Capital investment appraisal

Question 1

Features of Capital Investment (new projects)

Answer 1

• Large, irreversible resource commitment
• Subject to a significant degree of risk
• Needs to be based on strategic planning
• Should be based on reliable forecasting

Question 2

Compounding

Answer 2

Calculating the future value of a sum invested now using a rate of interest

Question 3

Discounting/Present Value

Answer 3

The value of money received in the future at the current time.

Question 4

The payback period

Answer 4

The amount of time it takes to recoup the money invested from the investment

Question 5

Internal Rate of Return

Answer 5

The cost of capital which gives a net present value of zero. I.e. the discount percentage which brings profits to exactly 0.

Question 6

IRR Interpolation

Answer 6

Is guessing two discount rates either side of the IRR, then using the following:
IRR = LR + [{LRNPV / (LRNPV + HRNPV)} x (HR-LR)]

Question 7

Accounting Rate of Return (equation)

Answer 7

ARR% = Average Profit / Capital Invested
x 100

Question 8

Payback Pros and Cons

Answer 8

Pro: Useful if cash flow is a problem, emphasises the importance of a quick return.

Cons: Ignores what happens after payback

Question 9

NPV pros and cons

Answer 9

Pro: Recognises that money loses value over time; theoretically the best method.

Cons: Deciding upon the correct discount rate

Question 10

ARR pros and cons

Answer 10

Pro: is the only method that uses the concept of profit and can therefore be likened to ROCE.

Con: ‘average profit’ may be misleading and hide large fluctuations

Question 11

IRR pros and cons

Answer 11

Pros: Gives a hurdle rate for comparison with the cost of borrowing

Cons: the most complex methods to calculate