Investment Decisions Flashcards
Replacement Analysis - equivalent annual cost (EAC)
EAC = NPV of one cycle of replacement / AF for this cycle length
Payback period
The time taken for cash inflows from a project to equal the cash outflows
Accounting rate of return
average annual profit from investment/initial investment * 100
OR
average annual profit from investment/average investment
average investment = initial outlay + scrap value/2
follow-on options
call option - after launching a project, it gives an opportunity to launch a second version of it. It gives the right to invest later versions.
abandonment options
put option - the project can be abandoned if things go wrong by selling the assets.
timing options
call option - projects can be delayed to see what will happen to market. the longer the option can be delayed, the more valuable the option
growth options
projects can start with a small capacity and expand later if market conditions are good.
flexibility options
investments can be adapted to fit as many different options as possible
systematic risk
Also known as market risk - cannot be eliminated by diversification.
E.g. changes in macroeconomic variables
unsystematic risk
the investment risk that can be eliminated by diversification
shareholder value analysis
- Sales Growth Rate
- Life of projected cash flows
- Operating profit margin
- Working capital investment
- Cost of capital
- Non Current Asset Investment
- Corporation Tax Rate
real options
the other reasons outside of NPV which may influence a project being accepted
risks of international investment
- political risk (tariffs, differing legal standards, restrictions, government stability)
- cultural risk (differing consumer markets, distribution networks)
- finance risk (differing taxation systems, restrictions on dividend remittances, forex risk)
how to calculate the sensitivity of selling price?
NPV / PV of revenue after tax
how to calculate the sensitivity of sales volume?
NPV/PV of contribution after tax
strengths of sensitivity analysis
- facilitates subjective judgement to decide the likelihood of the various possible outcomes considered
- easily identifies which areas are critical to the success of the project
weaknesses of sensitivity analysis
- assumes that variable changes are made independently
- does not identify the probability a change will occur
- it is not an optimising technique
examples of predictive analytics
- linear regression models
- decision trees
- simulations
advantages of linear regression
- are simple to use and easy to explain
disadvantages of linear regression
- there is not always a linear relationship
- can only consider the impact of one variables at a time
- does not consider the difference between correlation and causation
- the data collected must be accurate
advantages of decision trees
- easy to explain and logical
- can be used to consider the different outcomes that can occur based on changes in a number of variables
- can be used to consider multiple decisions
limitations of decision trees
- variables usually have to be restricted to a small number of possible outcomes
- large trees can become difficult to interpret
advantages of simulation
- gives more information about the possible outcomes and their relative probabilities
- it is useful for problems which cannot be solved analytically
disadvantages of simulations
- it is not a technique for making a decision
- can be time consuming without a computer
- can be expensive to design and run a simulation for complex projects
- Monte Carlo techniques require assumptions to be made about probability distributions and the relationships between variables
