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AC1025 Principles of Accounting > Investment Appraisal > Flashcards

Investment Appraisal Flashcards

Long-term planning

1
Q

What are the accounting methods of investment appraisal?

A
  1. Payback period
  2. Accounting Rate of Return (ARR)
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2
Q

What’s a capital investment?

A

Investment that typically requires a substantial sum of money and is expected to generate economic returns over a long period of time

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3
Q

Investment appraisal limitations

A
  1. Depends on accruacy of future expectations
  2. Decision can only be as good as the available information shows
  3. Payback period and ARR may have conflicting suggestions on action
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4
Q

What is payback period?

A

Calculates length of time expected to recover investment cost (similar to break-even concept)
Based on cash flows

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5
Q

Assumptions of payback period

A
  1. Projects are indivisible (firm must invest full amount required for each project, or none at all)
  2. Projects can’t be delayed (opportunity can’t appear again later once we choose not to invest)
  3. Projects can’t be abandoned (can’t stop a project once it has started)
  4. Profits, losses and cash flows arise evenly throughout time (annual basis)
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6
Q

Payback period formula

A
  1. Convert income statement info to cash flow by adjusting for depreciation and add back to P/L figures
  2. Cumulative cash flows
  3. Payback period in years and months
    = Year before Breakeven + (Unrecovered/Cash Flow in Recovery Year)
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7
Q

What are the advantages of payback period?

A
  1. Useful when business has cash constraints to invest and need immediate recover from investment to invest in other projects
  2. Cash flow basis, doesn’t include irrelevant cost like depreciation
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8
Q

What are the disadvantages of payback period?

A
  1. Need to compare one payback period to another to make a decision (can’t tell if 3.5 years is good/bad)
  2. Ignores absolute size of investment outlay and cash flows after
  3. Ignores size and direction of cash flows after payback period
  4. Doesn’t take into account the time value of money
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9
Q

What is the Accounting Rate of Return (ARR)?

A

AKA Return on Investment (ROI)
Ratio of average annual profit of project to investment in the project
No need to adjust for depreciation and non-cash flows

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10
Q

ARR Formula

A

Average Annual Profit/(Initial investment + resale/2) x 100%

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11
Q

What are the advantages of ARR?

A
  1. Fairly simple to calculate like payback period
  2. Familiar to manager (paying bonuses, set performance targets)
  3. Related to invetors’ required rate of return and based on profit figures which are widely used and understood
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12
Q

What are the disadvantages of ARR?

A
  1. Need to compare one ARR to another to make decision (can’t tell if 20% ARR is good/bad)
  2. Ignores absolute size of investment outlay and profit & cash flows after
  3. Uses profit so includes irrelevant costs like depreciation
  4. Subjective and depends on choice of investment calculation alongside accounting policies)
  5. Doesn’t take into account the time value of money
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13
Q

What are discounted cash flows?

A

Technique that only uses relevant costs & revenues and considers time value of money

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14
Q

Net Present Value (NPV) compared to Payback Period and ARR

A

Superior technique to make capital investment decisions bc considers magnitude of projects (projects w/ greater positive NPVs increase even more wealth compared to smaller NPVs)

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15
Q

Internal Rate of Return (IRR) purpose1

A

Assesses risk of investment decision related to discount rate used to reflect time value of money in NPV calculation

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16
Q

What is the time value of money?

A

The same amount of money paid/received in different points of time are worth different because (1) opportunity to spend or invest now (2) inflation reduces the real value of money in a year’s time (3) you may not be around to collect the money in the future

17
Q

What does discounted cash flow adjust?

A

Future cash receipts and payments amount to reflect that they are less valuable than same cash amount in the present

18
Q

What does the discount rate represent?

A

Change in money’s value as time goes by
aka opportunity cost of money (bank account interest rate)

19
Q

How does discounting work?

A

Take future cash flow
Work backwards to find cash needed in bank TODAY for investment to grow = future amount

20
Q

What is the Net Present Value (NPV)

A

Sum of all cash flows associated with given project
If (+): cash inflows > cash outflows = investment is worthwhile, vice versa

21
Q

What is Internal Rate of Return (IRR)

A

Discount rate for given project that results in NPV of project = ZERO

22
Q

NPV Assumptions

A

(1) all cash flows arise at ends of years where they relate (cash flow that happens today happen at year 0 and future cash flows happen at year 1, 2, etc.)
(2) Discount rate expressed in annual terms
(3) cash flow at year 0 always have discount factor = 1 (bc alr expressed in present terms)

23
Q

Future cash flow: single sum at single future point

A

Pv = Expect Receive x 1/(1+i^n)
the 1/1+i^n is Vn (discount factor)

e.g. expect $133 in 3 years time and discount rate 10%
Pv = $133 x (1-0.1)^-3 = $99.925 (3 decimals)

24
Q

Discount rate if same sum of money for every year (annuity)

A

i = 1-Vn / i
where n is last year and Vn is another formula

25
Q

Discount rate if same sum of money for every year for eternity (perpetuity)

A

1/i

26
Q

How to estimate IRR?

A

Linear interpolation (by making 2 discount rate guesses)
Higher discount rate (HDR) and Lower discount rate (LDR)
IRR = LDR + [Lower Rate NPV/(Lower Rate NPV - Higher Rate NPV) x (HDR-LDR)]

27
Q

What are the advantages of NPV and IRR?

A
  1. recognises time value of money
  2. Uses relevant costs and revenues
28
Q

What are the disadvantages of IRR?

A
  1. Can’t differentiate btwn projects involving initial cash outlay and projects involving borrowing (initial cash inflow)
  2. Doesn’t provide absolute value (can’t tell if IRR makes project worthwhile without comparing with discount rate)
  3. Can’t differentiate btwn mutually exclusive projects (can’t assume project with highest IRR also has highest NPV at particular discount rate)
  4. Certain projects may have more than one IRR (not unique)
29
Q

What are the disadvantages of NPV?

A
  1. Relies of forecasts and estimates future, which is uncertain
  2. Hard to determine appropriate discount rate in real life
  3. Appropriate discount rate may change in future
  4. Unrealistic cash flow timing assumption
30
Q

How to do senstivity analysis?

A

Looking at one estimate/forecast in project and see how much change needed to revert decision
e.g. If $100 investment not worthwhile at discount rate of 20%, how much annual cash inflow needed to change decision?
Set NPV = 0
$100 = x.discount factor aka 2.991
x = 100/2.991 = $33.43 (investment is worthwhile if cash inflow annually was higher than $33.43)

AC1025 Principles of Accounting (7 decks)

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