Capital Investment Appraisal Flashcards
What is capital investment decisions?
profit is generated by using company assets, companies need to invest in assets, capital available to invest is limited, capital investment often requires large scale investments and managers need to consider which projects to invest in to get ‘best return’
Why cant cash flows be manipulated?
they are a much more reliable measure for benefits and costs of a project, whereas accounting profits are very prone to manipulation.
What are sunk costs?
money already spent, out of pocket - but is not relevant
What are apportioned fixed costs?
Will be incurred whether or not project goes ahead - usually not relevant, but they become relevant if they eventually change, an incremental change may occur and it would incur an extra cost e.g. using more electricity to keep open at night.
Impact = relevant
No impact = not relevant
What is opportunity cost?
benefit foregone by using asset doe this project, what you are giving up for another project
Why is interest not a relevant cashflow?
it is dealt with via cost of capital, if it is not cashflow it is not relevant e.g. depreciation is not relevant
What is a paypack period?
number of years taken to recover an initial investment, can be easily calculated by working out how many years it takes before the cumulative net cash flows for each project equals the initial investment.
How can the payback method be modified?
it can be modified to accept discounted cash flows to give the discounted payback period.
It is widely used in practice and it is a screening method, but not used as a main investment decision.
What is the decision rule for the payback period?
accept the project if the payback period is within the company target payback period, choose the project with shortest payback period.
What will you assume with payback period?
may have to assume that cash flows accrue evenly throughout the year - you add the annual CF to the cumulative CF until you get the initial investment e.g. if its -1000 keep going till you get 0 or a positive number.
What are advantages of a payback period?
It is simple to use, easy to understand, cashflow based focuses on imminent cash flows, helpful for liquidity bases as can see next payments
What are disadvantages of a payback period?
Ignores time value of money, ignores cashflow size/timing, ignores cash flow outside payback period - there are serious flaws.
What is the Net Present Value?
involves discounting all relevant cash flows to their present value - use cost of capital or target rate of return as discount rate.
Sum of all present values less the initial cost gives you the NPV.
What is the decision rule for NPV?
accept project if NPV > 0 accept project with the highest NPV.
What is residual value?
remaining value/proceeds of the sale of an asset that has been invested in that project
What are advantages of NPV?
Takes into account the time value of money, takes into account the size of the investment - returning the absolute net value of investment allows for comparison across project. Takes into account the duration of the investment.
What are the disadvantages of NPV?
Difficult to understand, difficult to estimate cash flows, difficult to determine discount rate by itself, insufficient in comparing NPVs across investments of different amounts.
What is the accounting rate of return?
Shareholder often calculate profitability measures, such as company’s profits divided by its assets. Some financial managers may evaluate a project by calculating a profitability measure such as projects expected average profits divided by the projects average assets
What are the disadvantages of accounting return?
Ignores time value of money, it depend on average profits over the lifetime of the project and doesn’t take into account when these profits are received. No natural benchmark for judging whether a projects accounting return is attractive.
What matter are the cash flows that the proposed project is likely to generate and the opportunity cost of capital.
What is the internal rate of return (IRR)?
is the yield earned on a investment over the course of its economic life. It is equivalent to the discount rate (r) that will cause the NPV of an investment to be zero.
What is the decision rule for IRR?
accept project if IRR >= company’s cost of capital, accept project with the highest IRR
How can you find the IRR?
it can be done either using computer (excel), trial and error of different disount rates until NPV = 0 - a higher rate gives a number closer to 0, or found using linear interpolation formula
What is the linear interpolation formula for IRR?
IRR = r1 + (NPV1/NPV1 - NPV2) x (r2 - r1)
r1 = discount rate that gives you a positive NPV1
r2 = discount rate that gives a negative NPV2
NPV1 = the positive NPV obtained by applying discount rate r1
NPV2 = the negative NPV obtained by applying discount rate r2
What do you have to work out NPV2
You have to guess what rate to use, often between 10% and 40% - if you have a high value for NPV, then you will have to discount the NPV2 heavily by using a much higher DF.
You work out a new DF of a % of your choice for each year and then you work out the final NPV again and take this number into the calculation for IRR.
