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Questions and Answers
Which type of cash flow should generally be excluded in investment appraisal methods?
What does the term 'period 0' signify in cash flow timing assumptions?
Which of the following is an example of a cash flow that should be considered in investment appraisal?
What is a key characteristic of profits in relation to cash flows?
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What assumption is made regarding cash flows that arise at the start of a period?
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What is the primary purpose of the Payback Period method?
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Which of the following is NOT an advantage of the Accounting Rate of Return (ARR) method?
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What does a project require to be accepted using the ARR method?
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Which method is primarily used for cash flow-based evaluation?
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What is a disadvantage of the Payback Period method?
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In the Capital Assets Investment Cycle, which step follows screening investment proposals?
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Which of these evaluation methods incorporates the time value of money?
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What is the main disadvantage of using the Accounting Rate of Return (ARR) method?
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Study Notes
Capital Asset Investment Cycle Steps
- The capital asset investment cycle consists of five steps: identifying investment opportunities, screening investment proposals, analyzing and evaluating investment proposals, approving investment proposals, and implementing, monitoring, and reviewing investments.
Financial Evaluation Methods
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ROCE (Return on Capital Employed), or accounting rate of return, represents the average return of a project expressed as a percentage of the initial capital investment or average investment.
- Decision Rule: Accept the project if the ARR is greater than the target ARR.
- Advantages: It is expressed in terms familiar to managers and is easy to calculate. It also links with other accounting measures.
- Disadvantages: It does not account for differences in the life of mutually exclusive projects, ignores the time value of money, and varies depending on accounting policies.
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Payback Period is the time period required to recover the initial investment. It is based on cash flow.
- Decision Rule: Accept the project if the payback period is less than the target payback.
- Advantages: It's simple to use and understand, helping to maximize liquidity.
- Disadvantages: It does not give a measure of return, ignores the time value of cash flows, ignores cash flows after the payback period, and is subjective.
- NPV (Net Present Value) is a measure of profitability that takes the time value of money into account.
- IRR (Internal Rate of Return) is the discount rate that makes the NPV of a project equal to zero.
Relevant Cash Flows
- When evaluating investment appraisals, with the exception of ROCE, only relevant cash flows should be considered.
- Include: Future cash flows, incremental cash flows, cash-based, and opportunity costs.Â
- Ignore: Sunk costs, committed costs, non-cash items, allocated costs.
Assumptions on Timing of Cash Flows
- If cash flows arise during a period, it's assumed they arise at the end of that period.
- If cash flows arise at the start of a period, it's assumed they arise at the end of the preceding period.
- Period '0' is not a period; it represents the start of period '1'.
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Description
Test your knowledge on the capital asset investment cycle and financial evaluation methods. This quiz covers the five steps of the investment cycle and key financial metrics such as ROCE and Payback Period. Understand the decision rules and advantages and disadvantages of each method.
