BUSN1001 Study Guide - Final Guide: Cash Flow, Net Present Value, Discounting
Capital Investment Decisions
• Capital investment decisions – long-term decisions involving the purchase of new
equipment and the acquisition or expansion of facilities used in a business.
The Nature of Investment Decisions
• Investment decisions are of crucial importance for the following reasons:
o Large amounts of resources are often involved, therefore if mistakes are made,
the effect can be significant.
o It is often difficult and expensive to 'bail out' of an investment once it has been
made.
• The essential feature: the time factor.
Methods for Capital Investment Decisions
1.
Accounting
Rate of
Return
• ARR methods takes the average accounting profit the investment will
generate.
• ARR = average annual net profit/average investment to earn that
profit x 100%
• Average investment = (initial investment + expected residual value)/2
• Decision rules:
o For any project to be accepted, it must achieve a target ARR as
a minimum.
o If there are competing projects that exceed the minimum rate,
the one with the highest ARR would normally be chosen.
• Advantages:
o Easy to calculate and understand.
o Is a measure of profitability that is consistent with return on
assets (ROA).
• Disadvantages:
o ARR fails to take into consideration the time value of money.
o ARR uses accounting profit, however over the life of a project,
cash flow matters more than accounting profits.
2. Payback
Period (PP)
• PP - the length of time taken for an initial investment to be repaid out
of the net cash inflows from a project.
• Decision rules:
o For a project to be acceptable it would need to have a
maximum payback period (as a benchmark).
o If there are competing projects that meet (i.e. equal or shorter
than) the maximum payback period, the project with the
shorter payback period would normally be chosen.
• Advantages:
o Easy to calculate and understand.
o Enables a firm to determine how long it will take to get its
investment back.
o Favouring projects with a shorter period.
o Particularly useful when future cash flows are less certain.
• Disadvantages:
o With the payback period, it ignores the time value of the cash
flows.
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Document Summary
Capital investment decisions: capital investment decisions long-term decisions involving the purchase of new equipment and the acquisition or expansion of facilities used in a business. Investment decisions are of crucial importance for the following reasons: large amounts of resources are often involved, therefore if mistakes are made, the effect can be significant. It is often difficult and expensive to "bail out" of an investment once it has been made: the essential feature: the time factor. If there are competing projects that exceed the minimum rate, the one with the highest arr would normally be chosen: advantages, easy to calculate and understand. If the calculation of the minimum rate of return (the discount rate) is not accurate, then the npv is less reliable: depends on the accuracy of the estimates of future cash flows. Internal rate of return (irr) (because of poor estimates).
