Exam 4: Capital Investment Appraisal

A) They are not very popular with investors
B) They only work for projects over $1 million
C) They are expensive to carry out
D) They are relatively complex such that many people do not understand them and therefore do not use them

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D

A) Use all five CIA methods to get a rounded view of a project
B) Trust your gut instinct
C) Get your family and friends to give you their opinions
D) Analyse the business pages on websites and in newpapers

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Accounting Rate of Return
Strengths
Cons...

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The mechanics of Capital Investment Appr...

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A) The cost of salaries and weekly wages
B) Producing the annual income and expenditure budget
C) Expenditure on fixed assets
D) None of the above

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A) $1,000
B) $1,250
C) £1,276
D) Something less than $1,000

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A) It's worth about the same
B) It's worth less
C) You can't tell from the data provided
D) It's worth more

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A) Payback and Net Present Value
B) Accounting Rate of Return and Internal Rate of Return
C) Accounting Rate of Return and Payback
D) Internal Rate of Return and Payback

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A) There is not enough information here to work it out
B) $25,000
C) $20,000
D) $30,000

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C

A) It ignores the full life of projects
B) It is too complicated for most people to understand
C) There is no agreed methodology for calculating it
D) Lenders of funds don't like it

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CIA is important because businesses face...

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Step 1: Rank the projects in order of their favorability. \(\begin{array}{|l|c|c|c|} \hline & \text { Project A } & \text { Project B } & \text { Project C } \\ \hline \text { Investment } & \$ 250,000\left(2^{\text {nd }}\right) & \$ 230,000\left(1^{\text {st }}\right) & \$ 310,000\left(3^{\text {rd }}\right) \\ \hline \text { Payback } & 39 \text { months }\left(2^{\text {nd }}\right) & 33 \text { months }\left(1^{\text {st }}\right) & 51 \text { months }\left(3^{\text {rd }}\right) \\ \hline \text { NPV @ 13\% } & +\$ 70,000\left(1^{\text {st }}\right) & +\$ 62,000\left(2^{\text {nd }}\right) & +\$ 58,000\left(3^{\text {rd }}\right) \\ \hline \text { IRR } & 22 \%\left(1^{\text {st }}\right) & 19 \%\left(2^{\text {nd }}\right) & 15 \%\left(3^{\text {rd }}\right) \\ \hline \text { Discounted Payback } & 48 \text { months }\left(2^{\text {nd }}\right) & 40 \text { months }\left(1^{\text {st }}\right) & 62 \text { months }\left(3^{\text {rd }}\right) \\ \hline \end{array}\) Step 2: Diagnose results \(\bullet\)There is nothing to commend Project C, it is the most expensive, takes the longest to payback, has the lowest NPV, and the lowest IRR. This project should be eliminated from the considerations. \(\bullet\)There is little to separate Project A and Project B. Project B is slightly cheaper than Project A and pays back 6 months earlier using traditional Payback and 8 months earlier using Discounted Payback.. Project B by contrast has the highest NPV and the highest IRR. Technically we should go with the project with the highest NPV and in this case Project A would be the preferred case. Step 3: Qualitative considerations \(\bullet\)Given that in practice there is very little difference between Project A and Project B, it would be worth revisiting the assumptions that were fed into the CIA calculations just to make sure they are as robust as is reasonably possible.