Capital Investment Decisions

Flashcards covering key concepts of Capital Investment Decisions, evaluation methods (NPV, IRR, MIRR, PBP, ARR), relevant cash flows, inflation, taxation, APV, and international capital budgeting.

What is capital investment (capital expenditure or capital budgeting)?

It is the process by which an organization commits its funds into a long-term project that spans over one accounting period, such as the construction of bridges, roads, dams, refineries, power plants, land, and buildings.

What are the six procedures involved in capital budgeting decisions?

1. Identification of potential or possible projects
2. Evaluation or appraisal of potential projects
3. Authorization, selection and approval of the best alternative
4. Development or execution of project
5. Monitoring and controlling of projects
6. Post completion audit

What are the key characteristics of capital budgeting?

1. Involves huge capital outlay
2. Benefits accrue over a long period of time
3. Determines the future financial condition of the organization
4. Involves irreversible decisions
5. Business profitability depends on these large investments
6. Considered to be very risky

What are the two main categories of project evaluation methods under capital budgeting?

1. Discounted Cashflow Method
2. Non-Discounted Cashflow Method

What techniques fall under the Discounted Cashflow method?

• Net Present Value (NPV) • Internal Rate of Return (IRR) • Modified Internal Rate of Return (MIRR) • Duration • Discounted Payback Period

What formula is used to calculate the discounting factor ($DCF$)?

$DCF = (1+r)^{-n}$ or $DCF = \frac{1}{(1+r)^n}$ where $r$ is the cost of capital and $n$ is the useful life of the project.

What is the formula for calculating the discounting factor to perpetuity ($DCF_{\infty}$)?

$DCF_{\infty} = \frac{1}{r}$ or $DCF_{\infty} = \frac{A}{r}$ where $r$ is the cost of capital and $A$ is the annual cash flow.

What is the formula for calculating the Annuity Factor ($AF$) for a constant cash flow?

$AF = \frac{1-(1+r)^{-n}}{r}$ where $r$ is the cost of capital or discount rate and $n$ is the useful life.

What are the three determinants required for calculating Net Present Value (NPV)?

1. The relevant cash flows
2. The appropriate cost of capital (discount factor)
3. The useful life (number of years) of the project

What are the decision rules for accepting or rejecting projects using NPV?

For independent projects: Accept if $NPV > 0$, reject if $NPV < 0$, accept/reject on qualitative factors if $NPV = 0$. For mutually exclusive projects: Accept the project with the higher positive $NPV$.

What is the Internal Rate of Return (IRR)?

It is the rate that equates the Net Present Value of expected future cash flows to zero. It is also known as DCF yield, internal yield, and discounted rate of return.

What formula is used to calculate IRR via linear interpolation?

IRR = A + \begin{pmatrix} \frac{NPV_a}{NPV_a + NPV_b} \right) (B - A) where $A$ is the lower cost of capital, $B$ is the higher cost of capital, $NPV_a$ is the positive NPV, and $NPV_b$ is the negative NPV.

Based on the cash flow table for Ajanlekoko Ltd, what are the cash flows from Year 0 to Year 4?

Year 0: $(150,000)$ Year 1: $60,000$ Year 2: $75,000$ Year 3: $50,000$ Year 4: $25,000$

Why was the Modified Internal Rate of Return (MIRR) developed?

It was developed to correct the conflict between NPV and IRR decisions when dealing with unconventional cash flows, eliminating multiple IRR rates and reducing over-optimism.

What are the two formulas used to calculate MIRR?

1. Using terminal value of inflows: MIRR = \begin{pmatrix} \frac{D_o}{D_n} \right)^{\frac{1}{n}} - 1
2. Using present value of inflows: MIRR = \begin{bmatrix} \begin{pmatrix} \frac{PV_{inflow}}{PV_{outflow}} \right)^{\frac{1}{n}} \times (1+r) \right] - 1

What is the Payback Period (PBP), and how is accounting profit converted to cash flow for PBP?

