2. FM - Investment appraisal Flashcards
What are the 4 main appraisal techniques?
Payback = time taken to pay back the intial investment ARR = average return on initial investment NPV = PV of inflows - PV of outflows IRR = discount rate to give NPV = 0
What is Payback?
An appraisal technique Payback = time taken to pay back the intial investment
What is ARR?
An appraisal technique
ARR = average return on initial investment
What is NPV?
An appraisal technique
NPV = PV of inflows - PV of outflows
What is IRR?
An appraisal technique
IRR = discount rate to give NPV = 0
Which of the 4 appraisal techniques tend to be the most superior?
They are all used in practice
But in theory, NPV is superior
Why is NPV theoretically the most superior appraisal technique
- Takes acc of the time value of money (whereas ARR and payback do not)
- Is an absolutely measure of return (unlike IRR which is relative- sometimes better to have small return on large inv than large return on small investment
- Based on cash flows not profits - it is more appropriate to evaluate future cash flows than acc profits as profits are more subjective (and can’t be spent or used to pay dividends)
- Considers the whole life of the project (payback, for example, ignores cash flows after the payback period)
What does a +ve NPV result mean?
A +ve NPV should lead to the maximisation of SH wealth
What non-financial factors must also be considered when considering appraisal techniques?
- Compliance with legislation
- impact on key stakeholders
- Impact on reputation
- Sustainability
TYU1: Calculate whether the following project would be accepted using the NPV method
A 4 yr project requires the use of a machine costing £100k and would sell for £15k in 4 yrs time
Operating cash flows before dean are
Y1: £50k
Y2: £40k
Y3: £20k
Y4: £5k
Required rate of return for project appraisals is 10% and required payback period is 3 years. If using the accounting rate of return, the minimum return is 10%
T0 cash flow (100k) 10% DF 1 PV (100k)
T1 50k 10% DF 0.909 PV
etc. if +ve then accept
TYU1: Calculate whether the following project would be accepted using the IRR method
A 4 yr project requires the use of a machine costing £100k and would sell for £15k in 4 yrs time
Operating cash flows before dean are
Y1: £50k
Y2: £40k
Y3: £20k
Y4: £5k
Required rate of return for project appraisals is 10% and required payback period is 3 years. If using the accounting rate of return, the minimum return is 10%
Calc NPV at 10%
that is +ve therefore test another e.g. 20%
Then use IRR formula to calc point at which NPV = 0
TYU1: Calculate whether the following project would be accepted using the Payback method
A 4 yr project requires the use of a machine costing £100k and would sell for £15k in 4 yrs time
Operating cash flows before dean are
Y1: £50k
Y2: £40k
Y3: £20k
Y4: £5k
Required rate of return for project appraisals is 10% and required payback period is 3 years. If using the accounting rate of return, the minimum return is 10%
Time - Cash flow - Cumulative cash flow T0 (100k) T1 50k Cumulative (50k) T2 40k Cumulative (-10k) PAYBACK T3 20 k Cumulative 10k +ve
Therefore payback occurs at 2 years + 10k/20k = 2.5years
TYU1: Calculate whether the following project would be accepted using the ARR method
A 4 yr project requires the use of a machine costing £100k and would sell for £15k in 4 yrs time
Operating cash flows before dean are
Y1: £50k
Y2: £40k
Y3: £20k
Y4: £5k
Required rate of return for project appraisals is 10% and required payback period is 3 years. If using the accounting rate of return, the minimum return is 10%
Operating profit = 50K + 40K + 20k + 20k = £115k
Less total dean (£100k - £15k) = £(85k)
Total profit after dean = 30k
Average annual profit = 30k/4 = £7.5k
Initial investment = 100k
ARR = 7.5% = 7.5k/100k
ARR is less than 10% target therefore reject
How do you deal with delayed annuities or perpetuities
If an annuity or perpetuity doesn’t start at t1 then the discount factor must be adjusted
e.g. if a cash flow is received each year for 5 years but it starts at t4, then the discount factor is
AF fr 5 years x Simple DF for 3 years
How should you deal with changing discount rates?
