Making Long-term Investment Decisions

Question 1

what are long term investment decisions

Answer 1

projects with long term implications (more than one year)

Question 2

long term investment for profit seeking firm

Answer 2

new non-current asset, IT system, advertising campaign, accquisitions

Question 3

long term investment in the public sector

Answer 3

new transport, hospital

Question 4

what type of expenditure is relevant to long term decisions

Answer 4

capital expenditure
capital spent on NCA’s with depreciation applied

Question 5

what are the four stages of the investment appraisal process

Answer 5

identify possible investment projects
carry out initial screening
evaluate and approve the project
monitor and review the project

Question 6

what are some of the considerations of the investment appraisal process

Answer 6

alignment with company direction
is the project possible
are there better alternative investments
are there non-financial factors to consider

Question 7

what are the four methods of investment appraisal

Answer 7

payback period
net present value
internal rate of return
accounting rate of return

Question 8

what is the payback period

Answer 8

the time for the cash inflows to equal the initial cash investment

Question 9

what are some advantages of the payback period

Answer 9

simple to use and understand
it focuses on early payback which is better for liquidity
the risk is reduced when early cash flows are emphasised

Question 10

what is associated with large later cash flows

Answer 10

more risk and uncertainty

Question 11

what are some disadvantages of the payback period

Answer 11

cash flows after the payback period are ignored
these could be substantial and potentially large

Question 11

what is discounted cash flow

Answer 11

the time value of money
£1 today is not worth the same as £1 in one year

Question 11

what does discounted cash flow do

Answer 11

converts a future cash flow to a present value

Question 11

rate of return/discount value/cost of capital

Answer 11

chosen as the minimum expected return

Question 12

how do you calculate future value

Answer 12

investment(1+rate of return)^number of years

Question 12

how do you calculate present value

Answer 12

future value/(1+rate of return)^number of years

Question 13

what return would the shareholders expect

Answer 13

a comparison against the return from an alternative risk free investment

Question 14

equity capital

Answer 14

alternative investment rate or expected return

Question 15

debt capital

Answer 15

interest rate on the loan used for investment

Question 16

what do you record in year zero when discounting cash flows

Answer 16

the initial investment

Question 17

what does net present value (NPV) do

Answer 17

takes account of the time value of money using all cashflows
calculates the present value of expected future cash outflows and inflows and compares them to the initial investment

Question 18

if NVP is positive

Answer 18

company financially better

Question 19

if NVP is zero

Answer 19

acceptable but creates no value

Question 20

if NPV is negative

Answer 20

company is financially worse

Question 21

NPV =

Answer 21

sum of all present values (FV/(1+r)^n) less the initial investment

Question 22

what is the internal rate of return (IRR)

Answer 22

the discount rate where NPV = zero the return internally generated by the project

Question 23

if IRR > cost of capital

Answer 23

project is financially accepted

Question 24

if IRR < cost of capital

Answer 24

project is financially rejected

Question 25

how do you calculate the IRR

Answer 25

trial and error using different discount rates until NVP = 0 IRR = lower discount rate + (NVP using lower rate/(NVP lower rate - NVP higher rate))(lower discount rate - higher discount rate)

Question 26

advantages of IRR

Answer 26

accounts for all cash flows in all years assumes the time value of money percentage returns can be easily understood

Question 27

disadvantages of IRR

Answer 27

takes no account of the size of the investment difficult to apply if a project has non-conventional cash flows

Question 28

what is different about the accounting rate of return (ARR)

Answer 28

it is profit based not cash based

Question 29

what does ARR compare

Answer 29

average profit and average investment

Question 30

ARR =

Answer 30

average profit/average investment x100%

Question 31

average profit =

Answer 31

(cashflow-depreciation)/life of project

Question 32

average investment =

Answer 32

(investment + residual value)/2

Question 33

how is ARR interpreted

Answer 33

compared with a minimum required ARR acceptable if it is greater than the required limit

Question 34

advantages of ARR

Answer 34

easy to calculate and understand returns over the whole life of the project considered similar to RoCE which is often monitored as an overall assessment of business performance

Question 35

disadvantages of ARR

Answer 35

no account of the time value of money it is a percentage so doesn't account for different sizes of investments based on accounting profits which are subjective and affected by accounting policies

Question 36

what are PB, NVP and IRR based on

Answer 36

forecast cash flows