Capital Investment Appraisal Flashcards
What is the Time Value of Money?
The time value of money refers to the benefit of having money now rather than at some future date (or conversely, the cost or loss in benefit of having to wait to acquire that money). We need to be able to measure this time value of money in order to compare cash inflows at one date with cash outflows at another.
Factors of Time Value of Money: Inflation
Inflation refers to the percentage fall in the purchasing power of money over time. This is generally assumed to be zero, but in certain cases may need to be specifically considered.
Factors of Time Value of Money: Opportunity Cost
An opportunity cost is the cost of opportunities foregone if the level was not available to invest. At the most basic level, this would be the risk free rate of return available on government securities, for example.
Factors of Time Value of Money: Risk
There will be a premium for the level of uncertainty in future cash-flows as a result of the possible consequences of intervening events.
By investing in a business opportunity which entails risk, the investor would expect to increase their return (effectively adding the risk free opportunity cost to the risk premium).
Factors of Time Value of Money: Consumption Preferences
In general, people appear to prefer consumption now to consumption in the future.
What is the Internal Rate of Return?
The internal rate of return is an alternative technique to NPV. It is the maximum cost of capital that can be applied to a project without causing harm to shareholders. It takes into account the time value of money, and represents the true interest rate earned on an investment over the course of its economic life.
How to calculate IRR?
IRR = A + (C / C - D) (B - A)
Where A = low trial discount rate
B = high trial discount rate
C = NPV at low trial rate
D = NPV at high trial rate
How to calculate IRR where cash flows are constant?
(Annual cash flow) x (Discount factor for no. of years for which cash is received) - (Investment cost) = 0
Rearranging this formula, IRR will be at the point where:
Discount factor = Investment cost / Annual cash flow
What is the Accounting Rate of Return?
The accounting rate of return is used to estimate the rate of accounting profit that the project will yield. If it exceeds a target rate of return, the project should be undertaken. ARR is the only investment appraisal method based on profits, not cash flows.
How to calculate ARR?
ARR = (Estimated average profits / Estimated average investments) x 100
How to Calculate the Average Annual Investment (AAI)?
AAI = (Initial investment + residual value) / 2
Strengths of ARR
Calculation is very straightforward
Easy to compare with overall ROCE for a business
Measurement that non-financial managers can readily understand
Weaknesses of ARR
Ignores the time value of money
Projects with cash flows occurring at the end of its live have the same ARR as projects with cash flows occurring early in its life
Strengths of Payback
The sooner the investment is recovered, the sooner the funds can be put to another use
Shorter payback period reduces the risk associated with changes in future economic conditions
Easy to calculate and understand
Weaknesses of Payback
Ignores the total life of the project and therefore profitability of investment (cash flows after the payback period are ignored)
Ignores the time value of money
If rapid recovery of funding is not a priority, payback provides little useful information.
Strengths of NPV
Accounts for time value of money
All cash flows of the project are accounted for
Deals with absolute values rather than percentages
Weakness of NPV
Can be difficult to explain to non-financial managers
Strengths of IRR
Accounts for time value of money
Weaknesses of IRR
Ignores absolute values, is instead expressed in percentage terms
NPV v IRR
NPV assumes that the cash flow generated is reinvested at the cost of capital.
IRR assumes that the cash flow is reinvested at a return equal to IRR of the original project (not realistic as firms should accept projects with returns equal to or greater than the cost of capital.
Which Capital Investment Appraisal method is best and why?
NPV:
All techniques are used extensively in practice.
Usually use more than one technique.
Computers make calculations of IRR and NPV easier.
Stages in Capital Investment Process
- Search for investment opportunities.
- Initial screening.
- Project authorisation.
- Control during the installation stage.
- Post-completion audit.
What is Stage 1 in Capital Investment Process?
- Search for investment opportunities:
Without a creative search for new investment opportunities, appraisal techniques are worthless.
What is Stage 2 in Capital Investment Process?
- Initial screening:
Preliminary assessment to ascertain if projects satisfy strategic and risk criteria.
What is Stage 3 in Capital Investment Process?
- Project authorisation:
Approval by top management committee or lower levels based on financial appraisal and strategic considerations.
What is Stage 4 in Capital Investment Process?
- Control during the installation stage.
Period reports required on over/under spending relative to stage of completion, estimated costs to complete and estimation completion date compared with original estimates.
What is Stage 4 in Capital Investment Process?
- Post-completion audit:
Compare the actual results with those included in the investment proposal.
Difficult to undertake because it is not easy to isolate the actual cash flows that stem from individual projects.
Recriminatory post-mortems should be avoided.
