Capital Investment Appraisal Flashcards
What methods are used to evaluate the investment proposals?
Payback period method, Net present value method, Accounting rate of return
What is the payback period decision rule?
Projects with a PP up to a defined maximum period (the maximum period set by business) are acceptable; the shorter the PP the more desirable
Accept - Payback period is less than your firm’s benchmark
Reject - Payback period is greater than your firm’s benchmark
What is Payback period?
It is the number of years needed to recover the original investment from the cash flows resulting from a capital project/ investment
What is the method of Payback period?
- It is simple to apply and understand
- It provides a measure of liquidity
However: - It does not say whether a project is a ‘good one’
- It ignores the time value of money
- Ignores cash flows after the payback period
What are the strengths of the Payback period?
- Very small scale investments
- Firms with severe capital rationing
- Exceptionally simple to understand
What are the weaknesses of the Payback period?
- Timing of cash flows
- Payments after the Payback period
- Arbitrary standard for the Payback period
What is the Payback period calculation when net annual cash flow is identical?
Payback period = Investment required/ Net annual cash flow
How do you calculate Payback period if annual cash flows are different?
Using a calculation of cumulative cash flow
What is the Net present value method?
It presents the value of all cash inflows less cash outflows
What is the Net present value decision rule?
Accept (in case of single project) = if positive (wealth creation)
Reject = if negative NPV
What is the method of Net present value method?
In the case of mutually exclusive projects = accept the project that gives the highest NPV
Never accept the project that gives negative NPV
Negative NPV = wealth destruction
