Investment appraisal

Question 1

Accounting rate of return

Answer 1

You’re looking at the project not the company.

Average annual profit of the project / Av investment x 100

Question 2

Average annual profit =

Answer 2

(Total net cash flows - total depreciation) / Length of project

Question 3

Average investment

Answer 3

(Initial invetsment + scrap value) / 2

Question 4

Cash flows + Accounting adjustments =

Answer 4

Profit

Question 5

Advantages of ROCE

Answer 5

Advantages
 It is simple to calculate
 As a percentage the measure is familiar to non-accountants
 It looks at the entire project
 It reflects the way external investors judge the organisation

Question 6

Disadvantages of ROCE

Answer 6

Disadvantages
 No account is taken of the project life
 No account is taken of the timing of the cashflows/it ignores the time value of money
 The result may vary according to the accounting policy used
 It may ignore working capital
 It does not measure absolute gain
 It does not give a definite decision

Question 7

A relevant cost is defined as a future incremental cash flow. In other words for a figure to be relevant it must pass three tests:

Answer 7

(1) Future
– A decision being made today cannot change the past and so only future costs are considered.
– Past costs are sometimes referred to as sunk costs and are not relevant and so are
ignored e.g. the price paid for something which is already owned.
Incremental
– Only those costs that are affected by the decision are incremental and therefore relevant.
– Costs that are sometimes referred to as committed costs and are not relevant and so are ignored e.g. unavoidable fixed costs.
– Businesses need to consider lost opportunity costs (revenue / contribution lost from diverting resources away from an alternative use), which are also relevant. Commonly the diverted resources are labour and materials. The diagrams below are useful to help determine the relevant cost in these situations:
Cash flows
– These are factual and not based upon accounting conventions. Also organisations live or die due to their cash position. So non-cash flows are not relevant e.g. depreciation.

Question 8

Perpetuities

Answer 8

Some annuities last forever, these are called a perpetuities.

Question 9

How to calc deprival value?

Answer 9

Lower of Replacement cost and the higher of either NRV and VIU

Question 10

Advantages of payback

Answer 10

Advantages
 It is simple to calculate
 It is easy to understand, especially for non-accountants
 It uses relevant cash flows
 It can be used as an initial screening tool on projects before undertaking a more detailed review
 It (rather crudely) allows for risk

Question 11

Disadvantages of payback

Answer 11

Disadvantages
 It ignores returns after the payback period
 It ignores the timing of the cash flows
 It does not give a definite decision
 It ignores project profitability

Question 12

what is the calc for present value?

Answer 12

PV = FV × (1 + r)–n

Question 13

Advantages of IRR

Answer 13

Advantages
 It allows for the time value of money
 It uses cash flows not profits
 It does not require the exact cost of funds to be known
 As a percentage, the measure is familiar to non-accountants
 It looks at the entire project
 It provides a relative measure of performance

Question 14

Disadvantages of IRR

Answer 14

Disadvantages
 It is not an absolute measure
 Interpolation provides only and estimate and an accurate estimate requires the use of a
spreadsheet programme
 It is fairly complex to calculate
 Non conventional cash flows may give rise to multiple IRRs
 It contains the inherent assumption that cash returned from the project will be re-invested at the project’s IRR which may not be true

Question 15

The relationship between real and nominal interest rates is:

Answer 15

(1 + i) = (1 + r) × (1 + h)

Question 16

Real rate

Answer 16

(excludes inflation, compensates the lender for the time value of money)

Question 17

Nominal rate

Answer 17

(includes inflation, compensates the lender for TVM and inflation)

Question 18

In choosing which rate to use we must be consistent:

Answer 18

 If the cash flows exclude inflation (‘real’ cashflows) then so must the discount factor (‘real’ rate)
 If the cash flows include inflation (‘nominal’ or ‘money’ cashflows) then so must the discount factor (‘nominal’ rate)
In the exam you may need to add inflation into the cash flows if you are using the ‘money/money’ approach, or remove inflation from the cash flows if you are using the ‘real/real’ approach.

