Investment Appraisal

Question 1

Name the 4 Investment Appraisal Techniques?

Answer 1

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Payback Period
• Return on Capital Employed (ROCE) or Accounting Rate of Return (ARR)

Question 2

What is NPV?

Answer 2

• 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

Question 3

How to change –ve NPV to +ve NPV?

Answer 3

• Change cash flows – reduce initial investment
• Reduce WACC

Question 4

What is Internal Rate of Return (IRR)?

Answer 4

• 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

Question 5

What are issues with IRR?

Answer 5

• 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

Question 6

What is Payback Period?

Answer 6

• Time taken to for net cash flow from a project to repay entire initial outlay

Question 7

Advantages and disadvantage of pay back period?

Answer 7

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

Question 8

What is ROCE or ARR?

Answer 8

• 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

Question 9

Advantages/Disadvantages ARR or ROCE?

Answer 9

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

Question 10

What are relevant Cash Flows?

Answer 10

• 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

Question 11

What are Components of Cash Flow?

Answer 11

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

Question 12

What are incremental Cash Flows?

Answer 12

• 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

Question 13

Does WACC include inflation cost?

Answer 13

• Cash flows should generally include inflation
• Different cash flows inflate at different rates.
• WACC is nominal - includes inflation

Question 14

Impacts of International Capital Budgeting?

Answer 14

• 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

Question 15

What is the project discount rate?

Answer 15

• 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%

Question 16

Why multiple hurdle rates?

Answer 16

• Large or small projects
• Projects with risk profiles higher or lower than norm
• Mandatory HSE projects
• Project crucial to core strategy
• Useful but non essential projects

Question 17

What is Beta equity?

Answer 17

• Two companies with same operating risk but different capital structures will have different βequity
• Operating risk of a company (βasset) is the weighted average of βequity and βdebt
• If operating risk measured by βasset remains the same βequity can change if gearing changes

Question 18

What is Beta asset?

Answer 18

• Companies operating in the same industry have the same operating or business risk
• Two companies with same operating risk but different capital structures will have different βequity
• Operating risk of a company (βasset) is the weighted average of βequity and βdebt
• If operating risk measured by βasset remains the same βequity can change if gearing changes

Question 19

What is the Profitability Index?

Answer 19

• Company must choose between competing projects
• Profitability Index = NPV/Investment

Question 20

Name 4 methods Adjusting Project AppraisalMethods for Risk?

Answer 20

• Expected Net Present Value
• Sensitivity Analysis
• Scenario Analysis
• Monte Carlo Simulation

Question 21

How to calculate Terminal Value?

Answer 21

TV = Post Tax Cash Flow for next year / (WACC – growth rate)

(Gordon’s growth model: equation 18)