Investment Appraisal Flashcards
Capital Investment Decisions
- Profit is partially generated by using company assets
- Companies need to invest in assets
- Capital available to invest is often limited
- Capital investment often requires large scale investments
- Managers need to consider which projects to invest in
Capital Investment Process
- Generating ideas
- Searching out relevant information
- Identifying possible alternatives
- Determining specific project details
- Evaluating financial consequences
- Assess ‘non-financial’ consequences
- Make a decision
Why is investment appraisal done?
- Management needs to allocate scarce resources efficiently
- Cash is one of the available resources
- Pay now, benefits in the future
- Objective is to maximise profits
Methods of Investment Appraisal
- Payback
- Net Present Value
- Internal Rate of Return
Payback Period
It estimates the length of time required for an investment project to pay back its initial cost.
Advantages of payback period
- Simple to calculate
- Helps identify which investment will break even quicker
- Short term measure of quick return on investment, hence less prone to inaccuracies
Disadvantages of payback period
- Ignores time value of money
- Doesn’t consider cash earned after payback period
- Annual cash flow can negatively be affected by unexpected external changes in demand
Net Present Value
It is the difference in the summation of present values of future returns and the original cost of investment.
Advantages of NPV
- Takes into account the time value of money
- Takes into account the duration of the investment
- NPV returns the absolute net value of the investment, hence allowing comparison
Disadvantages of NPV
- Complicated to calculate
- Can only be used to compare investments with same initial costs
- Difficult to determine discount rate, inaccurate value can influence final NPV result
Internal Rate of Return
It is the interest rate at which the net present value of all the cash flows from a project or investment equal zero.
IRR> company’s cost of capital.
Advantages of IRR
- Takes into account the time value of money
- Uses cash flow instead of accounting profit
Disadvantages of IRR
- It is a relative measure, hence ignoring the absolute values of payoff
- Multiple and indeterminate IRRs are possible
Capital Rationing
-Investment required for positive NPV projects is greater than capital available to invest.
-Hard: imposed externally
Company unable to raise any money either through equity or debt
-Soft: imposed internally
Due to internal policies, there may be restrictions on the amount of fund available on investment projects.
Single Period Rationing
Funds are restricted at t0
- Choose combination of projects that will maximise overall NPV
- Different techniques depending on nature of projects
Profitability Index
NPV/ initial investment
Indivisible Projects
- Need to consider all possible combinations
- Pick the combination which maxmises the return/ weighted average PI on the funds available
Incremental working capital
- Operational activity levels increase
- inventory/ receivables will increase
- partly funded by increase in payables
- rest is a cashflow
- Invested t0
- Annual incremental increases as outflow
- Released at the end of project
Taxation
Tax charged on profits made
- income will be taxable
- expenses will tax-decutible
Capital allowances for capital expenditure
- can be set against taxable profit
- government policy
Tax liability= taxable profit x%
Capital allowances
- Tax relief given on investments in tangible non-current assets
- Assume 25% reducing balance basis
- Some assets attract greater First Year Allowances
- Balancing allowances/ charges on disposal if disposal proceeds are less/ more than the tax written down value
Inflation
The appropriate discount factor depends on whether the cash flows are projected including or ignoring inflation
Inflation Method 1
Use nominal cash flows which include inflation.
Discount by nominal cost of capital.
Inflation Method 2
Use real cash flows which exclude inflation.
Discount by real cost of capital
Nominal v Real
(1 + rnominal)=(1 + rreal)(1 + inflation rate)
Non financial factors
- Compliance with current and future legislation.
- Impact on staff morale
- Impact on suppliers and customers
- Reputation of organisation
- Sustainability
