Investment appraisal techniques 2.0

Question 1

How is DPP calculated and what is the the general proforma to use ?

Answer 1

Based on cumulative discounted cash flows.
Proforma:
Year CF DF Cumulative. D.CF

Question 2

What is the effect of increasing cost of capital on IRR and DPP ?

Answer 2

IRR: No change
DPP: Increases !

Question 3

Why does an increase in cost of capital increase DPP ?

Answer 3

Reduces future cash inflows, increases time taken for cumulative discounted cash flows to become positive.

Question 4

What are the decision rules for IRR ?

Answer 4

IRR > Cost of capital, ACCEPT
IRR < Cost of capital, REJECT

Question 5

What is the method for finding an appropriate cost of capital for projects with different IRRs ?

Answer 5

Step 1 - Draw graphs, paying attention to positive / negative cumulative cash flows.
Step 2 - Test where each cost of capital would give a positive NPV.

Question 6

How do you calculate ARR when given cash flows of a depreciating asset ?

Answer 6

Must subtract the depreciation from the cash flows to get profit.

Question 7

How do you calculate the PV of a perpetuity (discounting perpetuities) ?

Answer 7

PV = Cash flow / r

(even if r changes)

Question 8

What is an example of an Appraisal cost ?

Answer 8

Testing and Inspecting.

Question 9

How do you calculate an Advanced annuity when there is an initial cash outlay, constant annual cash flows and a final cash outlay ?

Look for keyword: Immediately

Answer 9

(1) NPV of initial cash outlay:
Y0 : Net cash flow = Initial outlay + annual inflow.
(2) NPV of constant cash inflows:
Use table for N - 1 year (4th column)
NPV = annual cash flow x AF.
(3) NPV of final cash outlay:
Use table for N years (3rd column)
NPV = final outlay x DF
(4) Add together !

Question 10

If there are two ‘normal’ (not mutually exclusive) projects, what comments can be made about IRR and NPV ?

Answer 10

There will be no conflict between the two techniques.
IRR and NPV may not rank the projects in the same order.

Question 11

What is the effect of an increase in cash flows on IRR and PP ?

Answer 11

No change will occur to PP.
IRR will increase due to higher cash flows require greater costs of capital to make NPV = 0.

Question 12

How do you calculate the NPV of delayed cash flows ?

Answer 12

Calculate NPV as normal but ignore payment at T0.
Use n = 1 as first DF.

Question 13

What are some examples of external failure costs ?

Answer 13

Cleaning contaminated soil.
Government penalties.

Question 14

How do you calculate PP when given profits instead of cash flows from a depreciating asset ?

Answer 14

Add the depreciation back to profits to get cash flows, continue as normal.

Question 15

How do you calculate NPV when there is a change in cost of capital ?

Answer 15

In the year that cost of capital changes,
DF = 1 / [( 1 + r1 ) x ( 1 + r2 )]

Question 16

What comment can be made if a project has a unique IRR and the IRR is more than the cost of capital ?

Answer 16

IRR will give too much weight to later cash flows.

Question 17

How is Terminal value calculated using NPV ?

Answer 17

NPV = NTV x DF , where n is the life of the project.

Question 18

How is the IRR of a perpetuity calculated ?

Answer 18

IRR = Annual inflow / Initial investment x 100

Question 19

If projects all have the same initial outflow, constant annual inflows and the same lives, How will they be ranked based on NPV, PP and IRR ?

Answer 19

NPV and PP will give same ranking.
IRR and PP will give same ranking.
NPV and IRR will NOT give same ranking.