Kap 4 - Investment decision making Flashcards
What is the investment management process and why is it important to have one?
- Phase 1 (selection) answers the question: How do you know you have selected the best projects?
- Phase 2 (control) answers the question: What are you doing to ensure that the projects will deliver the planned benefits?
- Phase 3 (evaluation) answers the question: Based on your evaluation, did the systems deliver what you expected?
To survive in the long term, organizations seek to ensure that they do the right projects at the right time
Explain the purpose and content of a feasibility study
The feasibility study is the initial justification needed to determine if a project is ’doable’.
Purpose:
- assess the factors which might affect the project
- determine if a business opportunity is possible
- improve confidence in the project idea
Criteria:
- The business criterion - are the cost and timescale right for the business as a whole? Is the return big enough to justify the risk?
- The technical criterion - is it going to work?
- The functional criterion - will the result satisfy the end users?
Explain the purpose and content of a business case.
A business case is prepared to ensure that projects put forward for funding reflect business strategy and will deliver the required benefits and returns to shareholders and stakeholders.
Purpose is to obtain management commitment and approval for investment.
What is capital budgeting and what is its purpose?
A financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare and select projects is needed. This procedure is called ’capital budgeting’
What is the difference between financial and economic appraisal?
The financial appraisal tries to determine if the project will work as a business proposition. In other words, it considers only those costs and benefits which are relevant to the business and those that will finance it.
The economic appraisal seeks to decide if the flow of benefits is greater than the flow of costs, measured against broader socioeconomic criteria. Factors such as environmental impacts, employment effects, balance of payments effects and poverty alleviation might be ’taken into account.
What is an externality?
An externality is said to occur whenever somebody who is not directly involved in a transaction incurs a cost or enjoys a benefit as a result of that transaction.
What is sunk cost?
Costs which a business has already spent, or has contracted to spend, are not relevant to a decision made today about future capital investments.
The decision to incur such costs has been already taken and, by definition, the business will incur these costs regardless of decisions taken today. They are ’sunk costs’.
Explain what a discount rate (also known as hurdle rate and benchmark rate) is and how it is calculated.
The cost of capital is the minimum rate of return required from the project for it to be worthwhile.
What are the twelve different project prioritization techniques presented in Gardiner (2005)?
Prioritisation techniques should reflect:
the degree of business risk involved
the organisation’s internal and external environment
cost of prioritisation activities compared to expected project returns
- NPV
- IRR
- Payback
- Discounted payback
- PI-ratio
- Decision tree
- Scoring and ranking models
- Portfolio optimization
- Simulation
- Real options
- Cognitive modelling
- Cluster analysis
What techniques belongs to the category financial analysis project prioritization techniques?
- NPV
- IRR
- Payback
- Discounted payback
- PI-ratio
What is a project’s NPV?
What are the decision-making criteria for the NPV approach according to the lecture slides?
Minimum acceptance:
NPV > 0
Ranking:
Highest NPV
Must estimate cash flows, discount rate and initial investment
How is net present value affected by a change in cash flows, investment cost, timing and discount rate?
Cash flow: If a future cash flow is increases by 100 m.u., then the NPV is increased by a 100/(1 + r )t . In other words, the value of an additional 100 m.u. depends on both the discount rate and the timing. The higher the discount rate and the further into the future the additional 100 m.u. occur, the less it is worth in terms of NPV.
Investment cost: If the investment cost increases by 100 m.u., then the NPV is decreased by a 100 m.u.
Timing: Let’s say a positive cash flow of 100 m.u. is moved further into the future, then the NPV would decrease as it is being discounted more. On the other hand, if a negative cash flow of a 100 m.u was moved further into the future, then the NPV would increase due to additional discounting.
Discount rate: Increasing a discount rate would push any future cash flow closer to zero. This can be either good or bad depending on whether the cash flow is positive or negative. Hence, the overall effect of changing the discount rate will depend on the characteristics of the cash flow vector.
What is a project’s internal rate of return?
What are the decision-making criteria for the internal rate of return approach according to the lecture slides?
IRR = the discount rate that sets the NPV to zero.
IRR measures relative profit.
Minimum acceptance:
IRR > discount rate
- IRR decision-making criterion for individual capital investments is only valid when the relationship between NPV and discount rate is monotonically decreasing.
- The relationship is guaranteed to be monotonic when all future cash flows are positive.
Ranking:
Select alternative with the highest IRR
* Most other sources recommend not to use the IRR approach in this scenario.
- The issue is that IRR measures relative profit. In the end of day, however, it is the absolute monetary value of a project that matters.
- If the investment costs are not comparable, then IRR is not a well suited tool for choosing between mutually exclusive projects.
How is payback period and discounted payback period calculated?
What are the decision-making criteria for the payback period and discounted payback period approach?
How long does it take the project to pay back its initial investment, taking into account time value of money.
Minimum acceptance:
Accept capital investment opportunities which have a payback period equal to or shorter than the target payback period.
Ranking:
Accept the capital investment opportunity which has the shortest payback period.
How is profitability index calculated?
What are the decision-making criteria for the profitability index approach?
PI = Total PV of all future cash flows/initial investment
Minimum acceptance:
Accept if PI > 1.
Ranking:
Select alternative with the highest PI
