Investment appraisal Flashcards
(39 cards)
What is the difference between revenue and capital expenditure?
Revenue expenditure is spending on day-to-day operations, while capital expenditure is spending on assets for long-term use.
What are examples of tangible assets?
Land, buildings, plants & machinery, transport equipment.
What are examples of intangible assets?
Software licenses, development costs for software & systems, licenses & trademarks, patents.
How do Pike and Neale (2003) define investment appraisal?
“Any course of action that involves sacrifices now or in the near future in anticipation of higher future benefits.”
What does the Accounting Rate of Return (ARR) measure?
It measures the % return on investment over the whole life of a project.
How is ARR calculated?
(Average annual profit / Average investment) × 100%
How is average investment calculated?
(Initial investment + Scrap value) / 2
How is average annual profit calculated?
Net cash flow – Depreciation
What is the decision rule for a single investment project using ARR?
It must generate an ARR greater than the minimum acceptable return
What is the decision rule for mutually exclusive investment projects using ARR?
Select the project with the highest ARR, ensuring it is above the minimum required.
What are the advantages of ARR?
Simple
Widely used
Uses readily available data
Considers whole project life
What are the disadvantages of ARR?
Ignores timing of returns
Ignores time value of money
Not a measure of profitability
Doesn’t consider cash flows- based on profits which depends on judgement which can distort underlying patterns of cash flows
What is the payback period (PB)?
The time it takes for a project’s annual net cash flows to match the initial cost outlay.
What is the decision rule for a single investment project using PB?
It must generate sufficient cash inflows to repay the cash outflows within a maximum specified time period.
What is the decision rule for mutually exclusive investment projects using PB?
Select the project with the quickest payback and ensure it meets the specified minimum time period.
What are the advantages of the payback period method?
Simple
Useful with rapidly changing technology
Improves investment conditions
Favours quick returns (however can be risk adverse)
Uses cash flows
What are the disadvantages of the payback period method?
Ignores time value of money
Not an absolute measure
Doesn’t account for cash flows BEYOND the payback period
Why is discounting used in investment appraisal?
Future cash flows occur at different points in time and must be converted to a common point in time to be comparable.
What is the time value of money?
Money received today is worth more than the same sum received in the future due to its potential earning capacity.
How is Net Present Value (NPV) calculated?
NPV = Present Value (PV) of future net cash flows – Initial outlay
How do you calculate operational cash flows
profit + depreciaiton
How do you calculate net cash
op. cash flow- tax + tax benefit
How do you interpret NPV values?
Positive NPV → Accept the project.
Negative NPV → Reject the project.
Zero NPV → The discount rate equals the Internal Rate of Return (IRR).
What are the advantages of NPV?
Focuses on cash flow.
Absolute measure of return.
Considers the time value of money.
Considers the whole project life.
Helps maximise shareholder wealth.
