Pre Lecture 8 Capital Investment Decisions Flashcards
(20 cards)
What is the definition of capital investment decisions?
Long-term investments involving current spending for future benefits
Capital investments typically aim to generate future returns through projects such as new product lines, factories, or infrastructure upgrades.
List three examples of capital investments.
- New product lines
- Factories
- Equipment upgrades
- Infrastructure projects
These examples illustrate the types of projects that require significant upfront investment.
What are the characteristics of capital investment decisions?
- High initial investment
- Long time horizon
- Benefits uncertain
- Hard to reverse decision
These characteristics highlight the complexities and risks involved in capital investment.
What role does management accounting play in capital investment decisions?
Helps reduce risk by providing numerical analysis for decision making
Management accounting offers insights into financial data, aiding in better decision-making processes.
What is capital rationing?
When not all projects can be funded due to financial limits
Capital rationing forces organizations to prioritize projects based on available resources.
What are the two types of capital rationing?
- Soft capital rationing
- Hard capital rationing
Soft capital rationing refers to internal limits, while hard capital rationing is due to external constraints like bank credit limits.
Name two categories of capital investment appraisal techniques.
- Non-discounting techniques
- Discounting techniques
These categories include different methods for evaluating the viability of investment projects.
What are two examples of non-discounting techniques?
- Accounting rate of return (ARR)
- Payback Period (PP)
Non-discounting techniques provide simpler assessments of investment projects.
What are two examples of discounting techniques?
- Net present value (NPV)
- Internal rate of return (IRR)
Discounting techniques consider the time value of money in investment evaluations.
How is the Accounting Rate of Return (ARR) calculated?
ARR = Average annual operating profit / Average investment x 100
This formula provides a percentage return based on average profit and investment.
What is the first step in calculating ARR?
Calculate depreciation (if needed): (Cost - Residual value) / Useful life
This step is crucial for determining the annual profit after accounting for asset depreciation.
What decision rule applies to ARR?
Accept if ARR > company’s target rate
This rule helps in making informed decisions about which projects to pursue based on their expected returns.
List one advantage of using ARR.
- Can be linked to ROCE
This advantage allows companies to align investment decisions with their overall profitability metrics.
What is one disadvantage of using ARR?
- Uses profit not cash flow - subject to accounting choices
This limitation can lead to discrepancies in investment assessments due to varying accounting practices.
Fill in the blank: The __________ ignores size and timing of cash flows.
target ARR
This factor can lead to misleading evaluations of investment projects.
What is the method to calculate the Payback Period (PP)?
- Use cash flows (not profits)
- Calculate cumulative cash flows until investment is recovered
- For fractional year: PP = cumulative CF at start of payback year / cashflow in payback year x 12 months
This method focuses on cash inflows rather than accounting profits.
What are the decision rules for accepting a project based on Payback Period?
- Accept if PP < target period
- Choose the project with the shortest PP
These rules help prioritize projects based on liquidity and recovery time.
List three advantages of using the Payback Period method.
- Emphasises liquidity
- Quick and easy to calculate
- Cash flow based (more objective)
These advantages make the PP method attractive for quick assessments of investment viability.
List three disadvantages of using the Payback Period method.
- Ignores cashflows after payback
- Doesn’t measure profitability
- Risk assessment is limited
These disadvantages indicate potential shortcomings in evaluating long-term investments.
What is Capital Investment Appraisal?
A process used by companies to evaluate and prioritise long-term investments
This process helps organizations decide which projects to undertake based on financial analysis.
