Capital investment decisions

Question 1

The Nature of Investment Decisions

the essential feature of investment decisions is is?

Answer 1

time factor

Question 2

the nature of investment decisions are crucial importance for the following reasons:

Answer 2

Large amounts of resources are often
involved, therefore if mistakes are made,
the effect can be catastrophic

It is often difficult and expensive to ‘bail
out’ of an investment once it has been
made

Question 3

what are methods of investment evaluation?

Answer 3

Question 4

Question 5

Methods of Investment Appraisal

why are they used?

Answer 5

to evaluate investment opportunities such as profitiability of investment projects

Question 6

Account rate of return

describe

Answer 6

ARR method takes the average accounting
profit the investment will generate , and
expresses it as a percentage of the average
investment in the project as measured in
accounting terms:

Question 7

Accounting Rate of Return
how do you determine if ARR is acceptable?

Answer 7

compare this with the minimum required by the business

Question 8

Accounting Rate of Return
describe the ARR Decision Rules:

Answer 8

For any project to be accepted, it must
achieve a target ARR as a minimum (eg. previous investment had achieved measured by ROA or industry ROA )

• If there are competing projects that all seem capable of exceeding the minimum rate, the one with the highest ARR would normally be chosen

Question 9

Calculate the accounting rate of return

Taylor Ltd is about to invest in a new machine. The initial
investment in the machine would cost $200,000. The
machine has a useful life of 3 years and is expected to
be sold for $20,000 at the end of the third year. Taylor
Ltd uses straight line depreciation. Cost of capital 8%.

Answer 9

Question 10

advantages of acounting rate of return

Answer 10

• Easy for managers to understand figure
• Is a measure of profitability that is
consistent with return on assets (ROA)

many believe it is the correct way to evaluate investments

Question 11

problems with accounting rate of return

why do cash flows matter more than accounting profits?

Answer 11

cash is ultimate measure of economic wealth because cash is used to acquire resources and it is cash that is distributed to shareholders

accounting profit is a useful measure of profit over a short period (Half year, year) but cash is appropriate measure when considering performance over the life of a project

Question 12

problems with accounting rate of return

Answer 12

ARR fails to take into consideration the
time value of money (eg. benefits of investment arising in the first 12 months of the life vs benefits of investment arising in the last year, managers would much prefer to select investment where there are immediate benefits)

• dollars received at a later date are worth less than dollars received at an earlier date

• ARR uses accounting profit, however when measuring performance over
the life of a project, cash flows matter
more than accounting profits

Question 13

The accounting rate of return fails to take
account

Answer 13

of the fact that dollars received at a later
date are worth less than dollars received at an
earlier date

Question 14

payback period

what is this?

Answer 14

is the length of time taken for an initial
investment to be repaid out of the net cash
inflowsfrom a project.

since it takes into account time, PP method may overcome timing problem for APR

Question 15

calculate payback period

Answer 15

Question 16

decision rules for payback period

Answer 16

For a project to be acceptable it would need to have
a maximum payback period (as a benchmark)

• If there are two or more competing projects that meet that both meet the maximum payback period, the
project with the shorter payback period would
normally be chosen

Question 17

Required:
 (1) calculate the cash flows for each of the years
 (2) calculate the accounting rate of return
 (3) calculate the payback period

Answer 17

Question 18

advantages of payback period

Answer 18

• Easy to calculate and can easily be understood by managers
• Enables a firm to determine how long it will take
to get its investment back
• projects that can recoup their costs quickly are more economically attractive than projects with longer payback periods.
• Particular useful when future **cash flows are less
certain **

• improvement on ARR in respect of timing of the cash flows

Question 19

disadvantages of payback period

Answer 19

With the payback period, it ignores the
timing of the cash flows.
after the payback period, it ignores the
size and timing of the cash flows.

Question 20

The logic of using payback period is that

Answer 20

projects that can recover their cost quickly are
economically more attractive than those with
longer payback period.

Question 21

Time value of money

what does this mean?

Answer 21

 A dollar received today is worth more than a dollar to
be received tomorrow.

Question 22

Time value of money

what is the future value?

Answer 22

Future Value (FV) - An amount of money at some future 
time period

Question 23

Time value of money

what is the present value?

Answer 23

Present Value (PV) - An amount of money today, or the 
current value of a future cash flow

Question 24

time value of money

what is the period (n)?

Answer 24

Period (n) - A length of time (often a year, but can be a
month, week, day, hour, etc.)

Question 25

what are 4 features of time value of money

Answer 25

1. Present value (PV) 2. Future value (FV) 3. period (n) 4. Discount rate (r)

Question 26

Answer 26

Question 27

Answer 27

Question 28

formula for calculating future value?

Answer 28

Question 29

calculating present value

Answer 29

Question 30

Answer 30

Question 31

what is another way to calculate present value?

