Week 4 Flashcards
(24 cards)
What are Key factors of investment decision?
▪Require huge funds
▪High degree of risk
▪Long-term effect
What is the Process of investment decision-making?
▪Analysis and planning
▪Evaluation of costs and benefits
▪Project selection and implementation
▪Post-implementation evaluation
What is the need for investment appraisal?
- An important part of the overall financial strategy of the business.
- Maximise the value of the business by maximising (long-term)
profits. - Find out whether the returns of investments are sufficient to make it worthwhile investing the funds in the first place
In terms of Investment appraisal. What are non-discounted cash flow methods?
- Accounting rate of return (ARR)
- Payback Period (PP)
In terms of Investment appraisal. What are discounted cash flow methods?
- Net present value (NPV)
- Internal rate of return (IRR)
What is accounting rate of return?
Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. The ARR is a formula used to make capital budgeting decisions.
What is the equation for Accounting rate of return?
ARR = Operating Profit / Investment
What is annual profit equation?
annual profit = (total cashinflow - initial + residual)/years
What is average investment equation?
average investment = (initial + residual)/2
What is advantages of APR?
▪ It is much easier to communicate with other managers in accounting language rather than in finance language.
▪ The information needed to calculate ARR is readily available
in firm’s accounting system. Information on project cash
flows is not provided by the firm’s accounting system
automatically.
▪ The performance of managers is usually based on some
accounting measure, such as return on capital employed or
return on investment. These accounting measures are very
similar to ARR. So, many mangers are very concerned about the ARR of a project.
What are Problems with ARR?
❖Cannot handle competing investments
❖High degree of arbitrariness in defining the target ARR
❖Focuses on profit rather than cash flow
❖Ignores the time value of money
What is payback period?
The payback period is the amount of time it takes to recover or pay back the initial investment.
What is a decision rule for payback period?
◦ Shorter than an upper threshold set by the management.
◦ Projects accepted should have the shortest payback
period
What is the merit of payback period?
The payback rule is used by many companies because of its simplicity.
What are drawbacks of Payback period?
- Ignores cash flows after the PP.
- Does not take time value of money into account.
- Does not take risk fully into account (e.g., uncertainty in payments).
- High degree of arbitrariness in defining the target PP
What factors does discounted cash flow take into account?
▪ Interest forgone
▪ Inflation
▪ Risk premium
▪ Time preferences
What is net present value?
Net Present Value compares the present value of cash
inflows (benefits) to the present value of cash outflows
(costs)?
equation for NPV?
NPV = PV(Revenues) – PV(Costs) = PV(Net Profit)
What is the decision rule for NPV?
▪Accept projects with positive NPV
▪Between projects with positive NPVs, the higher the
better
What is a decision rule for accounting rate of return?
▪Accept a project if 𝐴𝑅𝑅 > 𝑇𝑎𝑟𝑔𝑒𝑡 𝐴𝑅𝑅
- The target ARR would be set by the management or the finance officer.
- If more than one project have ARRs over the target, then the one with the highest should be preferred
What is Internal Rate of Return?
he IRR is the specific discount rate(s) that produces an NPV of zero.
What are the decision rules for Internal Rate of Return?
▪Take any investment where the IRR exceeds the discount rate (the cost of capital). Turn down any investment whose IRR is less than the discount rate (the cost of capital).
What are merits of IRR?
- IRR remains useful for investment decision-making
- It measures the average return of the investment;
- It measures the sensitivity of the NPV to any estimation
error in the cost of capital.
What are Drawbacks of IRR
- In some cases, the IRR rule may disagree with the NPV rule and thus be incorrect.
- Select the project with the highest NPV.
- Selecting the project with the highest IRR may lead to mistakes.
- Situations where the IRR rule and NPV rule may be in conflict:
- Ignores the scale of investment
- Delayed Investments
- Nonexistent IRR
- Multiple IRRs
