F9 - Investment Apprisal

Question 0

What are the +Adv & -Adv of IRR?

Answer 0

+Adv

• considers the time value of money
• % therefore easy to understand
• cash flows not profits
• considers the whole life of project
• were IRR exceed Cost of capital - increases shareholders wealth
• comparison of projects of different scales
• Adv
• Not a measure of absolute profitability
• interpolation only gives estimate, accuracy requires spreadsheet programme
• fairly complicated
• non conventional cash flows may give rise to multiple IRR which means interpolation method can not be used

Question 1

+Adv & -Adv of using NPV

Answer 1

Theoretically superior to all other investment appraisal technique

+Adv

• considers the time value of money
• absolute measure of return ($)
• based on cash flows not profit
• considers the whole life of the project
• should lead to maxi. Of shareholders wealth
• Adv
• difficult to expand to managers
• requires knowledge of the cost of capital
• relatively complex

Question 2

What is the Equivalent annual costs (EACs) for replacement decision

Answer 2

The EAC is the equal annual cash flow (annuity) to which a series of uneven cash flows is equivalent in PV terms

EAC = PV of costs/ Annuity factor

The optimum replacement period (cycle) is the period that has the lowest EAC

Question 3

What are the Adv & Disadv of sensitive analysis?

Answer 3

Adv ——–>

• simple to use
• Provides additional information to enable managers to make subjective judgements
• Identifies critical estimates

Disadv——>

• assumes variables change independently of each other
• does not assess the likelihood of a variable changing
• does not directly identify a correct decision