Investment Appraisal

Question 1

What is an annuity?

Answer 1

Constant cash flow which lasts for a certain number of years e.g. £100k for 3 years

Question 2

How is the annuity factor calculated?

Answer 2

The sum of the discount factors for each year

Question 3

What is a perpetuity?

Answer 3

Constant cash flow which is assumed to last forever e.g. £100k pa forever

Question 4

What formula is used to calculate a perpetuity?

Answer 4

Cash flow / Return% - Growth%
(assumes first cash flow is at T1)

Question 5

What does NPV measure?

Answer 5

The value of a project as the future cash flows coming from that project

Question 6

What are relevant cash flows when calculating the NPV?

Answer 6

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)

Question 7

What is the effect of general inflation on the discount rate?

Answer 7

Need to calculate the money rate:
= (1+real rate) x (1+inflation rate)

Question 8

How do you calculate Working capital for an NPV question?

Answer 8

• 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

Question 9

How do you calculate delayed annuities and perpetuities?

Answer 9

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

Question 10

What is sensitivity analysis?

Answer 10

How much of one of the inputs would have to change for NPV to fall to zero (breakeven)

Question 11

How is sensitivity calculated?

Answer 11

NPV of the whole project / PV of cash flows affected by change

Question 12

Advantages of sensitivity analysis

Answer 12

Simple to understand
Can flex key assumptions
Identify areas which are critical for success

Question 13

Disadvantages of sensitivity analysis

Answer 13

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

Question 14

How does simulation compare to sensitivity analysis?

Answer 14

Monte Carlo simulation can change several variables but is expensive and time-consuming

Question 15

How do you calculate the inputs needed for the NPV to fall to zero (breakeven) using sensitivity?

Answer 15

The sensitivity is the percentage the initial inflow/outflow will have to fall by for it to breakeven

Question 16

What is predictive analytics?

Answer 16

Uses historic and current data to make predictions about the future

Question 17

What is linear regression?

Answer 17

A statistical technique that identifies factors associated with change in a dependant variable.
For example, identifies what causes revenue to increase/decrease

Question 18

Advantages of linear regression

Answer 18

Simple to understand
Predict impact of independent variables

Question 19

Disadvantages of linear regression

Answer 19

Not always in a linear relationship
Correlation does not mean causation
Relies on accuracy of data set

Question 20

What are decision trees?

Answer 20

A predictive analytics technique used to identify the impact of different decisions/variables on NPV

Question 21

Advantages of decision trees

Answer 21

Simple to understand
Considers multiple outcomes/decisions

Question 22

Disadvantages of linear regression

Answer 22

Hard to incorporate lots of different decisions

Question 23

What is prescriptive analytics?

Answer 23

Combines statistical tools utilised in predictive analytics with AI and algorithms to calculate the optimum outcome from a variety of business decisions

Question 24

List some statistical biases

Answer 24

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

Question 25

How do you calculate the Expected value (EV)?

Answer 25

Probability x outcome

Question 26

Advantages of using expected value (EV)?

Answer 26

Easy to understand and apply

Question 27

Disadvantages of using expected value (EV)?

Answer 27

Assumes situation is repeated indefinitely
EV might not be one of the possible outcomes
Probabilities may be bias
Ignores risk

Question 28

What is standard deviation?

Answer 28

Measure of the amount of variation in a data set
- higher = higher risk
- (=STDEV function)

Question 29

What is co-efficient of variation?

Answer 29

Standard deviation divided by the mean/expected value.
Shows how significant the variations are
- higher co-efficient % = higher risk

Question 30

What is correlation?

Answer 30

How strong the relationship is between two variables (=CORREL function)

Question 31

What does ‘real options’ mean?

Answer 31

NPV only considers identifiable cash flows. There could be other benefits in the future if certain courses of action are taken

Question 32

List four ‘real options’

Answer 32

• 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

Question 33

List some non-financial factors to consider in addition to a positive NPV

Answer 33

Legislation
Staff morale
Suppliers & customers
Reputation
Sustainability
Management time
Technological obsolescence

Question 34

Name four risks from domestic trading

Answer 34

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

Question 35

What is the Shareholder Value Analysis (SVA) approach to company valuation?

Answer 35

With SVA a company’s value is based on the PV of its future cash flows, so it is forward-looking.

Question 36

Name three additional risks from international trading

Answer 36

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

Question 37

What are the seven drivers of value?

Answer 37

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)

Question 38

What can environmental costs be classified (per US Environmental Protection Agency) as?

Answer 38

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

Question 39

What is replacement analysis?

Answer 39

Where an asset (must be replaced on a regular basis, then this
technique allows us to decide how often to replace the asset.

Question 40

How do you calculate replacement analysis

Answer 40

1 -year replacement: PV of cash flows / annuity factor for 1 year
2-year replacement: PV of cash flows / annuity factor for 2 years

Question 41

What are some limitations of replacement analysis?

Answer 41

Inflation and technology change will impact future costs

Question 42

What is capital rationing?

Answer 42

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

Question 43

What is hard and soft capital rationing?

Answer 43

‘Hard’ capital rationing – an actual shortage of funds.
‘Soft’ capital rationing – an internally imposed (budgetary) limit on funds.