Investment decisions

Question 1

Why are investment decisions important to a business?

Answer 1

1. Large amount of resources are often invovled

2. difficult to back out of an investment when undertaken

Question 2

what are the main investment appraisal method?

Answer 2

1. Accounting rate of return (ARR)
2. Payback period (PP)
3. Net Present Value (NPV)
4. Internal rate of Return (IRR)

Question 3

What is the formula for ARR?

Answer 3

Average annual operating profit / Average investment to earn that profit

Question 4

how do you calculate average annual profit?

Answer 4

Operating profit - Depreciation

Question 5

How do you work out average investment?

Answer 5

Investment at beginning + Investment at the end of the project / 2

Question 6

When decision Making - what 3 steps must you take?

Answer 6

Step 1 - Identify Relevant Cash
Step 2 - Establish the exact timing of relevant cash
Step 3 - Apply Investment appraisal tools

Question 7

how do you identify a relevant cost?

Answer 7

1. Only interested in future impact from the decision
2. If cost or revenue would have arisen in any event - NOT relevant
3. Past decisions even where the cost has not been settled is NOT relevant
4. Cash is RELEVANT

Question 8

whats the difference between Cash and Profit?

Answer 8

Profit - a measurement tool to enable financial results to be reported for specific period, Some judgement is also made.

Cash - the economic unit

Question 9

name some advantages and disadvantages of PayBack Period?

Answer 9

Advantages -

1. simple/ quick / easy to understand
2. can enhance liquidity
3. eliminates some risk

DisAd -

1. Ignores cash flows / timing of cash / time value of money
2. Unable to distinguish between projects with same payback period
3. may lead to excessive investment in short term

Question 10

What are the Advantages and limitations of ARR?

Answer 10

Advantages:

• Accounting profit can be easily calculated
• quick
• Easily understandable by non financial managers

Limitations:

• Ignores time value of money / length of project / investment
• relative measure
• subject to judement

Question 11

Why is NPV better then ARR and PP?

Answer 11

Fully addresses:

• timing of cash flows
• considers the relevant cash flows
• Wealth maximisation - Objective
• Based on cash - avoids subjectivty