Chapter 8: Capital Investment Decisions Flashcards
Why are investment decisions profound?
- large amounts of capital
2. difficult to bail out
Issues with ARR
ignores time factor
uses average investment, daft results possible
uses profit - cash is most important for long term
Positives about payback period
quick to calculate
emphasises importance of liquidity
Problems with payback period
doesnt use all relevant info
doesnt look at wealth creation
requires subjective target
Cost of capital incorporates
risk
lost interest
inflation
Why NPV is best technique
takes into account time value of money
considers all relevant cash flows
in line with objectives of business - wealth enhancement
What does IRR calculate?
point at which cost of capital is too high for a project to be accepted. if worried interest rates would rise etc, it would be what you were happy with them rising to.
what should the hurdle rate be logically?
the opportunity cost of capital
Problems with IRR
does not directly address wealth generation
ignores scale of investment
difficult to use on project with unconventional cash flows
what to do with interest payments when financing?
ignore - taken into account in NPV
Appraisal in real life
business use more than one method
larger businesses rely on discounting techniques - UK the most, japan the least
many small businesses do not use, perhaps due to ack of understanding
Rolls Royce use NPV to reassess old projects as well
Investments should be looked at in broader context of strategy
Drawbacks of Sensitivity Analysis
no clear rules to accept or not
no indication of likelihood of scenario
static analysis (scenario building when use more than one)
Problems with ENPV
underlying risk can be obscureed
can produce figure that may not be possible
5 stages of investment
- determine funds available
- identify oppurtunites
- evaluate projects
- approve the project
- monitor and control the project
