Capital investment decisions Flashcards
What is capital?
- F. accounting- capital denotes the financing providing by long term lenders and owners
- M. accounting-Capital relates to fixed assets purchased by the firm
What is capital budgeting?
How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products
e.g. ford manufacturer renovates factory to produce more cars
What are the four methods of capital investment appraisal?
- Net Present Value
- Internal Rate of Return
- Payback
- Simple rate of return
What are some examples of capital budgeting decisions?
- Equipment selection-which selection is best?
- Plant expansion-introduce now or later?
- Equipment replacement
- Lease or buy
- cost reduction
What is capital investment appraisal?
A set of quantitative methods that provide guidance to managers when making decisions (not perfect methods)- how to invest long term funds
What are the two broad categories of capital budgeting?
- Screening decisions
* Preference decisions
What are screening decisions in capital budgeting?
Does a proposed project meet some preset standard of acceptance? e.g. a firm may only purchase a new machine if the rate of return meets a set benchmark
What are preference decisions in capital budgeting?
Selecting from among several competing courses of action.
What are the assumptions when using capital appraisal methods?
• Certainty of cash flows of a long term investment
• Timing of cash flows- for payback and rate of return it is assumed cash flows are spread evenly throughout the year
-NPV- cash flows arrive on the last day of the accounting period
-Cash outflow for investment takes place now
•no taxes and no inflation
What is the time value of money?
The idea that a pound today is more valuable now than a pound received in the future
How do investment decisions take the time value of money into account?
- Investment options taking into account the time value of money are considered superior
- Time preference for returns to come sooner rather than later and the opposite for payments
Why is their a preference for investment decisions to take into account the time value of money?
- Investment preference- money received sooner can be reinvested (main preference)
- Consumption preference- if we have money sooner we can consume items desired
- Risk preference- risk disappears once money is received
What causes the effect of the time value of money?
- Interest lost
- Risk
- Inflation
What is the process of counting the present value called?
Discounting
What is the discounting process?
- The opposite of compound interest
* The value of cash flows for each year is discounted to their present values
What is the discount factor?
The cost to the business in order to finance the investment (required rate of return)
The expected rate of return that is used to adjust cash flows for the time value of money.
How is the present value calculated?
Through formulae or a discount table
What is the formulae for caluclating the PV for non-annuities?
Cash flow multiplied by 1/(1+r)^n
r=discount rate as a decimal
n=years
What is an annuity?
An investment that involves a series of identical cash flows at the end of each year is called an annuity
How is the NPV determined?
- Calculate the present value of cash inflows
- Calculate the present value of cash outflows
- Subtract the present value of the inflows from the present value of the outflows
Explain the NPV?
- Takes into account all of the cash flows over the life of a project and the time value of money
- difference between the PV of cash outflows and inflows give the NPV
- Method based on cash not profit
What are examples of cash outflows and inflows??
- Cash outflows e.g. maintenance, initial installation etc
* Cash inflows e.g. revue or reduction in costs
What are the permutations concerning the NPV?
- Postive value= acceptable project-returns greater than the required rate of return
- Zero= Acceptable- returns equal to the required rate of return e.g. 0 means exactly a 10% rate of return
- Negative= Unacceptable- promises returns less than the require rate of return
What is not included in the NPV calculation?
• Depreciation because
-It is not a current cash outflow.
-Discounted cash flow methods automatically provide for return of the original investment.
How is the discount rate decided?
- Usually the same as the firm’s cost of capital
- Can depend on who finances the business e.g. shareholders investment is risker than long term creditors so this may require a higher rate of return
What is a firm’s cost of capital?
The cost of capital is the average rate of return the company must pay to its long-term creditors and shareholders for the use of their funds.
What is the internal rate of return method? (IRR)
- The internal rate of return is the interest yield promised by an investment project over its useful life.
- The max rate of interest yield that can be paid on the finance for a project without making a loss
How is the IRR computed?
