Investment Appraisal RECAP

Question 1

Formula for ARR? (or return on capital employed)

Answer 1

AVERAGE Annual Profit before Income and Tax / Investment

It just gives a % return on your investment.

Question 2

Explain the process to be taken when calculating ARR

Answer 2

Right out the number years for the investment, i.e if it takes 4 years

Question 3

If we are told that depreciation has not been included in operating cash flows, how do we make sure to factor this in?

Answer 3

Total depreciation = cost we bought the asset - scrap value

Question 4

Why do we need to figure out depreciation for ARR?

Answer 4

Because deducting depreciation from total operating cash flows will give us our total profit figure.

Question 5

Within ARR, once we have our total profit figure, do we stop there?

Answer 5

NO, because the calculation is AVERAGE profit / investment, hence we must divide this total by the number of years we have received cash flow

Question 6

Payback period is what ?

Answer 6

This is the time taken to pay back the initial investment

Question 7

How do we know when to accept a ARR?

Answer 7

We will always be told a target, so we accept if above this

Question 8

When we put our cash flows into the proforma, what do we label them as?

Answer 8

Operating flows

Question 9

After totalling up all operating cash flows, what is the additional row required for pay back period?

Answer 9

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

Question 10

How do we calculate how the exact amount of years taken for us to have fully paid back our investment?

Answer 10

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

Question 11

If we want to know what our value is in months, e.g 0.7, how do we do this?

Answer 11

times 0.7 by 12

Question 12

How do we know when to accept for payback?

Answer 12

If our pay back is less than or equal to the required pay back period

Question 13

What is the NPV calculation?

Answer 13

PV inflows - PV outflows

Question 14

IRR is when?

Answer 14

The discount rate that results in the NPV = 0, we have broke even

Question 15

What is the discount often referred to as?

Answer 15

Discount factor = required rate of return = cost of capital

Question 16

Overall, why is NPV superior to all other calulations

Answer 16

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

Question 17

Overall, a positive NPV leads to?

Answer 17

A maximisation of shareholder wealth

Question 18

Whilst we have our discount factor table, when would we not be able to use this?

Answer 18

When the rate of return is not included in the table, e.g 12%

Question 19

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

Answer 19

cash flow * (1/(1+r)^n)

where r = discount rate
n = year the cash flow relates too

Question 20

What does annuity mean?

Answer 20

same yearly cash flow for a fixed period of time

Question 21

What does perpetuity mean?

Answer 21

same yearly cash flow for infinite amount of time

Question 22

Annuity discount factors from the table are found?

Answer 22

2nd column

Question 23

How do we find PV of a perpetuity CF?

Answer 23

CF * 1/r

Question 24

What is the formula for the PV of growing perpetuity?

Answer 24

CF at t1 * (1/r-g)

Question 25

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.

Answer 25

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

Question 26

If we are told cash flow wasnt received for 10 years, what do we use as n for our delayed discount factor calculation?

Answer 26

n = 9, because we always take 1 away from the total

Question 27

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

Answer 27

CF * 1 / (1+r add 1+r )

You add all of the different discount factors

e.g 200 * 1/1.1 + 1.2^2