Investment appraisal

Question 1

What is the impact of specific inflation on the NPV calculation? (2)

Answer 1

• Estimating the future cash flows of a project will require an estimate of the rate of inflation that those cash flows will suffer.
• This will not necessarily be the same as general inflation and may be different for different things.

Question 2

What is the impact of general inflation on the discount rate? (2)

Answer 2

• Investors in a project need compensation for the general rate of inflation.
• This relates to their ability to buy a basket of goods rather than any specific one product.

Question 3

2 disadvantages of IRR

Answer 3

• Does not calculate the change in absolute shareholder wealth so may provide the wrong result when alternative projects are being ranked.
• Non-conventional cash flows can create more than one IRR.

Question 4

2 advantages of IRR

Answer 4

• Normally gives the same result as NPV.

- May be easier for managers and employees to understand as it provides a percentage return.

Question 5

Equation for calculating IRR

Answer 5

IRR = a% + ((NPVa / (NPVa - NPVb)) x (b% - a%))
a is the higher discount rate
b is the lower discount rate

Question 6

When does an annuity factor apply?

Answer 6

To restate the present value of costs over a life cycle into an annuity, which represents the equivalent annual cost.

Question 7

What 3 factors will impact equivalent annual costs?

Answer 7

• Price changes
• Replacing with alternative or more advanced plant
• Timing of cash outflows may cause cash flow problems

Question 8

Should market research costs from before making the investment be included in NPV calculations?

Answer 8

No. It is a sunk cost.

Question 9

Should centralised fixed costs be included in NPV calculations?

Answer 9

No.

Question 10

Present value of a single cash flow

Answer 10

= cash flow x 1 / (1 + r)^n

Question 11

Present value of a perpetuity cash flow

Answer 11

= perpetuity cash flow x 1 / r

Question 12

Present value of growing perpetuity

Answer 12

= cash flow in year 1 x 1 / (r - g)

Question 13

3 criteria for relevant costs

Answer 13

1. Future
2. Incremental (based on a decision)
3. Cash flows

Question 14

How to calculate relevant cash flow?

Answer 14

Cash flow which arises if the course of action is taken

Less: Cash flow which arises if not taken

Question 15

When does the tax saving on capital allowances arise if an asset is bought at the start of an accounting period?

Answer 15

At T1

Question 16

When does the tax saving on capital allowances arise if an asset is bought at the end of an accounting period?

Answer 16

At T0

Question 17

What formula is used to account for inflation in the discount rate?

Answer 17

(1 + money rate) = (1 + real rate) x (1 + general inflation)

Question 18

What is the real @ effective method?

Answer 18

• Cash flows are left in real terms
• A specific effective discount is calculated using the formula (1 + effective rate) = (1 + money rate) / (1 + specific inflation rate)

Question 19

What is the optimal replacement cycle?

Answer 19

The one with the lowest equivalent annual cost.

Question 20

4 limitations of replacement analysis

Answer 20

1. Assumes a firm is continually replacing like for like.
2. Ignores changing technology, which can make machines obsolete and shorten replacement cycles.
3. Ignores inflation.
4. Ignores the effects of taxation.

Question 21

2 types of rationing

Answer 21

1. Soft

2. Hard

Question 22

Define soft rationing

Answer 22

Where internally the firm imposes its own constraint on the amount of funds raised.

Question 23

Define hard rationing

Answer 23

Where the external capital market limits the supply of funds.

Question 24

Define SVA

Answer 24

Shareholder Value Analysis is the process of analysing the activities of a business to identify how they will result in increasing shareholder wealth.

Question 25

7 principles of SVA

Answer 25

1. Sales growth rate
2. Life of projected cash flows
3. Operating profit margin
4. investment in Working capital
5. Cost of capital
6. investment in non-current Assets
7. corporation Tax rate

Question 26

5 real options

Answer 26

1. Follow-on options
2. Abandonment options
3. Timing options
4. Growth options
5. Flexibility options

Question 27

What is a follow-on option?

Answer 27

• Launching this project would give a later opportunity to launch a second (and third and so on) version which could be highly profitable or could lose money.
• Launching the first version effectively gives the right to invest in later versions. The right to invest or buy is known as a call option.

Question 28

What is an abandonment option?

Answer 28

• Both projects offer the right to abandon the project if things go wrong, by selling the assets. The value of the second option is much greater and could well be preferred by management.
• The right to sell is known as a put option.
• Some projects such as those in the natural resource industry (timber, mining etc) have inbuilt options to reduce capacity or suspend operations temporarily.

Question 29

What is a timing option?

Answer 29

• Projects where commencement can be delayed are often attractive. In a volatile market a project that can be delayed is like a call option with a long period of expiry. If the company can delay investment it can wait and see what happens to the market before investing or not (exercising the option or not). The longer the delay, the more valuable the option.
• The option to delay is only valuable if it offsets any loss from delaying; eg, delay might result in a competitor establishing a loyal customer base that makes it difficult for the company to enter the market later. Patents and other barriers to entry can offer some protection against this.

Question 30

What is a growth option?

Answer 30

1. New technology, deregulation etc, present uncertain growth opportunities for firms – investing could produce substantial losses.
2. Choices may include:
   - Full investment and hope it pays off (high risk)
   - Wait and see, but competitors might take a lead
   - Acquire ‘growth option’
3. Growth options include:
   - Start with small capacity, expanding later if market conditions are good
   - Joint ventures and strategic alliances as entry strategies into emerging markets eg, China
4. R&D avoiding ‘wait and see’ risk and, if prospects look poor, no full investment eg, pharmaceutical companies
5. Follow-on options, noted above

Question 31

What is a flexibility option?

Answer 31

• A project with dual options gives greater flexibility.

- This flexibility option has a value which must be included in the evaluation.

Question 32

What are the 3 major criteria when deciding what types of country a company should enter?

Answer 32

1. Market attractiveness
2. Competitive advantage
3. Risk

Question 33

6 types of political risk

Answer 33

1. Quotas
2. Tariffs
3. Non-tariff barriers
4. Restrictions
5. Nationalisation
6. Minimum shareholding

Question 34

4 types of cultural risk

Answer 34

1. Cultures and practices of customers and consumers
2. Media and distribution systems
3. Ways of doing business
4. The degree to which national cultural differences matter

Question 35

5 factors impacting the choice of finance for an overseas subsidiary

Answer 35

1. Local finance costs and any subsidies that might be available
2. Taxation systems of the countries in which the subsidiary operates
3. Restrictions on dividend remittances
4. Possibility of flexibility in repayments to parent companies
5. Access to capital

Question 36

Deprival value

Answer 36

Lower of:

Replacement cost or the higher of:

Value in use or net realisable value