7. Evaluating a Financial case Flashcards
What is the purpose of building a Financial case
To compare Financial benefits expected to flow from proposed projects given predicted costs
To determine if a project is worth undertaking
To evaluate Financial viability of a project proposal
A means of comparing projects and options
What is CBA
Cost benefit analysis - Used to weigh up 2+ options by their financial costs to aid decision makers
What is Payback
Payback is the point at which cumulative benefits exceed cumulative costs
What are the limitation of Payback
Does not consider costs and benefits after the breakeven point
Does not consider the “Time value of money”
What is DCF
Discounted cash flow - Is so called as it discounts the cash flow to calculate the Net Present Value (NPV)
What is the Purpose of the DCF
Discounted cash flow - Is a prediction on the purchasing power of money, we need to take into consideration the fact that the value of money reduces over time
Calculates the present value of a future amount
Who provides the Discount rate
Generally provided by an organisations finance department, based on company’s debts and equity is consistent across organisation
How do we work out the discount factor
1/(1+Discount rate)year
if discount rate was 10% we use 1/(1+0.1)1 for year one = 0.9091, 1/(1+0.1)2 for year 2 = 0.8264
What is NPV
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time
How do we work out NPV
Net present value is worked out by first using the discount factor to reduce the cash flow for each year to its present value, then adding all year cost and benefits together to get the NPV value of the project.
NPV is always numerical
What is the NPV decision rule
If NPV of a project is positive then proposed investment is worthwhile, as in theory it will yield more than invested in it
If NPV is negative then proposed investment is not worthwhile, will not yield more than invested
What, from a purely Financial POV is the best option for evaluating when multiple projects of similar size, risk and priority are competing for same funds?
The project with the greatest Net Present Value (NPV), measured over a set period of time
OR
The option that yields the greatest IRR
What is the IRR
Internal rate of return
The discount rate that yields a NPV of 0
The higher the IRR the better the option
How can we derive an IRR
Derived by time and error, recommendation to use Excel which has an IRR formula
What is an IRR hurdle?
The minimum IRR that a proposed project is required to deliver, the rate of return required to persuade an investor to invest
If IRR is less than hurdle rate, usually won’t be funded, however this ignores the relative size of projects
Who sets the IRR hurdle
The organisation based on investment experience
What is capital?
Capital is the money contributed by the proprietors of a business to enable it to function
What is Cost of Capital
The return expected by the providers of the capital
Difference between investing with capital and investing with Finance
No interest needed to be paid using Capital
Interest required when using Finance, making this option less profitable
What is Opportunity Cost
The lost opportunity of earning income from the best alternative investment
What is the IRR decision rule?
If the IRR of a project is greater than the “Investment hurdle” (i.e. the minimum required rate of return) then it is worthwhile
If IRR is less then the cost of capital is the project worthwhile?
No, IRR must be greater than Cost of Capital to be financially worthwhile
Will organisations set an investment hurdle higher than the cost of capital?
Yes, many Organisations will set an investment hurdle higher than the cost of capital, it depends on the Organisations attitude to risk and their investment experience
The more risk averse the Organisation the higher the investment hurdle
What is the purpose of the business case?
The business case sets out the arguments for and against a proposed action
- Assesses all options
- Details high level risks, assumptions, issues and dependencies
- Includes the financial case for the project
- Benefits (Tangible and intangible)
- Costs (Tangible and intangible)
Is a financial case different to the business case?
Yes, financial case evaluates a project based of monetary figures alone.
The business case looks at the wider impacting factors for a project and generally includes a financial case
What are the 2 types of cost for a proposal?
Opportunity cost - The lost opportunity of earning alternative income from other uses or investments of the funds invested in proposed project
Sunk cost - Money already spent that cannot be recouped
Is the business case the same as the Investment proposal?
Yes
What is the role of the BA in the business case?
The BA works with Stakeholders to assist with the development of the Business case
- Defining requirements that deliver benefits, supporting bus’ objectives
- Determine the feasibility of a project and options available, to solve problems outlined in the TOR
- Used to seek approval and funding of a project
Which of the following would you not find in a business case? Costs Benefits Cash Statement Accumulated cash flow
Cash Statement
When more than one project is being evaluated what would normally be preferred
the one with the highest NPV
What is a disadvantage of payback?
It does not consider the time value of money
Cash flow after the breakeven point are ignored
An investment hurdle is often used with which appraisal technique?
IRR
In an investment appraisal “year 0” is used to show what costs?
Upfront cost of the investment
Fill in the gaps
Cash Flow/net per year = ____ - ___
Cash flow/net per year = Total benefits - Total costs
Payback is in the year when cumulative cost is…?
The same as cumulative benefits
IRR = Discount rate that yields an NPV of?
Zero
IRR is compared to what when evaluating whether a proposed investment in a project is financially worthwhile?
Cost of capital
Net present value = Sum of ….?
The present value of cash flows per row
