Module 5 - Capital Investment Appraisal Flashcards
PPE
positive purpose expenditure
NPE
negative purpose expenditure
examples of NPE
- redundancy, plant closure costs
- plant mothballing expense
- compensation payments to partners, crystallisation of guarantee obligations
Payback
Assesment of the time taken by a project to recover initial capital outlay
Advantages of payback
- simple
- easy to see length of time capital is at risk
Disadvantages of payback
- doesn’t consider time value of money
- built in discrimination in favour of short term investments
- cash flows after payback ignored
- doesn’t provide measurement of absolute gain of wealth
accounting rate of return expresses?
the profits from a project as a percentage of capital costs
ARR formuls
AAP/ACI x100
AAP
annual cash flows - depreciation / number of years
ACI
1/2 (investment + residual value)
advantages of ARR
- calculation straightforward
- more easily understood technique
disadvantages of ARR
- decision remains subjective
- life of project ignored
- doesn’t account for time value of money
- doesn’t provide a measurement of absolute gain
Net present value
evaluates future net cash flows generated by an investment by discounting those flows at a rate which represents the cost to the firm of raising the funds to undertake the invesment
After tax cash flows in npv
cash flow x (1-t) where t is tax rates
Advantages of NPV
- time value of money
- easy
- exactly measures increase in shareholder’s welath
disadvantages of NPV
- Cost of capital only effective discount factor if the potential new investment has the same risk exposure
- can be difficult to understand for non-financial accountants
IRR
rate of return on the project (calculated as the rate that brings the net present value of all inflows and outflows to zero)
if IRR > cost of capital
increase shareholders wealth
advantages of IRR
easier to understand than NPV
- time value of money
disadvantages of IRR
- more difficult to understand
- if there are changes in direction of cash flow may need more than one IRR
- may give different rankings to NPV, use NPV when this occurs
Capital rationing
used when unable to undertake all profits which have a positive NPV,
always maximise NPV
