Long-term decision making: Capital Investment

Question 1

Definition of Payback Period?

Answer 1

Measures the rate of recovery of the original investment in terms of net cash flow

Question 2

What is the Payback Rule?

Answer 2

Specifies that a project should be accepted if its payback period is less than the specified cut-off period, specified by management

Question 3

What do you do if depreciation has been taken out?

Answer 3

Put it back in as it is not a cash flow

Question 4

How to calcuate Payback Period

Answer 4

1) Find out in which year the initial investment has been paid off
2) Work out how much is left to be paid off the year before
3) Divide that by the net cash flow in year it is paid off
4) Round to (usually) 2 decimals and multiply by 12 and round to 1 integer
5) = Year before paid off + (that answer) months

Question 5

Advantages of using Payback method

Answer 5

Simple and widely used in practice, appears to be a cautious approach as it favours projects that give an early return

Question 6

Disadvantages of using Payback method

Answer 6

Doesnt take into account time value of money, ignores net cash flows after investment has been paid off, doesnt measure profitability only net cash flow.

Question 7

What is Accounting Rate of Return (ARR)

Answer 7

Method of deciding if a project should be accepted, by if it acheives a target ARR as a minimum. The highest ARR project should be selected if both achieve the minimum

Question 8

How to calculate Accounting Rate of Return

Answer 8

Average annual operating profit / average investment x 100 (%)

average profit = total profit/years project runs for
average investment = (inital investment + final value) / 2

Question 9

Advantages of using ARR

Answer 9

Takes into account all the profits expected during the projects life, familiar accounting measures

Question 10

Disadvantages of using ARR

Answer 10

Doesnt take into account time value of money, ignores timing of profits, no insight of size of returns or investment

Question 11

How to calculate the future value of investment when you earn interest

Answer 11

Investment present value x (1+ interest rate as a decimal)

If more than one year, bracet to the power of 2 for 2 years, power of 3 for 3 years etc

Question 12

How to calculate Present Value from Future Value

Answer 12

Future value x 1/(1+interest rate as decimal)^number of years

You might be given the denominator

Question 13

What is Net Present Value (NPV)

Answer 13

The present value of net cash flows without initial investment

Question 14

How to caculate NPV

Answer 14

1) Find present values (on present value table)
2) Write them all down for all years
3) Multiply all present values by net cash flow in that year
4) Add together results
5) Add total and initial investment (but since its a negative initial investment you do total - II)

Question 15

Advantage of using NPV

Answer 15

Time value of money is taken into account, easy to compare the NPV of projects since the one with the highest NPV is the most profitable

Question 16

Disadvantages of using NPV

Answer 16

Doesnt work when the firm faces capital rationing (they might not have the money or needs to be paid back quicker)
Difficult to estimate the amount and timing of cash flows

Question 17

What is Internal Rate of Return (IRR)

Answer 17

The discount rate that once applied to future cash flows, will give a NPV of 0
Allows us to work out what the actual percentage return is

Question 18

What is the IRR rule

Answer 18

Accept the project if the IRR is higher than the initial investment

Question 19

How to calculate IRR

Answer 19

= 𝑎%+(𝐴/(𝐴−𝐵))× (𝑏−𝑎)% x 100 (%)

a = lowest discount factor (percentage)
b = highest discount factor (percentage)
A = lowest NPV
B= highest NPV

Select 2 percentages, one usually already worked out previously then one higher

calculate NPV of each then do formula

Question 20

Advantages of using IRR

Answer 20

Clear percentage return on investment (one % only)
Takes into account time value of money

Question 21

Disadvantages of using IRR

Answer 21

Cannot rank mutually exclusive projects as a project with higher IRR may have lower NPV

Question 22

How to know which project to choose when faced with all these methods

Answer 22

Always go for the one NPV shows, it is the preferred method as it accounts for time value of money and can be applied to a variety of problems with different structures

Question 23

What is an annuity

Answer 23

An investment that has identical cash flows at the end of the year for multiple years

There is a different annuity table for present values, which adds the previous one as you go down the collumns. But, unlikley it will ever happen where every year is same cash flow

Question 24

How to calculate profitability index

Answer 24

Present value of investment / investment required