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BU5032-Corporate Finance > Investment Appraisal > Flashcards

Investment Appraisal Flashcards

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1
Q

How do you calculate ROCE?

A

Average annual profit before interest and tax / initial capital costs x100%

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2
Q

What are the strengths of ROCE?

A

Expressed in terms familiar to managers - profit and capital employed
Easy to calculate the likely affect of a project on the profit and loss account / balance sheet
Managers are frequently rewarded in relation to performance against the variables
Business is judged by ROI by financial markets

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3
Q

What are the limitations of ROCE?

A

Does not ensure shareholder wealth maximisation
Figures are easily manipulated
Ignores the actual/incremental cash flows associated with the project

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4
Q

A project involves the immediate purchase of an item of plant costing $50,000.
Annual cash flows of $14,500 will be earned and the plant will be sold at the end of the four-year project life for $10,000.
Calculate the project’s ROCE using:
(a) Initial capital costs
(b) Average capital investment.

A

Average annual profit is used in both calculations:
(Total annual cash flows – total depreciation)/project life ($14,500 × 4 – ($50,000 – $10,000)/4 = $4,500 per annum
(a) Initial capital ROCE = $4,500/$50,000 × 100 = 9%
For average ROCE, need average capital investment: ($50,000 + $10,000)/2 = $30,000
(b) Average ROCE = $4,500/$30,000 × 100 = 15%
What if the target return were 12%? Would the project be accepted?
You would need to know whether the target related to the initial or average method.

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5
Q

Why is it more important to evaluate future cash flows rather than accounting profits in capital investment appraisal?

A 
profits cannot be spent 
profits are subjective 
cash is required to pay dividends. 
Major differences between profit and cash flows will relate to:  
asset purchase and depreciation 
changes in working capital 
deferred taxation 
capitalisation of research and development expenditure.
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6
Q

What do relevant cash flows ignore?

A

Sunk costs
Committed costs
Depreciation
Interest and dividend payments

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7
Q

what do relevant cash flows include?

A

Opportunity costs

Value of best missed opportunity

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8
Q

How do you calculate the pay back period?

A

Initial investment / annual cash flow

If cash flows are uneven then use cumulative cash flow over the life of the investment

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9
Q

What are the strengths of the payback method?

A

Easy to calculate and understand
Can be used in first stage screening to eliminate inappropriate projects
Bias in favour of short-term projects which tends to minimise business and financial risk
Can be used when there is capital rationing to identify the projects that generate additional has for investment quickly

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10
Q

What are the limitations of the pay back method?

A

Does not ensure shareholder wealth maximisation
Ignores the timings of cashflows in the project and the cash flows after the payback period and therefore total project return
Ignores the time value of money
Unable to distinguish between projects that have the same payback period
Tends to favour short-term projects
Takes account of the risk of timing cash flows but not the variability of cash flows

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11
Q

An expenditure of $2 million is expected to generate net cash inflows of $600,000 each year for the next seven years.
What is the payback period?

A

$2,000,000/600,000 = 3.33 years.
Or 3 years + 0.33*12 months
3 years and 4 months.

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12
Q

What is the time value of money?

A

Money received today is worth more than the same sum received in the future because:
Potential to earn interest
Impact of inflation
Effects of risk

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13
Q

What is compounding?

A

Calculates the future value of a sum of money

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14
Q

How do you calculate the compounding value?

A

F=P(1+r)^n

F=future value after n periods
P=present of initial value
r=rate of interest per period
^n=number of periods

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15
Q

What is discounting cash flows?

A

Conversion of future cash flows to their present value

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16
Q

How do you calculate the discounted cash flow?

A

P= F/(1+r)^n

(1+r)^-n is the discount factor
F = cash flow

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17
Q

What is NPV?

A

All future cash flows are discounted to their present value and added together.

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18
Q

What does a positive NPV indicate?

A

Project should be accepted

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19
Q

What does a negative NPV indicate?

A

Project should be rejected

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20
Q

What are the advantages of NPV?

A

Considers the time value of money
It is an absolute measure of return
Based on cash flows and not profit
Should lead to shareholder wealth maximisation
Higher discounts can be sued for riskier projects

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21
Q

What are the disadvantages of NPV?

