Brainscape's Knowledge GenomeTM


Top Flashcards (Certified)
All Flashcards

Management Accounting Level 6 > Investment Appraisal > Flashcards

Investment Appraisal Flashcards

(51 cards)

Start Studying
1
Q

What is Payback?

A

The time taken for cash inflows from a project to match the outflows and repay the initial investment
Cumulative cash flows are calculated year on year until they total the initial investment

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Advantages of Payback?

A

Simple
Favours liquidity
Minimises risk
Uses cash flows

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

Disadvantages of payback?

A

Ignores time value of money
Ignores cash flows after the cut off point
Ignores profitability

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What is ARR?

A

The impact on accounting profit of investing in an asset over the life of that asset

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Whats the decision rule of ARR?

A

ARR > company’s target = accept

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

How to calculate ARR?

A

(Average Annual Profit/ Average investment)*100

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What is annual average profit after?

A

Depreciation

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

How to calculate average investment for ARR?

A

(Initial Investment + Residual value)/2

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

ARR Proforma?

A

Project A
£
Total cash inflow 2,100
Less depreciation (2,000)
Accounting profit 100
Project life – years 4
Av. Accounting profit 25
Av. Investment 1,000
ARR calc. (25 / 1,000)
x 100
ARR 2.5%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

ARR Advantages?

A

Familiarity with profit
Focus on balance sheet
ROI used for performance appraisal
Simplicity

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

ARR Disadvantages?

A

Profit is more subjective than cash flows
May conflict with NPV
Ignores time value of money
Ignores length of project

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

What is the time value of money?

A

There is a time preference for receiving the same sum of money sooner rather than later
Reasons:
consumption preference
risk reference
investment preference

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What are the two discounted cash flow methods?

A

the net present value method (NPV)
the internal rate of return method (IRR)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

NPV Interest principle?

A

Compound interest:
£1 today invested at 5% will be worth £1 + 0.05 = £1.05

Present value:
£1 receivable in 1 years time (interest 5%) is worth
£1 / 1.05 = £0.952 today

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

If present value of a project’s net cash inflows exceeds that of the outflows?

A

The NPV will be positive and the project should be accepted

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

NPV Proforma?

A

Year DF PV
@ 5% A
0 1.000 (2,000)
1 0.952 952
2 0.907 907
3 0.864 43
4 0.823 41
NPV (57)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

Advantages of NPV?

A

Considers time value of money
Measure of absolute profitability
Considers cash flows
Considers whole life of project
Maximises shareholders wealth

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Disadvantages of NPV?

A

Fairly complex
Not well understood by non-financial managers
Difficult to determine cost of capital

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

What is IRR?

A

Variation of the NPV method
IRR is the discount rate at which the NPV is zero
Projects with an IRR greater than the company’s cost of capital should be accepted
IRR is determined by trial and error using the formula

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

What is the IIR Formula?

A

IRR = L + NL x (H – L)/
NL - NH

Where:
L = lower discount rate
H = higher discount rate
NL = NPV at the lower discount rate
NH = NPV at the higher discount rate

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

PV at 5% = 222
PV at 25% = (60)
What is the IRR formula?

Study These Flashcards
A

5%+(222/(222+60)) *(25-5)
= 20.74%

22
Q

What are the advantages of IRR?

Study These Flashcards
A

Considers time value of money
Easily understood as uses % return
Considers cash flows
Considers whole life of project
Can be calculated without cost of capital
A company selecting projects where IRR > cost of capital should increase shareholders wealth

23
Q

What are the disadvantages of IRR?

Study These Flashcards
A

Not a measure of absolute profitability
Interpolation only provides an estimate of IRR
Fairly complicated to calculate
IRR may conflict with NPV
Multiple IRRs

24
Q

What are annuities?

