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
