W5 - Long term Decision Making

Question 1

What is Investment Appraisal?

Answer 1

-Involves looking at long-term choices about specific investments in future projects
-These decisions usually look 10-20 years into future
-Capital for investment is normally scarce
-Usually biggest & riskiest expenditure decisions that a business will face to assessment helped by a disciplined approach

Question 2

Investment Decision Making Process

Answer 2

1. Origination of proposal
2. Project screening
3. Analysis & acceptance/rejection
4. Monitoring & review

Question 3

Payback period

Answer 3

Time is takes cash inflows to equal intital cash outflow

Question 4

Rules for payback period

Answer 4

-Accept project if payback period < maximum permitted
-Reject project if payback period > maximum permitted
-Ranking: Best project is that with the shortest payback period

Question 5

Advantages of payback

Answer 5

-Simplicity - quick and easy to calculate
-Focus on early payback can enhance liquidity
-Minimise risk
-Shorter term forecasts are more likely to be reliable
-Suitable when capital is rationed

Question 6

Disadvantages of payback

Answer 6

-Ingores benefits after payback period
-Ingores objective of wealth maximisation
-Unable to distinguish between projects with same payback period
-

Question 7

Average Rate of Return

Answer 7

Measures average profit from an investment expressed as a percentage of the average investment made

Question 8

Decision rules for ARR

Answer 8

-Accept project if ARR > required rate of return
-Reject project if ARR < required rate of return
-Ranking: best project is that with the highest ARR

Question 9

ARR calculation

Answer 9

Average operating profit / Average capital employed X100

Question 10

Average operating profit formula

Answer 10

Total profit / No. of years of project

Question 11

Average capital employed formula

Answer 11

Cost + scrap value / 2

Question 12

Advantages of ARR

Answer 12

-Comparison with company’s existing or targeted return
-Readily understood (familiarity with ROCE)
-Takes account of all the costs/benefits asociated with a project over entire project life

Question 13

Disadvanages of ARR

Answer 13

-Method is based on accounting profit BUT cash is the ultimate measure of economic wealth generated by investment
-The ARR percentage is potentially meaningless?
-Doesnt consider timing of profits
-Ignores time value of money