Chapter 2 Flashcards
What is the payback period and how do you calculate it?
How many years a project cash flows are needed to recover the initial investment
Calculate when cumulative cash flow on the project hits zero.
What is the AROR and how to calculate?
Represents annual % return on the project based on accounting profits
Average annual profit/ average initial investment
Avg investment = initial outlay +scrap value/2
What is the NPV? What does it represent?
Summing present value of future cash flows (discounted at COC) on a project by deducting upfront cost gives BPV
Represents the present value of the excess return on the project over and above the financing costs
How do you calculate PV of each cash flow?
Multiply it by discount factor:
1/(1+r)^n
R is the COC
N is the no of periods into the future
What is an annuity and how do you value it?
Constant annual cash flow (with cash flow at end of each year and first cash flow in years time)
PV of annuity: A/R x ((1-1/(1+r)^n)
What is a perpetuity and how do you calculate it?
Never ending constant annual cash flow (cash flow at end of each year and first cash flow in years time)
Use formula A/R
R is COC
A is annuity
How to calculate NPV using spreadsheet?
NPV(discount, cell range)
What is IRR? When is IRR good?
How do you calculate?
Internal rate of return: actual annual % return on the project (based on discounted future cash flows)
Good is IRR> COC
IRR(cell range)
Cell range is cash flows
Pros and cons of payback period?
Pros:
Simple easy to understand
Use as initial screening tool
Recognises importance of liquidity
Focuses on nearest more certain cash flows
Cons
Ignored time value of money
Only considers the cash flows up to payback date
Encourages short term decision making
No clear decision rule
Pros and cons of AROR
Pros
Simple to calculate and understand
Looks at entire life of project
Reflects way that external investors judge the organisation
Cons:
Ignores time value of money
Based on profits, not relevant cash flows
Doesn’t consider length of project
No clear decision rule
Pros and cons of NPV
Pros:
Takes into consideration TV of money
Shows the shareholders wealth created by project
Can allow for risk by adjusting COC
Clear decision
Looks at entire project life
Cons:
Requires COC to be estimated several years into future
Calculations can be time consuming and easily misunderstood
Doesn’t factor in liquidity or time taken to generate return
Assumes you can reinvest proceeds at COC
Pros and cons of IRR
Pros
Allows for TV if money
Does not require an exact cost of funds to be estimated
Easy to interpret (% return of project)
Looks at entire project life
Cons
Ignored size of investment require and total cash inflows
Can give conflicting answer to NPV when evaluating mutually exclusive projects
Assumes you can reinvest proceeds at the IRR
What are 5 non-financial factors associated with a decision?
Compliance with current or future legislation
Impact on staff morale
Impact on suppliers and customers
Reputation of organisation
Sustainability
What is the definition of relevant costs?
Incremental: costs and revenues impacted by decision, include lost opportunity costs (cash flows foregone if we proceed with project), exclude committed costs (overheads that will not be impacted by project)
Future: only consider cash flows arising in future and ignore past, sunken costs
Cash flows: ignore non cash items such as depreciation
Define opportunity costs
The cash flow foregone if a unit of the resource is used on the project instead of in the best alternative way
What is working capital?
How do we treat it in our calculation?
When does it need to be in place in our calculation?
Liquidity of the business
Increase in working capital investment ties up cash and so needs to be treated as cash outflow. Decrease in working capital is a cash inflow
At T0
What are the two impacts of taxation in investment appraisal?
Taxation of operating cash flows: operating cash flows are subject to corporation tax either in the year cash flows are generated or the following year
Capital allowances:
Lease to reduction in tax outflows and these savings should be included in our NPV as cash inflows
What is a balancing allowance and balancing charge?
Balancing allowance: TWDV>didposal value you get extra cap allowance
Charge: TWDV< disposal value you get negative capital allowance e
What are specific and general inflation rates?
Specific: rate of inflation on individual item or service
General: weighted avg of many specific inflation rates (CPI) and is applied to the real rate of interest in order to determine money rate
What are money and real cash flows
Money (nominal cash flows): where any inflationary effects have already been taken into account (2yr cash flow would need to be multiplied by (1+i)^2) to get it into money terms
Real: cash flows expressed in todays terms and have not been adjusted for future inflation
What are real and money (nominal rates)
Real: rates of interest that would be required in the absence of inflation in economy
Money(nominal): achieved by adjusting real rates of interest for the effect of general inflation
What is the calculation linking money rates, real rates and general inflation?
(1+m) = (1+r) (1+i)
M is money rate
R js real rate
I is general inflation
When performing NPV calcs you either need to use money cash flows and money rate of interest or real cash flows and real rate of interest. How do you deal with this?
Money method:
Adjust invidivhsl cash flows to incorporate specific inflation
Discount cash flows using money rate
Real method:
Remove effects of gen inflation from money cash flows to generate real cash flows
Discount using real rate
What is the effective rate?