A

Not easily explained to managers

Requires the cost of capital to be known

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22
Q

What are the assumptions used when discounting cash flows?

A

Unless told otherwise:
all cash flows occur at the start or end of a year
initial investments occur at time period 0 (t0)
other cash flows start one year after that (t1) e.g. sales revenue and variable costs earned/spent during the first year would be recorded at t1
do not include interest cash flows on funding (already taken into account within the cost of capital used).

23
Q

What is an annuity?

A

Constant annual chas flow for a number of years

24
Q

How do you calculate the present value of an annuity?

A

annual cash flows X 1-(1+r)^-n / r

1 - (1+r)^-n / r is the annuity factor

25
Q

What is a perpetuity?

A

The annual cash flow that occurs forever

26
Q

How do you calculate the present value of a perpetuity?

A

annual cash flow / interest rate

OR

annual cash flow X 1/r

1/r is the perpetuity factor

27
Q

How do you calculate the internal rate of return?

A 
L+(Nl/NL-NH) X (H-L)
L= lower rate of interest
H=higher rate of interest 
NL=NPV at lower rate of interest 
NH=NPV at higher rate of interest
28
Q

A potential project’s predicted cash flows give a positive NPV of $6,000 at a discount rate of 9% and a negative NPV of $3,000 at a discount rate of 12%. Calculate the project’s IRR.

A 
IRR = 9 + [$6,000/($6,000 + $3,000)] × (12 – 9) 
IRR = 9 + (0.667 × 3) = 11%
29
Q

What are the advantages of IRR?

A 
Considers time value of money
Percentage is easily understood
Uses cash flows
Considers whole life of a project
Does not need the cost of capital
If the IRR is higher than the cost of capital then the company should be maximising shareholder wealth
30
Q

What are the disadvantages of IRR?

A

Not a measure of absolute profitability
Small projects with high IRR’s might not enrich shareholder wealth as much as larger projects with smaller IRR’s
Interpolation only provides an estimate
Non-conventional cash flows may rise IRR

31
Q

How do you calculate real and money rates?

A

real discount rate (1+r) = (1+i)/(1+h)
Money discount rate (1+i)=(1+r)(1+h)

h = inflation rate

32
Q

An investor requires a real return on their investment of 12%, but in addition will need to be compensated for anticipated inflation of 3%.
Calculate the money rate of return required by the investor.

A

(1 + i) = (1 + r)(1 + h)
r = 0.12, h = 0.03
1 + i = 1.12 × 1.03 = 1.1536
i = 0.1536 or 15.36%

33
Q

What does the NPV Real method incorporate?

A

Excludes inflation
Uses todays prices
discount at the real uninflated rate
Useful if given current prices, costs, cash flows and uses a single rate of inflation

34
Q

What does the NPV Money (nominal) method incorporate?

A

Inflate the cash flows
uses specific rates for each cash flow
Discounts at the money inflated price
Useful if different cash flows have different rates of inflation

35
Q

What are the two tax affects to consider?

A

Tax payments on operating profits (use cash flows for an approximation of profit)
Tax saving from tax-allowable depreciation and either an extra tax saving from the balancing allowance on asset disposal or possible tax payment from the balancing charge on assets disposal.

36
Q

what is the impact of taxation on cash flows?

A

Unless stated otherwise:
Tax inflows and outflows are relevant cash flows for NPV purposes
Operating cash inflows will be taxed at the prevailing tax rate
Operating cash outflows will be tax deductible and save tax at the prevailing rate
Investment spending will attract tax-allowable depreciation
Tax is paid one year after the related operating cash flow is earned.

37
Q

What is tax allowable depreciation?

A

If a business buys a capital asset, it may claim tax-allowable depreciation to offset against its profits for tax purposes.
Tax-allowable depreciation is calculated based on the written down value of the assets.
The total amount of tax-allowable depreciation given over the life of an asset will equate to its fall in value over the period (cost less scrap proceeds)
Tax-allowable depreciation is given for every year of ownership of the asset except the year of disposal (the tax-allowable depreciation is allowed against profits and therefore reduces the tax bill – shown as an inflow of tax on the NPV)
In the year of disposal a balancing allowance or charge arises instead (tax equivalent of profit or loss on disposal and allowed against profits)

38
Q

How do you calculate the equivalent annual cost when making a replacement decision?

