Capital Investment Decisions: Appraisal Methods Flashcards
Capital investment decisions:
What does it involve? (2)
What does it represent and why?
Are…?
(3)
Assumption?
- Involve current outlays in return for a stream of benefits in future years
- Involve long-term investment (i.e., a significant elapses between the outlay and recoupment of the investment) - normally longer than one-year period
- Represent the most important decisions that a corporation makes, because they commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible. Examples: the projected capital expenditure for Tesco plc for 2016 were £2.6 billion.
- Are applicable to all sectors of society.
- Corporate investment decisions: plant & machinery, research & development, advertising & warehouse facilities. - Public investment decisions new roads, school, airports. - Individuals’ investment decisions house buying, the purchase of consumer durables, education.
Initially that all cash inflows and outflows are known with certainty, and that sufficient funds are available to undertake all profitable investment. No tax, no inflation!
Time value of money: Future and Present Values
The Three Rules of Time Travel?
Rule 1: Comparing and Combining Values
- It is only possible to compare or combine values at the same point in time.
- A dollar($) today and a dollar($) in one year are not equivalent
- To compare or combine cash flows that occur at different points in time, you need to convert the cash flows into the same units or move them to the same point in time
Rule 2: To move a cash flow forward in time, you must compound it
Rule 3: To move a cash flow back in time, you must discount it
Capital Investment Appraisal techniques (4)
Techniques that take into account the time value of money:
- Net Present Value (NPV)
- Internal rate of return (IRR)
Techniques that ignore the time value of money
- Payback Period (Payback)
- Accounting rate of return (ARR)
Net Present Value (NPV)
Technique that…?
What is it for?
What is the formula for NPV?
Alternatively…?
Technique that takes into account the time value of money
Suppose you want to value a stream of cash flows extending over a number of years. For multiple period, we have the discounted cash flow (or DCF) formula:
Net Present Value (NPV) of an investment decision:
𝑵𝑷𝑽=𝑷𝑽(𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔)−𝑷𝑽(𝒄𝒐𝒔𝒕𝒔)
To find the Net present value (NPV), we minus the initial cash flow of investment
Where I0 refers to investment outlay at time t, C refers to future cash flow and r refers to Discount rate
Alternatively, the NPV can be calculated by referring to a published table of present values:
- To use the table, simply find the discount factors by referring to each year of the cash flows and the appropriate interest rate.
see miro
NPV: Advantages and Disadvantages (3,4)
NET PRESENT VALUE lets you know whether the ______ of all _____ ______ that a project generates will exceed the _____ of starting that particular project. Basically, it will tell you whether your project has a positive or a negative outlook.. That is, whether the project should be undertaken or not
Advantages:
- Assumption of reinvestment, or take into account the time value of money
- Consideration of all cash flows
- Simple to interpret. Easy to visualise by manager.
Disadvantages
- Difficulty in determining the discount rate
- Assumes investment returns are static
- Difference in size of projects
- Extent of risk unknowns
NET PRESENT VALUE lets you know whether the value of all cash flows that a project generates will exceed the cost of starting that particular project. Basically, it will tell you whether your project has a positive or a negative outlook.. That is, whether the project should be undertaken or not
Internal rate of return (IRR)
What is it for?
What is it?
What does IRR represent?
What method to use and how does it work?
Alternative technique for use in making capital investment decisions that also takes into account the time value of money
IRR is the rate of return that gives an NPV of zero
- IRR represents the true interest rate earned on an investment over the course of its economic life
Trial and error method: Use a number of discount factors until the NPV equals zero. To calculate IRR, two discount rates are used to calculate the NPV, one giving a positive result and one giving a negative result.
IRR: Advantages and Disadvantages (3,3)
Advantages
- Take into account the time value of money
- Simple to interpret. Easy to visualise by manager
- No requirement of finding hurdle rate (required rate of return or discount rate)
Disadvantages
- Express the result as a percentage rather than in monetary terms. Comparison of percentage can be misleading as the economies of scale (scale of investment) are ignored.
- Where a project has unconventional cash flows, the IRR has a technical shortcoming.
- Does not directly address wealth maximisation
Payback Period (Payback)
Technique that…?
What is it?
What does it consider?
How to calculate it?
Technique that ignore the time value of money
It is the length of time that is required for a stream of cash proceeds from an investment to recover the original cash outlay required by the investment.
In another words, it simply considers the time taken for the initial investment to be repaid in terms of net cash flows. It uses CASH rather than account profit.
A simple example: If an investment requires an initial outlay of £60,000 and is expected to produce annual cash flows of £20,000 per year for five years, the payback period will be £60,000/£20,000 = 3 years.
How to calculate it: the payback period is calculated by adding up the cash inflows expected in successive years until the total is equal to the original outlay (initial investment).
Payback Method: Advantages and Disadvantages (2,3)
Advantages
- It is widely used in practice because it is particularly useful approach for ranking projects where a firm faces liquidity constraints and requires a fast repayment of investments.
- It is appropriate in situations where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are extremely difficult to predict.
Disadvantages
- Does not take into account cash flows that are earned after the payback period
- Ignore the time value of money: fails to take into account the differences in the timing of the proceeds that are earned before payback period –> discounted payback method
- Can result in the acceptance of projects that have a negative NPV
Accounting rate of return (ARR)
Technique that…?
What is also known as? (2)
What is its formula?
Assumption made?
Technique that ignores the time value of money
- Also known as the return on investment and return on capital employed
ARR = Average annual profits / average investment
- Assumption: depreciation represents the only non-cash expense, profit is equivalent to cash flows less depreciation – If straight line depreciation is used, it is presumed that:
average investment = ½initial investment + ½Scrap value
ARR: Advantages and Disadvantages (2,1)
Advantages
- Is superior to the payback period in one respect: it allows for differences in the useful lives of the assets being compared.
- Is used in practice because it is frequently used to measure the managerial performance of different business units within a firm.
Disadvantages
- Ignore the time value of money