Shortcut to use when trying to use the money method to discount perpetuity cash flows which are inflating at a steady rate:
(1+m)/(1+i) -1
What are the key components of a NPV formula?
Revenue
Variable costs
Contribution
Fixed costs
Net operating cash flow
Tax @ x%
Cap expenditure
Scrap value
Tax saving on cap allowance (W)
Working cap
Net cash flow
How do you lay out a capital allowance working
Time across top
Opening TWDV
CLOSIGN TWDV
capital allowance % WDA on opening TWDV
Tax saving (included on proforma)
What is replacement analysis and what technique should you use?
What EAC should be chosen and what does it represent
Involves choosing between two alternatives where the benefits are unequal (if over different number of years)
Use equivalent annual cost
PV of annuity = annuity cash flow x annuity factor
EAC= NPV/ annuity factor for project life
Represents constant annual cash flow that has the same present value as the actual cash flows
Proposal with lowest EAC should be chosen
What is capital rationing and what are the two types?
What could they be the result of ?
Capital rationing describes the situation where a company does not have sufficient funds to invest in all positive NPVs
Hard capital rationing: where an organisation would like to raise more funds but no stakeholder is prepared to invest. May result from potential returns not being high enough to compensate for risks involved
Soft:
Where an organisation could raise more funds but has decided not to. May result from a concern that the available finance is too expensive or may result in a loss of control
What is single period rationin?
How do you calculate profitability index
When funds are scarce in one year only and projects are divisible:
If investment projects are divisible, then investing only a proportion of the initial investment required would result in the same proportion of the project NPV being achieved
In such situations, we need to rank projects by identifying the NPV generated from each £1 of the initial investment, known as profitability index
NPV/ initial investment
What happens if you have indivisible projects in relation to capital rationing?
Can only accept projects as a whole and must find optimal combination
What is shareholder value analysis?
Process of analysing the activities of a business to identify how they will result in increasing shareholder wealth
What are the principles of SVA?
Business has a particular value at a particular time as determined by the present value of the project future cash flows from its activities
There are seven factors known as value drivers
What are the seven value drivers of SVA and how do you positively impact on the value drivers?
Sales growth rate: inc rate / prevent decline (using marketing, new products, changes)
Operating profit margin: inc in margin by inc prices and or reducing operating costs (using marketing, product improvements, cost control)
Corp tax rate: reduce effective rate using careful tax planning
Investment in non current assets: reduce investment without impacting business (try to inc useful life of business)
Investment in working capital: reduce investment without impacting business (reduce stock levels using careful inventory management)
Cost of capifal (reduce cost of capital (by finding cheaper sources of finance)
Life of projected cash flows (face lifting older products to increase life of cash flows)
What are real options and what are the five real options?
One problem with NPV: only considers cash flows related directly to project. Negative NPV project may be accepted for strategic reasons. There may be options with the project:
Follow on options: ability to launch future products off the back of this one or extend life of project
Abandonment options: the ability to exit the project early and sell assets
Timing options: ability to delay the start of the project to wait for favourable market conditions
Growth options: ability to dip your toe in the water with small initial investment and then grow
Flexibilitt: ability to change suppliers, materials, locations in the future if a cheaper project becomes available
What is political risk and what are the 5 measures and descriptions?
Is the risk that action by a foreign government will affect the position and value of the company
Quotas: limits on quantities of goods a subsidiary may buy from its parent for domestic sale
Tariffs: extra tax or duty sooolier to imports in order to make domestic goods more competitive
Non tariff barriers: extra quality or safety checks applied to imported goods
Restrictions: foreign companies prevented from buying domestic companies in certain industries
Nationalisation: of foreign owned companies and their assets
Minimum shareholding: insistence of a minimum shareholding in companies by residents
What are the four ways of dealing with political risks?
Negotiations with host government
Insurance: export credit guarantee department provide protection against nationalisation, currency problems, war or revolution
Production strategies: contract out some production to local sources or locate key parts of production and distribution overseas
Management structure: use of joint ventures with domestic companies or ceding control to local investors
What are the four benefits of understanding environmental costs?
Determine the correct cost and price of products and services
Reduce chances of incurring fines and liability
Ensure regulatory compliance
Reduce costs (saving energy generally leads to cost savinds)
What are the four types of conventional environmental costs?
Conventional: addressed in traditional cost accounting and inv appraisal but not usually considered environmental: cost of raw materials and utilities
Potentially hidden costs: costs captured by accounting systems which lose their identity in general overheads: cost of complying with environmental laws or costs incurred going beyond compliance
Contingent costs: costs to be incurred at a future date given their uncertain nature. Expected values could be used to build these costs into investment appraisal process. Such as cost of remedying and coenosbarinf future accidental releases of contaminents
Image and relationship costs: costs incurred to affect perceptions of managements, customers, employees etc: costs of preparing environmental reports, or to improve companies image
What are the three benefits of identifying key social impacts?
It affects an organisations relationship with key stakeholders
It affects an organisations reputation
It can assist in ESG reporting
