Investment Appraisal Flashcards
What is Payback?
The time taken for cash inflows from a project to match the outflows and repay the initial investment
Cumulative cash flows are calculated year on year until they total the initial investment
Advantages of Payback?
Simple
Favours liquidity
Minimises risk
Uses cash flows
Disadvantages of payback?
Ignores time value of money
Ignores cash flows after the cut off point
Ignores profitability
What is ARR?
The impact on accounting profit of investing in an asset over the life of that asset
Whats the decision rule of ARR?
ARR > company’s target = accept
How to calculate ARR?
(Average Annual Profit/ Average investment)*100
What is annual average profit after?
Depreciation
How to calculate average investment for ARR?
(Initial Investment + Residual value)/2
ARR Proforma?
Project A
£
Total cash inflow 2,100
Less depreciation (2,000)
Accounting profit 100
Project life – years 4
Av. Accounting profit 25
Av. Investment 1,000
ARR calc. (25 / 1,000)
x 100
ARR 2.5%
ARR Advantages?
Familiarity with profit
Focus on balance sheet
ROI used for performance appraisal
Simplicity
ARR Disadvantages?
Profit is more subjective than cash flows
May conflict with NPV
Ignores time value of money
Ignores length of project
What is the time value of money?
There is a time preference for receiving the same sum of money sooner rather than later
Reasons:
consumption preference
risk reference
investment preference
What are the two discounted cash flow methods?
the net present value method (NPV)
the internal rate of return method (IRR)
NPV Interest principle?
Compound interest:
£1 today invested at 5% will be worth £1 + 0.05 = £1.05
Present value:
£1 receivable in 1 years time (interest 5%) is worth
£1 / 1.05 = £0.952 today
If present value of a project’s net cash inflows exceeds that of the outflows?
The NPV will be positive and the project should be accepted
NPV Proforma?
Year DF PV
@ 5% A
0 1.000 (2,000)
1 0.952 952
2 0.907 907
3 0.864 43
4 0.823 41
NPV (57)
Advantages of NPV?
Considers time value of money
Measure of absolute profitability
Considers cash flows
Considers whole life of project
Maximises shareholders wealth
Disadvantages of NPV?
Fairly complex
Not well understood by non-financial managers
Difficult to determine cost of capital
What is IRR?
Variation of the NPV method
IRR is the discount rate at which the NPV is zero
Projects with an IRR greater than the company’s cost of capital should be accepted
IRR is determined by trial and error using the formula
What is the IIR Formula?
IRR = L + NL x (H – L)/
NL - NH
Where:
L = lower discount rate
H = higher discount rate
NL = NPV at the lower discount rate
NH = NPV at the higher discount rate
PV at 5% = 222
PV at 25% = (60)
What is the IRR formula?
5%+(222/(222+60)) *(25-5)
= 20.74%
What are the advantages of IRR?
Considers time value of money
Easily understood as uses % return
Considers cash flows
Considers whole life of project
Can be calculated without cost of capital
A company selecting projects where IRR > cost of capital should increase shareholders wealth
What are the disadvantages of IRR?
Not a measure of absolute profitability
Interpolation only provides an estimate of IRR
Fairly complicated to calculate
IRR may conflict with NPV
Multiple IRRs
What are annuities?
An annuity is a constant annual cash flow for a number of years
When a project has equal cash flows the annuity factor (AF) may be used to calculate the NPV and IRR
Therefore PV = annual cash flow x AF
Use cumulative present value tables for AF
What are perpetuities?
A perpetuity is an annual cash flow that occurs forever
PV of a perpetuity = cashflow
How to calculate IRR of a perpetuity?
(Annual cash flow / initial investment) * 100
What is capital budgeting for decision making?
Needs for expenditure forecast
Suitable projects identified
Alternatives appraised
Best alternatives selected and approved
Expenditure made and monitored
Deviations from estimated are examined
What is a capital expenditure committee?