Question 19

Risk is when

Answer 19

there is a range of possible outcomes and the likelihood of those outcomes can be quantified in the form of probabilities.

Question 20

Uncertainty is when

Answer 20

there is a range of possible outcomes, but the likelihood of the outcomes cannot be quantified

As a project’s life increases it becomes harder to quantify the likelihood and so the outcomes are more likely to be uncertain. There are a range of techniques to deal with both risk and uncertainty in project appraisal

Question 21

When calculating the sensitivity for a particular cash flow the following formula is used:

Answer 21

NPV / NPV of required variable

Question 22

When calculating the sensitivity to the cost of capital, the following formula is used

Answer 22

IRR - Cost of capital Cost of capital
× 100%

Question 23

Advantages of sensitivity analysis

Answer 23

Advantages
 Simple
 Provides more information to allow management to make subjective judgements
 Indicates which forecasts should be researched further
 Indicates which variables require the closest control once the project starts

Question 24

Disadvantages of sensitivity analysis

Answer 24

Disadvantages
 Assumes variables change independently of each other
 Does not assess the likelihood of change
 Does not lead to a definite decision

Question 25

Probabilities - If you want the probability of X ANd Z you?

If you want the probability of X OR Z you?

Answer 25

Multiply

Add

Question 26

The usefulness of probability analysis in assisting investment decisions is

Answer 26

 It allows us to evaluate risky investments
 It allows us to quantify the risk

Question 27

The limitations of using probability analysis are

Answer 27

 Expected values are not meaningful in one off decision making situations since they represent a long run average value. Take the example above, achieving sales of $510k will not happen (it will either be $600k, $500k or $400k) in an individual year. Hence, expected values are more appropriate for assessing decisions or cashflows which will be repeated.
 Expected values ignores the spread of possible returns (i.e. risk), as they average the outcomes. A separate measure is needed to show the spread of possible returns (such as the standard deviation or simulation).
 Expected values rely on the accuracy of the probabilities used

Question 28

Risk-adjusted discount rates

Answer 28

As we have already seen the discount factor reduces the future cash flows to allow for the time value of money.

As the future cash flows also contain risk, the discount factor can be adjusted to reflect this risk. So a project with more risk would have a higher discount factor applied to it and so the NPV would be reduced to reflect this risk.

Question 29

Adjusted payback

Answer 29

 The adjusted payback (also known as discounted payback) involves adjusting the cash flows in the payback calculation to take account of the risk.
 In practice this means reducing the future cash flows to reflect the risk in the estimated figures. As forecasting is generally harder the further into the future you predict, the reduction needs to be greater for more distant figures

Question 30

Asset replacement decisions using equivalent annual cost

Answer 30

Sometimes an investment decision will involve choosing between two alternatives where the benefits are unequal e.g. comparing renting one property for five years and an alternative for seven years.

Question 31

Equivalent Annual Cost =

Answer 31

NPV / Annuity factor for project life

Question 32

The EAC represents a

Answer 32

constant annual cashflow that has the same present value as the actual cashflows arising under each proposal. The proposal with the lowest EAC should be chosen

Question 33

PV of annuity =

Answer 33

Annuity X Annuity factor

Question 34

EAC =

Answer 34

Annuity

Question 35

Single period capital rationing describes

Answer 35

the situation where an organisation does not have sufficient funds to undertake all positive NPV projects at one particular point in time

Question 36

Profitability Index (PI)

Answer 36

Net present value / Initial Investment

Question 37

Capital rationing can be caused by two different reasons:

Answer 37

(1) The organisation would like to raise more funds, but no stakeholder is prepared to invest. This is known as hard capital rationing and may result from the potential returns not being high enough to compensate for the perceived risks involved.
(2) The organisation could raise more funds, but has internally decided not to. This is known as soft capital rationing and may result from a concern that the available finance is too expensive or may result in a loss of control.