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
