Long term decision making (PART B) Flashcards
what is this chapter about?
understand how managers make big investment decisions and practice using four techniques for investment appraisal
what is an investment appraisal?
collection of techniques used to identify attractiveness of an investment, usually biggest expenditure decisions
what is long term decision making??
for an organisation to survive it must look into the future
make LT decisions about organisations money
invest wisely now for future success
what decisions will allow them to prospere
what do LT decisions usually centre around?
choices in terms of big expensive things such as maintenance / It systems (that last 20-30 years)
why would you use investment appraisal?
- investment choices dictate future direction of the company, fit overall group strategy - dictate how you move forward
- todays investments = tomorrows profit
- If you always think short term then will pitter out
- capital for investment is normally scarce
- high level of risk and judgement involved in ivstemoent which can be helped by this disciplined approach
what id the investment decision making process?
- origination of proposal: something they think is worth investing in
- project screening - proposal is screened by someone higher, qualitative evaluation
- analyse: investment appraisal: accept or reject
- monitor and review: management make sure it is achieving what is set out to do
what four techniques are included in the investment appraisal?
- payback period
- accounting rate of return
- net present value
- internal rate of return
what is the capital expenditure proposal?
initial outlay and target return for different categories of capital expenditure and key features
what are the categories and key features of capital expenditure proposal?
cat; - replacements - obligatory - enhancement - aquistsions key; - strategic fit - financial strategies / evaluation alternatives - risk
what kind of evaluation is the investment appraisal?
quantitative
what is the qualitative valuation?
project screening
what does the payback period measure?
time it takes cash inflows to equal initial cash outflow
(often used as an initial screening method)
‘how long will it take to pay back its costs?’
- should have max payback
- you reject if it is more than mac payback period
what is payback period based on?
cash flows generated each year
what is calculation for payback period?
add up the cash a project makes each year until you reach the initial outlay amount
what do you do if you have profit in the payback period instead of cashflow?
you do:
profit + depreciation = cashflow
what are the advantages of paybackperiod?
- simplicity - quick and easy (that’s why it is good in the initial screening method)
- focuses on liquidity - money back quick
- minimise risk - quick repayment
- suitable when capital is low as you get your money back quicker
what are the disadvantages of payback period?
- ignores benefits after payback
- ignores objective of wealth maximisation
- ignores time value of money
- unable to distinguish between projects with the same payback period
- excessive investment in St projects (want money back quicker)
- not earn as much over long period
what is the accounting rate of return?
average profit from an investment expressed as a percentage of the average investment made
useful when comparing 2 projects - highest ARR is the best one
what are the decision rules in accounting rate of return?
- set a required ARR
- accept profit if ARR is higher than required rate
- ranking = highest ARR = best
how do you calculate the ARR?
(3 calculations needed)
- av. operating profit/av. capital employed x100
-AVP = total profit/years of project
(if you have cashflow)
= total cash - (cost - scrap) / no. years of project
- ACE = cost + scrap value / 2
what are the advantages of accounting rate of return?
- comparison to existing or targeted return
- readily understood (familiarity with ROCE or ROI)
- take sin to account all costs / benefits associated with a projectt over entire project life
what are the disadvantages of accounting rate of return?
- based on accounting profit BUT cash is the ultimate measure of economic wealth generated by investment, profit doesn’t represent actual money in pocket
- can be meaningless if no comparison
- ignores time value of money
- doesn’t take into account timing of profit (can be invested elsewhere)
which two investment appraisal techniques ignore the time value of money?
payback and ARR
what is the time value of money?
= idea that money available now is worth more compared to the same amount in the future
why is money worth less in the future?
- if we have money now rather than future we can spend it now (so it is worth more to us)
- start earning now, put in back and earn interest rather the n waiting five years and then earning interest
- less risky to have money now rather than the promise of money later
each year money earns interest in the bank, what are the types of interest?
- compound
- discount
what is compound interest?
interest on top of interest, compundning
what is discount interest?
opposite of compound, taking interest off future cash flow to recognise the fact that its not worth the same now and in future, cash flows in todays money terms
why do people do discount interest?
- realism/realistic
- reflects £1 earned after 1 year is more than £1 after two
- after discounting if money is left over then the project is worth it
how much should you disocunt?
company will have certain percentage rates in mind
usually; current interest rate or cost of capital
(CoC = what they have to payback to lenders)
in an exam where can you get scout factors from?
use tables in which have discount factor for a series of discount/interest rates (i.e present value of £1 received in one year)
based on formula
1 / (1+r)n
(you get them in the exam though)
what percentage rate should you choose when looking at discount factors?
(dependant on organisation)
in exam you are told the the rate to use and discount factors have to use use year
base choice on: interest rate, WACC or a company target
what is netbook present value?
= sum of all years discounted cash flows less present value of cash outflows
takes each years future cash flow + discounts them
what are the decision rules for net present value?
- if NVP is positive the return is greater than the discount rate used indicating project is viable
- if NVP = 0 there is no increase in shareholder wealth
- Projects with highest NPVs, using specified discount rate, are preferred
(you take the cash flow and multiply by the discount)
what are the advantages of netbook present value?
- takes into account time value of money
- linked directly to maximising shareholder profits
- based on cash flow not profit can incorporate risk into it
- provides clear decisions - positive: accept
what are the disadvantages of netbook present value?
- managers / shareholders often find it easy to interpret the meaning of a percentage return of project rather than sum of discounted cash flows (prefer to see%)
- accuracy of results depends on correct choice of discount codes
what is the internal rate of return?
measures the exact yield of the project / its exact rate of return IRR is the discount code required
(similar to ARR but more sophisticated as it gives you time value)
how is IRR different to ARR?
it considers time value of money
how is the internal rate of return calculated?
- find two discount factors, one which provides a positive net present value and one with a negative
- use this information to calculate a discount rate which could give a nil NPV
IRR = A + (C / C-D) X (B_A) A - low discount rate B - high discount rate (calculate NPV twice) C - NPV of cash inflow low D - NPV of cash inflow high
what is the advantage of internal rate of return?
- reasonably well understood
compare IRR with companies WACC, alternative projects - takes into account time value
what is the disadvantages of internal rate of return?
- doesn’t give weight to absolute size of funds generated or size of initial investment
why do you need other things swell as investment appraisal?
- not just fincinaicla
- depend on risk
- avaialbility of finds
links to objectives
