Chapter 10 Flashcards
Capital Investments
Capital Investment decisions, when implemented, involve business actions that are usually long term, high risk and require the spending of large amounts of money in relation to the size of the business.
The funds required for a capital investment project may be supplied by the business owner or owners or from borrowed money.
Examples of Capital Investments
Capital investment decisions involve actions, such as:
- the starting up of a new business
- the replacement of old plant and equipment
- the construction or opening of a new shop
- the manufacture of a new product
- the purchase of an existing business
Factors Affecting Capital Investment Decisions
Three factors the affect capital investment decisions are:
- Customer Preferences
- Competitors
- Government Regulation
Customer Preferences
The reason for making a capital investment is usually to generate large cash inflows from customers, for years into the future. In order to maximise the probability of achieving these cash inflows, a business, when it is evaluating a capital investment proposal, should understand the needs of its customers and know the size and expected growth rate of its market,
Competitors
A business should consider how its competitors are likely to react to a major capital investment. Competitor counter measures may reduce the benefits gained from a capital investment. A business should, therefore, understand the strengths and weaknesses of its competitors.
Government Regulation
A business must operate within the law and is influenced by government policies. The need to operate within the law and the policies of governments can add to or reduce the size of a capital investment.
Methods of Evaluating Capital Investment Decisions
- the payback period
- the net present value method
Payback Period
The payback period is the length of time a proposal is expected to take to repay its initial investment.
When two proposals are being considered and a business can only go ahead with one of these proposals, the proposal with the shorter payback period will be chosen, as long as the other characteristics of the two proposals are the same.
A business may set a payback time limit on a proposal. Any proposal that takes longer than the maximum time allowed to repay the initial investment will not be accepted.
The Time Value of Money
The expression “the time value of money” refers to the fact that a sum of money can be invested, and, over time, will grow into a larger sum of money as interest is added to the amount originally invested. Therefore, one dollar owned by a business today is worth more than one dollar that will be received in two years.
Net Present Value Method
When the net present value method is used a business can be determined if the expected rate of return on an investment is higher than, equal to or lower than the minimum rate of return that the business will accept. The rate of interest that is used in present value calculations is known as the discount rate.
The present value today of an amount invested for a fixed number of future periods for a given rate of interest per period.
Income Tax and the Net Present Value Method
A company pays income tax on the profit that it makes. The income tax must be considered when using the Net Present Value(NPV) method.
Expense Savings
The NPV method can also be used to calculate the return on an investment that results in expense savings.
