Chapter 5 - The investment decision making process

Question 1

Describe the three main and eight sub phases of the capital investment process

Answer 1

Main phases:

1) Creation phase
2) Decision phase
3) Implementation phase

Subphases:

1) Identify objectives (maximisation of wealth)
2) Search for investment opportunities
3) Identify states of nature

4) List possible outcomes
5) Measure payoffs
6) Select Investment projects

7) Obtain authorisation and implement projects
8) Review capital investment decisions

Question 2

What is a capital expenditure committee, what are it’s functions and who are member?

Answer 2

Committee responsible for overseeing capital investment process

They: coordinate capex policy, appraise and authorise capex and review actuals vs budget

Members can be engineer, management accountant and other specialists.

Question 3

Describe the time value of money concept and three reasons why money has a time value

Answer 3

Money received today is worth more than the same sum received in the future. Therefore money has a time value. Reasons:

• Strong preference for immediate rather than delayed consumption;
• Impact of inflation (loss of purchasing power over time);
• The earlier the more certain / less risk.

Question 4

What is compound interest and what is the formula?

Answer 4

Compounding means calculating the terminal value of a sum invested today which earns interest.

Formula:

V = X (1+r)n

Future Value = Initial Investment * (interest rate) to the power of number of time periods.

Question 5

What is discounting and what is the formula?

Answer 5

Discounting is opposite to compounding. It finds the value today (present value) of a sum receivable in the future.

Formula:

PV = Future Value X discount factor (in table)

Discount factor = 1 / (1+r)n or (1+r)-n

Question 6

What are the four widely used appraisal methods?

Answer 6

Net Present Value
Internal Rate of Return
Payback
Accounting Rate of Return

Question 7

What is the Net Present Value?

Answer 7

The difference between the sum of the projected discounted cash inflows and outflows attributable to a capital investment or other long term project.

In other words: the surplus of funds available to the investor/shareholder.

Question 8

Which assumptions are used in NPV?

Answer 8

All cash flows occur at the start of end of a year

Initial investments occur at once (T0), other cash flows start in one year’s time (T1). Please note: 31/12 and 1/1 can be both T1.

Question 9

What are the advantages and drawbacks of the NPV?

Answer 9

Advantages:

• consider time value of money;
• is an absolute measure of return;
• is based on cashflows not profits
• considers the whole life of a project;
• lead to maximisation of shareholder wealth (the primary objective of a business).

Drawbacks:

• difficult to explain to managers (you need to understand discounting);
• requires knowledge of the cost of capital (it’s calculation can be complex)
• relatively complex;

Question 10

What is the internal rate of return and what is the formula?

Answer 10

The IRR is the rate of return at which the project has a NPV of zero.

The formula using linear interpolation:

IRR = L + NL / NL - NH x (H-L)

L = Lower rate of interest
H = Higher rate of interest
NL = NPV @ L
NH = NPV @ H

This assumes the NPV moves downward in a straight line.

Question 11

How do you calculate the IRR with even cashflows for annuities and perpetuities?

Answer 11

When a project has equal annual cashflows from year 1 onwards (= annuities), the IRR can be found using the annuity table. Look for initial investment / annual inflow and check n (life of the project) in the table

When cashflows are perpetual then the IRR can be calculated as follows:

IRR = Annual Inflow / Initial Investment x 100

Question 12

What are the advantages and drawbacks of the IRR?

Answer 12

Advantages:

• consider time value of money;
• is a percentage and easy to understand;
• is based on cashflows not profits;
• considers the whole life of a project;
• can be calculated when the cost of capital is unknown (and used for external financing benchmark)

Drawbacks:

• it is not an absolute measure of profitability
• provides an estimate but margin between required return and IRR is small can lead to wrong decisions;
• non-conventional cashflows (for example with two or more periods when there is an outflow) can lead to no IRR or multiple IRRs.

NPV is in the end key. At a given cost of capital a positive NPV shows what is left/returned to the investors. Therefore IRR is useful when examing one project, helps determine the higest acceptable cost of capital.

Question 13

What is the modified IRR and how is it calculated?

