Investment Appraisal Flashcards
What is an annuity?
Constant cash flow which lasts for a certain number of years e.g. £100k for 3 years
How is the annuity factor calculated?
The sum of the discount factors for each year
What is a perpetuity?
Constant cash flow which is assumed to last forever e.g. £100k pa forever
What formula is used to calculate a perpetuity?
Cash flow / Return% - Growth%
(assumes first cash flow is at T1)
What does NPV measure?
The value of a project as the future cash flows coming from that project
What are relevant cash flows when calculating the NPV?
Inflows and outflows which change as a result of taking on the project
- Exclude sunk costs (e.g. market research
Include opportunity cost (profit from not using resources elsewhere)
What is the effect of general inflation on the discount rate?
Need to calculate the money rate:
= (1+real rate) x (1+inflation rate)
How do you calculate Working capital for an NPV question?
- T0 - Initial WC is a cost
- An increase in WC should be deducted and a decrease added back
- At the end, WC is ‘released’ and therefore gives raise to a cash flow
How do you calculate delayed annuities and perpetuities?
If an annuity or perpetuity doesn’t start at t1 then the discount factor must be adjusted. For example, if a cash flow is received each year for 5 years but starts at t4, then the discount factor is:
AF for 5 years × Simple DF for 3 years
What is sensitivity analysis?
How much of one of the inputs would have to change for NPV to fall to zero (breakeven)
How is sensitivity calculated?
NPV of the whole project / PV of cash flows affected by change
Advantages of sensitivity analysis
Simple to understand
Can flex key assumptions
Identify areas which are critical for success
Disadvantages of sensitivity analysis
Only changes one variable at a time
Ignores probability of the change happening
Only identifies issues and does not five decision on what to do
How does simulation compare to sensitivity analysis?
Monte Carlo simulation can change several variables but is expensive and time-consuming
How do you calculate the inputs needed for the NPV to fall to zero (breakeven) using sensitivity?
The sensitivity is the percentage the initial inflow/outflow will have to fall by for it to breakeven
What is predictive analytics?
Uses historic and current data to make predictions about the future
What is linear regression?
A statistical technique that identifies factors associated with change in a dependant variable.
For example, identifies what causes revenue to increase/decrease
Advantages of linear regression
Simple to understand
Predict impact of independent variables
Disadvantages of linear regression
Not always in a linear relationship
Correlation does not mean causation
Relies on accuracy of data set
What are decision trees?
A predictive analytics technique used to identify the impact of different decisions/variables on NPV
Advantages of decision trees
Simple to understand
Considers multiple outcomes/decisions
Disadvantages of linear regression
Hard to incorporate lots of different decisions
What is prescriptive analytics?
Combines statistical tools utilised in predictive analytics with AI and algorithms to calculate the optimum outcome from a variety of business decisions
List some statistical biases
Selection bias: Not representative of whole population
Observer bias: Researcher is bias
Cognitive bias: Data is presented in a bias way
Survivorship bias: Some data is already removed
How do you calculate the Expected value (EV)?
Probability x outcome
Advantages of using expected value (EV)?
Easy to understand and apply
Disadvantages of using expected value (EV)?
Assumes situation is repeated indefinitely
EV might not be one of the possible outcomes
Probabilities may be bias
Ignores risk
What is standard deviation?
Measure of the amount of variation in a data set
- higher = higher risk
- (=STDEV function)
What is co-efficient of variation?
Standard deviation divided by the mean/expected value.
Shows how significant the variations are
- higher co-efficient % = higher risk
What is correlation?
How strong the relationship is between two variables (=CORREL function)
What does ‘real options’ mean?
NPV only considers identifiable cash flows. There could be other benefits in the future if certain courses of action are taken
List four ‘real options’
- Follow-on option: opportunity to launch newer versions or related products/services
- Growth option: opportunity to expand later
- Timing option: can decide when to commence project
- Abandonment option: opportunity to reduce capacity or sell assets
List some non-financial factors to consider in addition to a positive NPV
Legislation
Staff morale
Suppliers & customers
Reputation
Sustainability
Management time
Technological obsolescence
Name four risks from domestic trading
Physical risk: goods may be stolen/lost in transit
Credit risk: risk of payment default by the customer
Trade risk: risk of the customer refusing to accept the goods on delivery
Liquidity risk: inability to finance the credit given to customers
What is the Shareholder Value Analysis (SVA) approach to company valuation?
With SVA a company’s value is based on the PV of its future cash flows, so it is forward-looking.
Name three additional risks from international trading
Political risk: may restrict opportunities to export or make process more expensive
Cultural risk: product/service may not be compatible with cultural preferences
Foreign exchange risk: FX rates will diminish revenue/increase costs
What are the seven drivers of value?
Impact size offuture cash flows:
1. Sales and growth (max)
2. Margin (max)
3. Invest in assets (min)
4. Investment in Working Capital (min)
5. Tax (min)
Impact their NPV:
6. Discount rate (min)
7. Length of time that detailed future plans are available for (max)
What can environmental costs be classified (per US Environmental Protection Agency) as?
Conventional: raw materials, capital goods - reduced usage is environmentally preferable
Potentially hidden: Captured by accounting systems but lost in ‘general overheads’ e.g. regulatory costs
Contingent: Future costs e.g. compensating for environmental damage
Image and relationship: intangible e.g. costs of environmental reports
What is replacement analysis?
Where an asset (must be replaced on a regular basis, then this
technique allows us to decide how often to replace the asset.
How do you calculate replacement analysis
1 -year replacement: PV of cash flows / annuity factor for 1 year
2-year replacement: PV of cash flows / annuity factor for 2 years
What are some limitations of replacement analysis?
Inflation and technology change will impact future costs
What is capital rationing?
Where there are a number of positive NPV projects
available, but insufficient funds to take on all these projects.
What is hard and soft capital rationing?
‘Hard’ capital rationing – an actual shortage of funds.
‘Soft’ capital rationing – an internally imposed (budgetary) limit on funds.
