lecture 18 and 19 Flashcards
what are some concerns for decisions regarding capital investment
they are projects involving large sums of money and a long time frame
- cuz of this, the time value of money is considered
long decisions are difficult to reverse if a wrong decision is made
what are techniques of appraisal
- non discounted cash flow techniques
- accounting rate of return
- payback method - discounted cash flow techniques
- net present value
- internal rate of return
what is the formula for ARR
ARR = average annual profit/ average investment
average net profit = total profit/ years
average investment = (initial investment + salvage value)/2
what are the disadvantages of ARR
- the measure is not a ‘true’ reflection of return
- time value of money is ignored
- ad hoc determination of target average return
- uses profit and book value instead of cash flow and market value
what are the advantages of ArR
- it is easy to calculate and understand
- it considers all profits of the project
what is the decision rule when using payback method
payback period is the number of years it takes to recover the initial investment
the decision rule is to accept the project with the shortest payback
what are the advantages of payback method
- it is simple to use
- objective= use cash flows instead of accounting profits
- favours projects with quick return = produce faster growth for firms and ensures more liquidity esp for smaller companies
- choosing projects with the fastest return will tend to minimise time related risk
disadvantages of cash flow
- it ignores cash flows after the payback period - not useful for long term projects
- ignores time value of money
what is the aim of introducing discounted cash flow methods
it is to take into consideration the time value of money (the principle that a dollar received today is worth more than a dollar received in the future - cuz it can be invested to earn interest)
what are the 2 important techniques regarding time value of money
- compounding
- discounting
what is net present value and its decision criteria
discounts all cash inflows and outflows to the present day and compares to the initial investment
- if NPV +ve, = accept project
- if NPV -ve = reject project
- if selecting between 2 projects, select the one with the highest NPV
what are annuities
an annuity is where the same sum is received every year for a number of years or for every period for a given number of period
what is cost of capital/ required rate of return
- used as a discount rate for NPV
- reflects the returns expected by investors in shares and debt
- it is the weighted average of all sources of capital
what are the advantages of the NPV method
- it accounts for the time value of money
- it takes into account all expected CF from the project
- its an absolute measure - shows the increase in the wealth of the shareholder
- its consistent with the objective of shareholder wealth maximization
what are the disadvantages of the NPV method
- need to estimate cost of capital
- not an easily understood concept and difficult to communicate to decision makers
what are some relevant costing principles
capital budgeting involves long term decisions - all relevant costing principles applies to capital budgeting
- relevant costs are future incremental cash flows
- other relevant costs: avoidable costs, opportunity cost
- irrelevant costs: sunk cost, fixed costs allocated, depreciation expense, interest expense
what is the internal rate of return method how do we calculate it
calculates the exact discounted cash flow rate of return which the project is expected to achieve
- calculate 2 NPV - one positive and one negative (both close to zero)
- apply formulae to derive IRR
decision criteria
- if IRR > cost of capital = accept project
- if IRR < cost of capital = reject
what are the advantages of IRR
- usually results in the same decision as the NPV - NPV/IRR criteria give the same accept/reject decision whenever the NPV of the project is a smoothly declining function of the discount rate
what are the disadvantages of the IRR
- it can be confused with ARR
- it ignores the relative size of the investment
- its a relative measure - doesn’t give the real impact on wealth - can cause problems if used to choose between problems = tells us the rate of return but not how much actual profit/ value a project creates
- its mathematically possible for a project to have more than one IRR = confusing
