Long term decision making

Question 1

Two categories of capital budgeting

Answer 1

Screening decisions- does a project do what we want it to and give back. Preference decisions- you can only do one project, which is the best

Question 2

What is Payback period

Answer 2

Measures the rate of recovery of original investment. No time value is taken into account. The shorter the better

Question 3

Payback formula

Answer 3

Take away until it is positive. Previous years answer/year it went positives cash flow. Month= answer x 12. Accept or not

Question 4

Advantages of Payback

Answer 4

Favours projects that gives early return of cash so is a cautious approach.
Simple

Question 5

Disadvantage of Payback

Answer 5

Does not take into account the time value of money, so will not be worth the same in future.
Ignores any net cash flow after payback period so could miss any increased profits

Question 6

What is Accounting rate of return

Answer 6

for a project to be acceptable, it must achieve a target ARR that a business sets. The highest ARR should be selected

Question 7

ARR formula

Answer 7

Average profit (total profit/how many years aborting profit for)/ average investment (initial investment + final investment /2) x 100 to give a %

Question 8

ARR advantage

Answer 8

Compared to Payback, takes into account all the profits expected

Question 9

ARR disadvantage

Answer 9

Does not take into account the time value of money.
Percentage return provides no insights into size of return, 10% return on £1 would be worse than a 2% return on £1m

Question 10

Calculating the future value

Answer 10

present value number (1 + interest rate as a decimal) ^ number of years

Question 11

Net present value

Answer 11

Expected rate of return giving up by investing in a project

Question 12

Net present value formula

Answer 12

Cash flow x discount rate for each year. add up and - year 0 cost

Question 13

Net present value formula- discount rate

Answer 13

1/(1 + interest rate as a decimal) ^ number of years

Question 14

Advantage of NPV

Answer 14

Time value of money is taken into account. Depends solely on the forecasted net cash flows and discount rate so other factors like managers taste will not affect the budget
The highest NPV gets chosen!

Question 15

Disadvantage of NPV

Answer 15

Can not just consider financial factors, you need to look at the company’s ethos etc.
Not easy to select a appropriate discount rate
When the firm is capital rationing it will fail as a decision rule

Question 16

Internal rate of return

Answer 16

discount rate is the rate of return when NPV is precisely zero

Question 17

IRR formula

Answer 17

lowest discount factor% +(the NPV of a/ NPV of a - NPV of B)
x (highest discount factor - lowest discount factor)% x 100

Question 18

Advantage of IRR

Answer 18

clear percentage return so easy to comprehend

Question 19

Disadvantage of IRR

Answer 19

Cannot determine which one to choose because the higher IRR may have a lower NPV

Question 20

What is a annuity

Answer 20

a series of identical cash flows

Question 21

IRR when just asked to find the aprox rate

Answer 21

try the % and work out the NPV. it is the answer closest to 0