Investment appraisal techniques Flashcards
What are the processes for appraising potential investment?
Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review
When should payback period be used?
Used as a screening tool
For projects with cash inflows and outflows
Uses cashflow - add back depn to profits
Assumes all cashflows generated evenly throughout yr
What are the advantages and disadvantages of the payback period?
Useful for screening, liquidity, shorter payback period = lower risk, shorter-term forecasts more reliable, quick and simple, understood
Ignores timings of cashflows, ignores after payback period cashflows, ignores time value of money, cannot distinguish between projects with same payback period, excessive investment in short-term projects, ignores potential variability, no definite decision
How do we calculate Accounting Rate of Return?
Average annual accounting profit/initial investment x 100
Average annual accounting profit/average investment
Average investment = 1/2 x (investment + final/scrap value)
What are the advantages and disadvantages of ARR?
Quick and simple, familiar concept, accounting profits easily calculated from financial statements, entire project life, more than one project to be compared
Doesn’t take into account timing of profits, based on accounting profits, relative measure, no account of length, ignores time value of money, no decision
How do we calculate compound interest?
Initial investment x (1 + interest rate)^periods
How do we calculate discounting?
Amount to invest = investment value at end of n periods x (1+ interest rate)^-periods
How do we calculate NPV?
Sum up the cashflow for the time period x discount factor for that period
What decisions are made from the NPV?
Positive - accept
Negative - reject
Zero - return = investment
Which part of the table is used for annuities?
Right hand column
What is the calculation for annuities that don’t start at T1?
PV = annuity value x annuity factor(start time - end time +1) x discount factor( end time +1)
How is perpetuity calculated?
PV = present value of perpetuity/time period
What is Net Terminal Value?
The cash surplus remaining at the end of a project after taking account of interest and capital repayments
NPV x (1+r)^n
What is the time value of money?
Why a present £1 is worth more than a future £1
Uncertainty, inflation, time preference, opportunity cost of capital
What are the advantages and disadvantages of NPV?
Consistent with maximising shareholder wealth, considers time value of money, all relevant cash flows, risk incorporated into decision making, clear unambiguous decisions
Assumes cashflows at annual intervals, estimate appropriate cost of capital, ignores capital rationing
How is NPV calculated for changing discount rates?
Multiply amount by 1/(original rate x new rate)
What is the Internal Rate of Return?
The percentage return when NPV = 0
How do we calculate the IRR using the interpolation method?
IRR = L + NPV lower/(NPV lower - NPV higher) x (higher - lower)
What are the advantages and disadvantages of IRR?
Easily understood, cost of capital does not have to be specified
Can get relevance and significance of ARR and IRR mixed up, ignores the relative size of investments, cannot be used with non-standard cashflows or choose between mutually exclusive projects
How many IRRs are there for non-standard cash flows?
The same amount as the changes in direction
What are the benefits from environmental costing?
Lower risk from banks
Less fines
Finance decisions made based on ESG
Regulatory compliance
Appropriate pricing
Cost savings
What are the environmental cost classifications?
Prevention costs - staff training, costs of prevention
Appraisal costs - site inspections, monitoring activities
Internal failure costs - waste disposal, product take back costs
External failure costs - fines, costs of cleaning oil spills
