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Capital investment decisions: appraisal methods

12 important questions on Capital investment decisions: appraisal methods

When should a firm only invest in capital projects?

Af firm should only invest in  capital projects if they yield a return in excess of the opportunity cost of the investment, which is also known as the minimum required rate of return, cost of capital, discount rate or interest rate.

Time value of money

The concept that $1 received today is worth more than $ received tomorrow is known as the time value of money.

Which four methods of appraising capital investments are there?

The NPV, IRR, Accounting rate of return and payback methods. The first tow take the time value of money into account, whereas the latter two don't.
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Internal rate of return

The internal rate of return (IRR) is an alternative technique for choosing which decision to make. The IRR represents the true interest rate earned on an investment over the course of its economic life. This measure is sometimes referred to as the discounted rate of return. It is the discount rate that will caus the NPV af an investment to be zero. It can also be described as the maximum cost of capital that can be applied to a finance project without causing harm to shareholders

What is the decision rule of IRR?

The decision rule is that if the IRR is greater than the opportunity cost of capital, the investment is profitable an will yield a positive NPV

The calculation of the IRR is easier when the cash flows are of a constant amount each year:

discount factor = investment costs/annual cash flow

Why is depreciation not included in the cash flow estimated for capital investment?

Because it is a non-cash expense.

How do we convert discount and interest rates per annum to month?

12(wortel: 1 + APR) - 1

When do mutually exclusive projects exist?

Mutually exclusive projects exist where the acceptance of one project lead to the exclusion of another. When evaluating mutually exclusive projects, the IRR can incorrectly rand projects, because of its reinvestment assumptions, and in these circumstance it is recommended to use the NPV.

Techniques that ignore the time value of money

Methods that ignore the time value of money are theoretically weak and may not led to the maximization of the market value of ordinary shares, but they're frequently used in practice.

Discounted payback method

The payback method can only be a valid indicator of the time that an investment requires to pay for itself if all cash flows are first discounted to their present values and the discounted values are then used to calculate the payback period.

When is the payback method useful?

The approach is useful when a firm faces liquidity contraints and requires a fast repayment of investment, or where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are extremely difficult to predict.

The question on the page originate from the summary of the following study material:

Samenvatting FIDM

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