Topic 6- Investment Appraisal Flashcards
What are capital assets used for?
Capital Assets are long-term assets used to:
- Create future revenues or cost savings
- Gives distribution, service or production capacity
What are qualitative capital budgeting res unique?
- Corporate Image
- Social Responsibility
- Growth & sustainability
What is the cost of capital?
The cost of capital illustrates the firms total cost of financing
K0=WdKd+WpKp+WeKe
What is the payback period?
Payback period= no. Of years to recover initial costs
- Minimum Acceptance criteria and ranking criteria set by management
What are the advantages and disadvantages of the payback period?
Advantages
- Easy to understand
- Biased towards liquidity
Disadvantages
- Ignores time value of money
- Ignore cash flows after the payback period
- Biased against long-term projects
What is the average accounting return?
Measure of accounting profit relative to book value:
ARR= (Average Net Income)/(Average book value of investment)
Appealing but limited method
What are the advantages and disadvantages of average accounting return?
Advantages
- Easy to calculate
- The accounting information is usually available
Disadvantages
- Ignores time value of money
- Uses an arbitrary benchmark cut off rate
- Based on book value, not cash flows & market values
What is the net present value?
- One of the most popular approaches but with highly limited disadvantages
- Any project with NPV>0 should be accepted
NPV= Initial Investment + PV for future CF’s
What are advantages to NPV?
Advantages
- NPV uses cash flows
- NPV uses all the cash flows of the project
- NPV discounts the cash flows properly
What is the profitability index?
Benefit-cost ratio:
PI= (Total PV of future CF’s)/(Initial Investment)
Accept if PI>1
What are advantages & disadvantages to PI?
Advantages
- Easy to understand & communicate
- Correct decision when analyzing independent projects
- May be useful when available investment funds are limited
What is Internal Rate of Return?
IRR: the discount rate that sets NPV to 0
Accept if IRR exceeds the required return
What are advantages & disadvantages to IRR?
Advantages
- Easy to understand & communicate
Disadvantages
- IRR may not exist, or there may be multiple IRRs
- Does not distinguish between investing & borrowing
- Problems with mutually exclusive investments
What is capital rationing?
Capital rationing takes place when restriction are placed on the total amount of capital expenditure during a particular period
What is soft and hard limitations on capital rationing?
Soft limitations
- within the firm
Hard limitations
- restrictions placed outside the company
