Investment Decision Making Flashcards
(26 cards)
What is the nature of investment decisions?
Large amounts of resources are often involved
Often difficult/expensive to bail out of an investment once undertaken
What is involved in the investment appraisal methods?
Accounting Rate of Return (ARR) Payback Period (PP) Average Return (AR) Net Present Value (NPV) Internal Rate of Return (IRR)
What is the formula for accounting rate of return (ARR)?
100 x Avg. annual operating profit/ Avg. investm to earn that profit
What is the ARR decision rule?
For a project to be acceptable, must achieve at least a min target ARR
Competing other projects exceed min rate, select the one with highest ARR
What are the problems with ARR?
Ignores the timing of cash flows
Use of avg investment
Use of accounting profit
Define payback period
The amount of time it takes to recover the cost of an investment.
What are the advantages of payback?
Simple
Most common
Earliest cash flows are easier to predict
Emphasises liquidity
What are the key issues with payback period?
Ignores cash flows after PP
Does not take risk fully into account
Does not take timing of cash flows fully into account
What is the PP decision rule?
Projects with a shorter payback period are the most attractive
Competing projects, select the one that pays back earlier
What are the equations for average return?
Income from investment - Cost of investment = Total profit from investment
TPFI/Expected life span of asset in years = Avg. Annual Profit
100 x AAP/Cost of investment = Avg. return
What is the average return decision rule?
Project to be acceptable - achieve min AR
Competing projects - select one with higher AR
What are the advantages of AR?
Considers levels of profit
Offers easy comparison
Project exceeds the firms required AR - project gets green light
What are the disadvantages of AR?
Doesn’t look at the timing of receipts
Define Net Present Value (NPV)
The difference between the present value of cash inflows and cash outflows over a period of time.
About NPV
Takes discounts of future money
Considers opportunity cost of the capital
Compares cash outflows today with future cash inflows
Discount at a rate to the company’s opportunity cost
What are the advantages of NPV?
Prioritises profit
Takes account of time value of money
Whole life of the investment is considered
Timing of cash flows considered
Terminal value of the project included
Can use that to compare mutually exclusive projects
What are the disadvantages of NPV?
Establishing what the discount rate should be
What the discount rate/factor should be (for NPV)?
Cost of capital (borrowing)/what it cost the firm to borrow money
Reflects inflation (low at the moment)
Reflects risk
Firm’s investment criteria: maybe 15% profit
What is the required return to cover finance cost?
Interest foregone (interest rate low - discount less but still a risky environ)
Inflation (i.e. 1 or 1%)
Risk premium
What is the formula for discount factor?
1/(1+r)^n
Where r = discount rate, n = no. of years
What are the basic NPV decision rules?
Accept all +ve NPV projects
Reject all -ve NPV projects
Choose highest +ve NPV project
NOTE: Must consider sensitivity and scenario (i.e. the worth of the pound)
Why is NPV better than Payback and ARR? What does NPV address?
The timing of the cash flows
The whole of the relevant cash flows
The objectives of the business (which is to make money)
Why you can’t fully use NPV when making the final decision?
Basic quantitative stuff is not sufficient
Must look at the background to the no.s
Further analysis:
Checking and validating assumptions (i.e. where info was taken from)
Bare in mind of - Sensitivities on key variables
Scenarios - base case, best case & worst case
Define internal rate of return (IRR)
Is a metric used in financial analysis to estimate the profitability of potential investments.
