Investment Appraisal RECAP Flashcards
Formula for ARR? (or return on capital employed)
AVERAGE Annual Profit before Income and Tax / Investment
It just gives a % return on your investment.
Explain the process to be taken when calculating ARR
Right out the number years for the investment, i.e if it takes 4 years
If we are told that depreciation has not been included in operating cash flows, how do we make sure to factor this in?
Total depreciation = cost we bought the asset - scrap value
Why do we need to figure out depreciation for ARR?
Because deducting depreciation from total operating cash flows will give us our total profit figure.
Within ARR, once we have our total profit figure, do we stop there?
NO, because the calculation is AVERAGE profit / investment, hence we must divide this total by the number of years we have received cash flow
Payback period is what ?
This is the time taken to pay back the initial investment
How do we know when to accept a ARR?
We will always be told a target, so we accept if above this
When we put our cash flows into the proforma, what do we label them as?
Operating flows
After totalling up all operating cash flows, what is the additional row required for pay back period?
The cumulative cash flow column, as this will begin negative and eventually will turn positive. The cumulation is based on the net cash flows for each time period
How do we calculate how the exact amount of years taken for us to have fully paid back our investment?
When we have the 2 years of which cumulative cash flow changes from negative to positive, we take the final negative cumulative cash flow amount and divide this by the following year’s net cash flow
If we want to know what our value is in months, e.g 0.7, how do we do this?
times 0.7 by 12
How do we know when to accept for payback?
If our pay back is less than or equal to the required pay back period
What is the NPV calculation?
PV inflows - PV outflows
IRR is when?
The discount rate that results in the NPV = 0, we have broke even
What is the discount often referred to as?
Discount factor = required rate of return = cost of capital
Overall, why is NPV superior to all other calulations
It takes into account the time value of money (whereas ARR and payback dont)
It is an absolute measure of return whereas IRR is relative
It looks at cashflows and not profits like ARR, where profits can often be subjective due to accounting polices etc
Overall, a positive NPV leads to?
A maximisation of shareholder wealth
Whilst we have our discount factor table, when would we not be able to use this?
When the rate of return is not included in the table, e.g 12%
Hence when the rate of return is not included in the table, how do we manually figure it out?
Note, if annuity, the manual formula is given to us so dont need to learn
cash flow * (1/(1+r)^n)
where r = discount rate
n = year the cash flow relates too
What does annuity mean?
same yearly cash flow for a fixed period of time
What does perpetuity mean?
same yearly cash flow for infinite amount of time
Annuity discount factors from the table are found?
2nd column
How do we find PV of a perpetuity CF?
CF * 1/r
What is the formula for the PV of growing perpetuity?
CF at t1 * (1/r-g)
If we are told than £700 is received for 3 years, starting in year 8, what do we need to find? What is the process for finding this.
The delayed annuity factor.
The process involves finding the annuity factor from the discount table as if this were not delayed (n= 3)
Then we look at the number of delayed years ( in this case it is 7 years hence n = 7).
We find the DF in the first column (the simple discount factor)
And we times both of these together to get the delayed annuity factor
If we are told cash flow wasnt received for 10 years, what do we use as n for our delayed discount factor calculation?
n = 9, because we always take 1 away from the total
What would we do if the discount factor changes over time?
E.g £200 received in year 3, where discount factor was 10% in year 1 and 12% in year 2 and 3
CF * 1 / (1+r add 1+r )
You add all of the different discount factors
e.g 200 * 1/1.1 + 1.2^2