Co-ordinate capital expenditure policy
Appraise and authorise capital expenditure on specific projects
Review actual expenditure on capital projects against the budget
What is a capital expenditure decision?
Decisions will affect the direction and pace of company’s future growth
Decision usually irreversible
What is needed for the authorisation of capital expenditure?
Outline of the project
Reason for the expenditure
Amount of capital expenditure required
Estimated life of project
Assessment of risks
Feasible alternatives
Effect of postponement or rejection
What is capital expenditure control?
Strict control required of large projects. Reports will include:
budgeted cost of the project
estimated cost to date
estimated cost to completion
date of completion
any penalties likely to be incurred
What is post completion appraisal and the reasons for it?
An objective and independent appraisal of the measure of the success of a capital expenditure project in progressing the business as planned
Reasons for use:
To discourage managers from spending on doubtful projects
To discern a trend of reliability in estimates from managers
Information may be useful for future projects
What is risk and sensitivity analysis?
A modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome
i.e. What would happen if demand fell by 10% or if variable costs were 5% higher?
Or: What is the maximum possible change in sales before the opportunity becomes non-viable?
What is the sensitivity margin calculation?
NPV / PV of flow under consideration
What are the advantages of sensitivity analysis?
Advantages:
Simple process using computer spreadsheets
Easy to apply
Directs attention to key variables
What are the disadvantages of sensitivity analysis?
Disadvantages:
In the real world a number of variables may alter at the same time
It assumes variables are independent of each other
Only identifies how far a variable needs to change not probabilities of that change
It is not an optimising technique
What are tax depreciation written down allowances?
Expressed as a percentage
Applied to asset cost on a reducing balance basis
Assume assets are bought at start of accounting period and first tax depreciation is offset against year 1 net cash flows
Not given in year of sale – instead given a balancing allowance or charge – ensures total allowances equal total fall in value
Allowance set against company profit to reduce liability to corporation tax
How does inflation effect Investment appraisal?
The decline in the purchasing power of money can impact the project outcome
What are he two methods of expressing cost of capital?
A money (or nominal) rate (m) – includes an element for inflation
A real rate (r) – the underlying return required before inflation adjustment
Real cashflows without inflation use?
Real Rate
Money, or actual, cashflows; including inflation use?
Money or nominal rate
Equation to find money rate of return?
(1 + m) = (1 + r)(1 + i)
Equation to find real rate f return?
(1 + r) = (1 + m) / (1 + i)
What are the two types of inlfation?
Specific inflation rate:
Each cash flow is affected by a specific rate
Inflate cash flows to money terms
Discount using money rate
General inflation rate:
Can use either real or money rates and respective cash flows
What is asset replacement?
Mutually exclusive options with unequal lives
Where two mutually exclusive projects have different life spans, this must be adjusted for before NPV can be used to choose
Calculation for annualised equivalents for each NPV (asset replacement)
PV of costs / Annuity factor for year n
What is capital rationing?
Arises when an organisation is restricted in the amount of funds available to initiate all worthwhile projects
What are the causes and types of capital rationing?
Causes:
Hard (external) capital rationing
Soft (internal) capital rationing
Types:
Single period – shortage of funds now, but expected to be freely available in later periods
Multi-period – funds shortage is expected to extend over a number of years
What are the categories of capital rationing?
Divisible projects – either the whole project or any fraction of the project may be undertaken
Indivisible projects – either the project must be undertaken in its entirety or not at all
How to create Optimal investment plan for Single period, divisible projects?
Calculating a profitability index (PI) for each project
Profitability index = NPV/ Initial investment
Ranking the projects according to their PI
Allocating funds according to the projects’ rankings until they are used up
What are the qualitative factors of capital rationing?
We have only considered quantitative issues, for example:
Purchase price of machinery
Installation costs
Costs savings – reduced labour costs, lower stock levels
Need to also consider qualitative factors, for example:
Costs – increase pollution, noise
Benefits – reduction in product development time, improved quality of product
