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Management Information > Investment appraisal techniques > Flashcards

Investment appraisal techniques Flashcards

1
Q

What are the distinct stages of Investment decision making ?

A

Origination of proposals
Project screening
Analysis and acceptance
Monitor and review

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2
Q

What is ‘The Payback Method’ ?

A

The payback period is the time required for the cash inflows to recover the initial cash outflow (‘the investment’).

How quickly you’ll get your money back!

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3
Q

What is the Decision Rule for Paybak period ?

A

When Payback period < Target period, Accept Project.

When Payback period > Target period, Reject Project.

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4
Q

Is Payback considered a ‘first screening’ ?

A

Yes, then more sophisticated investment appraisal techniques can be used.

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5
Q

Does Payback use cashflow or profits ?

A

Cash flow

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6
Q

How do you calculate ‘Constant annual cash flows’ ?

A

Payback period = Initial payment / Annual cash flow

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7
Q

How do you calculate ‘Uneven annual cash flows’ ?

A

By working out the cumulative cash flow over the life of the project.

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8
Q

What are the advantages of payback ? (4)

A

1.Simple to calculate
2.Easy to understand
3.Concentrates on ‘early cash flows’ - less risky, more reliable.
4.Useful for cash-strapped companies, enhance liquidity.

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9
Q

What are the disadvantages of payback ?

A
  1. Ignores cash inflows after the payback period.
  2. Doesn’t consider the time value of money (e.g., future cash is less valuable than cash today).

ETC

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10
Q

What is The Accounting Rate of Return (ARR) ?

A

ARR tells you how much average profit, an investment generates every year as a percentage of the money invested.
Based on accounting profits (not cash flows) and is used to evaluate whether an investment is worth undertaking.

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11
Q

What is the Decision Rule for ARR ?

A

ARR > Target rate, ACCEPT
ARR < Target rate, REJECT

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12
Q

How do you calculate ARR (initial) ?

A

Average annual profit / Initial investment x 100

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13
Q

How do you calculate ARR (average) ?

A

Average annual profit / Average investment x 100

Average investment = 1/2 [initial investment + final /scrap value]

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14
Q

What are the advantages of ARR?

SULA

A
  1. Simple to calculate and understand.
  2. Used by FA to appraise performance.
  3. Looks at entire project.
  4. Allows project comparison.
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15
Q

What are the disadvantages of ARR ?
SW
C
P
T
R

A

Doesn’t measure change in shareholder wealth.
Calculated in different ways - confusion.
Based on profits not cash.
Ignores time value of money.
Relative (%)

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16
Q

What is the general idea behind The Net Present Value method ?

A

Money received now is more valuable than money received in the future.

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17
Q

What does NPV measure ?

A

Change in shareholder wealth as a result of accepting a project.

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18
Q

What is the Decision rule of NPV ?

A

NPV > 0, ACCEPT
NPV < 0, REJECT

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19
Q

What does compounding calculate ?

A

The future or terminal value of a given sum invested today for a number of years.

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20
Q

How do you calculate the compounding sum (Terminal value) ?

A

TV = X (1 + r) ^ n

X = amount invested today
r = interest rate
n = No. of years

21
Q

How do you calculate Present Value ?

A

PV = X x 1 / (1 + r) ^ n

X = amount invested in n years’ time
r = interest rate
n = No. of years

22
Q

What are the assumptions used in discounting ?
(4)

A
  1. Cash flows occur at end of each year.
  2. Initial investments occur now (T0), calculate PV @ T0.
  3. Later cash flows occur at annual intervals, started @ T1
  4. 31.12.X0 = 1.1.X1
23
Q

What are the main features of The Internal Rate of Return (IRR) ?

A
  1. Is the discount rate which gives an NPV = 0.
    (future cash flows = initial cash flow)
  2. Can be found by linear interpolation.
24
Q

What are the decision rules of IRR ?

A

Discount rate < IRR, ACCEPT
Discount rate > IRR, REJECT

25
Q

How do you calculate IRR using linear interpolation ?

A
  1. Calculate 2 NPV’s for the project at two different costs of capital.
  2. IRR = L + Nl / (Nl - Nh) x (H - L)
    L = lower interest rate
    H = higher interest rate
    Nl = NPV at lower rate
    Nh = NPV at higher rate
26
Q

What does NPV represent ?

A

The surplus funds (after funding investment) earned on the project.

27
Q

If the company has 2 or more mutually exclusive projects under consideration it should choose the one with the higher NPV.

TRUE or FALSE

A

TRUE

28
Q

What is an Annuity ?

A

An annuity is a constant cash flow for a number of years.

So, discounting annuities is just using the NPV method using the annuity as cash flow.

29
Q

What is the Annuity Factor (AF) ?

A

Sum of the individual discount factors.

30
Q

How do you calculate PV of an annuity?

A

PV = annuity x AF

AF = 1/r (1 - 1/(1 + r) ^ n )

31
Q

What is a perpetuity ?

A

A perpetuity is an annual cash flow that ‘occurs forever’.

32
Q

How do you calculate the PV of a perpetuity ?

Discounting perpetuity

A

PV = Cash flow / r

33
Q

What is the main feature of an Advanced annuities and perpetuities ?

A

Cash flows start at T0 instead of T1.

34
Q

How do you calculate Advanced annuities and perpetuities ?

A

Calculate PV by ignoring payment at T0 when considering the number of cash flows, then,
add 1 to AF or PF.

35
Q

What is the main feature of an Delayed annuities and perpetuities ?

A

Cash flows starting later than T1.

36
Q

How do you deal with Delayed annuities and perpetuities ?

A

Apply appropriate factor to the cash flow as normal.
Discounting back to T0.

37
Q

What is the Net Terminal Value ?

A

Is the value of the project at the end of the project after taking into account interest and capital repayments.

38
Q

NPV with NTV

A

Project’s NPV = NTV x 1/(1+r)^n

39
Q

What is the Discounted payback (DPP) ?

A

Is the amount of time that project’s cumulative NPV takes to from negative to positive.

40
Q

IRR can lead to suboptimal decisions if there are non-conventional cash flows or mutually exclusive projects.

True or False

A

True

41
Q

What are the advantages of IRR ?

A

Time value of money.
Considers all relevant cash flows.
Easily understood as a percentage.
A firm selecting projects where IRR > cost of capital should increase SHW.

42
Q

What are the disadvantages of IRR ?

A

Relative not absolute.
No changing discount rates.
Zero or multiple IRRs.
Interpolation only provides estimate.

43
Q

How do you calculate the IRR of a perpetuity ?

A

Annual inflow / initial investment x 100

44
Q

What are the benefits of understanding environmental costs ?

A

Allows for better pricing calculations.
Avoid fines and save money.
Regulatory compliance.

45
Q

What is an example of prevention costs ?

A

Staff training to avoid waste pollution.

46
Q

What is an example of appraisal costs ?

A

Monitoring compliance with regulations.

47
Q

What is an example of internal failure costs ?

A

Recycling scrap materials.

48
Q
A

Management Information (13 decks)

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