Long Term Decision Making Flashcards
What are Investment Appraisals? What do they do?
- Looks at long-term choices about specific projects and future investments (normally 10-20 years into the future)
- Capital is normally scarce, so this is the biggest and riskiest decisions
Explain the process of an Investment Appraisal
- Origination of proposal: This involves Cost/return projections; the reasons for the project; Strategic fit and assessment of alternatives
- Project screening: Qualitative evaluation
- Analysis: Accept/Reject
- Monitor and Review
What are the 4 methods for assessing the successes of investment appraisals?
- Payback Period
- Accounting Rate of Return
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Which one of the 4 methods is Profit instead of cash? What should you do if profit/cash is given (wrong one)?
- Accounting Rate of Return is the only profit calculation
- Use formula: Profit + Depreciation = Cash Flow (Assume SL Depreciation)
What is the Payback Period? How is it calculated and how can a decision be reached?
- It is the time taken for cash inflows to equal initial cash outflows
- If payback period > max permitted; REJECT
- If payback period < max permitted; ACCEPT
- Most preferable is the shortest possible period
- To Calculate: Add up cash flows until you make back the outflows (use interpolation for Months)
What are some Advantages of the Payback Period?
- Quick and Easy
- Minimises risk
- Liquidity focused
- Short-term forecasts are reliable
- Suitable when capital is rationed
What are some Disadvantages of the Payback Period?
- Ignores the Benefits generated after the period
- Long-term investment is required simultaneously
- Ignores the time value of money
- No ranking between similarly performing projects
What is the Accounting Rate of Return? How is it calculated and how can a decision be reached?
- It is the average profit from an investment as a % of average investment
- If ARR < required rate of return; REJECT
- If ARR > required rate of return; ACCEPT
- Most preferable is the highest ARR
- To Calculate: Average operating profit / Average capital employed X 100
What are some Advantages of the Accounting Rate of Return?
- Good comparison with other projects
- Readily understood
- Takes into account all benefits
What are some Disadvantages of the Accounting Rate of Return?
- Can be pointless; other information is required as well
- Ignores time value of money
- You need cash
- Timings of profit is ignored
What is NPV? How is it calculated and how can a decision be reached?
- It is the sum of all year’s discounted cash flows minus inital cash flow
- If NPV < 0: REJECT
- If NPV > 0; ACCEPT
- Most preferable is the highest NPV
- To Calculate: Cashflow X Discounting Value = Current Cash Flows (Then sum)
What are some Advantages of NPV?
- Accounts for the time value of money
- Linked to maximising shareholder value
- Based on cash
- Incorporates Risk
- Binary (Accept/Reject)
What are some Disadvantages of NPV?
- Often harder to understand, compared to a %
- Accuracy of result changes with discounting rates
What is IRR? How is it calculated and how can a decision be reached?
- It is the exact yield of projects (gives a 0 NPV)
- To Calculate: Obtain a +ve NPV (low discount rate) and a -ve NPV (high discount rate)
- Then the equation;
A + C / (C-D) x (B-A) - A=Discount of Low trial
- B=Discount of High trial
- C=NPV of Low trial
- D=NPV of High trial
What are some Advantages of IRR?
- Reasonably understood (%)
- Takes time value into account
