Capital investment decisions Flashcards
The Nature of Investment Decisions
the essential feature of investment decisions is is?
time factor
the nature of investment decisions are crucial importance for the following reasons:
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
what are methods of investment evaluation?
Methods of Investment Appraisal
why are they used?
to evaluate investment opportunities such as profitiability of investment projects
Account rate of return
describe
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:
Accounting Rate of Return
how do you determine if ARR is acceptable?
compare this with the minimum required by the business
Accounting Rate of Return
describe the ARR Decision Rules:
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
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%.
advantages of acounting rate of return
• 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
problems with accounting rate of return
why do cash flows matter more than accounting profits?
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
problems with accounting rate of return
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
The accounting rate of return fails to take
account
of the fact that dollars received at a later
date are worth less than dollars received at an
earlier date
payback period
what is this?
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
calculate payback period
decision rules for payback period
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
Required:
(1) calculate the cash flows for each of the years
(2) calculate the accounting rate of return
(3) calculate the payback period
advantages of payback period
• 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
disadvantages of payback period
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.
The logic of using payback period is that
projects that can recover their cost quickly are
economically more attractive than those with
longer payback period.
Time value of money
what does this mean?
A dollar received today is worth more than a dollar to
be received tomorrow.
Time value of money
what is the future value?
Future Value (FV) - An amount of money at some future time period
what are 4 features of time value of money
- Present value (PV)
- Future value (FV)
- period (n)
- Discount rate (r)
formula for calculating future value?
calculating present value
what is another way to calculate present value?
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
Discounted cash flow methods
- net present value
why may it not be that easy when time is involved?
cash outflow (payment) will occur immediately. The inflows (receipts) will arise at a range of later times
Discounted cash flow methods
- net present value
describe this method
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 ____
