Capital Investment Appraisal Flashcards
What is the formula for ARR?
Accounting Rate of Returns
Average profit/Average investment x100
What are the steps for ARR?
Step 1 Calculate the Average Profit (add total of net cash flows, takeaway depreciation=profit over total of years \by number of years)
Step 2 Calculate the Average Investment (value at the start year add value at end of total years, \by 2)
Step 3 Use in formula
What are the steps for PAYBACK?
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.
What are the steps for NPV?
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
What does it mean if the NPV is positive?
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.
What are the 4 different ways of appraising projects for capital investment?
ARR (Accounting Rate of Return)
PAYBACK
NPV (Net Present Value)
Internal Rate of Return
What is the objective of Capital Investment Appraisal?
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.
How much should a project earn?
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
How much should a project earn?
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.
What are the typical decisions?
Having say to invest in the new staging equipment for your events , or lease it, or do nothing and fall behind your competitors.
What are the considerations in making the investment decisions
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.
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.
Business risk and Financial risk
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.
PAYBACK TIME
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.
What is the IRR formula?
Internal Rate of Return
IRR=LDR+(HDR-LDRxPNPV)PNPV+NNPV
What are the steps for IRR?
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.
