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BSc Business Management > 5016 - Investment and Financial Analysis - Investment Appraisal Part 1 - Traditional Methods and Discounted Cash Flow Methods p218 - 284 > Flashcards

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

1
Q

What is the simplified Capital Investment Process

A 
Search
Screening
Definition
Evaluation
Approval
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2
Q

Summary of the Search phase of the Capital Investment Process

A

Identify Opportunities

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3
Q

Summary of the Screening phase of the Capital Investment Process

A

Ethics, Strategic fit and payback are used to eliminate projects

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4
Q

Summary of the Definition phase of the Capital Investment Process

A

The collection of more detailed information, usually technical or financial

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5
Q

Summary of the Evaluation phase of the Capital Investment Process

A

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

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6
Q

Summary of the Approval phase of the Capital Investment Process

A

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

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7
Q

Things to consider in the selection of an investment

A
  • Security
  • Liquidity
  • Return
  • Growth Prospects
  • Spreading Risk
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8
Q

Steps of the Financial Evaluation Process

A

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

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9
Q

What is CAPM

A

The return you require for the risk you are taking

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10
Q

Traditional Methods Of Investment Appraisal

A

Accounting Rate of Return (ARR)

Payback

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11
Q

Discounted Cashflow Methods of Investment Appraisal

A

Net Present Value (NPV)

Internal Rate of Return (IRR)

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12
Q

4 Methods of Capital Investment Appraisal

A
  • Accounting Rate of Return
  • Payback
  • Net Present Value
  • Internal Rate of Return
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13
Q

ROIC calculation

A

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

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14
Q

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

A
  • 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
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15
Q

Arnold and Hatzopoulos (2000) Findings on Capital Investment Appraisal

A
  • 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
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16
Q

Summary of findings from surveys on Capital Investment Appraisal

A
  • 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
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17
Q

ARR meaning

A

Accounting Rate of Return

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18
Q

Two methods of Accounting Rate of Return (ARR)

A

Physical Investment (Property and Equipment):

Average annual profits / average investment x 100

Financial Investments:

Average annual profits / initial investment x 100

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19
Q

Making a decision with ARR Rules

A

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

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20
Q

Advantages of ARR

A
  • Percentages are easy to compare

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

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21
Q

Disadvantages of ARR

A
  • 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
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22
Q

Payback Period (PP) meaning

A

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

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23
Q

What does Payback Period (PP) do?

A

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

24
Q

What are the rules when using Payback Period

A
  • 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
25
Q

Advantages of Payback

A
  • 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
26
Q

Disadvantages of Payback

A
  • 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’
27
Q

Factors influencing the returns of a project

A
  • Inflation
  • Risk premium
  • Interest foregone
28
Q

Time Value of Money

A

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

29
Q

Compound Interest Formula

A

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

30
Q

Present Value

A

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

31
Q

Present Value Formula

A

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

32
Q

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

A

1,000/(1+0.05)^3

= 863.84

33
Q

Future Value Formula

A

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

34
Q

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

A 
900 x (1+0.05)^3
= 1041.86
35
Q

Difference between Present Value Formula and Future Value Formula

A

Present Value you divide

Future Value you times

36
Q

Net Present Value Steps

A
  • Determine Discount (Hurdle Rate) using WACC if needed

- Calculate Using this Rate

37
Q

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

A

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

38
Q

NPV Decision Rules

A

If Projects NPV is positive, it should be accepted, and vice versa

If competing projects have positive NPVs, highest selected

39
Q

Advantages of NPV over ARR and PP

A

NPV Addresses:

  • Timing of Cashflows
  • The whole of relevant cashflows
  • The objectives of the business
40
Q

Calculating NPV using Discount Factor

A

1 OVER (1+r)^n

Times that by Cash inflow for the year

41
Q

What are the two methods of calculating NPV

A

Formula:
Present Value =
Future Value OVER (1+r)^n

Using Discount Tables:
1 OVER (1+r)^n
42
Q

What is NPV Dependant on?

A
  • The Cashflow Forecast - Based on assumptions, if the cashflow is different so too will the real NPV be
  • The Discount Rate Used
43
Q

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

A
  • Sensitivity analysis

- Scenario Analysis

44
Q

A Positive and negative NPV represents

A

Positive means project should go ahead

Negative means the opposite

45
Q

Can a project have a positive and negative NPV

A

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

46
Q

Internal Rate of Return (IRR)

A

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

47
Q

Internal Rate of Return (IRR) Formula

A

Very hard to calculate unless using Excel, so, use excel

Lower Discount Rate + (Higher DR - Lower DR) x (NPV / LNPV - HNPV)

48
Q

IRR Decision Rules

A
  • Project must meet a minimum IRR Requirement (Opportunity cost of Finance)
  • If competing projects exceed minimum IRR Requirements, highest IRR selected
49
Q

Advantages of NPV

A
  • Accounts for time value of money
  • Guarantees most profitable project is chosen
  • Accounts for investment size
50
Q

Disadvantages of NPV

A
  • Can be complex with longer projects

- Choice of discount rate is crucial and it isn’t always clear which rate to use

51
Q

Advantages of IRR

A
  • Takes into account the time value of money

- As a percentage measure it’s easy to interpret and compare

52
Q

Disadvantages of IRR

A
  • 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
53
Q

Mutually Exclusive Projects

A

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

54
Q

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

A

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

55
Q

IRR Personal Notes

A

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

BSc Business Management (37 decks)

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