Investment appraisal

Question 1

The four main methods of
investment appraisal

Answer 1

Payback
ARR
NPV
IRR

Question 2

Basic idea: Payback

Answer 2

Time taken to pay back the initial investment

Question 3

Basic idea: ARR

Answer 3

Average return on initial investment

Question 4

Basic idea: NPV

Answer 4

PV of inflows minus PV of outflows

Question 5

Basic idea: IRR

Answer 5

Discount rate to give NPV = 0

Question 6

Reasons NPV theoretically supeiror

Answer 6

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).

Question 7

Non-financial factors in considering investment appraisal

Answer 7

Compliance with legislation

Impact on key stakeholders

Impact on reputation

Sustainability

Question 8

Formula: Present value of a single cash flow

Answer 8

1 / ((1+r)^n)

Question 9

Formula: Present value of an annuity cash flow

Answer 9

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

Question 10

Formula: Present value of a perpetuity cash flow

Answer 10

Perpetuity cash flow X (1/r)

Question 11

Formula: Present value of growing perpetuity

Answer 11

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

g = growth

Question 12

Relevant cash flow definition

Answer 12

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

Question 13

Relevant cash flow calculation

Answer 13

Cash flow if action taken

Minus

Cash flow if not taken

Question 14

Relevant cash flows: Things ignored

Answer 14

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

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

Question 15

Relevant cash flows: Opportunity cost definition

Answer 15

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

Question 16

Deprival value of asset =

Answer 16

Lower of

1. Replacement cost
2. Recoverable amount

Question 17

Deprival value of asset: Recoverable amount =

Answer 17

Higher of

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

Question 18

Working capital definition

Answer 18

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

Question 19

Investment appraisal: Treatment of working capital

Answer 19

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.

Question 20

Appraising investments: Tax: Impact of: Operating flows

Answer 20

More income – tax outflow
More costs – tax inflow

Question 21

Appraising investments: Tax: Impact of: Disposal proceeds

Answer 21

Capital allowances

Question 22

Appraising investments: Tax: Impact?

Answer 22

No tax impact

Question 23

Appraising investments: Tax assumptions: When paid

Answer 23

End of the year

Question 24

Appraising investments: Tax assumptions: Profit or loss?

Answer 24

Assuming company making profit

Question 25

Appraising investments: Tax assumptions: Capital allowances

Answer 25

**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)

Question 26

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

Answer 26

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

Question 27

Investment appraisal: The 2 effects of inflation

Answer 27

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

Question 28

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

Answer 28

Current cash flows

Question 29

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

Answer 29

Money cash flows

Question 30

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

Answer 30

Money rate

Question 31

Investment appraisal: Money rate formula

Answer 31

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

Question 32

Investment appraisal: 2 ways of dealing with impact of inflation

Answer 32

1. money @ money 2. real @ effective

Question 33

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

Answer 33

1. Inflate by specific rate 2. Discount using money rate *Preferred method*

Question 34

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

Answer 34

Perpetuities or long annuities

Question 35

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

Answer 35

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

Question 36

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

Answer 36

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

Question 37

Investment appraisal: 4 classes

Answer 37

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*

Question 38

Investment appraisal: Benefits of understanding environmental costs

Answer 38

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

Question 39

Replacement analysis: How to find the optimum economic life

Answer 39

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.

Question 40

Replacement analysis: EAC calculation

Answer 40

PV of costs / Annuity factor Annuity factor = sum of discount factors

Question 41

Replacement analysis: Assumptions

Answer 41

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*

Question 42

Investment appraisal: Capital rationing: Definition

Answer 42

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

Question 43

Investment appraisal: Capital rationing: Definition: 2 types

Answer 43

**1. 'Hard' capital rationing** an actual shortage of funds. **2. 'Soft' capital rationing** an internally imposed (budgetary) limit on funds

Question 44

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

Answer 44

**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

Question 45

Investment appraisal: Capital rationing: Infinitely divisible projects: Process

Answer 45

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.

Question 46

Investment appraisal: Capital rationing: Indivisible projects: Process

Answer 46

Trial and error

Question 47

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

Answer 47

*S*ales *L*ife of project *O*perating cash flows *W*orking capital *C*ost of capital *A*sset *T*ax

Question 48

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

Answer 48

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

Question 49

Investment valuation: 5 real options

Answer 49

**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.*

Question 50

4 Additional considerations when investing overseas

Answer 50

**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.*