Chapter 6 - Investment Appraisal - Further aspects

Question 1

What is the payback period?

Answer 1

Time a project will take to pay back the money spent on it.

Question 2

How to calculate the payback period and how to calculate in cases of uneven cash flows

Answer 2

Payback period = Initial investment / annual cash inflow.

If uneven cashflows work out the cumulative cash flows.

Question 3

What are advantages and disadvantages of the payback method?

Answer 3

Plus:

• Simple;
• In improving investment conditions it points to projects releasing funds soonest
• favours projects with rapid return/rapid company growth;
• uses cash flows

Min:

• project return is ignored (post payback is ignored);
• time value of money is ignored;
• no objective target/measure;
• project profitability is ignored

Question 4

What is the accounting rate of return? (include the important notions!)

Answer 4

A percentage return provided by the accounting profits of the project

Question 5

How do you calculate the ARR? How do you calculate the Average Annual Profit & How do you calculate the Average value of the investment?

Answer 5

Average Annual Profit / Average Value of the Investment

AAP: Net cash flow less depreciation

AVI: Initial investment plus residual value/2

Question 6

What are advantages and disadvantages of the ARR?

Answer 6

Plus:

• Simple to understand
• Widely used and accepted
• Considers whole life of the project

Min:

• Ignores time value of money
• not a measure of absolute profitability
• does not consider cash flows
• is subjective, will vary with different accounting techniques
• lack of objective target

Question 7

In dealing with taxation, which two tax effects are relevant for evaluating investments?

Answer 7

Corporation tax (usually paid in two installments)

Impact of tax depreciation (taxable profits will be the net cash flows from the project less any tax depreciation)

Question 8

How do you calculate / include tax depreciation?

Answer 8

Generally reducing balance.

Half the tax is saved in current year. Half in next year.

Assume asset is bought at T0.

Total tax depreciation is initial cost - residual value

Question 9

How is working capital it treated in investment/projects?

Answer 9

Only change in working capital is treated as cash flow. Ignored in tax and tax depreciation calculations, end of project its released.

Question 10

What is a different term for current cash flow?

Answer 10

Real Cashflow

Question 11

What is a real cashflow?

Answer 11

Cashflows which have not been increased for expected inflation.

Question 12

What is a money or nominal cashflow

Answer 12

Cashflows which have been increased to take account of expected inflation.

Question 13

What is the CIMA exam assumption in terms of used cashflow?

Answer 13

Nominal or Money cashflow where inflation is already applied.

Question 14

Which rate should be used for money cashflows and which rate for real cashflows?

Answer 14

Money rate and Real Rate.

Question 15

How can the real rate of return be calculated?

Answer 15

1 + r = 1 + m / 1 + inflation

Question 16

When do you use the real and when the money rate?

Answer 16

Is there one rate or more inflation rates? Is there tax or not in the question? If one rate and no tax both rates can be used (real for real cashflows and money for money terms cashflow) … if yes use the money specific rates.

Question 17

How can deflation affect business decisions?

Answer 17

Courage if long pay back

Borrowing money for assets which will fall in value requires courage. Money rates will be low but real rates higher

Difficult to reduce costs in line with deflation

Consumer may defer purchasing decisions.

Question 18

Which types of decisions can be made when considering capital asset replacement?

Answer 18

Mutually exclusive option with unequal lives

Optimum replacement cycle

Question 19

What is the mutually exclusive option with unequal lives?

Answer 19

Calculate the equivalent annual costs by PV’ing the costs and dividing them by the annuity factor for year n. Can also use lowest common multiple method.

Question 20

How do you calculate the optimum replacement cycle?

Answer 20

Consider each possible replacement cycle

Calculate PV of costs for each cycle

Divide by annuity factor for year n (1-(1+r)-n)/r

Lowest costs = decision driver

Question 21

What are the limitations of the replacement analysis?

Answer 21

The like for like assumption underlying the replacement method ignores:

• Changing technology
• Inflation
• Change in production plans