objective then profits that are dependant on the accounting policies decided by managers
Payback shows which project involves the least risk as it recognises cash received earlier is safer
Shows projects which benefit liquidity
Good in fast moving market with poor liquidity
What are the disadvantages of the payback method?
Ignores time-value of money
Ignores life expectancy of project
Does not consider all cash flows (after payback period are ignored)
Projects might have different cash flow patterns
How will mangers evaluate a project?
By comparing the capital investment with the future return of the project
What is the general pattern for money over time?
tendency for money to become less valuable
What is cost capital based on?
The weighted average cost of capital available to a business
What is cost capital based on?
The weighted average cost of capital available to a business
How is the net present value method of investment calculated?
taking present day value of all future net cash flows based on the businesses cost of capital and subtracting initial cost of investment
What does a discounting factor allow for?
the value of all future cash flows to be calculated in terms of their value if they were received today
What should you do if you are given a number of discounting factors to choose from?
select the one identified in the question as the cost capital (interest rate)
What projects should be considered with net present value?
Any project that yields a positive
Why might projects which have a negative present value still be accepted?
Keep customer happy
Keep good skilled workforce in business
Chance of future orders
What are the advantages of net present value method?
Can use different discount factors to view the impact of different scenarios
Opportunity cost can be considered
Time value of money taken into account
Relatively easily understood
Greater importance given to earlier cash flow
What does it mean that net present value accounts for money time value?
Takes into account value of current and future cash flows
What are the disadvantages of net present value method?
Inflows and outflows difficult to predict
Current cost of capital may change over project life
Life of project difficult to predict
Hard to compare projects with different initial cost
Complex to calculate
Not very realistic to have one discount factor over long period
What are the limitations of investment appraisal methods?
Figures used are only estimates
Hard to make direct comparisons between projects
Do not incorporate non-financial factors (social worthwhile)
What are relevant costs and revenues?
costs and revenue of future that will be affected by the decision
What is an example of an irrelevant costs?
a sunk cost as it has already occurred (so is a past cost not a future one)