Study These Flashcards
A

An annuity is a constant annual cash flow for a number of years
When a project has equal cash flows the annuity factor (AF) may be used to calculate the NPV and IRR
Therefore PV = annual cash flow x AF
Use cumulative present value tables for AF

25
What are perpetuities?
A perpetuity is an annual cash flow that occurs forever PV of a perpetuity = cashflow
26
How to calculate IRR of a perpetuity?
(Annual cash flow / initial investment) * 100
27
What is capital budgeting for decision making?
Needs for expenditure forecast Suitable projects identified Alternatives appraised Best alternatives selected and approved Expenditure made and monitored Deviations from estimated are examined
28
What is a capital expenditure committee?
Co-ordinate capital expenditure policy Appraise and authorise capital expenditure on specific projects Review actual expenditure on capital projects against the budget
29
What is a capital expenditure decision?
Decisions will affect the direction and pace of company’s future growth Decision usually irreversible
30
What is needed for the authorisation of capital expenditure?
Outline of the project Reason for the expenditure Amount of capital expenditure required Estimated life of project Assessment of risks Feasible alternatives Effect of postponement or rejection
31
What is capital expenditure control?
Strict control required of large projects. Reports will include: budgeted cost of the project estimated cost to date estimated cost to completion date of completion any penalties likely to be incurred
32
What is post completion appraisal and the reasons for it?
An objective and independent appraisal of the measure of the success of a capital expenditure project in progressing the business as planned Reasons for use: To discourage managers from spending on doubtful projects To discern a trend of reliability in estimates from managers Information may be useful for future projects
33
What is risk and sensitivity analysis?
A modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome i.e. What would happen if demand fell by 10% or if variable costs were 5% higher? Or: What is the maximum possible change in sales before the opportunity becomes non-viable?
34
What is the sensitivity margin calculation?
NPV / PV of flow under consideration
35
What are the advantages of sensitivity analysis?
Advantages: Simple process using computer spreadsheets Easy to apply Directs attention to key variables
36
What are the disadvantages of sensitivity analysis?
Disadvantages: In the real world a number of variables may alter at the same time It assumes variables are independent of each other Only identifies how far a variable needs to change not probabilities of that change It is not an optimising technique
37
What are tax depreciation written down allowances?
Expressed as a percentage Applied to asset cost on a reducing balance basis Assume assets are bought at start of accounting period and first tax depreciation is offset against year 1 net cash flows Not given in year of sale – instead given a balancing allowance or charge – ensures total allowances equal total fall in value Allowance set against company profit to reduce liability to corporation tax
38
How does inflation effect Investment appraisal?
The decline in the purchasing power of money can impact the project outcome
39
What are he two methods of expressing cost of capital?
A money (or nominal) rate (m) – includes an element for inflation A real rate (r) – the underlying return required before inflation adjustment
40
Real cashflows without inflation use?
Real Rate
41
Money, or actual, cashflows; including inflation use?
Money or nominal rate
42
Equation to find money rate of return?
(1 + m) = (1 + r)(1 + i)
43
Equation to find real rate f return?
(1 + r) = (1 + m) / (1 + i)
44
What are the two types of inlfation?
Specific inflation rate: Each cash flow is affected by a specific rate Inflate cash flows to money terms Discount using money rate General inflation rate: Can use either real or money rates and respective cash flows
45
What is asset replacement?
Mutually exclusive options with unequal lives Where two mutually exclusive projects have different life spans, this must be adjusted for before NPV can be used to choose
46
Calculation for annualised equivalents for each NPV (asset replacement)
PV of costs / Annuity factor for year n
47
What is capital rationing?
Arises when an organisation is restricted in the amount of funds available to initiate all worthwhile projects
48
What are the causes and types of capital rationing?
Causes: Hard (external) capital rationing Soft (internal) capital rationing   Types: Single period – shortage of funds now, but expected to be freely available in later periods Multi-period – funds shortage is expected to extend over a number of years
49
What are the categories of capital rationing?
Divisible projects – either the whole project or any fraction of the project may be undertaken Indivisible projects – either the project must be undertaken in its entirety or not at all
50
How to create Optimal investment plan for Single period, divisible projects?
Calculating a profitability index (PI) for each project Profitability index = NPV/ Initial investment Ranking the projects according to their PI Allocating funds according to the projects’ rankings until they are used up
51
What are the qualitative factors of capital rationing?
We have only considered quantitative issues, for example: Purchase price of machinery Installation costs Costs savings – reduced labour costs, lower stock levels Need to also consider qualitative factors, for example: Costs – increase pollution, noise Benefits – reduction in product development time, improved quality of product

Management Accounting Level 6 (9 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2025 Bold Learning Solutions. Terms and Conditions