Investment Appraisal (extra)

Question 1

What are the 3 projects when it comes to capital investment?

Answer 1

1. Launching a new product
2. Building a new factory
3. Buying another company

Question 2

Why are investments appraised?

Answer 2

1. Large amounts of shareholders’ money tied up for long periods (5,10, 15 years and so on)
2. Usually difficult and costly to reverse

Question 3

What is the aim of an investment appraisal?

Answer 3

1. Accept projects which are expected to create shareholder wealth
2. Reject projects which are expected to destroy shareholder wealth

Question 4

What is the difference between accounting profits and cash flows?

Answer 4

Cash flows are an objective (facts not opinions) measure of corporate performance whereas accounting profit is calculated by applying the accruals concept and thus includes certain subjective non cash flows like depeciation and change in provisions (liabilities).

Question 5

What profits are exclused in certain cash flows and are reflected on the balance sheet?

Answer 5

Changes in working capital

Capital costs and proceeds

Question 6

What is depreciation?

Answer 6

An accounting ESTIMATE to spread the initial cost of a non-current asset over several accounting periods

Question 7

What are the choice of methods to allocate the expense of depreciation?

Answer 7

Straight line or reducing balance (neither is wright or wrong).

Question 8

What is working capital?

Answer 8

1. Inventories (stock)
2. Trade receivables (debtors)
3. Trade payables (creditors)

Question 9

What type of working capital is a cash outflow (start of the poject?).

Answer 9

1. Purchase inventories

2. Pay suppliers before paid by customers

Question 10

What type of working capital is a cash inflow (end of project).

Answer 10

Net working capital investment is released

Question 11

What is the difference between relevant and irrelevant cash flows?

(Page 5).

Answer 11

Relevant cash flows are Incremental (change as a result of the decision to accept or reject a project) and included in all investment appraisal methods.

Whereas irrelevant cash flows are non-incremental (do not change as a result of the decision to accept or reject a project) i.e. Sunk or committed costs. Also depreciation, changes in provisions.

Question 12

How do you calculate the relevancy of a cash flow?

Answer 12

Cash flow if the project is accepted - the cash flow if the project is rejected.

Question 13

Does money have a time value?

Answer 13

Yes. £1 recieved today is worth more than £1 in the future because it can be invested to earn a return, doesn’t involve inflation and has a reduced risk of a promise being broken.

Question 14

What is the formula for the time value of money?

Answer 14

PV = FV(1 + r)-t

Question 15

What are the 5 types of invesment project? (slide 25 and 26).

Answer 15

1. Independent projects
2. Mutually exclusive projects
3. Mutually dependent projects
4. Divisible projects
5. Indivisible projects

Question 16

What is capital rationing?

Answer 16

when a company does not have the resources to invest in all projects that it would like to (i.e. a shortage of funds).

Question 17

What are the 2 forms of capital rationing?

Answer 17

1. Hard: externally-imposed constraints

2. Soft: internally-imposed constraints

Question 18

What is the objective of capital rationing?

Answer 18

To maximise shareholder wealth from available investment funds

Question 19

What process should i do when capital rationing exists and projects are independent and divisible?

Answer 19

1. Calculate the NPV of each project
2. Calculate the Profitability Index (PI) of each project
   PI = (NPV + Initial Investment) ÷ Initial Investment
3. Reject projects with a PI of below 1
4. Rank remaining projects in descending PI order
5. Accept projects in descending PI order until funds are exhausted (accept a percentage of the final project)

Question 20

What should i do when capital rationing exists and projects are independent but indivisible?

Answer 20

1. Calculate the NPV of each project
2. Select project(s) which give the highest combined NPV for the available investment (trial & error).

Notes:
Do not calculate the PI
The highest combined NPV may not require all of the available investment

Question 21

What is a REAL option?

Answer 21

An option gives the right, but not the obligation, to do something in the future.

Question 22

What are the 3 real options in capital investment appraisal?

Answer 22

1. Abandon – ease of terminating project in the future (i.e. choose project with the lower NPV).
2. Delay - defer investment until conditions improve or more information gathered (i.e. reject a project with a positive NPV)
   Could be advantageous to delay the project to acquire more information
3. Follow-on - investment may create opportunities in the future (i.e. accept a project with a negative NPV). You’ll find this in most industries.

Question 23

What is a caveat boilerplate when providing investment advice? (slide 32).

Answer 23

Based largely upon forecast information which is inherently uncertain

Based upon the information provided which may not have considered and/or quantified:
Associated cash flows (i.e. replacement projects or real options)

Implicit assumptions in the methodology used such as a cash flow pattern (discrete or evenly spread) or constant (tax, inflation and discount) rates.