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FM > Investment appraisal > Flashcards

Investment appraisal Flashcards

1
Q

The four main methods of
investment appraisal

A

Payback
ARR
NPV
IRR

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2
Q

Basic idea: Payback

A

Time taken to pay back the initial investment

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3
Q

Basic idea: ARR

A

Average return on initial investment

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4
Q

Basic idea: NPV

A

PV of inflows minus PV of outflows

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5
Q

Basic idea: IRR

A

Discount rate to give NPV = 0

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6
Q

Reasons NPV theoretically supeiror

A

Takes account of the time value of money (whereas ARR and payback do not)

Is an absolute measure of return (unlike IRR which is relative – sometimes it is
better to have a small return on a big investment than a large return on a small investment)

Is based on cash flows not profits – it is more appropriate to evaluate future cash flows than accounting profits, because profits are more subjective (and
can’t be spent or used to pay dividends)

Considers the whole life of the project (payback, for example, ignores cash
flows after the payback period).

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7
Q

Non-financial factors in considering investment appraisal

A

Compliance with legislation

Impact on key stakeholders

Impact on reputation

Sustainability

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8
Q

Formula: Present value of a single cash flow

A

1 / ((1+r)^n)

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9
Q

Formula: Present value of an annuity cash flow

A

**(1/r) X (1 - **1/((1+r)^n)

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10
Q

Formula: Present value of a perpetuity cash flow

A

Perpetuity cash flow X (1/r)

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11
Q

Formula: Present value of growing perpetuity

A

(Cash flow at t1) X (1/(r-g))

g = growth

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12
Q

Relevant cash flow definition

A

Future incremental cash flows which arise as a result of a decision being taken

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13
Q

Relevant cash flow calculation

A

Cash flow if action taken

Minus

Cash flow if not taken

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14
Q

Relevant cash flows: Things ignored

A

Finance costs (interest, divs…)
As accounted for in discount rate

Sunk costs
Committed costs
Allocated and apportioned costs
Non-cash items
Book values

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15
Q

Relevant cash flows: Opportunity cost definition

A

The change in cash flow if a unit of resource is used in a project rather than on the next best alternative

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16
Q

Deprival value of asset =

A

Lower of

  1. Replacement cost
  2. Recoverable amount
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17
Q

Deprival value of asset: Recoverable amount =

A

Higher of

  1. Value in use
    (Economic value)
  2. Net realisable value
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18
Q

Working capital definition

A

Cash ‘tied up’ in the project (Will get it back, but can’t use while in project e.g. inventory, receivables)

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19
Q

Investment appraisal: Treatment of working capital

A

The initial working capital required is a cost at the start of the project

If the working capital requirement changes during the project, only the increase (or decrease) is a relevant cash outflow (or inflow)

At the end of the project, all the working capital is ‘released’ and therefore gives rise to a cash inflow.

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20
Q

Appraising investments: Tax: Impact of: Operating flows

A

More income – tax outflow
More costs – tax inflow

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21
Q

Appraising investments: Tax: Impact of: Disposal proceeds

A

Capital allowances

22
Q

Appraising investments: Tax: Impact?

A

No tax impact

23
Q

Appraising investments: Tax assumptions: When paid

A

End of the year

24
Q

Appraising investments: Tax assumptions: Profit or loss?

A

Assuming company making profit

25
Q

Appraising investments: Tax assumptions: Capital allowances

A

Just 18%
Reducing balance

Except year of disposal, where a balancing figure
(Total allowances = fall in value of asset i.e. cost less scrap value)

26
Q

Appraising investments: Tax assumptions: What else to pay attention to?

A

Date asset bought (When is first period end so taxable allowance?)

27
Q

Investment appraisal: The 2 effects of inflation

A
  1. Specific inflation - on cash flows
    e.g. labor, materials
  2. General inflation - on discount rate
    i.e. for general goods
28
Q

Investment appraisal: Where cash flows have not been increased for expected inflation

A

Current cash flows

29
Q

Investment appraisal: Where cash flows have been increased to take account of expected inflation (Assume this in exam)

A

Money cash flows

30
Q

Investment appraisal: The rate investors expect
(Made up of the real rate & inflation rate)

A

Money rate

31
Q

Investment appraisal: Money rate formula

A

(1 + money rate) = (1 + real rate) x (1 + inflation rate)

