Capital Investment Decisions Flashcards
Four methods of evaluation
Accounting rate of return
Payback period
Net present value
Internal rate of return
Accounting rate of return formula
Average annual
Operating profit / av investment to earn that profit
ARR decision rule
For a project to be acceptable, it must achieve a target ARR as a minimum
When two or more competing projects exceed the minimum rate, the one with the higher (or highest) ARR should be selected
Payback period
The payback period is the length of time it takes for an initial investment to be repaid out the net cash inflows from a project
Payback period decision rule
For a project to be acceptable, it should have a shorter payback period than the max payback period set by the business
If two or more competing projects have payback periods shorter than the max payback period, the project with the shorter payback period should be selected
NPV
The present value of cash inflows are compared to the pv of cash outflows, the difference is the NPV
NPV decision rule
If the NPV of a project is positive it should be accepted, if negative reject
If two or more competing projects have positive NPV the project with higher NPV should be selected
PV of £1 received in future
1/(1+r)^t
Why is NPV superior to ARR and PP
Npv fully addresses the timing of cash flows, the whole of the relevant cash flows and the objectives of the business
Internal rate of return
The internal rate of return is the discount rate, which, when applied to the future cash flows of a project, will produce an NPV of precisely zero
IRR decision rule
For a project to be acceptable, it must meet a minimum irr requirement(opportunity cost of finance)
If two + competing projects exceed the minimum IRR the one with higher IRR should be selected
IRR Formula
IRR = A + (C/(C-D) x (B - A) ) %
Where a = first interest rate
B = second interest rate
C = first NPV
D= second NPV (neg figure)
