Week 7 Flashcards
(27 cards)
What is investment appraisal?
Known as capital budgeting.
Prices of evaluating and selecting long-term investments that would contribute towards the goal of increasing the firms value
What is the main motives for capital expenditure?
Expansion
Replacement
Renewal
What are the two types of projects?
- Independent projects
- Mutually exclusive projects
What are independent projects?
Projects whereby the acceptance of one does not preclude others from being considered
What are mutually exclusive projects?
Projects that serve the same function. The acceptance of one project in a group prevents all other projects from being chosen
What is cash flows?
Net amounts of cash received for a project
Formula:
Net cash flow = cash inflows - cash outflows
How do you calculate profit?
Net cash flows - depreciation
If depreciation not given, calculate it using straight-line method
What is deprecation?
Loss in the value of an asset
How do you calculate the straight line method?
Two ways:
(Cost price-scrap value) x %
Or
(Cost price-scrap value)/useful life
What are three investment appraisal techniques based on cash flow?
- pay back period
- bet present value
- internal rate of return
What is the one investment appraisal based on profits?
Accounting rate of return
What is the payback period?
Measures how long will it take for the investment to pay for itself out of net cash inflows which it is expected to generate
What are the advantages of the payback period?
Easy to apply
What are the disadvantages of the payback period?
Ignored cash flows beyond the payback period
Ignored the time value of money
What is the accounting rate of return method?
Compares the average cost of the investment
It uses profits instead of cash flow
How do you calculate the average investment?
Initial investment + end investment/2
How do you calculate the AAR
Average annual profit/average value of investment
Advantages of AAR?
Simple to calculate
Looks at the whole life of the project
Disadvantages of AAR?
Ignores time value of money
Uses profits instead of cash flows
Ignored taxation and capital allowances
What is the bet present value method?
Takes into account the time value of money. Makes use of a principle called discounting.
What is annuity?
It is a stream of similar receipts or payments that are receivable or payable in regular intervals
How do you project evaluate?
Net present value is the difference between discounted future cash outflows and discounted future cash inflows from an investment period.
NPV = 0 : accept
Project rate of return = business’s required rate of return
NPV = positive : accept
Project rate of return is greater than required rate of return
NPV = negative
Project rate of return is less than required rate of return
What is internal rate of return?
Represents true interest rate earned on an investment during its economic life
It’s the maximum cost of capital that can be applied to finance a project without causing harm to shareholders
When does interns rate of return happen?
When NPV = 0
