Investment Appraisal Flashcards
Capital Budgeting
The process a business undertakes to evaluate
potential major projects or investment.
3 Decisions a Manager can make
- Is Project A better than doing nothing?
- Is A better than B?
- Although A is better than B, should we still go ahead with B?
What are independent projects?
Undertaking one doesn’t necessarily exclude the others (if there is enough capital sufficient)
What are mutally exclusive projects?
Only one potential candidate can be undertaking (eg planning to buy a new machine and there are 2 which meet the requirements)
What is the Payback Period
“How long does it take before the original investment is recovered”; number of years required for future cumulative cash flows to match initial outlay
Ranking Criterion for Payback Period:
Independent Projects: accept if payback period is less than benchmark
Mutually exclusive projects: Select one with the lowest payback period
Pro’s of Payback Method
Quick and undeerstandable
Takes risk into account as it assumes shorter payback period is better than a longer one)
Cons for Payback Method
Ignores cashflows after the payback period
Ignores time value of money
Discounted payback period:
The discounted payback period is the length of time required for an
investment’s discounted cash flows to equal its initial cost
Discounted Payback Pros
Time value of money
Understandable
Cons of Discounted payback
Ignores cashflows after cut off date
Rate of Return, (ROCE), Return on Investment
Some measure of average accounting profit / Some measure of average accounting value
What are the choices of Return
Gross Profit
Profit Before Interest and Taxation
Profit Before Taxation
Profit After Taxation
What are the Choices of Investment?
Shareholder funds
All Long Term Funding Including Loans
All funding including short term debt
Decision rule for Accounting Rate of Return
Accept if AAR is greater than target return (for
independent projects) and highest AAR is preferable (for mutually
exclusive projects)
