Ch21: information for capital expenditure decisions

Question 1

What are the four elements to be considered for Capital expenditure decisions

Answer 1

• 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

Question 2

What are the techniques to analyse cash flows?

Answer 2

• payback method
• accounting rate of return
• discounted cash flows - NPV and IRR

Question 3

What are the six steps of CAPEX approval process?

Answer 3

• 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

Question 4

What is NPV and decision rule?

Answer 4

calculates cash flows in terms of present value

project acceptable if NPV is positive.

Question 5

What is the formula for discounting cash flows?

Answer 5

1/((1+r)^n)

Question 6

What is IRR?

Answer 6

• 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.

Question 7

What is the IRR decision rule?

Answer 7

• if IRR is greater than required rate of return the project is acceptable.

Question 8

What is the required rate of return?

Answer 8

Ror - based on organisations weighted average cost of capital. Minimum return needed to compensate suppliers of capital for committing resources.

Question 9

How does depreciation impact capex analysis?

Answer 9

These expenses are not cash flows so not included in capex analysis

Question 10

What are the key points comparing NPV and IRR methods?

Answer 10

• npv easier to calculate
• adjustments for risk possible
• only one answer
• overcomes unrealistic reinvestment assumption of IRR

Question 11

What are the two assumptions of discounted cash flows?

Answer 11

• year end timing of cash flows

- certainty of cash flows

Question 12

What are least cost decisions?

Answer 12

Capex may be approved even with negative NPV or less than acceptable IRR - strategic concerns.
- Minimising costs incurred rather than maximise cash flows.

Question 13

How can you compare alternative investments?

Answer 13

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.

Question 14

What is the payback method?

Answer 14

Amount of time taken for cash flows to offset original investment - does not consider time value of money.

Question 15

How is the payback method calculated with even cash flows?

Answer 15

payback period = initial investment / annual cash flow

Question 16

What is ARR?

Answer 16

Focuses on incremental accounting profit that results from a project.
= average annual profit from project / initial investment

Question 17

How do you calculate the Tax effect of an increase in sales

Answer 17

= incremental sales revenue less COGS * (1 - tax rate)

Question 18

How do you calculate the Tax effect of additional expenses

Answer 18

= incremental expenses * (1 - tax rate)

Question 19

How does depreciation impact on cash flows?

Answer 19

Non cash expenses e.g. depreciation, causes reduced cash outflow by reducing taxable income.

Question 20

What is the carrying amount of an asset?

Answer 20

Carrying amount = assets acquisition cost - accum. depreciation

Question 21

How can you calculate cash flows and tax effects on asset disposal?

Answer 21

sale price +
net loss or gain on sale * tax rate
= net cash flow

Question 22

What are the important factors of Post-completion audits of capex decisions

Answer 22

• 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

Question 23

How can capex decisions be made for advanced technologies?

Answer 23

May have negative NPV but still attractive for competitive purposes. Intangible benefits/long term benefits.

Question 24

What are six limitations of CAPEX analysis?

Answer 24

• 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

Question 25

What is IRR formula?

Answer 25

Solve for r
P is investment
N is life of project

P = net cash flows / (1 + r)^n

Question 26

For Arr how is average net profit calculates?

Answer 26

Avg cash flow - depreciation expense