Chapter 2 - Basic Investment appraisal techniques Flashcards
What is one stage in the capital budgeting process?
investment appraisal
What are the features of investment appraisal?
- assessment of the level of expected returns earned for the level of expenditure made
- estimates of future costs and benefits over the projects life
What are the 2 calculations that can be used to find the ROCE (accounting rate of return)?
(Average annual profits before interest and tax / initial capital costs) x 100%
(Average annual profits before interest and tax / Average capital investment) x 100%
How would a business decide whether to take on the project?
if the expected ROCE for the investment is greater than the target or hurdle rate (as decided by the manager) then project will be accepted
How do you calculate average capital investment?
Initial investment + scrap value / 2
What are some advantages of ROCE?
Simple
Widely used and accepted
It considers the whole life of the project
What are some disadvantages of ROCE?
Does not consider cash flows
Ignore the time value of money
Is not a measure of absolute profitability
Uses subjective accounting profits, which include depreciation
In capital investment appraisal, why is it more appropriate to evaluate future cash flows rather than accounting profits?
- profits cannot be spent
- profits are subjective
- cash is required to pay dividends
Major differences between profit and cash flows will relate to what?
- asset purchase and depreciation
- changes in working capital
- deferred tax
- capitalisation of research and development expenditure
What are cash flows and relevant costs?
- future
- incremental (number changes because of a decision)
- cash flows (accounting estimate not included)
What are costs that are ignored?
- sunk
- committed
- allocated (accounting estimates)
- apportioned (accounting estimates)
- non-cash items e.g., depreciation
What is payback technique based on?
expected cash flows
What is the payback technique?
considers the time a project will take to pay back the money invested in it.
To use the payback technique a company must do what?
set a target payback period
What is the decision criteria for a payback period?
compare payback period to the company’s target return time and if the payback for the project is quicker, the project should be accepted
