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A - accounting spring > Long term decision making (PART B) > Flashcards

Long term decision making (PART B) Flashcards

1
Q

what is this chapter about?

A

understand how managers make big investment decisions and practice using four techniques for investment appraisal

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2
Q

what is an investment appraisal?

A

collection of techniques used to identify attractiveness of an investment, usually biggest expenditure decisions

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3
Q

what is long term decision making??

A

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

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4
Q

what do LT decisions usually centre around?

A

choices in terms of big expensive things such as maintenance / It systems (that last 20-30 years)

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5
Q

why would you use investment appraisal?

A
  • 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
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6
Q

what id the investment decision making process?

A
  • 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
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7
Q

what four techniques are included in the investment appraisal?

A
  • payback period
  • accounting rate of return
  • net present value
  • internal rate of return
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8
Q

what is the capital expenditure proposal?

A

initial outlay and target return for different categories of capital expenditure and key features

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9
Q

what are the categories and key features of capital expenditure proposal?

A 
cat;
- replacements 
- obligatory 
- enhancement 
- aquistsions 
key;
- strategic fit 
- financial strategies / evaluation 
alternatives 
- risk
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10
Q

what kind of evaluation is the investment appraisal?

A

quantitative

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11
Q

what is the qualitative valuation?

A

project screening

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12
Q

what does the payback period measure?

A

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

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13
Q

what is payback period based on?

A

cash flows generated each year

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14
Q

what is calculation for payback period?

A

add up the cash a project makes each year until you reach the initial outlay amount

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15
Q

what do you do if you have profit in the payback period instead of cashflow?

A

you do:

profit + depreciation = cashflow

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16
Q

what are the advantages of paybackperiod?

A
  • 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
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17
Q

what are the disadvantages of payback period?

A
  • 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
18
Q

what is the accounting rate of return?

A

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

19
Q

what are the decision rules in accounting rate of return?

A
  • set a required ARR
  • accept profit if ARR is higher than required rate
  • ranking = highest ARR = best
20
Q

how do you calculate the ARR?

A

(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
21
Q

what are the advantages of accounting rate of return?

A
  • 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
22
Q

what are the disadvantages of accounting rate of return?

A
  • 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)
23
Q

which two investment appraisal techniques ignore the time value of money?

A

payback and ARR

24
Q

what is the time value of money?

A

= idea that money available now is worth more compared to the same amount in the future

25
Q

why is money worth less in the future?

A
  • 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
26
Q

each year money earns interest in the bank, what are the types of interest?

A
  • compound

- discount

27
Q

what is compound interest?

A

interest on top of interest, compundning

28
Q

what is discount interest?

A

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

29
Q

why do people do discount interest?

A
  • 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
30
Q

how much should you disocunt?

A

company will have certain percentage rates in mind
usually; current interest rate or cost of capital
(CoC = what they have to payback to lenders)

31
Q

in an exam where can you get scout factors from?

A

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)

32
Q

what percentage rate should you choose when looking at discount factors?

A

(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

33
Q

what is netbook present value?

A

= sum of all years discounted cash flows less present value of cash outflows
takes each years future cash flow + discounts them

34
Q

what are the decision rules for net present value?

A
  • 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)

35
Q

what are the advantages of netbook present value?

A
  • 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
36
Q

what are the disadvantages of netbook present value?

A
  • 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
37
Q

what is the internal rate of return?

A

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)

38
Q

how is IRR different to ARR?

A

it considers time value of money

39
Q

how is the internal rate of return calculated?

A
  • 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
40
Q

what is the advantage of internal rate of return?

A
  • reasonably well understood
    compare IRR with companies WACC, alternative projects
  • takes into account time value
41
Q

what is the disadvantages of internal rate of return?

A
  • doesn’t give weight to absolute size of funds generated or size of initial investment
42
Q

why do you need other things swell as investment appraisal?

A
  • not just fincinaicla
  • depend on risk
  • avaialbility of finds
    links to objectives

A - accounting spring (7 decks)

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