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Financial Management > Chapter 2 > Flashcards

Chapter 2 Flashcards

1
Q

What is the payback period and how do you calculate it?

A

How many years a project cash flows are needed to recover the initial investment

Calculate when cumulative cash flow on the project hits zero.

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2
Q

What is the AROR and how to calculate?

A

Represents annual % return on the project based on accounting profits

Average annual profit/ average initial investment

Avg investment = initial outlay +scrap value/2

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3
Q

What is the NPV? What does it represent?

A

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

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4
Q

How do you calculate PV of each cash flow?

A

Multiply it by discount factor:

1/(1+r)^n

R is the COC
N is the no of periods into the future

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5
Q

What is an annuity and how do you value it?

A

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)

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6
Q

What is a perpetuity and how do you calculate it?

A

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

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7
Q

How to calculate NPV using spreadsheet?

A

NPV(discount, cell range)

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8
Q

What is IRR? When is IRR good?

How do you calculate?

A

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

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9
Q

Pros and cons of payback period?

A

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

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10
Q

Pros and cons of AROR

A

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

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11
Q

Pros and cons of NPV

A

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

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12
Q

Pros and cons of IRR

A

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

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13
Q

What are 5 non-financial factors associated with a decision?

A

Compliance with current or future legislation

Impact on staff morale

Impact on suppliers and customers

Reputation of organisation

Sustainability

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14
Q

What is the definition of relevant costs?

A

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

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15
Q

Define opportunity costs

A

The cash flow foregone if a unit of the resource is used on the project instead of in the best alternative way

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16
Q

What is working capital?
How do we treat it in our calculation?
When does it need to be in place in our calculation?

A

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

17
Q

What are the two impacts of taxation in investment appraisal?

A

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

18
Q

What is a balancing allowance and balancing charge?

A

Balancing allowance: TWDV>didposal value you get extra cap allowance

Charge: TWDV< disposal value you get negative capital allowance e

19
Q

What are specific and general inflation rates?

A

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

20
Q

What are money and real cash flows

A

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

21
Q

What are real and money (nominal rates)

A

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

22
Q

What is the calculation linking money rates, real rates and general inflation?

A

(1+m) = (1+r) (1+i)

M is money rate
R js real rate
I is general inflation

23
Q

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?

A

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

24
Q

What is the effective rate?

A

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

25
Q

What are the key components of a NPV formula?

A

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

26
Q

How do you lay out a capital allowance working

A

Time across top

Opening TWDV
CLOSIGN TWDV
capital allowance % WDA on opening TWDV
Tax saving (included on proforma)

27
Q

What is replacement analysis and what technique should you use?

What EAC should be chosen and what does it represent

A

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

28
Q

What is capital rationing and what are the two types?
What could they be the result of ?

A

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

29
Q

What is single period rationin?

How do you calculate profitability index

A

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

30
Q

What happens if you have indivisible projects in relation to capital rationing?

A

Can only accept projects as a whole and must find optimal combination

31
Q

What is shareholder value analysis?

A

Process of analysing the activities of a business to identify how they will result in increasing shareholder wealth

32
Q

What are the principles of SVA?

A

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

33
Q

What are the seven value drivers of SVA and how do you positively impact on the value drivers?

A

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)

34
Q

What are real options and what are the five real options?

A

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

35
Q

What is political risk and what are the 5 measures and descriptions?

A

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

36
Q

What are the four ways of dealing with political risks?

A

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

37
Q

What are the four benefits of understanding environmental costs?

A

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)

38
Q

What are the four types of conventional environmental costs?

A

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

39
Q

What are the three benefits of identifying key social impacts?

A

It affects an organisations relationship with key stakeholders

It affects an organisations reputation

It can assist in ESG reporting

Financial Management (10 decks)

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