Chapter 2 Investment appraisal Flashcards
1.1 Investment appraisal techniques
- Payback: time taken to pay back the initial investment
- ARR: average return on initial investment
- NPV: PV of inflows – PV of outflows
- IRR: discount rate to give NPV = 0
NPV is theoretically superior as it takes the time value of money, is an absolute measure of return, is based on cash flows not profits and considers the whole life of the project. A positive NPV should lead to the maximisation of shareholder wealth. But non-financial factors need to be considered, such as compliance with legislation, impact on key stakeholders, impact on reputation and sustainability.
2.1 Relevant cash flows
Relevant cash flows are future incremental cash flows which arise as a result of a decision being taken. The relevant cash flow is therefore the difference between the cash flow which arises if the course of action is taken and the cash flow which arises if it is not. We should ignore:
Sunk costs, committed costs, allocated and apportioned costs, non-cash items and book values.
Finance costs (such as interest and dividends) should also be ignored as they are taken account of within the discount rate. Some types of relevant cost problems are:
- an opportunity cost is the change in cash flow if a unit of resource is used in a project rather than on the next best alternative.
- Deprival value of assets. This is the higher of the replacement cost and the recoverable amount (itself is the higher of value in use or net realisable value)
3.1 Working capitals
Investment often requires additional investment in working capital. This will not impact profit but are relevant because they represent cash tied up for the duration of the project. The treatment of working capital is:
- The initial working capital required is a cost at the start of the project
- If the working capital requirement changes during the project, only the increase (or decrease) is a relevant cash flow
- At the end of a project, the working capital is released and therefore gives rise to a cash inflow
4.1 Tax
The impact of tax must be considered when appraising investment projects. The impact includes operating flows (more income is a tax outflow, more costs is a tax inflow), fixed asset cost and disposal proceeds (tax relief given as capital allowances) and working capital flows (has no tax impact).
5.1 Inflation
Inflation is an increase in prices leading to a decline in the real value of money. Inflation has two impacts on the NPV calculation. The effect of specific inflation (estimating the future cash flows of a project requires an estimate of the rate of inflation) and the effect of general inflation on the discount rate (investors need compensation for the general rate of inflation).
The effect of specific inflation on the cash flows
Where cash flows have not been increased for expected inflation they are known as current cash flows. Where cash flows have been increased to take account of expected inflation they are known as money cash flows.
The effect of general inflation on the discount rate
In times of inflation, the fund providers will require a return made up of two elements: a real return for the use of their funds and an additional return to compensate for inflation.
The total required return is the money or nominal rate of return. Calculated using the formula:
(1 + money rate) = (1 + real rate) (1 + inflation)
5.2 Using the real at effective method
The impact of inflation can be dealt with in two different ways.
- Money at money: inflate each cash flow by its specific inflation rate (covert it to a money flow) and discount using the money rate (this is the preferred method in the exam)
- Real at effective: this method can be used for perpetuities or long annuities. Cash flows are left in real terms. A specific effective discount rate is calculated for each given cash flow. The effective rate is:
1 + effective rate = 1 + money rate / 1 + specific inflation rate
6.1 Environmental costing
Can be classified as prevention (staff training to avoid pollution), appraisal (monitoring compliance with regs), internal (recycling scrap materials) and external (cost of clearing up an oil spill) failure costs. These need to be considered as part of the appraisal process as they are likely to influence consumer and investor decisions. These costs can be difficult to quantify. The benefits of understanding environmental costs are:
- Including these in costing system allows for better pricing decisions
- Managing and controlling these costs may avoid fines and save money
- Regulatory compliance
7.1 Replacement analysis (optimum economic life)
this technique allows us to decide how often to replace an asset. To find the optimum economic life of the asset we need to establish the equivalent annual cost (EAC) for each potential replacement cycle. The method can be summarised as follows:
- Calculate the NPV of a single asset cycle
- The NPV of each option is then converted into an equivalent annual cost. This is the equal annual cash flow (annuity) to which a series of uneven cash flows is equivalent in PV terms. It is calculated as (PV of costs / annuity factor)
- Choose the strategy with the lowest EAC
The techniques assumes that the cost of the asset will not be subject to inflation, the efficiency of assets different ages will be similar, and the asset will be replaced in perpetuity or at least into the foreseeable future.
8.1 Capital rationing
This is where a number of positive NPV projects are available, but insufficient funds to take on all the projects. This can be due to hard capital rationing (actual shortage of funds) or soft capital rationing (internally imposed budgetary limit on funds).
The techniques calculates the optimal use of the limited capital. The method used will depend upon the type of project. The project will either be infinitely divisible (can do part of the project and gain part of the NPV) or indivisible (project done in full or not at all).
8.2 Infinitely divisible projects
Projects should be ranked according to the NPV earned per £1 invested in the cash-restricted period. Funds should then be applied to the projects in ranking order until they are gone.
9.1 Shareholder value analysis
The value of a company is driven by the NPV of all its expected future cash flows. Managers should be encouraged to focus on those factors that enhance the NPV of the expected future cash flows. The seven drivers of value include sales and growth in sales (maximise), margin (maximise), investment in fixed assets (minimise), investment in working capital (minimise), tax (minimise), discount rate (minimise) and length of time that detailed future plans are available for (maximise).
10.1 Real options
NPV does not consider of the strategic value of a project. A superior analysis would therefore be worth of a project = traditional NPV + value of any associated options. Where the options include:
- Follow on options: producing a product could allow the launch of a new version
- Abandonment options: projects with a feasible option to abandon
- Timing options: projects which are flexible in when they start
- Growth options: when time commitment is expected
11.1 Investing overseas
There are a number of additional considerations when investing overseas:
- Market attractiveness: for example, GDP and forecast demand in region
- Competitive advantage: do they have experience and understanding of similar markets
- Political risk: any political or government action likely to attract value, for example import quotas, tariffs, legal restrictions on products, restriction on foreign over ship and enforced nationalisation
- Cultural risk: differences in culture and business behaviours in a foreign country