5016 - Investment and Financial Analysis - Investment Appraisal Part 1 - Traditional Methods and Discounted Cash Flow Methods p218 - 284

Question 1

What is the simplified Capital Investment Process

Answer 1

Search
Screening
Definition
Evaluation
Approval

Question 2

Summary of the Search phase of the Capital Investment Process

Answer 2

Identify Opportunities

Question 3

Summary of the Screening phase of the Capital Investment Process

Answer 3

Ethics, Strategic fit and payback are used to eliminate projects

Question 4

Summary of the Definition phase of the Capital Investment Process

Answer 4

The collection of more detailed information, usually technical or financial

Question 5

Summary of the Evaluation phase of the Capital Investment Process

Answer 5

Use of formalised selection criteria e.g. Payback, ARR, NPV, IRR

Question 6

Summary of the Approval phase of the Capital Investment Process

Answer 6

Conclusion of the evaluation is endorsed usually and is transmitted through the hierarchy to relevant people.

Question 7

Things to consider in the selection of an investment

Answer 7

• Security
• Liquidity
• Return
• Growth Prospects
• Spreading Risk

Question 8

Steps of the Financial Evaluation Process

Answer 8

Stage 1: Determine Investment funds available

Stage 2: Identify profitable project opportunities

Stage 3: Refine and classify proposed projects

Stage 4: Evaluate the proposed project or projects

Stage 5: Approve the Projects

Stage 6: Monitor and Control the Project

Question 9

What is CAPM

Answer 9

The return you require for the risk you are taking

Question 10

Traditional Methods Of Investment Appraisal

Answer 10

Accounting Rate of Return (ARR)

Payback

Question 11

Discounted Cashflow Methods of Investment Appraisal

Answer 11

Net Present Value (NPV)

Internal Rate of Return (IRR)

Question 12

4 Methods of Capital Investment Appraisal

Answer 12

• Accounting Rate of Return
• Payback
• Net Present Value
• Internal Rate of Return

Question 13

ROIC calculation

Answer 13

Net Operating Profit minus adjusted taxes divided by invested capital (equity and debt)

Question 14

Pike (1988, 1996) Findings on the use of Capital Investment Appraisal

Answer 14

• Payback used the most and often used as a screening process
• ARR was used the least
• IRR is the 2nd most popular method followed by NPV

Question 15

Arnold and Hatzopoulos (2000) Findings on Capital Investment Appraisal

Answer 15

• Payback is widely used
• IRR is as popular as NPV
• ARR is used the least
• 72% of small firms used 3 or more methods
• Smaller firms rely less on sophisticated techniques

Question 16

Summary of findings from surveys on Capital Investment Appraisal

Answer 16

• Businesses tend to use more than one method
• NPV and IRR have become more popular
• Payback and ARR continue to be popular
• Large businesses rely more on NPV than IRR compared to smaller businesses

Question 17

ARR meaning

Answer 17

Accounting Rate of Return

Question 18

Two methods of Accounting Rate of Return (ARR)

Answer 18

Physical Investment (Property and Equipment):

Average annual profits / average investment x 100

Financial Investments:

Average annual profits / initial investment x 100

Question 19

Making a decision with ARR Rules

Answer 19

For the project to be considered it must achieve a minimum target ARR

Where competing projects exceeds the minimum rate, the one with the highest ARR should be selected

Question 20

Advantages of ARR

Answer 20

• Percentages are easy to compare

- ARR measures profitability - useful to shareholders to evaluate managerial performance

Question 21

Disadvantages of ARR

Answer 21

• Terminology is ambiguous
• It does not account for investment scale, e.g. a 20% return on 1000 is better than a 40% return on 100
• Ignores Cash flows
• Ignores value of money

Question 22

Payback Period (PP) meaning

Answer 22

Time takes for initial investment to be repaid out of projects net cash inflows

Question 23

What does Payback Period (PP) do?

Answer 23

Measures length of time it takes the cash inflows from a capital investment project to equal the cash outflows

Question 24

What are the rules when using Payback Period

Answer 24

• Project should have a shorter payback period than required maximum
• If competing projects have payback periods shorter than the max, one with shortest PP is used

Question 25

Advantages of Payback

Answer 25

- Simple to calculate and understand - Shows which projects repay themselves the fastest, favours low risk projects - Good where future is uncertain - No need to forecast cashflow - Often in firms capital is rationed, payback is useful in these cases

Question 26

Disadvantages of Payback

Answer 26

- Payback is ambiguous, may not be clear if firms have included working capital or not - Ignored cash flows arising after PP - Payback Fails to allow for 'real time value of money'

