Investment Decision Making

Question 1

What is the nature of investment decisions?

Answer 1

Large amounts of resources are often involved

Often difficult/expensive to bail out of an investment once undertaken

Question 2

What is involved in the investment appraisal methods?

Answer 2

Accounting Rate of Return (ARR)
Payback Period (PP)
Average Return (AR)
Net Present Value (NPV)
Internal Rate of Return (IRR)

Question 3

What is the formula for accounting rate of return (ARR)?

Answer 3

100 x Avg. annual operating profit/ Avg. investm to earn that profit

Question 4

What is the ARR decision rule?

Answer 4

For a project to be acceptable, must achieve at least a min target ARR

Competing other projects exceed min rate, select the one with highest ARR

Question 5

What are the problems with ARR?

Answer 5

Ignores the timing of cash flows
Use of avg investment
Use of accounting profit

Question 6

Define payback period

Answer 6

The amount of time it takes to recover the cost of an investment.

Question 7

What are the advantages of payback?

Answer 7

Simple
Most common
Earliest cash flows are easier to predict
Emphasises liquidity

Question 8

What are the key issues with payback period?

Answer 8

Ignores cash flows after PP
Does not take risk fully into account
Does not take timing of cash flows fully into account

Question 9

What is the PP decision rule?

Answer 9

Projects with a shorter payback period are the most attractive

Competing projects, select the one that pays back earlier

Question 10

What are the equations for average return?

Answer 10

Income from investment - Cost of investment = Total profit from investment

TPFI/Expected life span of asset in years = Avg. Annual Profit

100 x AAP/Cost of investment = Avg. return

Question 11

What is the average return decision rule?

Answer 11

Project to be acceptable - achieve min AR

Competing projects - select one with higher AR

Question 12

What are the advantages of AR?

Answer 12

Considers levels of profit
Offers easy comparison
Project exceeds the firms required AR - project gets green light

Question 13

What are the disadvantages of AR?

Answer 13

Doesn’t look at the timing of receipts

Question 14

Define Net Present Value (NPV)

Answer 14

The difference between the present value of cash inflows and cash outflows over a period of time.

Question 15

About NPV

Takes discounts of future money

Answer 15

Considers opportunity cost of the capital

Compares cash outflows today with future cash inflows

Discount at a rate to the company’s opportunity cost

Question 16

What are the advantages of NPV?

Answer 16

Prioritises profit
Takes account of time value of money

Whole life of the investment is considered
Timing of cash flows considered
Terminal value of the project included
Can use that to compare mutually exclusive projects

Question 17

What are the disadvantages of NPV?

Answer 17

Establishing what the discount rate should be

Question 18

What the discount rate/factor should be (for NPV)?

Answer 18

Cost of capital (borrowing)/what it cost the firm to borrow money
Reflects inflation (low at the moment)
Reflects risk

Firm’s investment criteria: maybe 15% profit

Question 19

What is the required return to cover finance cost?

Answer 19

Interest foregone (interest rate low - discount less but still a risky environ)
Inflation (i.e. 1 or 1%)
Risk premium

Question 20

What is the formula for discount factor?

Answer 20

1/(1+r)^n

Where r = discount rate, n = no. of years

Question 21

What are the basic NPV decision rules?

Answer 21

Accept all +ve NPV projects
Reject all -ve NPV projects
Choose highest +ve NPV project

NOTE: Must consider sensitivity and scenario (i.e. the worth of the pound)

Question 22

Why is NPV better than Payback and ARR? What does NPV address?

Answer 22

The timing of the cash flows
The whole of the relevant cash flows
The objectives of the business (which is to make money)

Question 23

Why you can’t fully use NPV when making the final decision?

Answer 23

Basic quantitative stuff is not sufficient
Must look at the background to the no.s
Further analysis:
Checking and validating assumptions (i.e. where info was taken from)
Bare in mind of - Sensitivities on key variables
Scenarios - base case, best case & worst case

Question 24

Define internal rate of return (IRR)

Answer 24

Is a metric used in financial analysis to estimate the profitability of potential investments.

Question 25

What are the advantages of IRR?

Answer 25

Express as a %
Compare with target IRR
Takes into account time value of money
Popular method

Question 26

For investment appraisal in practice, what do many surveys have tended to show?

Answer 26

Businesses uses more than one method when assessing each investment decision
Increased use of discounting methods (NPV & IRR) over time
Still use ARR and payback period
Larger businesses - use discounting methods & more than one method