Chapter 10

Question 1

What is Capital Investment?

Answer 1

The term capital investment refers broadly to large expenditures made to purchase fixed assets

such as machinery, buildings, or equipment, develop new product lines, or acquire subsidiary companies.

• Such decisions commit funds for long periods of time and are difficult, if not impossible, to reverse once the funds are invested. Furthermore, the funds to purchase a capital item must be paid out immediately whereas the income or benefits accrue over time

Question 2

What is investment appraisal?

Answer 2

• Investment Appraisal uses a variety of techniques/methods to help decide whether or not to go ahead with a project OR Which project to go ahead with.

• In general, managers choose investment projects where the benefits of the investment outweigh the costs.

Question 3

What are the main investment appraisal methods?

Answer 3

1. Accounting Rate of Return (ARR)
2. Payback period
3. Net Present Value (NPV)

Question 4

What is the Accounting Rate of Return (ARR) method?

Answer 4

• This method measures the return/profit on the investment project.

It does not focus on cash flows - rather it focuses on accounting income (profit).

Question 5

What is the formula for the accounting rate of return

Answer 5

Question 6

What is a weakness of the ARR method

Answer 6

It ignores the time value of money

Question 7

What are advantages of the ARR method

Answer 7

The strengths of the ARR method are that it is simple, easy to understand and considers profitability.

Question 8

What is the payback period method?

Answer 8

The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
• It provides businesses with an idea as to when they will get their money back from their investment.

• This method uses CASH FLOWS (NOT PROFIT) as a basis for calculation.

Question 9

What is the formula for the payback period?

Answer 9

Question 10

Answer 10

Question 11

Advantages of the payback method

Answer 11

• Easy & relatively quick to calculate.
• It is a good method when liquidity is more important than profitability.
•It is a useful technique in times of high inflation, political uncertainty, economic uncertainty & fast changing technology.

Question 12

Disadvantages of the payback method

Answer 12

•Does not consider the time value of money
•Does not take into consideration the cash flows that occur after the pay back.

Question 13

What is the time value of money

Answer 13

A basic concept of a net present value procedure is that a sterling pound is worth more today than tomorrow because today’s sterling pound can be invested and can generate earnings. In addition, the uncertainty of receiving a sterling pound in the future and inflation make a future sterling pound less valuable than if it were received today.

Question 14

What things does the present value figure when calculating the time value of money depend on?

Answer 14

(1) the amount of the future cash flow.
(2) the length of time that the investor must wait to receive the cash flow, and
(3) the rate of return (discount rate or cost of capital) required by the investor.

Question 15

What is the net present value of money?

Answer 15

• This technique use cash flows and not accounting profit.
Business investments extend over long periods of time, so we must recognize the time value of money. This technique recognize the time value of money.

Question 16

How do you calculate the present value of a cash flow

Answer 16

Question 17

How to determine the net present value

Answer 17

Question 18

What are cash outflows

Answer 18

Cash outflows include the initial cost of an investment plus any other expected future cash outflows associated with the investment such as operating expenses ( e.g. rent, bills, repairs and maintenance).

Question 19

What are cash inflows

Answer 19

Cash inflows include all expected future revenues or cost savings directly associated with an investment a well as salvage value of the project.

Question 20

If the net value is positive then the investment is?

Answer 20

Then the project is . . .
Acceptable, since it promises a return greater than the required rate of return.

Decision rule - all positive NPV investments enhance shareholders’ wealth; the greater the NPV, the greater the enhancement and the more desirable.

Question 21

If the net value is zero then the investment is

Answer 21

Acceptable, since it promises a return equal to the required rate of return.

Question 22

If the net value is negative then the investment is

Answer 22

Not acceptable, since it promises a return less than the required rate of return.

Question 23

Answer 23

Question 24

Answer 24

Question 25

3. If the NPV of an investment project is negative, management should

a) reject the investment.
b) invest as this is a rare opportunity.
c) recalculate their figures as NPV should never be zero.
d) seek investment partners because the investment will cost more than planned.

Answer 25

a) reject the investment.

Question 26

4. The length of time required to recover the initial cash outlay for a project is determined by using the

a) discounted cash flow method.
b) the payback method.
c) the net present value method.
d) the simple rate of return method.

Answer 26

b) the payback method.

Question 27

Answer 27

Question 28

Answer 28

Question 29

Answer 29

A

Question 30

8. The simple rate of return method places its focus on cash flows instead of on accounting operating profit.
   a) True
   b) False

Answer 30

B) False

Question 31

9. One criticism of the payback method is that it ignores cash flows that occur after the payback point has been reached.
   a) True
   b) False

Answer 31

A) True

Question 32

Answer 32

A