Topic 8: Making Capital Investment Decisions

Question 1

Net Present Value (NPV)

Answer 1

The difference between an investments market value and it’s cost.

NPV Rules:
If NPV is positive the investment should be accepted

If NPV is negative the investment should be rejected

Note: Check example

Question 2

Discounted Cash Flow Valuation

Answer 2

The process of valuing an investment by discounting it’s future cash flows

Note: Check example

Question 3

Incremental Cash Flows

Answer 3

The difference between a firm’s future cash flows with a project and those without the project.

Essentially shows consequences of taking the project on the company.

Question 4

Sunk Cost

Answer 4

A cost that has already been incurred and cannot be returned. This should not be considered an investment decision

Question 5

Opportunity Cost

Answer 5

The most valuable alternative that is given up if a particular investment is undertaken.

Question 6

Net working capital

Answer 6

The aggregate amount of all current assets and current liabilities (short term capital).

Is used to measure the short-term liquidity of a business - often investment projects require additional short term capital e.g. more cash.

Question 7

What are Pro Forma Financial statements

Answer 7

Financial statements projecting future years operations

usually made up of an income statement and balance sheet

Summarises accounting profits, not cash flows

Note: Check example of a Pro Forma financial statement on notes

Question 8

Sales (Revenue)

Answer 8

Unit sales multiplied by the price per unit

Question 9

Variable costs

Answer 9

A cost that varies with the number of units produced

Calculated as unit sales multiplied by the cost per unit

Question 10

Gross profit

Answer 10

Sales minus the cost of the goods sold

Calculated as the total sales minus the variable costs

Question 11

Fixed Costs

Answer 11

A cost that is fixed and does not vary with the number of units sold (e.g. rent)

Question 12

Depreciation

Answer 12

The allocation of the cost of a capital asset

It is an accounting adjustment to make sure that the cash flow cost of an asset is allocated fairly over the whole period which the asset is used.

Asset’s initial capital cost / Period of its useful life

Question 13

Tax

Answer 13

Profit before tax multiplied by the tax rate

Question 14

Net income (Profit)

Answer 14

Profit after all expenses and costs have been deducted

Question 15

Straight line depreciation definition and formula

Answer 15

Spreads the cost of the asset evenly over it’s useful life. (Charges an equal annual amount as a depreciation expense on the income statement).

Formula: Economic cost of asset / Economic life

i.e; original cost less and scrap or residual value

Note: Check examples on notes

Question 16

Reducing Balance depreciation definition and formula

Answer 16

Is this needed??? Check presentation!

Question 17

Project Cash Flow Formula

Answer 17

Project cash flow = Project OCF - Project CAPEX

Where:
OCF = Operating cash flow
CAPEX = Capital Expenditure

Note:
Operating cash flow = Net income + depreciation +/- Net working capital

Then Operating cash flow +/- Capital spending = Project Cash flow

REVIEW PROJECT CASH FLOW QUESTIONS IN NOTES

Question 18

Net working capital

Answer 18

The aggregate amount of all current assets and current liabilities (Short term capital). It is used to measure the short term liquidity of a business.

Question 19

Valuation

Answer 19

The process of valuing an investment by discounting its future cash flows.