Capital investment appraisal - Lecture 9a

Question 1

Net present value method

Answer 1

A technique known as ‘discounted cash flow’. The process of ‘discounting’ is the opposite of ‘compounding’.

In ‘discounting’ we try to answer the question: “If we know we are to receive £1 in 3 years’ time, how much is that worth now?”.

Question 2

Payback method

Answer 2

Determine the length of time it takes for the investment to pay for itself, i.e. for the revenues to cover the costs.
This should not be confused with ‘break-even analysis’ (the
objective of which is to determine the break-even level of output).

Question 3

Internal rate of return method

Answer 3

calculate the cost of capital (interest rate) above which the project is not worthwhile. In other words, if you think interest rates are going to rise above the figure you arrive
at (for a substantial part of the projects’ duration) then you do not take on the project. It is calculated using the ‘discounted cash flow’
technique outlined in method 1. We ascertain the cost of capital which gives us a net present value of zero. In order to do this we first of all obtain a ‘c.o.c.’ (cost of capital) which gives us a positive N.P.V., and one which gives us a negative N.P.V.

Question 4

Accounting rate of return method - The a.r.r. on initial investment: FORMULA

Answer 4

A.R.R.% =
average (mean) profit of project
/
Initial capital required for project

x 100

Question 5

Accounting rate of return method - The a.r.r. on average investment: STEPS

Answer 5

Step 1: Total revenue
Step 2: less total costs
Step 3: gives ‘profit’
Step 4: divided by no of years gives the average profit per year
Step 5: dividing by the average investment in the
machine across the course of its life, so we take what it is worth at the mid-point.

Question 6

Accounting rate of return method - The a.r.r. on initial investment: STEPS

Answer 6

Step 1: Total revenue
Step 2: less total costs
Step 3: gives ‘profit’
Step 4: divided by no of years gives average profit per year
Step 5: divide by initial investment and x by 100:

Question 7

PAYBACK pros/cons

Answer 7

Advantage: useful if cash flow is a problem; emphasises the
importance of a quick return

Disadvantage: ignores what happens after payback

Question 8

NPV pros/cons

Answer 8

Advantage: recognises that money loses value over time;
theoretically the best method.

Disadvantage: deciding upon the appropriate discount rate

Question 9

ARR pros/cons:

Answer 9

Advantage: Is the only method that uses the concept of ‘profit’ and can therefore be likened to ROCE.
Disadvantage: ‘average profit’ can be misleading and hide large fluctuations

Question 10

IRR pros/cons:

Answer 10

Advantage: gives a ‘hurdle rate’ for comparison with the cost of borrowing
Disadvantage: the most difficult to calculate