Week 2 - Capital Investment Decisions Flashcards
What is investment appraisal?
The process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing shareholders’ wealth.
What are the two types of expenditure?
- Capital expenditure
- Operating expenditure
What is capital expenditure?
An outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year.
What is operating expenditure?
An outlay of funds by the firm resulting in benefits received within 1 year.
Why do we need to perform investment appraisal?
To allocate limited funds among numerous competing projects and assess long-term impacts.
What is capital rationing?
The process through which companies decide how to allocate their capital among different projects.
What are mutually exclusive projects?
Projects that compete with one another; the acceptance of one project eliminates all others from further consideration.
What are independent projects?
Projects that do not compete with one another; the acceptance of one does not eliminate the others.
What is an accept-reject approach in capital budgeting?
The evaluation of capital expenditure proposals to determine whether they meet a firm’s minimum acceptance criterion.
What is a ranking approach in capital budgeting?
The ranking of capital expenditure projects based on some predetermined measure, such as the rate of return.
What are the five steps of the investment appraisal process?
- Proposal generation
- Review and analysis
- Decision making
- Implementation
- Follow-up
What are the four main investment appraisal techniques?
- Accounting rate of return (ARR)
- Payback period (PB)
- Net present value (NPV)
- Internal rate of return (IRR)
What is the Accounting Rate of Return (ARR)?
The average accounting profits that the investment will generate, expressed as a percentage of the average investment.
How is ARR calculated?
ARR = (Average profits / Average investment) x 100%
What is the Payback Period (PB)?
The length of time required for a firm to recover its initial investment in a project from cash inflows.
What is Net Present Value (NPV)?
The present value of the future cash inflows of a project minus the initial investment.
What is the formula for NPV?
NPV = Present value of cash inflows – Initial investment
What is the discount rate used in NPV calculations?
The cost of capital of the company.
What does a positive NPV indicate?
The project should be accepted.
What is the Weighted Average Cost of Capital (WACC)?
WACC = weighted average cost of debt + weighted average cost of equity.
Fill in the blank: The investment appraisal process consists of _______.
[five steps]
True or False: The Payback Period takes into account cash inflows beyond the payback period.
False
What is the main disadvantage of the Accounting Rate of Return (ARR)?
It ignores the time-value of money.
What is a disadvantage of the Payback Period (PB)?
It does not take into account the time value of money.
What is the primary focus of investment appraisal techniques?
To evaluate potential investments and their impact on shareholder wealth.
What is the importance of follow-up in the investment appraisal process?
To monitor results and compare actual costs and benefits with those that were expected.
What is the present value of cash flows?
The present value of cash flows is the current worth of a future sum of money or stream of cash flows given a specified rate of return.
This incorporates the time value of money.
What does NPV stand for?
Net Present Value
NPV is a method used to evaluate the profitability of an investment by calculating the difference between the present value of cash inflows and the present value of cash outflows.
Fill in the blank: The formula for IRR involves finding a discount rate where the NPV is _______.
zero
What is the decision criterion when evaluating projects using IRR?
If the IRR is greater than the cost of capital, accept the project; if less, reject it.
This ensures that the firm earns at least its required return.
What is the primary advantage of using NPV?
It incorporates the time-value of money and provides clear signals.
NPV takes into account all relevant information and the timing of cash flows.
What is a disadvantage of using NPV?
Calculating a discount rate can be problematic.
The weighted average cost of capital can be difficult to determine.
What does IRR stand for?
Internal Rate of Return
IRR is the discount rate that makes the net present value of all cash flows equal to zero.
List three methods of calculating IRR.
- Trial and error
- Excel function
- Interpolation method
Interpolation method uses two rates to find the IRR between them.
True or False: NPV is the preferred method for investment appraisal.
True
What should be ignored when evaluating relevant cash flows?
- Past costs incurred
- Future costs that remain unchanged regardless of the decision
These do not vary with the decision and are therefore not relevant.
What is meant by ‘cash flows not profit flows’?
Cash flows focus on actual cash in and out rather than accounting profits.
Adjust profit flows for non-cash items like depreciation to derive cash flows.
What is the impact of discount rate on present value?
A higher discount rate decreases the present value of future cash flows.
This reflects the time value of money.
What is the ethical consideration in investment appraisal?
The ethical, social, and environmental impacts of the project.
These considerations affect stakeholders such as employees and the community.
Fill in the blank: The objective of investment appraisal is to maximize _______.
shareholders’ wealth
What are relevant cash flows?
Cash flows that vary with the decision being made.
These include opportunity costs and exclude fixed costs.
What is the formula used to calculate IRR?
IRR = Lr + [(NL / (NL - NH)) * (Hr - Lr)]
Where Lr is the lower discount rate, Hr is the higher discount rate, NL is the NPV at the lower rate, and NH is the NPV at the higher rate.
What does the term ‘mutually exclusive’ mean in project selection?
Only one project can be accepted among competing options.
This is relevant when comparing projects with similar objectives.
What is a consideration for decision-making in investment appraisal?
The assumptions made in the calculations and their validity.
What are the common investment appraisal techniques used by CFOs?
- IRR
- NPV
- Payback approach
These techniques are more prevalent in larger firms.
