17 - Investment appraisal

Question 1

simple interest formula

Answer 1

s = x + rXn

s = final sum
x = amount invested
r = interest rate as a decimal
n = number of periods investment is held for

Question 2

AER formula

Answer 2

(1 + R) = (1 + r)2

R = annual rate
r = period rate

Question 3

what is discounting

Answer 3

opposite of compounding, evaluating the same value at earlier point in time

Question 4

discounting a single cash flow equation

Answer 4

x = s / (1 + r) ^n

eg how much should be invested now to get 1610 at end of 5 years earning 10% pa

= 1610 / 1.1^5
= 1000

Question 5

present value meaning

Answer 5

the value in todays prices of a future cash flow

Question 6

what is an annuity

Answer 6

constant sum of money paid or received each and every period for a given number of periods

Question 7

what is perpetuity

Answer 7

an annuity which continues to be paid at regular intervals forever

Question 8

what is the payback period

Answer 8

a measure of how many years it takes for the cash flows affected by the decision to invest to repay the cost of the original investment

Question 9

implication of length of payback period

Answer 9

longer = considered risky because it relies on cashflows in future

Question 10

advantages and disadvantages of payback

Answer 10

ADVANTAGES
- simple way of screening out risky cash flows
- useful when a company has cash flow problems

DISADVANTAGES
- ignores timing of cash flows
- ignores cash flows outside payback period
- ignores time value of money

Question 11

what is NPV

Answer 11

comparison of the discounted value of the future cash flows with cost of setting up project today

Question 12

what is the decision made on the figure of NPV

Answer 12

positive NPV = accepted
negative NPV = rejected

Question 13

cost of capital meaning

Answer 13

required return by investors

Question 14

advantages and disadvantages of NPV

Answer 14

ADVANTAGES
- shareholder wealth maximised
- takes time value of money into account
- based on cash flows, more objective
- shareholders benefit if positive NPV project accepted

DISADVANTAGES
- can be difficult to identify appropriate discount rate
- assume all cash flows occur at year ends when they may not
- some unfamiliar with the concept

Question 15

what is IRR

Answer 15

a discounted cash flow technique that calculates annual percentage return given by a project

it is the discount rate at which the net present value of the investment is zero

Question 16

when should IRR be accepted/rejected

Answer 16

if IRR > cost of capital = accepted

if lower rate of return than COC = rejected, NPV would also be negative

Question 17

step approach to calculating IRR

Answer 17

1. calculate NPV of project at the first rate (usually cost of capital given in q)
2. calculate NPV of project at second rate
3. calculate IRR using the formula

Question 18

IRR formula

Answer 18

a + NPV a / NPV a - NPV b x (b - a)

where a = lower
b = higher

Question 19

advantages/disadvantages of IRR

Answer 19

ADVANTAGE: gives annual % return of a project so is easy for non financial managers to understand

DISADVANTAGE: can result in dysfunctional behaviour

Question 20

which one is better - NPV or IRR?

Answer 20

= NPV

because it doesn’t have same problems as IRR, IRR is useful to justify to non financial staff but not used as financial justification

however, NPV does also reject non financial benefits

Question 21

how to find payback period

Answer 21

do the cumulative cash flow (including the initial cost of the machine)

work out the years by the point it breaks even to profit

find months by doing = amount left in year it breaks even (will be a minus) / cash flow coming in in the next year

x12 to get months amount

Question 22

delayed annuity formula

Answer 22

CDF @ end of period - CDF @ years missed

eg, annuity starts at end of 3rd yr and finishes end of 10th yr

CDF @ 10 - CDF @ 2 = df we use
x cash flow = present value