If a discount rate changes over a period then the formula for calculating the discount factor must be adapted.
E.g. if a cash flow is received in 2 years’ time, but the discount factor is 10% in yr 1 and 12% in yr 2 then the DF = 1/ (1.1 x 1.12)
What is a relevant cash flow?
Future incremental cash flows which arise as a result of a decision being taken
What is the relevant cash flow the difference between?
- Cash flow which arises if the course of action is taken
- Cash flow which arises if not
What costs should be ignored when calculating the relevant cash flow?
- Sunk costs
- Committed costs
- Allocated and apportioned costs
- Non-cash items
- Book values
Finance costs should also be ignored as they are taken into account within the discount rate
Give an example of some particular types of relevant costs problems likely to be seen in the exam?
- Opportunity costs and revenues
TYU2: Calculate the PV of the following assuming a discount rate of 10%
a) £500 received each year for next 5 years
PV = £500 x 1/0.1 (1 - 1/1.15^5) PV = £1,895
TYU2: Calculate the PV of the following assuming a discount rate of 10%
b) £300 received each year in perpetuity
PV = £300 x 1/0.1 = £3k
TYU2: Calculate the PV of the following assuming a discount rate of 10%
c) £400 received next year, then growing by 2% in perpetuity
PV = £400 x 1/(0.1-0.2) = £5k
TYU2: Calculate the PV of the following assuming a discount rate of 10%
d) £700 received for 3 years with the first cash flow received in year 8
PV = £700 x 1/0.1 x (1 - 1/1.1^3) x 1/1.1^7 PV = £893
TYU2: Calculate the PV of the following assuming a discount rate of 10%
e) £600 received in 4 years’ time which then grows by 3% in perpetuity
PV = £600 x 1/(1.1- 0.03) x 1/1.1^3 PV = £6,437
TYU2: Calculate the PV of the following assuming a discount rate of 10%
f) £200 received in year 3, where a discount rate is 10% for year 1 but 12% in year 2 and 3
PV = £200 x 1/(1.1 x 1.12^2) = £145
What is the treatment of working capital?
- Initial working capital required is a cost at the start of the project
- If the working capital requirement changes during the project, only the incr/decr is a relevant cash outflow/inflow
- At the end of the project, all woking capital is released and therefore gives rise to a cash inflow
Why must tax be taken into account when appraising investment projects?
As tax has the following impacts on cash flows
- Operating flows (more income- tax outlflow, more costs - tax inflow)
- Fixed asset cost and disposal proceeds (tax relief is given as cap allowances (tax equiv of depn)
- Working capital flows have no tax impact though
What is the impact of tax on cash flows when operating flows change?
More income - tax outflow
More costs - tax inflow
What is the impact of tax on cash flows when considering fixed asset cost and disposal proceeds
Tax relief given as capital allowances
What is the impact of tax on cash flows when considering working capital flows?
Has no tax impact
TYU3: A material currently in stock is required for a project. If not used on the project it could either be sold for £2k or used instead of another material which would otherwise cost £2.5k
a) what is the relevant cost of using the material?
b) would this change if you were told that the material is constantly in use and could be replaced for £2,200?
a. The relevant cost is £2,500 - the saving opportunity lost if we do the project
The £2k scrap value is a red herring. If the project isn’t undertaken, the material would not be sold and used in place of another material that would cost £2.5k, therefore £2k is irrelelvant
b. Yes - the relevant cost is now £2.2k
if the project were not undertaken the company would achieve a saving of £2.5k as before- however if the project were undertaken the company would simply buy more material for £2.2k
The saving of £2.5k would still be achieved- the only diff being the extra cost of buying in more material
What are the tax assumptions for FM?
