Investment Appraisal Flashcards
What is the straight-line method of depreciation?
The straight-line method reduces the value of an asset by equal amounts over its useful life. For example,
- A van costs £10k and has an expected scrap value of £1k. The depreciable asset cost is therefore 9k.
- It is expected to have a useful life of 4 years and therefore depreciates by 25% each year
- 25% depreciation rate x £9k depreciable asset cost = 2.25k annual depreciation.
What is capital budgeting?
Capital budgeting is a widely used term for the process of evaluating investments in projects.
What are the four investment appraisal techniques?
- Net Present Value
- Internal Rate of Return
- Payback Period
- Accounting rate of return (ARR)
What are the advantages of ARR?
- it is simple to calculate
- it uses accounting numbers rather than harder to obtain cash flows
- it is easy to use and to understand.
What are the disadvantages of ARR?
- it is based on profits which can be ‘managed’ more easily than cash flows
- it ignores the time value of money
- older projects with low net book values for capital investments can show very high returns which may deter reinvestment.
What is a relevant cash flow?
Only the cash flows that occur as a result of making a proposed investment should be considered.
Note that depreciation and amortisation are accounting entries and not cashflows. Costs that occur regardless of an investment decision are not relevant; they are sunk.
What are the four methods for adjusting project appraisal for risk?
- Expected net present value (ENPV)
- Sensitivity analysis
- Scenario analysis
- Monte Carlo simulation
What are the five reasons why organisations typically use a hurdle rate that is higher than the WACC
- finance managers responsible for project appraisal do not trust the cash flow forecasts provided in the DCF analysis.
- positive projects are charged a higher hurdle rate to compensate for negative NPV projects that must be undertaken,
- to reflect the option value of delaying a project until later - it might be cheaper to hold off.
- to compensate for changes to the cost of debt or equity over time.
- some projects are riskier than the current average for the organisation. So, by adding a premium to the WACC, organisations are adjusting for relative project risk.
What is cost-benefit analysis?
Cost-benefit analysis is an analysis of the cost-effectiveness of a project in order to see whether the benefits outweigh the costs.
What is the Internal Rate of Return?
It is the discount rate that gives a zero NPV and is also known as the ‘yield’. It can be thought of as the maximum possible financing cost that could be paid for funding.
What are the disadvantages of IRR?
- It does not provide an indication of the scale of a project.
- A higher IRR does not necessarily mean a higher NPV at all discount rates; thus it cannot be used to compare competing projects.
- Projects with varying cash flows that change from positive to negative, more than once, can result in multiple IRRs, which makes it difficult to use in capital investment decisions.
- It assumes that all monies generated by a project will be invested at the same rate of return, the IRR.
What method can be used to analyse the cost savings in a replacement decision? HINT: Think of NPV analysis.
To calculate the present value of a constant stream of savings, use the PV of an annuity formula.
A project is worth carrying out if the cost savings are greater than the NPV from of the project cost i.e. spending on the investment.
An adjustment to the hurdle rate should be made for projects which are atypical in terms of risk.
Where does the risk come from? HINT there are two types.
- Operating risk - the operating or business risk of a company is in a sense the weighted average of the operating risks of its divisions. Not all part of an organisation carry the same levels of risk.
- Financial risk – the second type of risk is to do with how the project or division is financed. For example, the more debt finance there is in the capital structure, the riskier the cash flows to equity investors.
What does NPV represent?
NPV is the present value of all future cash flows discounted back to today’s values.
It is the present value of the expected cash flows minus the present value of the expected costs.
A positive NPV is one where the future cash flows outweigh the present value of the investment and its costs; thus, value is created.
How do you calculate the ARR?
Annual ARR = EBIT / average capital employed over the year.
