long-term decision making Flashcards
(19 cards)
investment decision making process
- origination of a proposal
- project screening (qualitative eval)
- analysis and acceptance/ rejection
- monitoring and review
investment appraisal
looking at long-term choices about specific investments in future projects (10-20 years)
what does payback period measure?
time it takes cash inflows to equal initaial cash outflow
how to turn yearly profits into cash flows?
equation
profit + depreciation = cash flow
advantages of payback
- simplicity
- focus on early payack can enhance liquidity
- minimse risk
- suitbale when capital is rationed
disadvantages of payback
- ignores benefits after the payback period
- ignored objective of wealth maximisation
- ignoreds time value of money
- cannot distinguish between projects with same payback period
what does accounting rate of return (ARR) measure?
Average profit from an investment expressed as a percentage of the average investment made
ARR
equation
average operating profit/ average capital emplpyed x 100
Average operating profit
equation
total profit/ no.of years of project
average capital employed
equation
cost + scrap/ 2
ARR advantages
- comparison with companies existing or targeted return
- readily understood
- takes account of all the costs/ benefits over project life
ARR disadvantages
- method based on profit but cash is ultimate measure of economic wealth
- arr percentage is potentially meaningless
- doesnt consider timing of profits
- ignores time value of money
time value of money
money avaible at present time worth more than same amount at a future date
why consider time value of money?
- can spend or invest now
- less risky to have it now than the promise of it in the future
- payback and ARR do not consider this
how can businesses incorporate the time value of money into investment appeal?
discount= future cash flows by a given amount to turn them into todays money
discount rate process
start with future value and convert it to present by applying discount rate
what does net present value (NPV) measure?
sum of all years discounted cash flows less inital cash outflow
NPV Evaluation
- takes time vlaue of money into account
- linked to objective of maximisng shareholder wealth as it measured the effect of taking on the project
- based on chas flows not profits
- can incorporate risk into decision
- provides clear decisions
NPV disadvantages
- managers find it easier to interpret the meaning of a % return from a project rather than the sum of discounted cash flows
- accuracy of results subject to correct chocie of dicosunt rates to be applied
