Chapter 5 - Investment decision Flashcards
What are the features of relevant cash flows?
- Future
- Incremental
What is the ARR formula?
(Average profit / average investment) x 100
What is the formula for average investment?
(Initial investment + scrap value) / 2
What are the advantages of ARR?
PAWS
- Percentage (relative)
- Accounts figure (can be taken from FS so easily available)
- Whole life of project
- Simple to understand
What are the disadvantages of ARR?
TAM
- Time value ignored
- Accounting policies
- Manipulations
What is ARR?
The return on investment based on profit
What are the advantages of payback?
RECS
- Risk minimised through quick payback
- Easy calc
- Cashflows not profits
- Screening technique for comparing projects
What are the disadvantages of payback?
POT
- Post payback ignored
- Objectivity ignored (other factors)
- Time value ignored
What is the definition of NPV?
The present value of future cash flows discounted at the cost of capital
What are the advantages of NPV?
TALC
- Time value of money
- Absolute return
- Life of project considered
- Cashflows - relevant
What are the disadvantages of NPV?
DEC
- Difficult calculation
- Estimated figures
- Cost of capital required
If a cash flow occurs at the beginning of a period when is it assumed to have occurred?
At the end of the previous period
What is the IRR?
The rate at which NPV = 0
What are the advantages of IRR?
TLCS
- Time value of money
- Life of project considered
- Cashflows - relevant
- Simple
What are the disadvantages of IRR?
- Doesn’t deal with non-conventional cash flows
- Assumes funds reinvested at IRR i.e. realistically cannot reinvest funds at 20% in bank.