PBP is the period (usually in years) required for cash inflows to equal cash outflows. To convert: $\text{Cash Flow} = \text{Accounting Profit or Loss} + \text{Depreciation}$.

What formula is used to calculate Payback Period for constant cash inflows?

$$PBP = \frac{\text{Cash Outflow}}{\text{Constant Cash Inflow}} \text{ years}$$

What is the Accounting Rate of Return (ARR) formula?

$ARR = \frac{\text{Estimated Average Annual Profit}}{\text{Estimated Average Investment}} \times 100$ where $\text{Average Investment} = \frac{\text{Initial Outlay} + \text{Residual Value}}{2}$.

How is interest treated when determining relevant cash flows for capital investment decisions?

Interest is an irrelevant cost and should be ignored because it is already incorporated in the cost of capital; including it would result in double dipping.

How are sunk costs and opportunity costs treated in investment appraisal?

Sunk costs (past historical costs like market research or development) are irrelevant and ignored. Opportunity costs (benefits forgone by choosing one course of action over another) are relevant cash flows and must be included.

What are the three working capital assumptions in capital investment appraisal?

1. Cash flows are introduced at the beginning of project life (treated as outflow in year 0 or prior year).
2. Cash flows are recovered fully at the end of useful life.
3. For incremental working capital, only the increment is considered each year, and the total working capital is recovered at the end.

What is the difference between General Inflation and Specific Inflation?

General inflation is the average increase in prices of goods and services across the economy, affecting both cash flows and discount rates. Specific inflation affects individual project elements (e.g., materials, labor), impacting cash flows only without affecting discount rates.

What are the formulas to convert between Real Cash Flow (RCF) and Money Cash Flow (MCF)?

Real to Money: $MCF = RCF \times (1+i)^n$ Money to Real: $RCF = \frac{MCF}{(1+r)^n}$ where $i$ is inflation and $n$ is the period.

What equations represent the Fisher effect for calculating discount rates under inflation?

$(1+m) = (1+r)(1+i)$$m = (1+r)(1+i) - 1$$r = \frac{1+m}{1+i} - 1$$i = \frac{1+m}{1+r} - 1$ where $m$ is money cost of capital, $r$ is real cost of capital, and $i$ is general inflation rate.

What is the difference between a Balancing Allowance and a Balancing Charge?

A Balancing Allowance arises when tax written down value (TWDV) is higher than sales proceeds ($TWDV > \text{Sales Proceed}$), creating allowable relief. A Balancing Charge arises when $TWDV < \text{Sales Proceed}$, creating taxable profit.

What is Adjusted Present Value (APV) and when should it be used?

APV is the NPV of a project financed solely by equity plus the PV of financing benefits (such as debt tax shields). It is used when the company's financial risk (debt/equity ratio) changes significantly upon undertaking a project while business risk remains constant.

What formula is used to calculate Purchasing Power Parity Theory (PPPT) spot rates?

$S_T = S_o \times \frac{1 + i_d}{1 + i_f}$ where $S_T$ is estimated spot rate, $S_o$ is current spot rate, $i_d$ is domestic inflation rate, and $i_f$ is foreign inflation rate.

What formula is used to calculate Interest Rate Parity Theory (IRPT) forward rates?

$F_o = S_o \times \frac{1 + i_d}{1 + i_f}$ where $F_o$ is forward rate, $S_o$ is current spot rate, $i_d$ is domestic interest rate, and $i_f$ is foreign interest rate.

What three methods are used by parent companies to avoid foreign exchange restrictions on remittances?

1. Management Charges (billing for general managerial support based on hours)
2. Royalties (charging fixed or variable fees for patents, trade names, or technical know-how)
3. Transfer Pricing (setting internal prices for goods supplied or services rendered between divisions)

What are the five main categories of risk associated with international capital investment appraisal?

1. Exchange Rate Risk
2. Political Risk
3. Economic Risk
4. Fiscal Risk
5. Regulatory Risk