- Corporation tax = 17%
- Tax is aid at the end of the year in which profits are earned
- Company is earning net taxable profits overall
- Investment spending attracts capital allowances (WDA) which are tax deductible, calc’ed on an 18% reducing balance basis
- Allowances are given in full every year of ownership except in year of disposal when a balancing charge or balance allowance arises (tax equiv of prof/loss on disposal)
- NOTE: total allowances given over the life of an asset should always = fall in value of the asset over the period (i.e. cost less any scrap proceeds)
What must be done regarding the timing of asset purchase?
Care must be taken to identify the exact time of asset purchased
- Assets are normally assumed to be bought at T0 - could be v end of an acc period or at the start of another
- There is no distinction between these dates for discounting but there is for tax
What impact does the timing of the purchase of an asset have on the tax relief on the asset? (if it is bought at the start of the period)
- If the asset is bought at the start of an acc period, then this is deemed to be T0
- The first cap allowance therefore won’t be given until the end of the acc period
Therefore the tax saving arises as a result of the first capital appearance will be in t1
What impact does the timing of the purchase of an asset have on the tax relief on the asset? (if it is bought at the end of the period)
- If bought at the end of the acc period, then this is deemed to be t0
First capital saving allowance will be given immediately
Therefore tax saving arises as a result of the first capital allowance will appear at t0
What is inflation?
Inflation is a increase in prices leading to a decline in the real value money
What are the 2 impacts inflation has on a NPV calc?
The effect of specific inflation on the cash flows
The effect of general inflation on the discount rate
TYU5: A company expects sales for a new project to be as follows
Y1: £200k
Y2: £250k
Y3: £150k
Y4: £180k
Working capital equal to 10% of the coming years sales is required and needs to be in place at the start of each year.
Calc the working capital flows for incorporation into the NPV calculation
Step 1: Calc the absolute amounts of WC needed over the project
sales
Total WC required (10% sales 1 yr in adv)
Step 2: Work out the incremental investment required for each year (full inv is released at the end of the project
WC
t0 -20k
t1 -5k
t2 10k
t3 -3k
t4 18k
Should add up to 0
For NPV purposes, the increases are -ve (i.e. outflows) and the released WC is capital (inflows)
How does the effect of general inflation on the discount rate impact the NPV calc?
Investors in a project need compensation for the general rate of inflation ( as well as interest and risk)
This relates to their ability buy a basket of goods rather than any specific one product
What is a current cash flow?
- Where cash flows have not been increased for expected inflation, they are known as current cash flows
What is a money cash flow?
Where cash flows have been increased to take into account of expected inflation
What is the difference between current cash flow and money cash flow?
- Where cash flows have not been increased for expected inflation, they are known as current cash flows
- Where cash flows have been increased to take into account of expected inflation, they are known as money cash flows
Do you assume cash flows given in the exam are money cash flows or current cash flows?
Assume money cash flows unless told otherwise
What must be done if the examiner specifies that cash flows are in current terms?
You will generally need to ut these in money terms before you can discount them?
i.e. Where cash flows have been increased to take into account of expected inflation
If you are told that sales for the next 3 years are £100 in current terms but are expected to inflate by 10%, what will the actual sales be?
Y1: £110
Y2: £121
Y3: 133.10
i.e. these are in money terms
But note: sometimes the examiner will trick you by giving you the cash flows in Year 1 terms with subsequent inflation
If you are told that sales will be £100 in the first year, but are then going to inflate by 10% for next 2 yrs, what will sales actually be?
Y1: £100
Y2: £110
Y3: 121
What is the difference between these 2 questions
a. If you are told that sales for the next 3 years are £100 in current terms but are expected to inflate by 10%, what will the actual sales be?
b. If you are told that sales will be £100 in the first year, but are then going to inflate by 10% for next 2 yrs, what will sales actually be?
a. you inflate right away, i.e. answer would be
Y1: £110
Y2: £121
Y3: 133.10
b. The first year isn’t inflated, so the answer would be
Y1: £100
Y2: £110
Y3: 121
THE EXAMINER WILL DO THIS TO TRICK YOU
When inflation is occurring, what are the 2 elements that a fund provider required a return to be made up of?