A

PV of costs/annuity factor

The lowest EAC is the optimum replacement cycle

39
Q

What is capital rationing?

A

Shareholder wealth is maximised if a company undertakes all positive NPV projects it has available.
Capital rationing is where there are insufficient funds to do this. It comes in two forms.
Hard capital rationing – an absolute limit on financing available is imposed by the funders of the business. The business cannot raise further cash.
Soft capital rationing – an internally imposed limit on investment capital. This is contrary to the rational view of shareholder wealth maximisation.

40
Q

What does it mean by a divisible project?

A

If a project is divisible then any proportion of the project may be undertaken and the returns from the project are expected to be generated in exact proportion to the amount of investment undertaken. (e.g. develop a whole plot of land or share the investment with another developer and develop 50% each)

41
Q

What is the profitability index (PI)?

A

The profitability index (PI) can be used to rank projects against each other in order to determine which ones to undertake to maximise the total NPV earned from the available capital.

42
Q

How do you calculate the Profitability index?

A

NPV/ Investment needed in capital restricted period

43
Q

What is risk?

A 
Risk – quantifiable. Possible outcomes have associated probabilities, thus allowing the use of mathematical techniques. 
Expected values 
Simulation 
Adjusted payback 
Risk-adjusted discount rates.
44
Q

What is uncertainty?

A

Uncertainty – unquantifiable. Outcomes cannot be mathematically modelled.
Set shorter payback targets
Make prudent estimates of cash flows in the appraisal
Assess best and worst case scenarios
Use sensitivity analysis.

45
Q

What is the sensitivity analysis?

A

Calculate how much one input value must change before he decision changes from rejection to acception

46
Q

How do you calculate the sensitivity margin?

A

NPV/ PV of flow under consideration x 100%

Smaller the margin the more sensitive the decision is

47
Q

What is probability analysis?

A

When there are several possible outcomes for a decision and probabilities can be assigned to each, a probability distribution of expected cash flows can be estimated, recognising that there are several possible outcomes, not just one. This could then be used to:
Calculate an expected value (EV)
Measure risk by:
– calculating the worst possible outcome and its probability
– calculating the probability that the project will fail (e.g. that a negative NPV will be the outcome)
– assessing the standard deviation of the outcomes.

48
Q

How do you calculate the EV?

A

E(X)= Summation of px

p=probability of each outcome
x=the cash flow from each outcome

49
Q

A company has to choose between three mutually exclusive projects, the outcomes of which depend on the state of the economy.
The following estimates have been made:
State of the economy poor good excellent
Probability. 0.4 0.5 0.1
Project:NPV ($000) NPV ($000) NPV ($000)
A 150 70 10
B (10) 40 600
C 75 75 125
Determine which project should be selected on the basis of expected NPVs.

A

EV project A = [150 × 0.4] + [70 × 0.5] + [10 × 0.1] = 96
EV project B = [(10) × 0.4] + [40 × 0.5] + [600 × 0.1] = 76
EV project C = [75 × 0.4] + [75 × 0.5] + [125 × 0.1] = 80
Choose project A

50
Q

What are risk adjusted discount rates?

A

Increasing the discount rate used to appraise a project will reduce its NPV.
If a project is perceived to be more risky than usual, the appraisal could therefore be done with a higher discount rate than usual, making it harder for the project to gain a positive NPV.
Decision makers could there be more confident that those projects that do earn a positive NPV are worthwhile.

51
Q

What is risk simulation?

A

Simulation addresses one of the weaknesses of sensitivity analysis by calculating the effect of changes in multiple variables at a time. It produces a distribution of the possible outcomes from the project, the probabilities of which can then be calculated by reference to the frequencies on which they occur.

52
Q

What is adjusted payback?

A

Shortening the payback period required places more emphasis on earlier (less risky) cash flows.

53
Q

What is discounted payback?

A

When calculating the payback period, the cumulative position can be calculated using the discounted cash flows instead of the cash flows themselves. This removes the disadvantage of payback calculations failing to take into account the time value of money.

BU5032-Corporate Finance (11 decks)

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