By finding the discount rate that will cause the net present value of a project to be zero.
What is the calculation of the IRR for an annuity?
PV factor for the internal rate of return
=Investment required/ Net annual cash flows
• This value is then found on the discount table to find the discount rate
What are the permutations of the IRR?
- If the IRR> cost of capital it is accepted
- If the IRR- cost of capital it is accepted
- If the IRR< cost of capital it is rejected
When there is not an annuity what is the calculation of the IRR?
𝐼𝑅𝑅=𝑎%+(𝐴/(𝐴−𝐵))× (𝑏−𝑎)%
a = the lowest discount factor you used b = the highest discount factor you used A = the NPV of a B = the NPV of b
Why is the NPV superior to the IRR?
- Easier and quicker
- Assumes cash inflows are reinvested at the discount rate which is realistic
- NPV should be calculated ahead of the IRR when they give different outputs for different projects
Why is the IRR inferior?
- Longer process
- Assumes cash inflows are reinvested based on the IRR which could be unrealistic if it’s very high
- Alternating cash inflows to outflows can generate several IRRs
- Also possible to have no IRR where there are large outflows at the start and end of a project
To compare competing investment projects, what NPV approaches can be used?
• Total-cost
• Incremental cost
note=both methods generate the same figures
What is the total cost approach?
- Includes all cash inflows and outflows for each project
- Infinite number of alternatives can be compared side by side
- Which project has the higher NPV is chosen
What is the incremental approach?
- Used for only 2 alternatives
- Less calculation but more thought
- Only discount the revenues and costs that differ between the two different approaches
How does an incremental approach work?
Work out difference in a cash flow (incremetal difference) and then multiply by the DF for each difference. The total of these gives by how much one approach has a higher NPV
When revenues aren’t involved, how should managers choose between alternatives?
Managers should choose the alternative with the least total cost from a PV perspective. e.g. John lewis doesn’t charge for delivery but still occurs costs
What are the complications with using techniques to compare alternative projects?
- Simplifying assumptions not neccessarily mirrored in real life
- Sometimes difficult to convert a benefit to a financial cost as many benefits are indirect and intangible e.g. H+S may increase increase employee moral and therefore productivity
How else can investment projects be ranked?
Profitability index with the higher the index, the more desirable
What is the profitability index equation?
Profitability index= Present value of cash inflows/ Investment required
Why might the payback method and the simple rate of return method be used instead of NPV and IRR?
More straight forward to calculate
What is the payback period?
The length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates
What is the formula for the payback period when there is an annuity? and what to do if not
=Investment required/Net annual cash inflow
Note: if not an annuity then inflows need to be applied and compared to the investment required on a year by year basis
When is the payback period suitable?
Pragmatic approach for when:
- If cash inflows are desired quickly
- Economic uncertainty
What is the positive evaluation of the payback method?
- Widely used
- Pragmatic method for a company with cash restraints to evaluate projects
- ALso good with economic uncertainty
- useful as a first quick “back of the envelope” assessment but NPV should have final say
What is the negative evaluation of the payback method?
- Doesn’t include the time value of money
- Ignores the cash flow after the payback period
- lacks objectivity in terms of what the payback period should be
- note: can work out discounted payback
What does the simple rate of return focus on?
Does not focus on cash flows – rather it focuses on accounting income
What is the formula for the SRR but also info about how firms might apply formula?
=(Incremental revenues -incremental expenses )/ Initial investment
• expenses inc depreciation
• Equation can differ between firms
• The figure is compared to a benchmark figure
• initial investment should be reduced by any salvage value from old equipment
What are the benefits of the SRR?
- Links decision making to the conventional measure of success being profit
- Should only be used for quick ‘back of the envelope’ assessment
What are the drawbacks of the SRR?
- Not recommended as results are unreliable although widely used
- Doesn’t take into account the time value of money
