KCB WEEK 7 - Investment Appraisal Methods

Question 1

3 main decisions re financing (long term capital)

Answer 1

1. Financing decision Sources of finance (how to raise capital): how much will be from each of equity/debt capital (fixed interest rate on debentures) risk capital of the company
2. Project/investment decisions: how to select projects
3. Dividend decision: all stakeholders paid and then the shareholders (how much to pay out)
    First : suppliers of raw material/landlord/employees/suppliers of other services
    Then: debenture holder(s)/government (tax) – all other stakeholders external
    Profit after tax: belong to shareholders – how much to distribute vs. retain

Question 2

Traditional methods of project appraisal

Answer 2

• ARR
• Payback period

Question 3

Modern methods of project appraisal (take time value of money into account - more sophisticated)

Answer 3

• Internal Rate of Return
• Net profit value
• Discounted payback method
• Profitability index method

Question 4

ARR METHOD

Answer 4

ARR = Average Annual Profit / Average Investment
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Annual depreciation = (cost - scrap ) / x ( x is years of useful life)
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Av. annual profit = annual cash flow - depreciation
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Av. investment = (Initial inv. + Scrap) / 2
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ARR = (Av. Annual Profit / Av. Investment) x 100%

Question 5

Advantages and disadvantages of ARR method

Answer 5

Advantages
* Widely accepted
* Simple to calculate
* Uses profit which are readily recognisable by managers - manager performance can be evaluated using ROCE. As profit figures are audited, they can be relied on to some degree
* Focuses on profitability for entire project period
* Easy to compare with other projects as it is linked with other accounting methods
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Disadvantages
* Ignores factors such as project life/working capital/other economic factors which may affect profitability of project
* Based on accounting profits which vary depending on acc. Policies (ex. depreciation policy) – can be manipulated
* It does not take into account the time value of money.
* The return calculated via ARR can be calculated using different formulas. For example, the return can be calculated using profit after interest and tax, or profit before tax – thus leading to different outcomes. It is important to ensure that returns calculated via ARR are calculated on a consistent basis when comparing investments.
* Not useful for evaluating projects where investment is made in stages at different times. Does not take into account profits reinvested during the project period.

Question 6

Payback period method

Question 7

Advantages and disadvantages of payback period method

Answer 7

Advantages
* Uses (relevant) cash flows not profits (cannot be manipulated)
* Simple to calculate
* Adaptable to changing needs
* Encourages quick return/faster growth
* Useful certain situs ex. rapidly changing tech
* Maximises liquidity (cash availability)

Disadvantages
* Ignores time value of money (cash-flows after payback period)
* Very subjective – no definitive investment answer to help
* Payback period ignores timing of cash flow
* Only calculates payback period – ignores profitability

Question 8

NPV method

Answer 8

(value of future money today using discounting (cost of cap)) TEXTBOOK EXAMPLE 13.6

Net value of a capital investment calculated by adding discount PVs of all cash inflows and outflows of that project at an appropriate discounting rate(cost of capital)

Present value (DISCOUNTING ) = PV Number / (1 + %)%)^n (yrs)

Future value (COMPOUNDING) = Number present * (1 + %)^n (yrs)
% = the cost of capital or rate given
YR 1 = 1 + 1.1
Yr 2 = 2 + 1.1
Yr 3 = 3 + 1.1
Net present value = Investment = £ 100m
Net present value = £ 10m

      (£121m @ future discount =  £110)
	 Is today’s (net) value positive (accept) = what earn on today vs future

NPV = PV of cash inflows – PV of cash outflows

Question 9

Advantages and disadvantages of NPV method

Answer 9

Advantages:
* Theoretically superior
* Considers TVM through discount rate
* It’s an absolute measure of return
* Based on cash flows, not profits (which diff based on accounting policies)
* Takes account of all cash flows throughout the life of a project
* Maximise SH wealth - only accept positive NPV ensures surplus over cost of finance

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Disadvantages
* Can be difficult to explain to mgrs as uses cash flow rather than accounting profits
* Calculation of discount rates can be hard – requires knowledge of cost of capital
* Relatively complex compared to non-discounting methods (ex PBP and ARR)

Question 10

IRR METHOD

Answer 10

based on cash-flow –

Yr 0    = £100m
Yr1     = £121m	 (121/100 = 1.21 = 1 / 0.21)
Return = 21p for every £1 investment / for every £100 investment = £21 
		21% per annum

Where cost of capital is 10% - return is higher than cost of capital, leaves ^11% to keep – where higher than cost of capital, KEEP

Question 11

What is an annuity/discounting

Answer 11

Annuity: series of fixed amount paid at annual intervals for a fixed period of time

       	PV of annuity=   fixed annual cash-flow x PV of annuity

Question 12

What is a perpetuity/calculating

Answer 12

Perpetuity: an infinite series of fixed amounts paid at annual intervals

	PV of perpetuity = fixed annual cash flow x PV of perpetuity
			    = fixed cash flow / discounting rate