long-term decision making

Question 1

investment decision making process

Answer 1

• origination of a proposal
• project screening (qualitative eval)
• analysis and acceptance/ rejection
• monitoring and review

Question 2

investment appraisal

Answer 2

looking at long-term choices about specific investments in future projects (10-20 years)

Question 3

what does payback period measure?

Answer 3

time it takes cash inflows to equal initaial cash outflow

Question 4

how to turn yearly profits into cash flows?

equation

Answer 4

profit + depreciation = cash flow

Question 5

advantages of payback

Answer 5

• simplicity
• focus on early payack can enhance liquidity
• minimse risk
• suitbale when capital is rationed

Question 6

disadvantages of payback

Answer 6

• ignores benefits after the payback period
• ignored objective of wealth maximisation
• ignoreds time value of money
• cannot distinguish between projects with same payback period

Question 7

what does accounting rate of return (ARR) measure?

Answer 7

Average profit from an investment expressed as a percentage of the average investment made

Question 8

ARR

equation

Answer 8

average operating profit/ average capital emplpyed x 100

Question 9

Average operating profit

equation

Answer 9

total profit/ no.of years of project

Question 10

average capital employed

equation

Answer 10

cost + scrap/ 2

Question 11

ARR advantages

Answer 11

• comparison with companies existing or targeted return
• readily understood
• takes account of all the costs/ benefits over project life

Question 12

ARR disadvantages

Answer 12

• method based on profit but cash is ultimate measure of economic wealth
• arr percentage is potentially meaningless
• doesnt consider timing of profits
• ignores time value of money

Question 13

time value of money

Answer 13

money avaible at present time worth more than same amount at a future date

Question 14

why consider time value of money?

Answer 14

• can spend or invest now
• less risky to have it now than the promise of it in the future
• payback and ARR do not consider this

Question 15

how can businesses incorporate the time value of money into investment appeal?

Answer 15

discount= future cash flows by a given amount to turn them into todays money

Question 16

discount rate process

Answer 16

start with future value and convert it to present by applying discount rate

Question 17

what does net present value (NPV) measure?

Answer 17

sum of all years discounted cash flows less inital cash outflow

Question 18

NPV Evaluation

Answer 18

• takes time vlaue of money into account
• linked to objective of maximisng shareholder wealth as it measured the effect of taking on the project
• based on chas flows not profits
• can incorporate risk into decision
• provides clear decisions

Question 19

NPV disadvantages

Answer 19

• managers find it easier to interpret the meaning of a % return from a project rather than the sum of discounted cash flows
• accuracy of results subject to correct chocie of dicosunt rates to be applied