Chapter 11 Investment appraisal techniques

Question 1

1.1 The investment decision-making process

Answer 1

Investment decisions that managers make are vital to the success of a business. Investment decision making has a number of distinct stages.
- Origination of proposals: where many different alternatives are discussed and introduced
- Project screening: where sensible projects are looked at with the company’s long term aims in mind
- Analysis and acceptance: detailed investment appraisal techniques/financial analysis are undertaken, with qualitative issues discussed
- Monitor and review: progress is monitored, comparison to capital expenditure budgets is made and timing reviewed

Question 2

2.1 Payback method

Answer 2

This is the time required for the cash inflows to recover the initial cash outflow. Companies/managers need to decide on their target period. The decision rule is:
- Payback period < target period, accept project
- Payback period > target period, reject project
Payback is considered a first screening method, if it passes the test, then more sophisticated investment appraisal techniques should be used before a decision to proceed is made. Payback uses cash flows, not profits.

Question 3

2.2 Calculation of payback

Answer 3

Payback period = initial payment / annual cash flow
In practice, cashflows are unlikely to be constant, payback is calculated here by working out the cumulative cash flow over the lift of the project.

Question 4

2.3 Advantages and disadvantages of payback

Answer 4

Advantages include:
- Simple to calculate
- Easy to understand
- Concentrates on early cash flows which are less risky and more reliable
- Useful for cash-strapped companies, hence, can focus to enhance liquidity
Disadvantages include:
- Does not measure change in shareholder wealth
- Ignores later cash flows
- Requires a target period, difficult to set and arbitrary
- Ignores time value of money (but can-do discounted payback)
- Unable to distinguish between projects with same payback
- Lead to too many short-term projects
- Does not take account of variability of cash flow

Question 5

3.1 The accounting rate of return (ARR)

Answer 5

Expresses profits of project as a percentage of capital outlay. The decision rule is:
- ARR > Target rate, accept project
- ARR < target rate, reject project

Question 6

3.2 The calculations of ARR

Answer 6

The two ways to calculate ARR are:
- ARR (initial): average annual profit / initial investment x 100
- ARR (average): average annual profit / average investment x 100 (where average investment is ½ (initial investment + final/scrap value)

Question 7

3.3 The advantages and disadvantages of ARR

Answer 7

Advantages include:
- Simple to calculate and understand
- Often used by financial analysts to appraise performance
- Looks at the entire project
- Allows project comparison
Disadvantages include.
- Does not measure change in shareholder wealth
- Can be calculated in different ways which may cause confusion
- Based on profits not cash
- Ignores time value of money
- Requires a target rate – difficult to set and arbitrary
- Relative %

Question 8

4.1 The net present value method

Answer 8

Money received now is more valuable than money received in the future due to interest, risk and inflation. NPV measures change in shareholder wealth as a result of accepting a project. The decision rule is:
NPV > 0, accept project. NPV < 0 reject project

Question 9

4.2 Compounding and terminal values

Answer 9

A sum invested today will earn interest. Compounding calculates the future or terminal value of a given sum invested today for a number of years.
TV = X (1 + r) ^n
X is the amount invested today, r is the interest rate and n is the number of years

Question 10

4.3 Discounting and present values

Answer 10

In potential investment project cash flows will arise at different points in time. For a comparison they must be converted to a common point in time, usually the present day. Discounting is:
PV = X x discount factor
PV = X x 1(1 + r) ^n
X I the amount invested in n years’ time, r is the interest rate and n is the number of years
The assumptions used in discounting include:
- Cash flows occur at year end
- Initial investments occur now (T0), and we calculate the PV at T0
- Later cash flows occur at annual intervals, starting at T1

Question 11

4.4 Net present value

Answer 11

To appraise the overall impact of a project using discounted cash flow techniques involves discounting all relevant cash flows associated with the project back to their present value. The net present value of a project is the sum of the present values of all cash flows that arise as a result of doing the project. The NPV represents the surplus funds (after funding the investment) earned on the project. The decision rule is:
- If NPV is positive – the project is financially visible
- If NPV is 0 – the project breaks even
- If NPV is negative – the project is not financially viable
If the company has two or more mutually exclusive projects under consideration it should choose the on with the highest NPV

Question 12

4.5 Discounting annuities

Answer 12

An annuity is a constant annual cash low for a number of years. The present value can be found using an annuity formula or annuity tables. The annuity factor is the name given to the sum of the individual discount factors. The present value of an annuity is found using the formula:
PV = annuity x AF
AF1 = 1 / r x (1 – (1/ (1 + r) ^2))

Question 13

4.6 Discounting perpetuities

Answer 13

A perpetuity is an annual cash flow that occurs forever. It is often described by examiners as a cash flow continuing for the foreseeable future. The PV of a perpetuity is found using the formula:
PV = cash flow / r, or
PV = cash flow x 1/r

Question 14

4.7 Advanced annuities and perpetuities

Answer 14

Some regular cash flows may start at T0 rather than T1.
Calculate the PV by ignoring the payment at T0 when considering the number of cash flows and then adding one to the annuity or perpetuity factor.

