11: Investment Appraisal Flashcards
What are the four stages of investment decision making?
- Origination of proposals
- many different alternatives and introduced and disvissed - Project screening
- ‘sensible’ projects looked at with aims in mind - Analysis and acceptance
- investment appraisal techniques/qualitative issues discussed - Monitor and review
- progress monitored
- comparison to capital expenditure made
- timing review
What is the payback period?
PP is the time required for the cash inflows to recover from the initial cash outflows
Need to decide on target period!
A ‘first screening’ method, before more sophisticated techniques are used
Uses cash flows, not profits
What is the decision rule for payback period?
Period < target period, accept project
Period > target period, reject project
What are the two ways of calculating the payback method?
Constant cash flow:
Initial payment / annual cash flow
Uneven cash flow:
Whenever the cumulative cash flows hit 0
What to do with payback period if 0 is between two years?
Divide the cumulative cash flow figure with the smallest (minus)
But the regular cash flow figure for the next year!
You will get a decimal. Times this by 12, round up to the nearest whole number, and add onto the year as the number of months!
What to do with depreciation in the payback method?
Add it onto the profit to make the cash inflow!
Ads of payback period?
Simple to calculate
Easy to understand
Concentrates on early cash flows, which are more reliable
Useful for cash-strapped companies, can focus on liquidity
Dis of payback period?
Does not measure change in shareholder wealth
Ignores later cash flows
Requires a target period
Ignores time value of money
Unable to distinguish between projects with same payback
Lead to too many short-term projevts
Does not account for variability of cash flows
What is accounting rate of return and what is the decision rule?
Expresses profits as a percentage of capital investment (or capital outlay)
ARR > Target rate, accept!
ARR < Target rate, reject!
What is the formula for ARR?
Average Annual Profit
——————————
Initial or Average Investment
X 100
(Exam will tell you initial or average!)
How to calculate:
- annual accounting profits
- average investment
AAP: profits - depreciation
AI: initial investment + residual value / 2
Ads of ARR?
Simple to calculate and understand
Often used by financial analysts
Looks at entire project
Allows project comparison
Dis of ARR?
Does not measure change in shareholder wealth
Can be calculated differently - may cause confusion
Based on profits not cash
Ignores time value of money
Requires a target rate
Relative (%)
Three reasons why money is more valuable now than in the future?
Interest
Risk
Inflation
What does NPV measure?
The decision rule?
Change in shareholder wealth as a result of accepting a project
How much profit an investment will add add to the firm, accounting for time value
NPV > 0, accept project
NPV < 0, reject project
How to value money in the future?
Compounding, which calculated the future or terminal value of a sum invested today
TV = X (1 + r)*n
X - amount invested today
r - interest rate
n - number of years
How to value money in the past (going backwards)?
And the equation?
Convert the future amount to the time using a discount factor!
X times by
1
—————
(1+r)*n
X - amount invested in n years time
r - interest rate
n - number of years
What are other names for interest rate?
Cost of capital, discount rate, required rate of return
What 3 assumptions are used with discount factors?
Cash flows occur at the end of each year
Initial investments occur at T0
Later cash flows occur at annual intervals
What actually is the NPV?
The sum of the present values of all cash flows, which have been discounted back to their present value
Represents the surplus funds
Three steps to calculating NPV?
- Determine net cash flow for each year
- Times by discount factor to get PV
- Sum all of the PVs to get the NPV
What is an annuity? How does the process change with annuities?
A constant annual cash flow for a number of years
Annuity factor can be used instead of discount factor.
You can just times one of these inflows by the annuity factor to get the inflow for the whole annuity period
What is a perpetuity and how is it calculated?
Annual cash flow that occurs for the foreseeable future
PV = annual inflow / interest rate
What are advanced annuities and perpetuities?
How to calculate?
When the cash inflow starts at T0 rather than T1!
Annuity: annual inflow x (1 + AF)
Perpetuity: annual inflow x (1 + (1/interest rate)
What is the Net Terminal Value?
The value of the project (cash surplus) at the end of the project, after taking in any interest and capital repayments
Need to use a project discount rate
Basically all of the terminal values added together
The 5 steps to calculating the net terminal value?
- Write out cash flow for the year
- Find the terminal value: (1 + r)*n
- Create this per year on the no. of years until the end of the projevt
- Calculate the terminal value for each year
- Add them up to get the NTV
What is the discounted payback period?
The amount of time that the project’s cumulative NPV takes to turn from being negative to positive
How should you deal with changing discount rates?
If the discount rate changes, create a composite rate
Just times the two rates for the two interest levels together!
Ads of NPV?
Shows increase in shareholder wealth in absolute terms
Accounts for time value of money
Considers relevant cash flows
Can factor in risk by adjusting company’s discount rate
Clear, unambiguous decisions
What is the IRR?
The Internal Rate of Return is the discount rate at which the NPV of an investment is 0
Can be found through linear interpolation
Discount rate where future cash inflows equate to cash outflows
Decision rule on IRR!
IRR > Discount Rate, accept project
IRR < Discount Rate, reject project
What are the two steps to doing IRR?
- Calculate two NPVs using two different costs of capital (ie. 8% and 10%)
(ideally one NPV should be positive and the other negative!)
- Put these NVPs and rates into the formula
What is the formula for IRR?
L +
NL
———
(NL - NH)
X
(H - L)
Why are there two different lines on a linear interpolation graph for IRR?
True IRR would be curved, and less
But the equation (linear interpolation) can only produce a straight line!
How do you find the IRR of annuities?
- Find cumulative discount factor.
Initial investment / annual inflow - Find the life of the project, n
- Look on the table for cumulative discount factors = find closest!
Calculation for IRR of perpetuities?
Annual inflow / initial investment x 100
Ads of IRR?
Takes account of time value of money
Considers all relevant cash flows
More easily understood by management as percentage
Should increase shareholder wealth
Dis of IRR?
Relative not absolute
Cannot cope with changing discount rates
May be multiple IRRs
Interpolation only provides an estimate, accurate estimate is hard
Only increases until project not worth accepting
Should you choose a project with higher NPV or IRR?
Choose project with higher NPV!
Only NPV can be used to distinguish between two mutually-exclusive projects
Can you use IRR for any cash flow other than ‘investment followed by inflows’?
No!
Lots of outflows and inflows creates ‘non-conventional’ cash flows.
Can lead to ambiguous results and more than one IRR, as the line crosses the discount rate more than once!
3 benefits for understanding environmental costs?
Including these within costing system allows for better pricing decisions
Avoid fines and save money
Regulatory compliance
Part of appraisal process, likely to influence consumer and investor decisions
4 types of enviro cost? And examples?
Prevention - staff training
Appraisal - monitoring compliance
Internal failure - recycling scrap materials
External failure - cost of clearing up an oil spill
What must you do with dep in a payback period question?
Add it onto the profit!
Payback looks at cash flows, not profit!
