Capital Investment Decisions

Question 1

What is the importance of capital investment decisions?

Answer 1

• The essential feature is the time factor
• Large amount of resources are often involved, therefore if mistakes are made, the effect can be significant
• It is often difficult and expensive to bail out of an investment once it has been made

Question 2

What is the time value of money?

Answer 2

• A dollar received today is worth more than a dollar to be received tomorrow
• Because of risk of not receiving it & inflation

Question 3

What is future value and how is it calculated?

Answer 3

• An amount of money at some future time period

- FVn = PV(1+r)^n

Question 4

What is present value and how is it calculated?

Answer 4

• An amount of money today, or the current value of a future cash flow
• PV = FVn / (1+r)^n

Question 5

What is the difficulty of calculating future value and how is this overcome?

Answer 5

• For annual cash flows, need to sum all present values for each year
• A quicker method is to refer to a table of discount factors of values of r and n
• Just multiply the annual cash flow by the PV of $1 from the table to calculate the PV of each years cash flow and sum them

Question 6

What are the methods of investment appraisal?

Answer 6

• Accounting rate of return (ARR)
• Payback period (PP)
• Net present value (NPV)
• Internal rate of return (IRR)

Question 7

What does ARR do and what is its basis?

Answer 7

• 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
• Based on Profit (depreciation included)

Question 8

How is ARR calculated?

Answer 8

• ARR = (Average annual net profit / Average investment to earn that profit) x 100
• Average investment = (initial investment + expected residual value)/2

Question 9

What are the decision rules for ARR?

Answer 9

• For any project to be accepted, it must achieve a target ARR as a minimum
• If there are competing projects that exceed the minimum rate, the one with the highest ARR would normally be chosen

Question 10

What are acceptable ARR benchmarks?

Answer 10

• Return on assets - indicates return earned from past projects
• Industry average R.o.A.
• Other businesses ARR

Question 11

What is the working for ARR?

Answer 11

• Calculate annual net profit (total net profit/years)
• Divide by average investment
• Express as percentage (x 100)
• Compare to benchmark or cost of capital

Question 12

What are the pros/cons of ARR?

Answer 12

• Easy to calculate & understand
• Is a measure of profitability that is consistent with ROA
• Fails to take into consideration the time value of money - calculated with averages
  
  • Projects that earn profit quickly are more preferred than projects that earn profits later or over the whole period - ARR for all these projects can be the same
• Uses accounting profit, however over the life of a project, cash flows matter more than accounting profits

Question 13

What is payback period and what is it’s basis?

Answer 13

• The length of time taken for an initial investment to be repaid out of the net cash inflows from a project
• Based on cash flows (no depreciation)

Question 14

What are the PP decision rules?

Answer 14

• For a project to be acceptable it would need to have a maximum payback period (benchmark)
• If there are competing projects that meet (i.e. equal or shorter than) the maximum payback period, the project with the shorter period would normally be chosen

Question 15

What is the process for calculating PP?

Answer 15

• Ascertain the cumulative net cash flow for each year (i.e. don’t count depreciation or accruals/unearned revenue)
• (Initial investment - previous years cumulative net cash flow) / PP year net cash flow
• (convert to months by * by 12)
• Add this figure to the amount of years that precede the PP year

Question 16

What are the pros/cons of PP?

Answer 16

• Easy to calculate and understand
• Enables a firm to determine how long it will take to get its investment back
• Favouring projects with a shorter period (to some extent takes into account the time value of money)
• Particular useful when future cash flows are less certain
• Ignores the time value of money in the payback period
• Beyond the payback period, it ignores the size and timing of the cash flows

Question 17

What is net present value and what is it’s basis?

Answer 17

• Comparing the sum of the present value of all expected cash flows with the present value of the expected cash outflows related to a project
• Based on cash flows

Question 18

How is net present value calculated?

Answer 18

NPV = PVcash inflows - PVcash outflows

Question 19

What is the decision rule for NPV?

Answer 19

Accept the highest possible NPV, reject all negative NPV’s

Question 20

What is the process for calculation of NPV?

Answer 20

• Calculate the PV of each years cash flow either with the present value formula or by multiplying the PV of $1 given r and n (from a table)
• (including the initial negative cash flow - the investment itself)
• Sum these

Question 21

What are the pros/cons of NPV?

Answer 21

• Considers all of the costs and benefits of each investment opportunity
• Accounts for the timing of these costs and benefits through present value
• Does not determine actual rate of return or a relative measure of return
• If the calculation of the minimum rate of return (r) is not reliable, then NPV is less accurate
• Depends on the accuracy of the estimates of future cash flows

Question 22

What is the discount rate?

Answer 22

A rate applied to future cash flows to derive the present value of those cash flows

Question 23

What is the internal rate of return and what is it’s basis?

Answer 23

• At the internal rate of return level NPV = 0
• IRR is the rate at which PVcash inflows = PVcash outflows
• Based on cash flows

Question 24

What is the decision rule for IRR?

Answer 24

• For a project to be acceptable, it must meet (equal or higher than) a minimum IRR requirement
• If there are competing projects that meet the minimum IRR, accept the highest

Question 25

What is the process of calculating IRR?

Answer 25

• Pick a discount rate (r) to try
• Multiply each annual cash flow by the PV of $1 according to a table (or use the formula for PV)
• Sum all annual cash flow PV’s
• Compare to initial investment
• Readjust the discount rate estimate - if the sum of all PV’s is lower than the investment then the discount rate is too high, if the sum of all PV’s is higher than the investment then the discount rate is too low.

Question 26

What are the pros/cons of IRR?

Answer 26

• Is based on cash flows
• Does not treat cash received in different years as equal, thus incorporates the time value of money
• Uses the concept of a rate of return that is familiar to many managers
• Focuses on the rate of return and ignores the scale of the investment
• Depends on the accuracy of the estimates of future cash flows
• More difficult to calculate if you do not have computer or financial calculator

Question 27

What is true of investment appraisal in practice?

Answer 27

• Research shows that businesses tend to use more than one method to assess each investment decision
• NPV and IRR seems to be more the popular methods used in practice
• ARR and PP continue to be popular despite their shortcomings and the rise of popularity of the DCF methods
• Large businesses tend to use the discounting methods and apply multiple methods for each decision