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
Time value of money
what is the present value?
Present Value (PV) - An amount of money today, or the current value of a future cash flow
time value of money
what is the period (n)?
Period (n) - A length of time (often a year, but can be a
month, week, day, hour, etc.)
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 include
- Net present value (NPV)
- Internal rate of return (IRR)
Discounted cash flow methods
- net present value
conclusion
investment will make the business 24190 better off. the benfits from investing in the machine are worth a total of 124190 today
Discounted cash flow methods
- net present value
describe NPV decision rules
Accept the highest positive NPV, reject all
negative NPVs
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 ____
discounted cash flow methods
net present value
describe disadvantages of net present value
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
discounted cash flow methods
net present value
describe advantages of net present value
Considers all of the costs and benefits of each
investment opportunity
Accounts for the timing of these costs and benefits
Discounted cash flow methods: Internal rate of return
what is this method?
IRR is the rate at which PVinflows = PVoutflows
Discounted cash flow methods: Internal rate of return
what is the IRR decision rule?
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.
Advantages of internal rate of return
- Is based on all cash flows
- Does not treat cash received in different years as equal,and thus incorporates the time value of money.
- Uses the concept of a rate of return that is familiar to many managers
Disadvantages of IRR
difficulty handling projects with unconventional cash flows
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 early in the project may be inferior to projects with lower IRR but significant cash inflows later in the project
Disadvantages of IRR
- 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
- difficulty in handling projects with unconventional cash flows
- More difficult to calculate if you do not have a computer or financial calculator
Investment Appraisal in Practice
what does research show?
businesses tend to use
more than one method to assess each
investment decision
investment appraisal in practice
what methods are more popular in practice?
NPV and IRR seem to be the more popular
methods used in practice
investment appraisal in practice
what do large businesses use?
Large businesses tend to use the discounting
methods and apply multiple methods for each
decision
investment appraisal in practice
what other methods are popular?
ARR and PP continue to be popular despite their
shortcomings and the rise of popularity of the
DCF methods
Difference between ARR and ROA?
ROA assess performance of a business after the period has passed
ARR assesses an investment opporutnity before it takes place
why is NPV superior to ARR and PP
- timing of cash flows
2. the whole of the relevant cash flows
3. Objectives of the business
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)
why is NPV superior to ARR and PP
- timing of cash flows
2. the whole of the relevant cash flows
- Objectives of the business
NPV includes all of the relevant cash flows irrespective of when they are expected to occur. they can all influence the decision
why is NPV superior to ARR and PP
1. timing of cash flows
- the whole of the relevant cash flows
- Objectives of the business
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 **
why is NPV superior to ARR and PP
- timing of cash flows
- the whole of the relevant cash flows
- Objectives of the business
How is internal rate of return similar to NPV?
involves discounting future cashflows
What is the internal rate of reutrn?
the discount rate for a project which will have the effect of producing a zero NPV. It reprsents the yield from an invesment opportunity
how to convert profit flows into cash flows?
sales revenue
Less Variable Expenses
Less other expenses
Net cash inflow