Question 15

4.8 Delayed annuities and perpetuities

Answer 15

Some regular cash flows may start later than T1. These are dealt with by:
- Applying the appropriate factor to the cash flow as normal
- Discounting your answer back to T0

Question 16

4.9 Net terminal value

Answer 16

The net terminal value is the value of the project (cash surplus) at the end of the project, after considering any interest and capital repayments. The NTV discounted at the project’s discount rate will give the project’s NPV.

Question 17

4.10 Discounted payback

Answer 17

The discounted payback period (DPP) is the amount of time that the project’s cumulative NPV takes to turn from being negative to positive.

Question 18

4.11 Changing discount rates

Answer 18

As risk, inflation and interest rates change, so will the discount rate.
NPV = X1 x 1/ (1 + r) + X2 x 1/ (1 + r1) (1+r2) + ….

Question 19

4.12 The advantages and disadvantages of NPV

Answer 19

Advantages include:
- Shows increase in shareholder wealth in absolute (£) terms
- Accounts for time value of money
- Considers relevant cash flows (covered in financial management)
- Can factor in risk by adjusting company’s discount rate
- Clear, unambiguous decisions
Disadvantages include:
- More complicated
- The cost of capital may not be known

Question 20

5.1 IRR

Answer 20

The internal rate of return (IRR) is another project appraisal method using discounted cash flow techniques. It has the following features:
- Represents the discount rate at which the NPV of an investment is zero
- Can be found by linear interpolation, either through graph or formula
- Discount rate which equates future cash inflows to initial cash outflow (for example rate that gives NPV = 0)
- The decision rule is discount rate < IRR, then project is accepted. If the rate is the discount rate is more than IRR, then the project is rejected.

Question 21

5.2 The calculations of IRR

Answer 21

Calculating the IRR using linear interpolation, the steps are:
- Calculating two NPVs for the project at two different costs of capital
- Use the following formula to find the IRR (IRR = L + (NL / NL – NH) x (H-L), where:
L is the lower rate of interest, H is the higher rate of interest, NL is the NPV at lower rate of interest and NH is the NPV at higher rate of interest.

Question 22

5.3 Calculating the IRR of a project with even cash flows

Answer 22

The simpler technique available if the project cash flows are annuities:
- Find the cumulative discount factor, Initial investment / annual flow
- Find the life of the project, n
- Look along the n year row of the cumulative discount factors until the closest value is found
- The column in which this figure is found is the IRR

Question 23

5.4 Calculating the IRR of a project where the cash flows are perpetuities

Answer 23

IRR of a perpetuity = annual inflow / initial investment x 100

Question 24

5.5 The advantages and disadvantages of IRR

Answer 24

Advantages include:
- Takes account of time value of money
- Considers all relevant cash flows
- More easily understood by management as percentage
- Means a firm selecting projects where the IRR exceeds the cost of capital should increase shareholders wealth
Disadvantages include:
- It is relative (%), not absolute (£)
- Cannot cope with changing discount rates
- May be multiple IRRs (or none)
- Interpolation only provides an estimate, and an accurate estimate requires the use of spreadsheet programme

Question 25

6.1 Mutually exclusive projects

Answer 25

Both NPV and IRR are investment appraisal techniques which discount cash flows and are superior to the basic techniques. However, only NPV can be used to distinguish between two mutually exclusive projects.

Question 26

7.1 Environmental costing

Answer 26

Environmental costs can be classified as prevention, appraisal, internal and external failure costs. These need to be considered as a part of the appraisal process as they are likely to influence consumer and investor decisions. These costs can be difficult to quantify, making it difficult to include them within the appraisal process
The benefits of understanding environmental costs include:
- Including these within the costing system will allow for better pricing decisions
- Managing and controlling these costs may avoid fines and save money
- Regulatory compliance

Question 27

7.2 Environmental cost classification

Answer 27

• Environmental prevention costs: such as staff training to avoid waste pollution
• Environmental appraisal costs: such as monitoring compliance with regulations
• Environmental internal failure costs: such as recycling scrap materials
• Environmental external failure costs: such as the cost of clearing up an oil spill