Investment Dicision Making

Question 1

What is the nature of investment decisions?

Answer 1

Large amount of resource’s are involved

It’s often difficult and or expensive to bail out a investment decision

Question 2

What are the methods of evaluation?

Answer 2

Accounting rate of return

Payback period

Average return

Net present value

Internal rate of return

Question 3

How do you calculate average rate of return?

Answer 3

Average annual operating profit/Average investment to earn that profit x100

Question 4

What is the average rate of return decision rule?

Answer 4

For a project to be selected it must meet the minimum target rate of return

When completing projects that exceed the average rate of return, the one with the highest average should be selected

Question 5

What are the disadvantage of average rate of return?

Answer 5

Ignores cash flow timing

Uses average investment

Uses accounting profit

Question 6

What is payback period?

Answer 6

Is the time it takes to pay the initial investment out of the net cash inflow of the project

Question 7

How do you calculate payback period?

Answer 7

1: Consider previous year’s income
2: on final year amount remaining/amount earned x 365

Question 8

What are advantages of payback?

Answer 8

Simple

Earliest cash flow easy to predict

Very extensive usage

Emphasizes liquidity

Question 9

What are the disadvantages of payback?

Answer 9

Doesn’t take cash flow timing into consideration

Ignores cash flow after repayment

Doesn’t take risk into account

ignores profit

Question 10

What is the payback decision rule?

Answer 10

Payback must be shorter than the maximum payback period

When completing projects with multiple payback periods the one with the shortest payback period should be selected

Question 11

What are the advantages of average return?

Answer 11

Considers different levels of profit

Offers easy comparisons

If project exceed average return then project can go ahead

Question 12

What are the disadvantages of average return?

Answer 12

ignores timing of receipts

Question 13

What is residual value?

Answer 13

This value is added to the net cash flow after the required period

Question 14

What is net present value?

Answer 14

It brings future cash flow to be compared to present cash flow.

It Considers income and expenses and the discount factor

It considers the timing of cash flow

Question 15

What is discount factor?

Answer 15

It reflects inflation, it takes risk into account and shows cost of borrowing to the firm

Question 16

How do calculate discount factor?

Answer 16

1/(1+r)n power

r = discount rate

n = number of years

Question 17

How do you calculate net present value?

Answer 17

Multiply the net cash flow by the appropriate discount rate and then add up the cash flows minus the initial investment. If they come to more than the initial investment then it merits consideration.