9. Making capital investment decisions

Question 1

What does “Time value of money” mean?

Answer 1

Time Value of Money refers to the fact that a unit of currency (£,$, €, ¥, etc) today is worth more than a unit of currency promised at some point in the future.

Question 2

Why would a unit of currency today be worth more than a unit of currency in the future?

Answer 2

• Compounding – the process of accumulating interest on an investment over time to earn more interest
• Compound interest - ?
• Simple interest - ?
• Discounting – the process of calculating the present value of some future cash flows.

Question 3

Suppose you deposit €100 today in an account paying 8 per cent. In one year, you will deposit another €100. How much will you have in two years?

Answer 3

224.64

Question 4

What is important about “cash flow timing”?

Answer 4

In present and future value problems, cash flow timing is critically important. In almost all such calculations, it is implicitly assumed that the cash flows occur at the end of each period.

Question 5

What is the present value of the cash flows at 6%, 1000 each year for 5 years?

Answer 5

Question 6

What is an annuity?

Answer 6

A level stream of cash flows for a fixed period of time.

Question 7

What is a perpetuity?

Answer 7

A level stream of cash flows forever.

Question 8

How do you calculate the Net Present Value?

Answer 8

The difference between the sum of the present value
of the future cash flows and the initial investment cost.

Question 9

What is the “Net Present Value” investment rule?

Answer 9

NPV is greater than 0 –> ACCEPT
NPV is less than 0 –> REJECT

Question 10

What are the strengths of “NPV”?

Answer 10

• Uses Cash Flows (Cash Flows are better than Earnings)
• Uses all Cash Flows (Other approaches ignore cash flows beyond a certain date)
• Discounts Cash Flows (Fully incorporates the Time Value of Money)

Question 11

What is the “internal rate of return” (IRR)?

Answer 11

The discount rate that makes the NPV of an
investment zero.

Question 12

What are the “multiple rates of return”?

Answer 12

The possibility that more than one discount rate will make the NPV of an investment zero.

Question 13

What is a problem with IRR?

Answer 13

Mutually Exclusive Investments:

“A situation in which taking one investment prevents the taking of another”

Question 14

What are the advantages of “IRR”?

Answer 14

1. Closely related to NPV, often leading to identical decisions
2. Easy to understand and communicate

Question 15

What are the disadvantages of “IRR”?

Answer 15

1. May result in multiple answers, or not deal with non-conventional cash flows
2. May lead to incorrect decisions in comparison to mutually exclusive investments

Question 16

What is the “payback rule”?

Answer 16

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Question 17

What are problems with the “payback rule”?

Answer 17

• Does not take timing of cash flows fully into account
• Ignores cash flows after PP
• Does not take risk fully into account
• Ignores the time value of money
• Arbitrarily determined target payback period

Question 18

What is the “discounted payback period”? (DPP)

Answer 18

The length of time required for an investment’s
discounted cash flows to equal its initial cost.

Question 19

What is “Accounting Rate of Return”? (ARR)

Answer 19

( average annual profit / average investment to earn that profit ) x 100

Question 20

What must the “ARR” equal?

Answer 20

For a project to be acceptable, it must achieve at least a
minimum target ARR

Where competing projects exceed the minimum rate, the one with the highest ARR should be selected

Question 21

What are problems with “ARR”?

Answer 21

• Ignores the timing of cash flows
• Use of average investment
• Use of accounting profit
• Competing investments