Investment Appraisal

Question 1

What are the components of relevant cash flows in investment appraisal?

Answer 1

Relevant:
- Initial capital outlay
- Annual operating cash flows
- Terminal Cash flow
- Changes in working capital
Excludes:
- Sunk Costs
- Financing Costs

Question 2

How is ARR calculated and what does it indicate?

Answer 2

ARR = (Avg annual operating profit/ avg investment) x 100%
Indicates the average yearly return percentage expected from an investment, based on accounting profits.

Question 3

What are 3 advantages/ disadvantages of ARR?

Answer 3

Adv:
- Easy to calculate/ simple to understand
- Involves familiar concept of percentage return
- Looks at entire project life
Disadv:
- Ignores time value of money
- Based on accounting profits not cash flows
- Does not take into account size/ length of project

Question 4

What does Payback Period measure and why is it important?

Answer 4

Measures how quickly an investment can recover its initial costs from cash inflows. Important for assessing risk and liquidity but ignores cash flows after the payback period.

Question 5

What is the formula for NPV and what does it measure?

Answer 5

NPV = Sum of (Ct/ (t+i)^t)
Where :
- Ct is the net/ sum of cash flow at year t
- i is interest/ discount rate
Provides a comprehensive measure of the project’s profitability by considering all cash flows and their time value.

Question 6

What are adv/ disadvantages of NPV?

Answer 6

Adv:
- Recognises time value of money
- Recognises differences in size of investment
- Allows for additivity
Disadv:
- Provides answers in monetary terms, not % (harder to compare)

Question 7

What is the definition and formula of IRR, and when is a project accepted using IRR?

Answer 7

IRR is a discount rate that makes the NPV of all cash flows equal zero in a discounted cash flow analysis.
Formula:
NPV = Sum of (Ct/ (1+ IRR)^t) - C0 = 0
Where C0 denotes initial investment costs.
Decision rule:
Accept project id IRR > hurdle rate (wacc)

Question 8

What are 3 Adv/ Disadvantages of IRR?

Answer 8

Adv:
- Considers Time value of money
- Gives clear message in simple % terms
- Can be used to compare projects of different sizes
Disadv:
- Projects with non-conventional/ irregular cash flows may produce multiple IRRs
- IRR presumes cash inflows from a project will be reinvested at the projects own IRR.

Question 9

What is capital rationing?

Answer 9

Involves selecting a combination of projects under a fixed budget to maximise the firm’s value.

Question 10

What is Asset Replacement?

Answer 10

Decision involves comparing the NPV of continuing with existing assets against replacing them.

Question 11

What is profitability analysis?

Answer 11

Focuses on evaluating projects based on profitability metrics such as IRR and NPV, critical for long-term strategic decision making