Week 10 - ACCY 111 RJD Lecture 7

However investment may be limited by availability of

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However, investment may be limited by availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.
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Internal rate of Return (IRR) Advantages of IRR: Is based on all cash flows, incorporates the time value of money, specifies an actual expected return Disadvantages of IRR: Difficult to calculate, there may be multiple returns, is not based on wealth increments
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A comparison of IRR and NPV $NPV % Rate of Return Accept Positive NPV Reject negative NPV 0 IRR + -
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Discounted cash flow methods Relevant costs should be determined and used, e.g. ignore costs already incurred, past costs etc. Future costs should also in some cases be ignored e.g. costs that will be incurred whether or not the project goes ahead Opportunity costs arising from benefits foregone must be included
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Discounted cash flow methods Taxation on profits and also tax relief should be accounted for Interest payments should not be included when using DCF techniques as the discount factor already takes account of cost of financing
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Discounted cash flow methods For most projects, a simple accept or reject decision should be the same Differences arise in the conclusions between IRR and NPV in the following situations: Mutually exclusive projects Capital rationing situations
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Mutually exclusive projects Mutually exclusive projects are projects where a choice has to be made between alternatives, but in which only one can actually be undertaken. As a general rule, the internal rate of return is dependent on the magnitude of the outlay – the higher the outlay, the lower the rate of return. Where capital funds are in short supply the internal rate of return will tend to favour smaller projects.
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Capital rationing Capital rationing occurs when there are limits imposed on the amount of capital invested Capital rationing leads to the need to rank projects in some way, which is a problem for the NPV method There are two common strategies to overcome this problem: - Profitability index or benefit / cost ratio - NPV per $1 of investment
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Capital rationing Profitability Index = present value of inflows initial investment Benefit/Cost Ratio = present value of inflows present value of outflows The decision rule in either case is to accept any project with a result greater than 1.
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Capital rationing NPV per $1 of Investment = NPV investment As the general rule is to accept projects with a positive NPV, where capital is limited a ranking projects, starting with the maximum NPV per $1 invested, will ensure the maximisation of total NPV.
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Investment Appraisal in Practice Research shows that businesses tend to use more than one method to assess each investment decision NPV and IRR seem to be the more popular methods used in practice ARR and PP continue to be popular despite their shortcomings and the rise of popularity of the DCF methods Large businesses tend to use the discounting methods and apply multiple methods for each decision
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Investment Appraisal in Practice
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