Chapter 1 investment decisions Flashcards
Payback
time taken for cash inflows from a project to equal cash outflow
ACCEPT = payback < TARGET
Accounting rate of return (two formulas, what is average investment?)
ARR= Average annual profit from investment/initial investment x 100
or
Average profit from investment/ average investment x 100
where average investment = initial outlay+scrap value/2
PROFIT IS AFTER DEPRECIATION
ACCEPT = ARR>target
Net Present value
maximum investor would pay for a given set of cash flows (@ his cost of capital), compared to how much he is being asked to pay
the difference = NPV (change in wealth of the investor as a result of investing in the project
ACCEPT= NPV POSITIVE
Internal rate of return
cost of capital at which NPV = 0
IRR usually found via interpolation using two discount rates
IRR = NPV a/ NPVa - NPV x (b-a)
where:
a= lower discount rate giving NPV a
b= higher discount rate giving NPV b
ACCEPT = IRR% > cost of capital
Relevant cash flows
RCF: Future, Incremental cash flows arising from the decision being made
the figures being put into the NPV working must be relevant to the decision being made
Cash flows only - E.g. No depreciation
Future amounts- no sunk costs
Directly relevant - no allocated costs (overheads) which would be incurred without the job taking place
Finance related cash flows- normally excluded from project appraisal as discounting takes account of cost of capital
Opportunity cost- include costs incurred or revenues lost from diverting existing resources from their existing use (contribution)
Relevant costs MATERIALS
*RC = relevant cost
NOT IN STOCK
have to buy - RC = current replacement cost
IN STOCK
In constant use - must replace- RC = current replacement cost
No other use- No need to replace- RC = current resale/scrap value
Scarce- cannot replace- RC = opportunity cost
Relevant cost of labour (spare v full capacity)
CURRENT WORKFORCE:
SPARE CAPACITY
RC = Nil labour cost + variable overhead (if any)
FULL CAPACITY
workforce available for hire - RC = Current rate of pay + extra variable overhead incurred
No workforce available - RC = opportunity cost
working capital
e.g. P has following sales over 3 years - 10,000,15,000, 20,000. they want 10% working capital in place at the start of the year and it will recover at the end of year 3
working:
top line is WC at start of year
bottom line is cash flow
y0 y1 y2 y3
WC 1000 1500 2000 0
CF -1000 -500 -500 2000
Taxation
two effects :
1) tax payment (benefits) on operating profit (losses)
2) tax benefit from capital allowances on cap expenditure
Capital allowances
calculate cap allowance at 18% reducing balance - deduct the 18% off of the expenditure, thats the starting point for year after
tax the WDA and that goes into the NPV calculation
NO WDA in year of sale, balancing allowance/charge instead
the amount of expenditure left (after deducting WDAs) is the balancing charge/allowance- then taxed and put into NPV calc
Inflation (real and money/nominal rates)
REAL RATES = the rates of interest that would be required in the absence of inflation in the economy
MONEY RATES, REAL RATES AND GENERAL INFLATION (CPI), LINKED BY THE FOLLOWING;
(1+m) = (1=r) x (1+i)
where:
m= money (nominal) rate r= real (effective) rate i= general inflation
Inflation: Discounting and practical considerations
discounting - money method
adjust individual cash flows for their specific rates to convert to money cash flows (flows which will actually occur)
discount these money flows using the money rate- (rate of interest that will actually occur)
practical considerations:
general inflation may not be constant
longer term estimates become more prone to error
NPV proforma
operating cash flows : -Revenue* -costs* net cash flow tax
Asset: purchase scrap Tax on WDAs + balance charge/allowance working capital Net flows PV cash flows (DF%, y1-Yx) less outflow at Y0
NPV
*adjust for inflation and include only relevant cash flows
