Making Capital Investment Decisions

Question 1

Why use NPV

Answer 1

The timing of cash flows
- takes into account time value of money since cash flows are discounted. this incorporates the opportunity cost of capital

The whole of the relevant cash flows
- includes all of the relevant cash flows. treated differently according to their date of occurrence but all taken into account therefore have an influence on decision making.

The objective of a business
- NPV only method of appraisal which the output of the analysis has a direct bearing on the wealth (+NPV increases wealth vice versa)

Question 2

Limitations of payback period

Answer 2

ignores time value of money (discounted PBM).

 Ignores cash flows after the payback period.

 No indication of actual amount of wealth created.

 Subjective benchmark

Question 3

why is payback period widely used

Answer 3

Simple to understand.

 Appropriate where liquidity constraints exist and a fast payback isrequired.

 Appropriate for risky investments in uncertain markets.

 Often used as an initial screening device.

Question 4

Accounting rate of return formula

Answer 4

average annual profit/ average investment to earn that profit

avg annual profit = (average annual operating profit - depreciation/reserves/provision)

avg investment over useful life= (cost of machine + disposal value)/2

Question 5

Pros of ARR

Answer 5

Highlights earnings and useful life of the investment (better than PP)

Information already collected and understood by businesses (similar to financial and managerial performance indicators)