Ch21: information for capital expenditure decisions Flashcards
What are the four elements to be considered for Capital expenditure decisions
- long term decision to determine acceptability of project
- long term benefits considered
- cash outflow - initial cost of project and increases in costs incurred
- cash inflow - cost savings and additional revenues
What are the techniques to analyse cash flows?
- payback method
- accounting rate of return
- discounted cash flows - NPV and IRR
What are the six steps of CAPEX approval process?
- project generation
- evaluation and analysis of projected cash flows
- progress to approval
- analysis and selection of projects
- implementation of projects
- post completion audit of projects
What is NPV and decision rule?
calculates cash flows in terms of present value
project acceptable if NPV is positive.
What is the formula for discounting cash flows?
1/((1+r)^n)
What is IRR?
- actual economic return earned by the project over its life
- the IRR is the discount rate at which the NPV of cash flows is equal to zero.
What is the IRR decision rule?
- if IRR is greater than required rate of return the project is acceptable.
What is the required rate of return?
Ror - based on organisations weighted average cost of capital. Minimum return needed to compensate suppliers of capital for committing resources.
How does depreciation impact capex analysis?
These expenses are not cash flows so not included in capex analysis
What are the key points comparing NPV and IRR methods?
- npv easier to calculate
- adjustments for risk possible
- only one answer
- overcomes unrealistic reinvestment assumption of IRR
What are the two assumptions of discounted cash flows?
- year end timing of cash flows
- certainty of cash flows
What are least cost decisions?
Capex may be approved even with negative NPV or less than acceptable IRR - strategic concerns.
- Minimising costs incurred rather than maximise cash flows.
How can you compare alternative investments?
NPV - highest value is most favourable
IRR - can rank incorrectly due to reinvestment assumption.
- Cannot always compare NPVs from difference projects as projects may not have same life.
- Strategic and competition factors should always be considered.
What is the payback method?
Amount of time taken for cash flows to offset original investment - does not consider time value of money.
How is the payback method calculated with even cash flows?
payback period = initial investment / annual cash flow
What is ARR?
Focuses on incremental accounting profit that results from a project.
= average annual profit from project / initial investment
How do you calculate the Tax effect of an increase in sales
= incremental sales revenue less COGS * (1 - tax rate)
How do you calculate the Tax effect of additional expenses
= incremental expenses * (1 - tax rate)
How does depreciation impact on cash flows?
Non cash expenses e.g. depreciation, causes reduced cash outflow by reducing taxable income.
What is the carrying amount of an asset?
Carrying amount = assets acquisition cost - accum. depreciation
How can you calculate cash flows and tax effects on asset disposal?
sale price +
net loss or gain on sale * tax rate
= net cash flow
What are the important factors of Post-completion audits of capex decisions
- comparing actual cash flows with projected cash flows
- provides feedback to accuracy of estimates
- control cash flow fluctuations
- assess outcome
- rewards for those involved
- identify under performing projects
How can capex decisions be made for advanced technologies?
May have negative NPV but still attractive for competitive purposes. Intangible benefits/long term benefits.
What are six limitations of CAPEX analysis?
- use of unrealistic status quo: maintain current cash flows, compare reduction in cash flows if project doesn’t go ahead
- hurdle rates may be too high
- time horizons may be too short
- difficulty in gaining approval for large projects leads managers to take on small projects with only incremental improvements
- advanced technology holds great uncertainty
- hard to quantify benefits are excluded from analysis
What is IRR formula?
Solve for r
P is investment
N is life of project
P = net cash flows / (1 + r)^n
For Arr how is average net profit calculates?
Avg cash flow - depreciation expense
