L8 - Long Term Decision-Making: Capital Investment Appraisal Flashcards
What is capital budgeting?
How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and the introduction of new products
What are the two types of Capital Budgeting?
Capital budgeting tends to fall into two broad categories . . .
- Screening decisions - Does a proposed project meet some preset standard of acceptance?
- e.g. if the RoR hits a set benchmark set by the organisation
- Preference decisions- Selecting from among several competing courses of action.
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What are the three main reasons for time preference of money?
- Consumption preference
- If we had the money now or sooner we can spend it on things we want now that we want
- Inflation preference
- as time goes on inflation occurs
- lenders expect to be compensated for the loss of purchasing power
- Risk preference
- Uncertainty grows the further it is into the future
- Investment preference
- Money can be invested now either internally or externally
- Investments that promise returns earlier in time are preferable to those that promise returns later in time
Is depreciation important for NPV?
Depreciation is not deducted in computing the present value of a project because . . .
- It is not a current cash outflow.
- Discounted cash flow methods automatically provide for the return of the original investment.
- The cash that is generated is immediately invested into another project that provides a return equal to the discount rate
When do we accept an NPV appraisal?
When it’s positive or zero –> still promises a value equal or greater than the rate of return
What is the cost of capital?
- The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate.
- The cost of capital is the average rate of return the company must pay to its long-term creditors and shareholders for the use of their funds.
- If they have more shareholders –> they need a higher cost of capital as shareholders require a greater RoR
What is the Internal rate of return?
- The internal rate of return is the interest yield promised by an investment project over its useful life.
- The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.
- IIR can be thought of as the maximise rate of interest that can be pay on the financial project without making a loss
How do you calculate the PV factor for the internal rate of return?
PV factor = Investment required/Net annual cashflows/savings
Too find IRR you look at the number of period in the table and go across until you find the corresponding PV factor
(this only works for the same cashflows - annuity)
How do you calculate IRR for different cashflows?
IRR = a% + (A/A-B) x (b-a)%
- a = the lowest discount factor you used
- B = the highest discount factor you used
- A = the NPV of a
- B = the NPV of b
Net Present Value vs IRR?
- CHECK FINANCIAL ECONOMICS AND WRITTEN STUFF
- NPV is easier to calculate whereas IRR is a lot lengthier and harder to compute by hand
- If NPV and IIR define different values for mutually exclusive projects - always use NPV
- NPV assumes cash inflows will be reinvested at the discount rate. This is a realistic assumption
- However with IIR if we assume the same but if it is very high this could be unrealistic assumptions
- Possible to not get an IIR if there are significant outflows at the start and end of a project
What are the two NPV Methods?
To compare competing investment projects we can use the following net present value approaches:
- Total-cost - longer, take the higher NPV value from the lower to say what the monetary advantage of one project is
- Incremental cost - quicker when on have two options, looking at the difference in each stage in the investment
What is the Least Cost Decisions?
In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective
NPV calculation as normal but for costs, so looking at the lowest value
As before to state the investment preference to minus the larger cost from the smaller cost
What is the problem with investment appraisals?
- Investments in automated equipment tend to be very large in dollar/pounds sterling amount.
- The benefits received are often indirect and intangible - its very hard to convert this into a financial value
- Therefore we often ignore it we work out the financial value
- we then consider the non financial benefits afterwards e.g. improved health and safety etc.
How are Investment Projects ranked?
Profitability Index = PV of all cashflows /Investment required
The higher the profitability index the more desirable the project
What is the Simple Rate of return also called?
The accounting rate of return