32
Q

Investment appraisal: 2 ways of dealing with impact of inflation

A
  1. money @ money
  2. real @ effective
33
Q

Investment appraisal: Dealing with inflation: Money @ money: Steps

A
  1. Inflate by specific rate
  2. Discount using money rate

Preferred method

34
Q

Investment appraisal: Dealing with inflation: Real @ effective: Can be used for

A

Perpetuities or long annuities

35
Q

Investment appraisal: Dealing with inflation: Real @ effective: Steps

A
  1. Cash flows are left in real terms.
  2. A specific ‘effective’ discount rate is
    calculated for each given cash flow:
36
Q

Investment appraisal: Dealing with inflation: Real @ effective: Effective discount rate formula

A

1 + effective rate = (1 + money rate)/(1 + specific inflation rate)

37
Q

Investment appraisal: 4 classes

A
  1. Prevention
    e.g. staff training
  2. Appraisal
    e.g. monitoring regulatory compliance
  3. Internal failure
    e.g. recycling scrap materials
  4. External failure
    e.g. cleaning oil spill
38
Q

Investment appraisal: Benefits of understanding environmental costs

A

Including these within the costing system will allow for better pricing decisions

Managing and controlling these costs may avoid fines and save money

Regulatory compliance

39
Q

Replacement analysis: How to find the optimum economic life

A
  1. For each possible economic life, calculate the NPV of a single asset cycle.
  2. The NPV of each option is then converted into an ‘Equivalent Annual Cost’. This is the equal annual cash flow (annuity) to which a series of uneven cash
    flows is equivalent in PV terms.

3 Choose the strategy with the lowest EAC.

40
Q

Replacement analysis: EAC calculation

A

PV of costs / Annuity factor

Annuity factor = sum of discount factors

41
Q

Replacement analysis: Assumptions

A
  1. The cost of the asset will not be subject to inflation
  2. The operating efficiency of assets different ages will be similar
    in practice, new technology and/or obsolescence will mean that regular
    replacement is preferred
  3. The asset will be replaced in perpetuity or at least into the foreseeable future
    in practice, products and therefore the assets required for their production
    usually have a finite life cycle
42
Q

Investment appraisal: Capital rationing: Definition

A

Where there are a number of positive NPV projects available, but insufficient funds to take on all these projects

43
Q

Investment appraisal: Capital rationing: Definition: 2 types

A

1. ‘Hard’ capital rationing
an actual shortage of funds.

2. ‘Soft’ capital rationing
an internally imposed (budgetary) limit on funds

44
Q

Investment appraisal: Capital rationing: Definition: 2 types of project

A

1. Infinitely divisible
Can do part of the project and gain part of the NPV

2. Indivisible
Has to be done in full to receive any NPV

45
Q

Investment appraisal: Capital rationing: Infinitely divisible projects: Process

A
  1. Ranked according to the NPV earned per £1 invested in the cash-restricted period.
  2. Funds should then be applied to the projects in ranking order until they are
    gone.
46
Q

Investment appraisal: Capital rationing: Indivisible projects: Process

A

Trial and error

47
Q

7 Drivers of value of a business (That benefit future cash flows)
(More popular than profit/ratios now)

A

Sales
Life of project
Operating cash flows
Working capital
Cost of capital
Asset
Tax

48
Q

Investment valuation: What doesn’t any NPV calculation take into account of?

A

Real options

Effectively flexibility

A superior analysis would be:
Worth of a project = Traditional NPV + Value of any associated options

49
Q

Investment valuation: 5 real options

A

1. Follow on options
E.g. A firm is considering developing a new product. Even though its NPV is
negative, producing this product would allow the launch of a new version of the product in a few years’ time.

2. Abandonment options
E.g. A firm is considering investing in two projects, the first requiring investment in specialised plant with a very low resale value, the second requiring investment in land. Even though the first project might have a higher NPV, the second has a
feasible option to abandon.

3. Timing options
E.g. A firm is looking at two projects. The first has to be started now; the second can be started at any point in the next five years.

4. Growth options
E.g. A firm is looking at two projects, one requires a full commitment now, the other allows it to start with a small capacity but to expand later on if the market conditions
are right.

50
Q

4 Additional considerations when investing overseas

A

1. Market attractiveness
For example, GDP and forecast demand in the region.

2. Competitive advantage
Do we have experience and understanding of this and/or similar markets?

3. Political risk
Is political or government action likely to affect value. This might include:
– import quotas and/or tariffs
– legal restrictions on products
– restriction on foreign ownership
– enforced nationalisation.

4. Cultural risk
Differences in culture and business behaviours in a foreign country.

FM (11 decks)

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