Week 2 - Capital Investment Decisions

Question 1

What is investment appraisal?

Answer 1

The process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing shareholders’ wealth.

Question 2

What are the two types of expenditure?

Answer 2

• Capital expenditure
• Operating expenditure

Question 3

What is capital expenditure?

Answer 3

An outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year.

Question 4

What is operating expenditure?

Answer 4

An outlay of funds by the firm resulting in benefits received within 1 year.

Question 5

Why do we need to perform investment appraisal?

Answer 5

To allocate limited funds among numerous competing projects and assess long-term impacts.

Question 6

What is capital rationing?

Answer 6

The process through which companies decide how to allocate their capital among different projects.

Question 7

What are mutually exclusive projects?

Answer 7

Projects that compete with one another; the acceptance of one project eliminates all others from further consideration.

Question 8

What are independent projects?

Answer 8

Projects that do not compete with one another; the acceptance of one does not eliminate the others.

Question 9

What is an accept-reject approach in capital budgeting?

Answer 9

The evaluation of capital expenditure proposals to determine whether they meet a firm’s minimum acceptance criterion.

Question 10

What is a ranking approach in capital budgeting?

Answer 10

The ranking of capital expenditure projects based on some predetermined measure, such as the rate of return.

Question 11

What are the five steps of the investment appraisal process?

Answer 11

• Proposal generation
• Review and analysis
• Decision making
• Implementation
• Follow-up

Question 12

What are the four main investment appraisal techniques?

Answer 12

• Accounting rate of return (ARR)
• Payback period (PB)
• Net present value (NPV)
• Internal rate of return (IRR)

Question 13

What is the Accounting Rate of Return (ARR)?

Answer 13

The average accounting profits that the investment will generate, expressed as a percentage of the average investment.

Question 14

How is ARR calculated?

Answer 14

ARR = (Average profits / Average investment) x 100%

Question 15

What is the Payback Period (PB)?

Answer 15

The length of time required for a firm to recover its initial investment in a project from cash inflows.

Question 16

What is Net Present Value (NPV)?

Answer 16

The present value of the future cash inflows of a project minus the initial investment.

Question 17

What is the formula for NPV?

Answer 17

NPV = Present value of cash inflows – Initial investment

Question 18

What is the discount rate used in NPV calculations?

Answer 18

The cost of capital of the company.

Question 19

What does a positive NPV indicate?

Answer 19

The project should be accepted.

Question 20

What is the Weighted Average Cost of Capital (WACC)?

Answer 20

WACC = weighted average cost of debt + weighted average cost of equity.

Question 21

Fill in the blank: The investment appraisal process consists of _______.

Answer 21

[five steps]

Question 22

True or False: The Payback Period takes into account cash inflows beyond the payback period.

Answer 22

False

Question 23

What is the main disadvantage of the Accounting Rate of Return (ARR)?

Answer 23

It ignores the time-value of money.

Question 24

What is a disadvantage of the Payback Period (PB)?

Answer 24

It does not take into account the time value of money.

Question 25

What is the primary focus of investment appraisal techniques?

Answer 25

To evaluate potential investments and their impact on shareholder wealth.

Question 26

What is the importance of follow-up in the investment appraisal process?

Answer 26

To monitor results and compare actual costs and benefits with those that were expected.

Question 27

What is the present value of cash flows?

Answer 27

The present value of cash flows is the current worth of a future sum of money or stream of cash flows given a specified rate of return. ## Footnote This incorporates the time value of money.

Question 28

What does NPV stand for?

Answer 28

Net Present Value ## Footnote NPV is a method used to evaluate the profitability of an investment by calculating the difference between the present value of cash inflows and the present value of cash outflows.

Question 29

Fill in the blank: The formula for IRR involves finding a discount rate where the NPV is _______.

Answer 29

zero

Question 30

What is the decision criterion when evaluating projects using IRR?

Answer 30

If the IRR is greater than the cost of capital, accept the project; if less, reject it. ## Footnote This ensures that the firm earns at least its required return.

Question 31

What is the primary advantage of using NPV?

Answer 31

It incorporates the time-value of money and provides clear signals. ## Footnote NPV takes into account all relevant information and the timing of cash flows.

Question 32

What is a disadvantage of using NPV?

Answer 32

Calculating a discount rate can be problematic. ## Footnote The weighted average cost of capital can be difficult to determine.

Question 33

What does IRR stand for?

Answer 33

Internal Rate of Return ## Footnote IRR is the discount rate that makes the net present value of all cash flows equal to zero.

Question 34

List three methods of calculating IRR.

Answer 34

* Trial and error * Excel function * Interpolation method ## Footnote Interpolation method uses two rates to find the IRR between them.

Question 35

True or False: NPV is the preferred method for investment appraisal.

Answer 35

True

Question 36

What should be ignored when evaluating relevant cash flows?

Answer 36

* Past costs incurred * Future costs that remain unchanged regardless of the decision ## Footnote These do not vary with the decision and are therefore not relevant.

Question 37

What is meant by 'cash flows not profit flows'?

Answer 37

Cash flows focus on actual cash in and out rather than accounting profits. ## Footnote Adjust profit flows for non-cash items like depreciation to derive cash flows.

Question 38

What is the impact of discount rate on present value?

Answer 38

A higher discount rate decreases the present value of future cash flows. ## Footnote This reflects the time value of money.

Question 39

What is the ethical consideration in investment appraisal?

Answer 39

The ethical, social, and environmental impacts of the project. ## Footnote These considerations affect stakeholders such as employees and the community.

Question 40

Fill in the blank: The objective of investment appraisal is to maximize _______.

Answer 40

shareholders’ wealth

Question 41

What are relevant cash flows?

Answer 41

Cash flows that vary with the decision being made. ## Footnote These include opportunity costs and exclude fixed costs.

Question 42

What is the formula used to calculate IRR?

Answer 42

IRR = Lr + [(NL / (NL - NH)) * (Hr - Lr)] ## Footnote Where Lr is the lower discount rate, Hr is the higher discount rate, NL is the NPV at the lower rate, and NH is the NPV at the higher rate.

Question 43

What does the term 'mutually exclusive' mean in project selection?

Answer 43

Only one project can be accepted among competing options. ## Footnote This is relevant when comparing projects with similar objectives.

Question 44

What is a consideration for decision-making in investment appraisal?

Answer 44

The assumptions made in the calculations and their validity.

Question 45

What are the common investment appraisal techniques used by CFOs?

Answer 45

* IRR * NPV * Payback approach ## Footnote These techniques are more prevalent in larger firms.