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