CHAPTER 12 Capital investment 52312.4 What is the difference between risk and return in finance? LO1
12.5 What factors must be taken into consideration in determining the discount rate used in
investment decisions? LO1, 2
12.6 Define the accounting rate of return. What are the two components of the investment
that must be known in order to perform this calculation? LO2
12.7 What factors are taken into consideration in determining an appropriate ARR? LO2
12.8 Discuss the factors that would lead to an investment being selected with a shorter payback
period. LO3
12.9 Define the term ‘discount rate’ and explain how entities set their rates. LO4
12.10 How does inflation impact on the setting of discount rates? LO4
12.11 Compare the calculation of the ARR with the IRR. What advantages does the IRR have
compared with the ARR? LO2, 5
12.12 Outline the differences between inflation and deflation. Discuss investment strategies
for each. LO4
Exercises
BASIC | MODERATE | CHALLENGING
12.13 LO2
Defco Constructions is offered two contracts on the same day for building a new retirement
village and a new library complex respectively. The contracts promise total profits of $11 million
and $14 million, extending over four years and five years, respectively. Each will require
investment of $8 million. On the basis of ARR, which contract is more profitable?12.14 LO3
Defco Constructions (in exercise 12.13) recovers its project investment by straight-line methods
so that the $10 million is recovered by the end of each project. Assuming profits are also booked
in a straight-line fashion, what is the PP for each contract?12.15 LO2, 3
Given the analyses you have completed in exercises 12.13 and 12.14, which of the two contracts
would you recommend? Why?
12.16 LO2
Coconut Plantations Pty Ltd is contemplating acquiring a new machine to be used for a relatively
short period until its new factory is built with computerised equipment installed. Two machines
are being investigated.Machine A B
Cost ($) 75 000 120 000
Cost savings — Year 1 15 000 22 500
Cost savings — Year 2 18 000 30 000
Cost savings — Year 3 23 000 37 500
Salvage value — end Year 3 34 500 52 500Calculate the ARR of each machine. Which machine would you recommend?
12.17 LO3
What are the PPs for each of the machines in the Coconut Plantations exercise 12.16? What are
the risks associated with these investment analyses?
12.18 LO4
What are the NPVs for the two machines in exercise 12.16 if Coconut Plantations has an RRR of
10 per cent? Demonstrate your answer using the discount table in appendix 12A at the end of this
chapter.