8- Investment appraisal and the capital budget Flashcards
What are the 6 evaluation methods for investment appraisal?
- Payback period
- Accounting rate of return
- Net present value
- Discounted payback
- Internal Rate of Return
- Modified Internal Rate of Return
What is the payback period and how is it used?
Time taken for cash inflows from a project to equal outflows with the firm accepting if the payback period is quicker than their target
What is accounting rate of return (ARR) and how is it used?
ARR = Average annual profit from investment/intial investment
Accept all projects with ARR above target
What is net present value (NPV) and how is it used?
Represents the change in wealth of the investor as a result of investing in the project.
Accept all projects with a positive NPV
What is discounted payback period (DPP)?
DPP is the time it will take before a project’s NPV turns from being negative to positive
Accept all projects that payback within their lifetime
What is the internal rate of return (IRR) and how is it used?
Cost of capital at which the NPV of a project would be £0
Accept all projects with an IRR above the cost of capital
How do you calculate IRR through interpolation using 2 discount rates?
- Calculate NPV at a given cost of capital
- Calculate NPV at a second discount rate (higher if positive, lower if negative)
- Plug values into formula
What are the 2 adjustments made with the modified internal rate of return (MIRR)?
- Multiple rates of return
- Assumption that cash flows are reinvested at the Cost of Capital not IRR
How does post completion audit (PCA) work?
Capital projects are evaluated and chosen based on estimates of revenue and costs then ranked to get highest profits and returns
How do firms perform capital rationing?
Rank projects by profitability index: NPV/capital invested
What are the 3 steps in calculating incremental cash flow after tax?
- Calculate capital allowances (WDA)
- Calculate incremental taxes arising from the project
- Tax effect of balancing allowance
What is scenario analysis?
Calculation of probable outcomes based on variance of variables from sensitivity analysis
