Ch 12 - Strategic Investment Decisions

Question 1

Six Stages of Investment Decision Making

Answer 1

Managers must consider six stages in making investment decisions:

Stage 1: Determine Investment Funds Available

Stage 2: Identify Profitable Project Opportunities

Stage 3: Define and Classify Proposed Projects

Stage 4: Evaluate the Proposed Project(s)

Stage 5: Approve the Project(s)

Stage 6: Monitor and Control the Project(s)

Question 2

Investments

Answer 2

An investment is typically one large amount and the benefits arrive as a series of smaller amounts over a fairly protracted period.

Investment decisions are very important because:
Large amounts of resources are often involved. It is often difficult and/or expensive to bail out of an investment once it has been undertaken.

Question 3

Four Methods of Investment Appraisal

Answer 3

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

Question 4

Accounting rate of return (ARR)

Answer 4

ARR ) method takes the average accounting profit that the investment will generate and expresses it as a percentage of the average investment made over the life of the project.

ARR = (Average annual profit / Average investment to earn that profit) * 100

Question 5

Payback period (PP)

Answer 5

The length of time it takes for an initial investment to be repaid out of the net cash inflows from a project

A manager using PP would need to have a maximum payback period in mind.

The decision rules to be used are:

1. For any project to be acceptable, it must fall within the maximum payback period.
2. Where there are competing projects that meet the maximum payback period requirement, the project with the shortest payback period should be selected.

Question 6

Net present value (NPV)

Answer 6

Considers all of the costs and benefits of each investment opportunity

Makes a logical allowance for the timing of those costs and benefits.

The decision rules are:
For any project to be acceptable, the NPV must be positive.

Where there are competing projects with positive NPVs, the one that gives the highest positive NPV should be accepted.

Question 7

Internal rate of return (IRR)

Answer 7

Closely related to the NPV method in that, like NPV, it also involves discounting future cash flows.

The internal rate of return (IRR) is the breakeven discount rate that makes NPV 0

If the discount rate is lower than the IRR, then the NPV will be positive.

IRR expressed as a percentage.

Question 8

ARR and ROCE

Answer 8

ARR and the return on capital employed (ROCE) ratio take the same approach to performance measurement: they both relate accounting profit to the cost of the assets invested to generate that profit.

ARR is an approach that assesses the potential performance of a particular investment, taking the same approach as ROCE, before the fact.

Question 9

Advantages of ARR

Answer 9

ROCE is a widely used measure of business performance.

ARR is consistent with this overall approach to measuring business performance.

Managers feel comfortable with using measures expressed in percentage terms as ARR does.

Question 10

Problems with ARR

Answer 10

ARR Ignores Time Value of Money

ARR Can Lead to an Illogical Decision
(i.e give away equipment with no disposal value increases that ARR % but is not a wise choice for the company!)

ARR Is Based on the Accounting Profit, Not the Future

ARR Measures Relative Size and Not Absolute Size of the Return

Question 11

Advantages of PP

Answer 11

Quick and easy to calculate

Can easily be understood by managers

Emphasizes liquidity

Question 12

Disadvantages of PP

Answer 12

Cash flows arising beyond the payback period are ignored.

PP only looks at the risk that the project will end earlier than expected.

PP is not linked to promoting increases in the wealth of the business

Question 13

Discount Rate

Answer 13

The appropriate discount rate to use in NPV assessments is the opportunity cost of funds.

This will normally be the cost of the mixture of funds (shareholders’ funds and debt) used by the business usually known as the cost of capital.

Question 14

The cost of capital

Answer 14

the cost of the mixture of funds (shareholders’ funds and debt) used by the business

Question 15

Which method is superior: NPV, ARR, or PP?

Answer 15

NPV is a better method of appraising investment opportunities than either ARR or PP because it fully takes account of each of the following:

1. The timing of the cash flows.
2. The whole of the relevant cash flows.
3. The objectives of the business.

Question 16

IRR Hurdle Rate

Answer 16

The minimum required IRR is often referred to as the hurdle rate.

It is usually the firm’s weighted average cost of capital (WACC).

The following decision rules should be applied:

For any project to be acceptable, it must exceed the minimum IRR requirement

Where there are competing projects, the one with the highest IRR should be selected.

Question 17

Limitations of IRR

Answer 17

It does not correctly address the question of wealth generation.

Could therefore lead to the wrong decision being made.

It has difficulty handling projects with unconventional cash flows.

Question 18

Practical Points to consider when making investments

Answer 18

Practical points to keep in mind in an investment appraisal:
Sunk costs
Common future costs
Opportunity costs
Taxes
Cash flows, not profit flows
Interest payments
Other factors

Question 19

Do businesses use more than one appraisal method?

Answer 19

All four methods identified are widely used

The discounting methods (NPV and IRR) show a steady increase in usage over time

Many businesses use more than one method

Larger businesses seem to be more sophisticated in their choice and use of appraisal methods than smaller ones.

Question 20

Triple Bottom Line

Answer 20

Triple Bottom Line Accounting: adds environmental and social responsibility performance reporting into the mix alongside traditional financial performance.

“People, Planet, and Profit.”

“People” refers to fair business practices by corporations toward labour, community, and region.

“Planet” refers to sustainable environmental practices.