Investment Appraisal Flashcards
Money discount rate?
(1 + money rate) = (1 + real rate) × (1 + general inflation rate)
When considering risk in project appraisal, what is the main advantage of using simulations to assist the appraisal?
More than one variable can change at a time.
ROCE (Accounting rate of return)
Average annual profit before interest and tax/Initial capital costs x 100%
Payback period?
Initial payment/Annual cash flow
Strengths of payback period?
- Simple to calculate and understand
- It favours quick return
- Helps company grow and minimizes risk
Limitations of payback period?
- Does not ensure that shareholder wealth is maximised.
- Ignore timings of cash flows
- Ignores returns after the payback period
- It is subjective - no definitive investment decision.
Which of the following statements is/are true regarding sensitivity?
The sensitivity of NPV to a change in sales volume can be calculated as NPV divided by the present value of future sales contribution after tax.
Using the average investment method and assuming operating cash flows of $729,000 per year, what is the return on capital employed of the investment project?
Annual operating cash flow = $729,000
Annual depreciation = 1,800,000/4 = $450,000
Annual profit = 729,000 - 450,000 = $279,000
Average investment = 1,800,000/2 = $900,000
ROCE = 279,000/900,000 x 100 = 31%
Which of the following statements relating to debt finance is correct?
A new issue of loan notes by Link Co will take place in the primary market
Which of the following statements relating to competition policy is/are correct?
Scale economies are an advantage of monopoly and oligopoly
Social costs or externalities are an example of economic inefficiency arising from market failure
Monopoly is discouraged because it can lead to inefficiency and excessive profits
Limitations of expected values
Average unlikely to be achieved
Averages not useful for one off decisions
EVs hide risk levels
If price falls by more than 19.9%, project is not viable
Cause for concern if lower price becomes most likely
ROCE Strengths
Expressed in term familiar to managers - profit and capital employed.
Easy to calculate the likely effect of the project on the reported profit and loss.
Businesses are judged on return on investment measures by financial markets.
ROCE Limitations
Does not ensure that shareholder wealth is maximised.
Figures easily manipulated.
Ignores the actual/incremental cash flows associated with the project.
Payback period strengths?
Simple to calculate
It favours quick return
Helps company grow
Minimises risk
Payback period limitations?
Does not ensure that shareholder wealth is maxmised
Ignores timing of cash flows
Ignores returns after the payback period.
Internal rate of return advantages?
Does consider the time value of money
A percentage is easily understood
Uses cash flow
It considers the whole life of the project.
It does not need the cost of capital to be known
Internal rate of return limitations?
It is not a measure of absolute profitability
It is fairly complicated to calculate
Interpolation only provides an estimate
Non-conventional cash flows may give rise to multiple IRRs
NPV Strengths?
It considers the time value of money
It is an absolute measure of return
It is based on cash flows not profits
It considers the whole life the project
It should lead to the maxmisation of sahreholders wealth
NPV limitations
Not easily explained to managers
Requires that the cost of capital is known
Hard capital rationing
An absolute limit on the amount of finance available imposed by the lending institutions.
Industry wide factors limiting funds
Company specific factors
Soft capital rationing
A company may impose its own rationing on capital e.g. from a desire to control the rate of expansion.
Sensitivity analysis?
The maximum possible change is often expressed as a percentage.
Sensitivity margin = NPV/PV of flow under consideration x 100%
