Chapter 2 Flashcards
Payback period
Time taken for cash inflows from a project to equal outflows
Accounting rate of return initial investment
Average annual profit from investment / initial investment * 100
ARR average investment
Average annual profit from investment / average investment
Average investment
(Initial Outlay + Scrap value ) /2
NPV definition
the maxima an investor would pay for a given set of cash flows compared to the actual amount they are being asked to pay. The difference represents the change in wealth of the investor.
IRR definition
A cost of capital at which the NPV of a project would be zero
Payback period benefits
Simple to understand,
quick for initial screening
considers risk (Crudely)
Payback period issues
Unsophisticated
Doesn’t take account of TV of money
Ignores CF after payback period
ARR Benefits
Using profit consistent with ROCE and EPS
Use of BS values (asset backing)
relative score easy to understanding
ARR Issues
Not consistent with wealth maximisation
Ignores TV money
investment decisions should be based on CF not accounting profit
Percentage may be misleading when choosing between alternatives
Profits can be manipulated
NPV benefits
Takes TV Money into account
Absolute measure
Allows comparison of projects
considers all CF
NPV Negatives
Need to estimate cost of capital
Difficult to estimate all relevant cost/benefit
assume CF occur annually
IRR Benefits
TV Money,
Represents breakeven point so don’t nee exact COC
Considers all CF of projects
IRR Negatives
May conflict with NPV decision for mutually exclusive projects - projects may have lower NPV than another but higher IRR
Assumes cash invested at IRR
Easy to use and communicate practically
Adjustments to make if income statement information is provided
Depreciation
Working capital
Definition of relevant cash flow
Future incremental cash flows arising from the decision being made
Opportunity cost definition
Cash flow foregone if a unit of resource is used on the project instead of in the best alternative way
Relevant cost of material if not in stock
Current replacement cost
Relevant cost of material in stock in constant use
Current replacement cost
Relevant cost of material in stock with no other use
Current resale value / scrap value lost
Relevant cost of scarce material that cannot replace
Opportunity cost
Relevant cost of labour if spare capacity
Nil labour + variably OH
Relevant cost of labour if full capacity and workforce available for hire
Current rate of pay plus extra OH incurred
Relevant cost of labour if full capacity and no workforce available
Opportunity cost
Deprival value is the
Lower of replacement cost and recoverable amount
Recoverable amount is the higher of
Value in use (PV CF)
NRV
Money rate calculation
(1+m) = (1+r) * (1+i)
Discount current terms CF using effective rate calculation
1 + e = (1 + m) /(1+is)
Benefits of understanding environmental costs (5)
Ethical reasons
Can help with pricing which in turn improves profitability
Poor behaviour can result in fines and damage reputation
Recording is important as some require compliance
Benefits of understanding environmental costs (5)
Ethical reasons
Can help with pricing which in turn improves profitability
Poor behaviour can result in fines and damage reputation
Recording is important as some require compliance
Saving energy may leave to saving costs
Environmental prevention costs definition
Costs required to eliminate environmental impacts before they occur
Environmental appraisal cost definition
Costs involved with establishing whether activities are complying with environmental standards and policies
Environmental internal failures costs
Costs of activities that must be undertaken when contaminants and waste have been created by a business but not released into the environment
Environment external failure costs
Costs arising when business releases harmful waste into the environment, which could damage reputation
The optimal replacement cycle is
The one with the lowest equivalent annual value
PV of annuity
Annuity * annuity factor (DCF)
Annual equivalent =
ANNUITY * ANNUITY FACTOR
Limitations of replacement analysis - Changing tech
Changing technology - machines can become obsolete and shorten cycle, when replaced not replacing identical
Limitations of replacement analysis - Inflation
Alters costs of assets over time means optimal replacement cycle can vary
If affects all variables equally, best to exclude and discount at real rate
Different inflation rates means optimal cycle varies over time
Limitations of replacement analysis - tax
Effects of taxation are ignored but could be incorporated
Limitation of replacement analysis - use of machines
Unlikley to continue in perpetuity
Divisible projects are ranked using
NPV per £ of scarce capital
Indivisible projects are ranked using
Trial and error to maximise NPV
Hard rationing definition
External capital market limits supply of funds
Soft rationing definition
Firm internally imposes own constraint on the amount of funds raised
Shareholder value analysis
The process of analysing the activities of a business to identify how they will result in increasing shareholder wealth
7 value drivers of SVA
Life of projected CF
Sales growth rate
operating profit margin
tax rate
Investment in NVA
Investment in WC
Cost of capital
How does sales growth rate benefit sharheolders
If more sales can be generated than expected, more cashflows should be created and therefore more value.
How does operating profit margin benefit shareholders
Operating profit margin is ratio of net profit (before interest and tax) to sales.
Higher ratio more CF from each £1 of sale
How does corporation tax rate benefit shareholders
Affects cash flows, ability to affect the tax rate tends to be marginal, but can avoid some
How does investment in NCA benefit shareholders
Normally cash needs to be invested in additional NCA to enhance SH value. if can limit outlay without limiting effectiveness of business often enhance shv
How does investment in working capital benefit shareholders
Steps that can be taken to reduce working capital required will bring CF forward and generate cost
How does COC benefit shareholders
Cost of funds used to finance activities of business will usually be big determinant in SHV. If can find cheaper source of LT finance value tends to be achieved
How does life of CF benefit Sh
Longer life of any cash generating activity, greater potential to generate value
Real option - follow on
Launching the first effectively gives the right to invest in the later versions.Right to invest/buy is a call option
Real option - abandonment option
Right to sell is known as a put option, beneficial if can abandon and sell
Real option - timing options
Projects where commencement can be dealyed are often attractive. Longer delay, more valuable
Only valuable if offsets any loss from delaying
Real options - Growth options
Choices may be full investment, wait and see and acquire a growth option, start with small capacity and expand later if market good, joint ventures and strategic alliance as entry to emerging markets.
Real options - Growth options
Choices may be full investment, wait and see and acquire a growth option, start with small capacity and expand later if market good, joint ventures and strategic alliance as entry to emerging markets.
Real options - flexibility options
Use asset for different things - must include the value of flexibility in the evaluation
Political risk
The risk that political action will affect the position and value of a company
Examples of political risks
Quotas
Tariffs
non-tariff barriers
Restrictions
Nationalisation
Minimum shareholding
Factors to take into account when assessing political risks
Government stability
political and business ethics
economic stability / inflation
degree of country’s international indebtedness
financial infrastructure
level of import restrictions
remittance restriction
evidence of expropriation
existence of special taxes and regulations on overseas investors or investment incentives
Strategies to limit effects of political risk
Negotiations with host government
insurance
production strategies
Management structure
cultural risk important areas
Cultures and practices of customers and consumers
Media and distribution system
Different ways of doing business
degree to which national cultural differences matter for the product concerned