- Real return for the use of their funds (to compensate for interest and risk)
- Additional return to compensate for inflation
The total of the 2 is called the money or nominal rate of return
What is the total required return for an investor when inflation is taken into account?
The money or nominal rate of return
How are the real and money (nominal) rate of returns linked? i.e. what is the calc to get from one to the other
(1 + money rate) = (1+ real rate)(1 + inflation rate)
If the examiner gives you the discount are in real terms, what needs to be done before you can start discounting?
You will generally need to add in the inflation to get the money rate before you can start discounting
i.e. (1 + money rate) = (1+ real rate)(1 + inflation rate)
If the real rate is 8% and the general rate of inflation is 2%, then what is the money rate to use for discounting?
(1.08 x 1.02) - 1 = 10.16%
1 + money rate) = (1+ real rate)(1 + inflation rate
What is the ‘real @ effective’ method of dealing with inflation?
A maths trick which provides a useful shortcut when discounting a long annuity subject to inflation
SHOULD NOT BE USED IN EXAM UNLESS SPECIFIED OTHERWISE
What are the 2 ways the impact of inflation can be dealt with?
Money @ money
or Real @ effective
What is the Money @ money method for dealing with inflation?
- Inflate each cash flow by its specific inflation rate
i.e. convert it to a money flow - Discount using the money rate
THIS METHOD SHOULD BE USED IN TEH EXAM UNLESS SPECIFIED OTHERWISE
What is the real @ effective method used for?
Perpetuities and long annuities
What is the effect rate when using the real @ effective method?
1 + effective rate = (1 + money rate ) / (1 + specific inflation rate)
Describe the real @ effective method
Cash flows are left in real terms
a Specific ‘effective’ discount rate is calculated for each given cash flow
Effective rate is given by: 1 + effective rate = (1 + money rate ) / (1 + specific inflation rate)
How is the pro forma for the majority of investment appraisal questions (i.e. for laying out long NPV questions)
Down the LHS
Relevant operating cash flows adj for inflation
E.g. Sales less costs = net operating income less corporation tax (Each in sep columns)
Relevant asset flows E.g. purchase price, scrap, tax relief on WDAS (all in sep columns)
Net flows
Discount factor
PV of cash flows
Sum of PVs = NPV
What is another name for replacement analysis?
Optimum economic life
What is the replacement analysis used for?
Where an asset or class of assets must be replaced on a regular basis, then this technique allows us to decide how often to replace the asset
Show how different replacement frequencies impacts a business, using a fleet of cars as an example
- Where a company has a fleet of cars, frequent replacement may lead to more purchase cost
- But less frequent may result in higher maintenance costs and a lower resale value
How is the optimum economic life of an asset determined?
Using the replacement analysis
Need to establish the equivalent cost for each potential replacement cycle
How do you find the optimal economic life of an asset?
- For each possible economic life, calc the NPV of a single asset cycle
- The NPV of each option is then converted into an ‘Equivalent annual cost’
This is the equal annual cash flow (annuity) to which a series of uneven cash flows is equivalent in PV terms. Calculated as ‘equivalent annual cost = PV of costs/ annuity factor - Choose the strategy with the lowest EAC
What are the assumptions of the replacement analysis technique?
- The cost of the asset will not be subject to inflation
- The operating efficiency of assets different ages will be similar
- Asset will be replaced in perpetuity or at least in the foreseeable future
What are the limitations of the replacement analysis technique?
- it assumes that the operating efficiency of assets different ages will be similar, but in practice new tech and/or onsolescence will mean that regular replacement is preferred
- It assumed that an asset will be replaced in perpetuity or at least in the foreseeable future, but in practice, products and therefore the assets required for their production usually have a finite life cycle
What is capital rationing?
