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Flashcards · 7127 · Topic 13
Capital investment appraisal flashcards
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Topic 13: Capital investment appraisal
- Relevant cash flows: which of these are included? Depreciation, a survey already paid, a share of existing rent, residual value
- Residual value: yes, in the final year. Depreciation: no (non-cash). Survey already paid: no (sunk cost). Share of existing rent: no (paid whether or not the project goes ahead).
- Sunk cost
- Money already spent that the decision cannot change, so it is not a relevant cash flow.
- A van costs £60,000 and saves £16,000 cash a year. Payback?
- 60,000 ÷ 16,000 = 3.75 years: 3 years 9 months.
- Outlay £70,000; inflows £30,000, £25,000, £20,000 in years 1 to 3. Payback?
- Cumulative (40,000), (15,000), then +5,000. 2 years + (15,000 ÷ 20,000) × 12 = 2 years 9 months.
- Outlay £50,000; £22,000 a year for 3 years; factors 0.893, 0.797, 0.712. NPV?
- PVs 19,646 + 17,534 + 15,664 = £52,844. NPV +£2,844: accept on financial grounds, though the margin is small.
- Discount factor for year 2 at 6%, to three decimal places
- 1 ÷ 1.06² = 0.890.
- Forecast profit £14,000 after depreciation of £9,000. Net cash flow?
- 14,000 + 9,000 = £23,000: depreciation is non-cash, so add it back.
- Why does NPV fall when the cost of capital rises?
- A higher rate gives smaller discount factors, so every future inflow has a lower present value while the year-0 outlay is unchanged.
- Payback: two benefits and two limitations
- Benefits: quick and easy to understand; favours early cash, helping liquidity; relies on nearer forecasts. Limitations: ignores cash after payback; ignores the time value of money; cut-off period is a judgement.
- NPV: two benefits and two limitations
- Benefits: allows for the time value of money; uses all cash flows; shows value added in £. Limitations: harder to explain; the cost of capital is hard to estimate; assumes year-end cash flows.
- Project P has the shorter payback; project Q the higher positive NPV. Why might a business still choose P?
- If it is short of cash, or Q's later forecasts look unreliable, because P recovers the outlay sooner. NPV alone favours Q.