Capital Investment Appraisal Flashcards
What is capital budgeting?
The decision-making process for accepting or rejecting projects
What is the NPV method of appraisal?
It uses discounted cash flows to evaluate capital investment projects
What does the NPV method do?
It compares the present value of all cash flows with the present value of all cash outflows
What are the key attributes of NPV?
It uses cash flows, it uses all the cash flows of the project, and it discounts the cash flows properly
What happens if the NPV is greater than 0?
The project should be accepted
What happens if the NPV is less than 0?
The project should be rejected
What are weaknesses of NPV?
There is a single market rate of interest for both borrowing and lending, an individual can borrow or lend any amount of money at that rate, there are no transaction costs or taxes, and investors are rational
What are disadvantages of NPV?
Project cash flows may be difficult to estimate, accepting all projects with positive NPV only possible in a perfect capital market, cost of capital may be difficult to find, and cost of capital may change over project life, rather than being constant
What is the payback period method of project appraisal?
It calculates the length of time required for the stream of cash inflows from the project to equal the original outlay
What happens if the payback period is less than the benchmark?
The project should be accepted
What happens if the payback period is greater than the benchmark?
The project should be rejected
What are the problems with the payback period?
The timing of cash flows within the payback period, payments after the payback period, and arbitrary standard for payback period
What are the advantages of payback period?
Very small scale investments, firms with severe capital rationing, and exceptionally simple to understand
What could be used instead of the payback period?
The discounted payback period
Why was the discounted payback period established?
Due to some of the disadvantages of the payback period method
What happens if the discounted payback period is less than the benchmark?
The project should be accepted
What happens if the discounted payback period is greater than the benchmark/?
The project should be rejected
What are the strengths of the discounted payback period?
Simple and uses time value of money
What are the weaknesses of the discounted payback period?
It ignores cash flows beyond the benchmark, and the arbitrary benchmark
What is the average accounting return method?
It is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life
What happens if the average accounting return is greater than the target return?
The project should be accepted
What happens if the average accounting return is less than the target return?
The project should be rejected
What is net income?
Net cash flow minus depreciation and taxes
What are the strengths of the average accounting return?
Simple return-based measure
What are the weaknesses of the average accounting return?
Does not use cash flows or time value of money, arbitrary target rate, and it does not work with the right raw materials
What is the internal rate of return?
it is the discount rate, which, when applied to the future cash flows of a project will produce an NPV of 0
What does the internal rate of return represent?
It represents the yield from an investment opportunity, and it represents the average percentage return on the investment, taking account of the fact that cash may be flowing in and out of the project at various points in time
What happens if the internal rate of return is greater than discount rate?
The project should be accepted
What happens if the internal rate of return is less than the discount rate?
The project should be rejected
What is an independent project?
One whose acceptance or rejection is independent of the acceptance or rejection of other projects
What is a mutually exclusive project?
You can accept a or you can accept B or you can reject both of them, but you cannot accept both of them
What are the problems with the IRR approach?
Investing or financing? and, multiple rates of return
What is the IRR problem specific to mutually exclusive projects?
The scale problem and timing problem
Where does IRR go wrong?
It ignores the issue of scale and ignores the timing of cash flows
What is the general rule with mutually exclusive investments?
To avoid issues such as timing and scale, use incremental NPV or incremental IRR
What is the probability index?
It is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment
What is capital rationing?
It occurs when there is not enough cash to invest in all positive NPV projects
