investment decision rules

Question 1

Five methods of evaluating projects

Answer 1

• Accounting rates of return
• -> not finance, no time value of money
• payback period
• -> how long will it take in years to get back to initial investment
• > no time value of money, only a relative comparison, no income amounts after payback period
• > quick and easy
• NPV
• > discounted cash flow analysis
• > time value of money, maximise shareholder wealth, absolute decision
• > bad = npv does not say capital needed
• profitability index
• > PI = PV/Initial outlay
• > PI = 1+ NPV/Initial outlay
• Helps rank projects

Question 2

accounting rates of return

Answer 2

-> Return on capital
=> expected annual profit after tax / average investment on capital

• > return on equity
• -> expected profit after tax/ book equity

-> expected annual profit after tax / assets

Question 3

NPV

Answer 3

• work out expected after tax cash flows, e.g. CF1, CF2, CF3 ..
• Discount them back to today if you have required rate of return or cost of capital,
• > work out NPV
• > NPV= PV+CFo (normally negative CFo)
• Accept reject
• > Independent = accept if NPV is >0
• > mutually exclusive = accept one with highest positive NPV