Answer 31

quicker method is to refer to a **table of discount factors for a range of values of r and n** (available in Atrill et al. 2012 chapter 11 “Appendix 11.1 Present value table”, p621 )  A **discount factor is a rate applied to future cash flows to derive the present value** of those cash flows

Question 32

_Discounted cash flow methods_ include

Answer 32

1. Net present value (NPV) 2. Internal rate of return (IRR)

Question 33

Discounted cash flow methods - net present value conclusion

Answer 33

investment will make the business 24190 better off. the benfits from investing in the machine are worth a total of 124190 today

Question 34

Discounted cash flow methods - net present value describe NPV decision rules

Answer 34

Accept the highest positive NPV, reject all negative NPVs

Question 35

Discounted cash flow methods - net present value why may it not be that easy when time is involved?

Answer 35

cash outflow (payment) will occur immediately. The inflows (receipts) will arise at a range of later times

Question 36

Discounted cash flow methods - net present value describe this method

Answer 36

if the benefits are greater than cost,(total net profit over period - cost of machine) then this would lead us to conclude that the project should go ahead, because the business would be better off by \_\_\_\_

Question 37

Answer 37

Question 38

discounted cash flow methods net present value describe disadvantages of net present value

Answer 38

Does not determine **actual rate of return or a relative measure of return**. If the calculation of the _*minimum rate of return is not accurate*_, then the NPV is less reliable. Depends on the *_accuracy of the estimates of future cash flows_*

Question 39

discounted cash flow methods net present value describe advantages of net present value

Answer 39

 Considers all of the **costs and benefits of each investment** opportunity  Accounts for the **timing of these costs and benefits**

Question 40

Discounted cash flow methods: Internal rate of return what is this method?

Answer 40

IRR is the rate at which PV_inflows = PV_outflows

Question 41

Discounted cash flow methods: Internal rate of return what is the IRR decision rule?

Answer 41

 For a **project to be acceptable,** it must meet (i.e. equal or higher than) a minimum IRR requirement.  If there are **competing projects that meet the minimum IRR**, *_accept the highest IRR._*

Question 42

Answer 42

Question 43

Advantages of internal rate of return

Answer 43

1. **Is based on all** cash flows 2. Does *_not treat cash received in different years as equal,_*and thus incorporates the time value of money. 3. Uses the concept of a rate of return that is *_familiar to many managers_*

Question 44

Disadvantages of IRR difficulty handling projects with unconventional cash flows

Answer 44

projects do not necessarily have negative cash flow at start of line then positive thereafter. They may have both positive and negative cash flows at future points in its life. higher IRR with significant cash flows ear​ly in the project may be inferior to projects with lower IRR but significant cash inflows later in the project

Question 45

Disadvantages of IRR

Answer 45

1. Focuses **on the rate of return** and ignores the **scale of the investment **eg. unable to recognise difference between 15% cost of finance, $1m invested at 20% and $0.5m invested at 24%. While choosing project with higher rate of return can effectively increase wealth, the IRR does not say anything about the scale of investment 2. difficulty in handling projects with unconventional cash flows 3. More *_difficult to calculate_* if you do not have a computer or financial calculator

Question 46

Investment Appraisal in Practice what does research show?

Answer 46

businesses tend to use **more than one method to assess each investment decision**

Question 47

investment appraisal in practice what methods are more popular in practice?

Answer 47

NPV and IRR seem to be the more popular methods used in practice

Question 48

investment appraisal in practice what do large businesses use?

Answer 48

Large businesses tend to use the **discounting methods and apply multiple methods** for each decision

Question 49

investment appraisal in practice what other methods are popular?

Answer 49

ARR and PP continue to be popular despite their shortcomings and the rise of popularity of the DCF methods

Question 50

Difference between ARR and ROA?

Answer 50

ROA assess performance of a business after the period has passed ARR assesses an investment opporutnity before it takes place

Question 51

why is NPV superior to ARR and PP ## Footnote 1. timing of cash flows **2**. the whole of the relevant cash flows **3. Objectives of the business**

Answer 51

NPV is the only appraisal method in which the result bears directly on the wealth of the business (positive NPVs enhance wealth, negative ones reduce it)

Question 52

why is NPV superior to ARR and PP ## Footnote 1. timing of cash flows **2. the whole of the relevant cash flows** 3. Objectives of the business

Answer 52

NPV includes all of the relevant cash flows irrespective of when they are expected to occur. they can all influence the decision

Question 53

why is NPV superior to ARR and PP ## Footnote **1. timing of cash flows** 2. the whole of the relevant cash flows 3. Objectives of the business

Answer 53

discounting the various cash flows associated with each project according to when they are expected to arise takes into account the fact that **cash flows do not all occur simultaneously **

Question 54

why is NPV superior to ARR and PP

Answer 54

1. timing of cash flows 2. the whole of the relevant cash flows 3. Objectives of the business

Question 55

How is internal rate of return similar to NPV?

Answer 55

involves discounting future cashflows

Question 56

What is the internal rate of reutrn?

Answer 56

the discount rate for a project which will have the effect of producing a zero NPV. It reprsents the yield from an invesment opportunity

Question 57

how to convert profit flows into cash flows?

Answer 57

sales revenue Less Variable Expenses Less other expenses Net cash inflow