Question 27

Factors influencing the returns of a project

Answer 27

- Inflation - Risk premium - Interest foregone

Question 28

Time Value of Money

Answer 28

Money in the future is not the same as money raised today

Question 29

Compound Interest Formula

Answer 29

Sum x (1 + % return) to the power of x years or the periods in which you receive interest

Question 30

Present Value

Answer 30

The value used to compare a future sum of money with todays capital cost

Question 31

Present Value Formula

Answer 31

Amount / (1 + Interest in Decimal Form) to the power N for number of years X / (1 + 0.Y) to power N Future Value OVER (1+r)^n

Question 32

Present Value Example: $1,000 to be received in 3 years, 5% compound interest

Answer 32

1,000/(1+0.05)^3 | = 863.84

Question 33

Future Value Formula

Answer 33

Amount x (1 + Interest in Decimal Form) to the power number of years

Question 34

Future Value Example: $900 to be received in 3 years, 5% compound interest

Answer 34

``` 900 x (1+0.05)^3 = 1041.86 ```

Question 35

Difference between Present Value Formula and Future Value Formula

Answer 35

Present Value you divide Future Value you times

Question 36

Net Present Value Steps

Answer 36

- Determine Discount (Hurdle Rate) using WACC if needed | - Calculate Using this Rate

Question 37

Net Present Value Example: 900 invested, 600 from equity at 8%, 300 from debt at 6% Outflow of 900 Yr1 Inflow of 720 in Yr2 500 in Yr3

Answer 37

WACC = (600/900x8) + (300/900x6) = 7.33% Add Risk Premium (personal view of risk) say 1.67% That makes minimum hurdle rate 9% Yr2: 720/1.09^2 = 606.00 Yr3: 500/1.09^3 = 386.09 900 - 606 - 386.09= NPV = -92.09

Question 38

NPV Decision Rules

Answer 38

If Projects NPV is positive, it should be accepted, and vice versa If competing projects have positive NPVs, highest selected

Question 39

Advantages of NPV over ARR and PP

Answer 39

NPV Addresses: - Timing of Cashflows - The whole of relevant cashflows - The objectives of the business

Question 40

Calculating NPV using Discount Factor

Answer 40

1 OVER (1+r)^n Times that by Cash inflow for the year

Question 41

What are the two methods of calculating NPV

Answer 41

Formula: Present Value = Future Value OVER (1+r)^n ``` Using Discount Tables: 1 OVER (1+r)^n ```

Question 42

What is NPV Dependant on?

Answer 42

- The Cashflow Forecast - Based on assumptions, if the cashflow is different so too will the real NPV be - The Discount Rate Used

Question 43

What assessment might be made to Consider the Impact of Changes in Cashflow

Answer 43

- Sensitivity analysis | - Scenario Analysis

Question 44

A Positive and negative NPV represents

Answer 44

Positive means project should go ahead Negative means the opposite

Question 45

Can a project have a positive and negative NPV

Answer 45

Yes, the calculated NPV is based on assumptions and what actually happens is different as it is vulnerable to changes e.g. bank increases interest rates

Question 46

Internal Rate of Return (IRR)

Answer 46

To some degree the Break Even Discount Rate, Represent the Discount rate that, when applied to future projects cash flow, produces a NPV of Zero The rate that will discount that cashflow forecast to 0

Question 47

Internal Rate of Return (IRR) Formula

Answer 47

Very hard to calculate unless using Excel, so, use excel Lower Discount Rate + (Higher DR - Lower DR) x (NPV / LNPV - HNPV)

Question 48

IRR Decision Rules

Answer 48

- Project must meet a minimum IRR Requirement (Opportunity cost of Finance) - If competing projects exceed minimum IRR Requirements, highest IRR selected

Question 49

Advantages of NPV

Answer 49

- Accounts for time value of money - Guarantees most profitable project is chosen - Accounts for investment size

Question 50

Disadvantages of NPV

Answer 50

- Can be complex with longer projects | - Choice of discount rate is crucial and it isn't always clear which rate to use

Question 51

Advantages of IRR

Answer 51

- Takes into account the time value of money | - As a percentage measure it's easy to interpret and compare

Question 52

Disadvantages of IRR

Answer 52

- Surveys suggest it is often confused with ARR - IRR ignores the scale of an investment project - In certain cases, projects have more than one IRR

Question 53

Mutually Exclusive Projects

Answer 53

When a firm can do one project or another but not both

Question 54

When using an IRR and a NPV value which should you go by

Answer 54

The one with the higher NPV, even if IRR is lower

Question 55

IRR Personal Notes

Answer 55

Include ''Year 0'' figures (Outflow) - caused confusion to begin with