It is where there are a number of +ve NPV project available, but insufficient funds to take on all those projects.
How does capital rationing occur? i.e. what are the options?
Hard capital rationing - an actual shortage of funds
Soft capital rationing - an internally imposed (budgetary) limit on funds
How does capital rationing occur? i.e. what are the options?
Hard capital rationing - an actual shortage of funds
Soft capital rationing - an internally imposed (budgetary) limit on funds
What does capital rationing calculate? i.e. what is its purpose?
It calculates the optimal use of the limited capital
What does the method for capital rationing depend on?
It depends on the type of project.
The project will either be
- Infinitely divisible, meaning we can do part of the project and gain part of the NPV
- Indivisible, meaning the project has to be done in full or not at all
What is the process behind infinitely divisible projects for capital rationing?
Projects should be ranked according to the NPV earned per £1 invested in the cash restricted period
Funds should then be applied to the projects in ranking order until they are gone
What is the process behind indivisible projects for capital rationing?
Where projects can’t be done in part, the optimal combination can only be found by trial and error
What is the process behind indivisible projects for capital rationing?
Where projects can’t be done in part, the optimal combination can only be found by trial and error
What is shareholder value analysis?
Traditionally supposed that the value of the company was driven b reported profits and accounting ratios such as EPS
More recently, it has shown that the expectation of future cash flows and the risk inherent in them is far more important to determine value
i.e. value of a company is driven by NPV of all its expected future cash flows
So managers should be encouraged to focus on those factors that enhance the NPV of expected future cash flows (known as value drivers)
What impact does the shareholder value analysis have on businesses?
It means managers should be encouraged to focus on those factors that enhance the NPV of expected future cash flows (known as value drivers)
as the value of a company is driven by NPV of all its expected future cash flows
What are the 7 drivers of value and what do they relate to?
7 drivers of value are those that maximise NPV - looked at in shareholder analysis
5 impact size of the future cash flows - Sales and growth - Margin - Investment in fixed Assets - Investment in working capital - Tax 2 impact their NPV - Discount rate - Length of time that detailed future plans are available SLOW CAT
Why are real options deemed more accurate than NPV?
As NPV doesn’t take into account the strategic value of the project
Real options create flexibility and make the scenario more accurate as it is unlikely absolutely everything will go to plan
What is the worth of the project when considering the real options?
Worth of project = Traditional NPV + value of any associated options
Give some examples of real options?
Follow on options
Abandonment options
Timing options
Growth options
Give an example of the value a follow on option creates
If a firm is considering a project for say 4 years, they may not want to just shut down after 4 years, if items were still selling
Can you extend the period to maximise NPV?
Is the machine used still in tact to keep going or is it obsolete?
Will trends have moved on or still be there?
Give an example of the value an abandonment option creates
How easy it is to stop a project?
i.e. are there loans that have to be repaid? Can you keep meeting them if you stop?
Give an example of the value a timing option creates
If a firm has 2 projects, one starting now and the next starting at any point in next 5 years whenever is best = flexibility
If a competitor about to bring out a similar product, do we halt launching to see how theirs goes? Better to steal their market than them steal yours
Give an example of the value a growth option creates
E.g. can you expand a project if it is going well? i.e. is there any spare capacity for growth depending on the market
How are real options tested?
Often test the area in a practical way by saying ‘what else would you consider in deciding whether to take on the project’
Need to make it relevant to the scenario
What are some considerations to make when investing overseas?
- Market attractiveness e.g. GDP and forecast demand in the region
- Competitive advantage i.e. do we have the experience and understanding of other similar markets
- Political risk
e.g. import quotas/tariffs
legal restrictions on products
restriction on foreign ownership
Enforced nationalisation - Cultural risk e.g. differences in culture and business behaviours in a foreign country
- Currency risk
