Ch.2 - Investment Appraisal Flashcards
4 methods of investment appraisal
- Payback method
- ARR
- NPV
- IRR
4 methods of investment appraisal
- Payback method
- ARR
- NPV
- IRR
Disadvantages of payback method
- arbitrary decision
- doesn’t take time value of money into account
- ignores future CF
Formula for ARR
Average return (profit)/Initial investment
Disadvantages of ARR
- arbitrary decision
- uses profits rather than CF
Formula for IRR
IRR = r(a) + {NPV(a)*[r(b)-r(a)]/[NPV(a)-NPV(b)]}
Advantages of NPV
- takes into account time value of money
- absolute measure of return
- based on CF not profits
- considers whole life of the project
Non-financial factors affecting NPV
- compliance with legislation
- impact on key stakeholders
- impact on reputation
- sustainability
Annuity discount factor formula
1/r*{1-[1/(1+r)^n]}
Perpetuity discount factor formula
1/r
Growing perpetuity discount factor formula
1/(r-g)
What CF should be included in calculation of NPV?
Future incremental cash flows which arise as a result of decision being taken.
Which costs should be ignored when calculating NPV?
- sunk costs (e.g. historical market research)
- commited costs (e.g. salaries, unless paid extra to do the project)
- non-cash items (e.g. depreciation)
- book values (e.g. cost of machine bought)
- allocated costs (e.g overhead allocation)
What is an opportunity cost?
Change in CF if a unit of resource is used in a project rather than on the next best alternative.
How to calculate deprival value?
Deprival value is lower of:
- replacement cost
- recoverable amount (which is higher of:
=> value in use
=> net realisable valueWhat is working capital?
Represents cash tied up for the duration of the project.
What is the treatment of working capital?
- initial working capital is a cost at the start of the project
- during the project only incremental (increase or decrease) relevant CF
- at the end of the project, working capital is “released”
What is the tax treatment in NPV?
- tax is paid at the end of the year in which the profits are earned (17%)
- capital allowances are available at 18% WDA (17% tax relief on WDA calculated) on investment spending
- balancing charge or balancing allowance arises in the year of disposal
- if asset is bought at the start of the period, first tax relief is available in T1
if asset is bought one day before the start of the period, the first tax relief is available in T0
What is the effect of inflation on NPV?
- specific inflation affects specific CF
- general inflation affects basket of goods
What is the difference between current and money CF?
Money CF take into account expected inflation.
What rate of discounting is used in calculating NPV?
Money rate needs to be used when discounting CF.
1+money rate)=(1+real rate)*(1+inflation rate
What does discount rate compensate for?
- interest
- risk
- inflation
How do you calculate NPV using money @ money method?
- inflate each cash flow by specific inflation
- discount using money rate
How do you calculate NPV using real @ effective rate method?
- CF are left in real terms
- discounted at specific effective rate that is
(1+effective rate)=(1+money rate)/(1+specific inflation rate)
=> used for perpetuities or long annuities
How to lay out NPV question?
Relevant operating CF adjusted for inflation Sales Costs Net operating income Corporation tax (17%) Relevant asset flows Purchase price Scrap value Tax relief on WDAs Working capital flows Net flows Discount factor (rounded to 3 decimal places) PV of cash flows
What is replacement analysis?
Finding the optimal economic life:
1. calulculate NPV for each possible economic life
2. convert NPVs into ‘Equivalent Annual Cost’ by
EAC = NPV/Annuity factor
3. choose lowest EAC
What are limitations of replacement analysis?
- not accounting for inflation
- operating efficiency of assets in different ages is assumed similar
- assumed that it is replaced in perpetuity
What is capital rationing?
Method of prioritising different projects when insufficient funds are available.
a) infinitely divisible projects
- ALWAYS accept + NPV with CF inflow
- NEVER accept - NPV with CF outflow
- rank any + NPV with CF outflow (NPV/Investment)
- consider - NPV with CF inflow
b) indivisible projects
- trial and error
What is shareholder value analysis?
SVA concentrates on a company’s ability to generate value and thereby increase shareholder’s wealth. It is based on the premise that the value of a company is driven by the NPV of all of its expected future CF (of all its activities).
The value of business is calculated from the cash flows generates by drivers 1-6 which are then discounted at the company’s cost of capital (driver 7). SVA links business’ value to its strategy (via the value drivers).
What are seven drivers of value?
SLOW CAT acronym
Maximise:
Sales and growth (CF)
Length of time for future projects (NPV)
Operating margins (CF)
Minimise: Working capital investment (CF) Cost of capital/Discount rate (NPV) Assets investment (fixed assets) (CF) Taxation (CF)
What are other real options of a project? What else to consider when deciding whether to take on the project?
- Follow on options - opens up a new project
- Abandonment options - might chose lower NPV as in case all goes wrong it is easier to abandon
- Timing options - delaying starting date of the project
- Growth options - investing more as project continues
What to consider when investing overseas?
- market attractiveness
- competitive advantage
- polical risk
- cultural risk
What types of political risk can be encountered overseas?
Political risk is the risk that political action will affect the position and value of a company:
- quotas/tariffs/barriers imposed by the o/s government
- nationalisation of assets by the o/s government
- stability of the o/s government
- political and business ethics
- economic stability/inflation
- special taxes
- regulations on o/s investors
What strategies can be used to limit political risk?
- negotiations with host government
- insurance
- production strategies
- management structure
