Long-term decision making: Capital Investment Flashcards
Definition of Payback Period?
Measures the rate of recovery of the original investment in terms of net cash flow
What is the Payback Rule?
Specifies that a project should be accepted if its payback period is less than the specified cut-off period, specified by management
What do you do if depreciation has been taken out?
Put it back in as it is not a cash flow
How to calcuate Payback Period
1) Find out in which year the initial investment has been paid off
2) Work out how much is left to be paid off the year before
3) Divide that by the net cash flow in year it is paid off
4) Round to (usually) 2 decimals and multiply by 12 and round to 1 integer
5) = Year before paid off + (that answer) months
Advantages of using Payback method
Simple and widely used in practice, appears to be a cautious approach as it favours projects that give an early return
Disadvantages of using Payback method
Doesnt take into account time value of money, ignores net cash flows after investment has been paid off, doesnt measure profitability only net cash flow.
What is Accounting Rate of Return (ARR)
Method of deciding if a project should be accepted, by if it acheives a target ARR as a minimum. The highest ARR project should be selected if both achieve the minimum
How to calculate Accounting Rate of Return
Average annual operating profit / average investment x 100 (%)
average profit = total profit/years project runs for
average investment = (inital investment + final value) / 2
Advantages of using ARR
Takes into account all the profits expected during the projects life, familiar accounting measures
Disadvantages of using ARR
Doesnt take into account time value of money, ignores timing of profits, no insight of size of returns or investment
How to calculate the future value of investment when you earn interest
Investment present value x (1+ interest rate as a decimal)
If more than one year, bracet to the power of 2 for 2 years, power of 3 for 3 years etc
How to calculate Present Value from Future Value
Future value x 1/(1+interest rate as decimal)^number of years
You might be given the denominator
What is Net Present Value (NPV)
The present value of net cash flows without initial investment
How to caculate NPV
1) Find present values (on present value table)
2) Write them all down for all years
3) Multiply all present values by net cash flow in that year
4) Add together results
5) Add total and initial investment (but since its a negative initial investment you do total - II)
Advantage of using NPV
Time value of money is taken into account, easy to compare the NPV of projects since the one with the highest NPV is the most profitable
Disadvantages of using NPV
Doesnt work when the firm faces capital rationing (they might not have the money or needs to be paid back quicker)
Difficult to estimate the amount and timing of cash flows
What is Internal Rate of Return (IRR)
The discount rate that once applied to future cash flows, will give a NPV of 0
Allows us to work out what the actual percentage return is
What is the IRR rule
Accept the project if the IRR is higher than the initial investment
How to calculate IRR
= 𝑎%+(𝐴/(𝐴−𝐵))× (𝑏−𝑎)% x 100 (%)
a = lowest discount factor (percentage)
b = highest discount factor (percentage)
A = lowest NPV
B= highest NPV
Select 2 percentages, one usually already worked out previously then one higher
calculate NPV of each then do formula
Advantages of using IRR
Clear percentage return on investment (one % only)
Takes into account time value of money
Disadvantages of using IRR
Cannot rank mutually exclusive projects as a project with higher IRR may have lower NPV
How to know which project to choose when faced with all these methods
Always go for the one NPV shows, it is the preferred method as it accounts for time value of money and can be applied to a variety of problems with different structures
What is an annuity
An investment that has identical cash flows at the end of the year for multiple years
There is a different annuity table for present values, which adds the previous one as you go down the collumns. But, unlikley it will ever happen where every year is same cash flow
How to calculate profitability index
Present value of investment / investment required