Answer 13

The MIRR measures the economic yield of the investment under the assumption that any cash surplus are reinvested at the firm’s current cost of capital.

MIRR = ((terminal value of inflows / PV of outflows) 1/n)-1

Question 14

How do you calculate (formula) the PV with equal cashflows? (describe two methods and in the second method the formula)

Answer 14

NPV = Annual cash flow x Annuity Factor (only works with equal cashflows!). Use table or below formula

Annuity Factor = 1-(1+r)-n / r

Question 15

How do you calculate a perpetuity (cashflow that occurs forever)?

Answer 15

In case of perpetuities the perpuity factor is 1/r and the PV = cashflow / r or PV = cashflow x 1/r

Question 16

Describe the issue with advanced and delayed annuities and perpetuities and how to solve it?

Answer 16

Advanced annuities or perpetuities:

Calculate the PV by ignoring the payment at T0 and simply add 1 to the factor which is then found.

Delayed:

Discount the annuity as usual (= PV = Cashflow x AF) and discount the answer back to T0.

Question 17

How to deal with changing discount rates per year?

Answer 17

In reality discount rates might change over time. Discount factors need to be calculated individually. How:

divide the discount factor for the previous year by 1 + the coc of the year in question.

Example

yo = 1
y1 (10%) = 1/1.10=0.909
y2 (12%) = 0.909/1.12=0.812 etc…

Question 18

How to deal with non annual periods discount rates (and provide formula for quarter, 6 months and 2 yearly)

Answer 18

pro-rate the discount rate:

Months: (1+i)1/12-1
Quarters: (1+i)1/4-1
6 months: (1+i)1/2-1
2 years: (1+i)2-1

Question 19

What is capital rationing

Answer 19

Capital rationing occurs when insufficient funds are available to undertake all beneficial projects.

Can be soft capital rationing (internally imposed) or hard capital rationing (inability to obtain funds).

Question 20

What are the underlying assumptions of capital rationing?

Answer 20

• individual projects are divisble
• annual cashflows cannot be delayed or brought forward;
• capital funds are restricted in just one period

Question 21

How is a profitability index calculated?

Answer 21

Profit ability index (PI) = NPV of a project / Initial Cash Outflows

Calculate PI per project. Rank decending. Allocate capex until zero.

Question 22

What is a discounted payback profitability index (DPBI) and how is it calculated?

Answer 22

It’s an alternative to the profitability index and measures the number of times a project recovers the initial funds invested (< 1 is negative NPV).

DPBI = PV of net cash inflows / initial cash outlay.

Question 23

How to deal with indivisible projects?

Answer 23

Use common sense, trial and error to select the available projects. Can leave some of the funds unutilised.

Question 24

What is the real options theory and which classifications can be used?

Answer 24

Flexibility adds value to an investment. Real options theory attempts to classify and value flexibility by using ideas from the financial option pricing. In short, have an option to invest.

Different classifications:
- Option to delay/defer without losing opportunity (example a drug patent);

• Options to switch/redeploy (example flexible manufacturing systems which can be changed to customer needs easily)
• Options to expand/contract (example football club stadium build strong one tier stand with option to put a second on top)

Options to abandon (example project with clear milestones)

Question 25

Which factors need to be considered when abandoning a project?

Answer 25

Only relevant future costs!

• future cashflows;
• alternatives/more profitable uses.

Question 26

What is a post completion audit?

Answer 26

Appraisal which reviews all aspects of an ongoing project in order to assess whether it has fulfilled it’s initial expectations.

Forward looking
Aids organisational learning
Carried out by Capital Expenditure committee

Question 27

What are benefits and problems with a post completion audit?

Answer 27

Benefits:

• more accurate and realistic assumptions for future;
• identify steps to improve efficiency
• forecasting can be improved;
• motives managers to meet target if they know it’s appraised;
• reveals reliability and quality of contractors/suppliers
• learning experience for managers

Potential problems:

• difficult to identify seperate cost/benefits of the project;
• time consuming/costly exercise;
• can lead to over cautious and risk averse managers;
• may take years for effects of a project to materialise;
• many uncontrollable factors involved.