6) Investment appraisal - further aspects

Question 1

Formula to calculate the Payback Period of a project

Answer 1

Initial investment / Annual cash inflow

Question 2

How to convert a decimal number representing part of a year into years and months?

Answer 2

Multiply the decimal by 12 to get the number of months.

The number before the decimal point is obviously already the number of full years.

Question 3

Formula to calculate ARR (Accounting rate of return) of a project

Define the elements of the formula

Answer 3

Average annual profit / Average value of investment

Average annual profit = the total of annual net cash flows less the total depreciation / (divided by) the number of years of the project

Average value of the investment = average capital employed over the life of the project = Initial investment plus residual value / 2

Question 4

Formula to calculate “Average value of investment”

Part of the ARR Accounting Rate of Return formula

Answer 4

Initial investment plus residual value / 2

Question 5

ARR formula if asked to calculate based on initial investment

Answer 5

Average annual profit / Initial investment

Question 6

Real/current cash flows vs. Money/nominal cash flows - what is the difference? - which are you given in the exam unless told otherwise?

Answer 6

Real = not increased for expected inflation

Money = represent expected flows of money, therefore have been increased to take expected inflation into account

Assume money cash flows are given in the exam unless told otherwise

Question 7

Formula to calculate the “Real rate of return” (r)

Answer 7

(1+r) = (1+m) / (1+ i)

m = money cost of capital (company’s normal cost of capital)

i = rate of inflation

Question 8

How to choose between money method and real method?

Factors: Tax / Inflation / Perpetuities / Annuities

Answer 8

Generally choose money method. Safer and easier to use when questions incorporate multiple inflation rates and tax.

However if only one rate of inflation and no tax, real method will be quicker. And for perpetuities the real method is the only possible method.

Question 9

Formula to calculate equivalent annual cost

When considering mutually-exclusive capital asset replacement decisions

Answer 9

PV of costs / Annuity factor for year n