Investment Appraisal Flashcards
1
Q
Name the 4 Investment Appraisal Techniques?
A
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Payback Period
- Return on Capital Employed (ROCE) or Accounting Rate of Return (ARR)
2
Q
What is NPV?
A
- NPV is present value of all future cash flows discounted back to today’s values (time = 0)
- Investment decision rule - positive NPV indicates a project is worth undertaking
3
Q
How to change –ve NPV to +ve NPV?
A
- Change cash flows – reduce initial investment
- Reduce WACC
4
Q
What is Internal Rate of Return (IRR)?
A
- IRR, or yield, of a project is the discount rate which gives a zero NPV
- IRR is the maximum cost of funding you could afford to pay to undertake a project
5
Q
What are issues with IRR?
A
- Scale of Projects: IRR gives no impression of the scale of a project
- Competing Projects: Even with projects of similar scale higher IRR does not mean higher NPV at all discount rates
- Varying Cash Flows: Multiple changes in cash flow can lead to multiple IRRs
6
Q
What is Payback Period?
A
- Time taken to for net cash flow from a project to repay entire initial outlay
7
Q
Advantages and disadvantage of pay back period?
A
Advantages
- Simple screen to eliminate poor projects
- Eliminates long payback period that would put strain on company’s liquidity
Disadvantages
- Ignores cash received after payback date
- Ignores time value of money
Discounted Payback Period
8
Q
What is ROCE or ARR?
A
- Also known as accounting rate of return (ARR)
- Annual ARR during life of project = EBIT/Average Capital Employed
- Average ARR over life of project = Average EBIT/Average Capital Employed
9
Q
Advantages/Disadvantages ARR or ROCE?
A
Advantages
- Simple to calculate
- Uses accounting numbers rather than cash flows
Disadvantage
- Based on profits which can be “managed” more easily than cash
- Ignores time value of money
- Older projects with low net book values can show very high returns which may deter re-investment
10
Q
What are relevant Cash Flows?
A
- Cash flow NOT accounting income
- Incremental cash flows ONLY
- Capital budgeting only considers additional cash flows that a project generates
- Free cash flow is cash available for investors
- Free cash flow = after tax operating income+ depreciation
- capital expenditure
- change in working capital
11
Q
What are Components of Cash Flow?
A
INCLUDE
- Initial capital investment
- Terminal value of initial capital investment
- Investment in working capital
EXCLUDE
- Depreciation is a non cash expense
- Interest expense is already included in WACC
12
Q
What are incremental Cash Flows?
A
- Must identify difference between cash flows if firm doesn’t undertakes project and cash flows if it does undertake the project
- Sunk Costs – cash flow that occurs before consideration of project
- Opportunity Costs – cash flow that could have been generated from an asset that the firm already owns
- Externalities – impact on other areas of firms business – will a new product negatively impact demand for existing products
13
Q
Does WACC include inflation cost?
A
- Cash flows should generally include inflation
- Different cash flows inflate at different rates.
- WACC is nominal - includes inflation
14
Q
Impacts of International Capital Budgeting?
A
- Differing project and parent cash flows due to difficulties in remitting cash to the parent and FX controls
- FX rates may not be constant throughout a project’s life
- Different tax rates may apply in host country and parent’s country
- Decide whether to use home currency or local currency
15
Q
What is the project discount rate?
A
- Hurdle rate vs WACC
- Companies adjust WACC upwards before using it as discount rate
- Counter over optimism of managers
- Compensate for mandatory projects with –ve NPV
- Reflect option value of delaying project
- Possible future changes to cost of debt and/or equity
- Relative project risk
- UK companies typically add 1%
