Lecture 2 - Basic Investment Appraisal Techniques

Question 1

What is capital budget?

Answer 1

List of planned investment projects.

Question 2

What is the capital budgeting decision (capital expenditure or CAPEX decision)?

Answer 2

Decision to invest in tangible or intangible assets.

Question 3

What is the purpose of investment appraisal?

Answer 3

To select appropriate capital expenditure projects (long term investment projects).

Question 4

What are the features of investment appraisal?

Answer 4

• Assess the level of expected returns earned for the level of expenditure made.
• Estimate future costs and benefits over the project’s life.

Question 5

What are independent projects?

Answer 5

Managers can choose any or all projects as long as those projects are financially viable. Usually independent projects are unrelated to each other. The decision rule for independent projects is that they must exceed a minimum acceptance criterion.

Question 6

What are mutually exclusive projects?

Answer 6

Only one of several potential projects can be chosen. Projects’ cash flows compete with each other. Usually mutually exclusive projects serve the same purpose. The decision rule for mutually exclusive projects is to rank all alternatives and select the best one. The acceptance of one project will eliminate other projects from consideration. They may use the same facilities, such as land etc.

Question 7

What are contingent projects?

Answer 7

A project can be accepted only if one or more other projects is accepted first. One project is dependent on others. The decision rule is that they must be considered as singular investments/projects.

Question 8

What is disposal value or residual value?

Answer 8

The value of an asset when it is sold at the end of a project.

Question 9

What is disposal value/residual value estimated as?

Answer 9

The book value at the end of depreciation.

Question 10

How do you calculate disposal value/residual value?

Answer 10

Initial investment minus total depreciation.

Question 11

What is the decision rule for accounting rate of return (ARR)?

Answer 11

• For independent projects, only select projects when the expected ARR is greater than the target or hurdle rate (as decided by management).
• For mutually exclusive projects, choose between options on the basis of the highest rate of return.

Question 12

What are the advantages of accounting rate of return (ARR)?

Answer 12

• Simple to calculate and easy to understand.

- Links with other accounting measures.

Question 13

What are the disadvantages of accounting rate of return (ARR)?

Answer 13

• Ignores/does not consider the time value of money. It takes no account of project life or timing of cash flows. We don’t discount future cash flows.
• It is based on accounting profits rather than cash flows.
• Varies depending on accounting policies.
• It is a relative measure rather than an absolute measure; it tells us as a per cent (%), a proportion, rather than the amount of return.
• No definitive investment signal; the hurdle rate is arbitrary. There is no formula, the decision is made by the manager.

Question 14

In capital investment appraisal, why is it more appropriate to evaluate future cash flows than accounting profits?

Answer 14

• Profits cannot be spent. Profits are only a guide to cash availability.
• Profits are subjective to different accountants and accounting methods. For example, the time period in which income and expenses are recorded are a matter of judgement. Here the focus is on cash flows instead of transactions.
• Cash is required to pay dividends. Dividends transfer wealth to shareholders. Firms may have large profits but low cash, and cash is what is used to pay dividends in order to maximise shareholder wealth; the financial objective of a corporation.

Question 15

What are the major differences in cash and profits?

Answer 15

• Changes in working capital; sometimes profits can ignore this. There is no direct relationship between profits and changes in working capital. If there is a increase in working capital it is a cash outflow, and if there is a decrease in working capital it is a cash inflow.
• Asset purchase and depreciation. In accounting when you purchase an asset (for example, a building or equipment) it shows up on the left hand side of a balance sheet and each year there is a depreciation charge that is deducted. However, in corporate finance if a firm buys an asset (for example, a building or equipment) there is no depreciation charge and it is a cash outflow.
• Deferred taxation. This is a concept in accounting not corporate finance. Taxes are considered on cash payments. If a firm pay taxes this is a cash outflow.
• Capitalisation of research and development expenditure.

Question 16

Profits are not equal to…

Answer 16

Cash flow.

Question 17

What is the payback period (PP)?

Answer 17

Time until cash flows recover the initial investment in the project. The payback rule states that a project should be accepted if its payback period is less than a specified cutoff period.

Question 18

What does the payback period tell us?

Answer 18

It tells us the liquidity of the project and how quickly the project is profitable. It is a measure of liquidity.

Question 19

What is the decision rule for the payback period method?

Answer 19

For independent projects, a project should be accepted if its payback period is less than a target/specified cut off period. If the projects payback period is less than the specified cut off period it means that the project can quickly recover its initial investment.
For mutually exclusive projects, we need to rank projects based on their payback period and choose between options based on the fastest/shortest payback.

Question 20

What are the advantages of the payback period rule?

Answer 20

• It is simple to calculate and easy to understand.
• It uses cash flows rather than accounting profits. It is objective not subjective. The payback rule is not subject to different accounting methods.
• It links with company growth, risk and liquidity. Rapid project payback leads to rapid growth. Shorter the payback period, the less likely the project will go wrong and more likely risk is reduced. Rapid payback can reduce risk level. Short term forecasts are more likely to be true than long term forecasts. Payback period is a measure of liquidity, it tells us the cash availability of a firm. If a firm has more projects with a quicker payback period then it is considered more liquid and has more cash.
• It is useful in certain situations, such as when technology is changing rapidly. For example, a new plant is likely to be used only for a short term period and later it might be replaced by a better and newer plant. Here we can use payback period to see how likely and fast the initial investment is going to be recovered. Furthermore, if investment conditions are expected to improve in the near future, we can select projects with faster payback as this means that financial resources can be released and the firm can take advantage of better investment conditions.

Question 21

What are the disadvantages of the payback period rule?

Answer 21

• The time value of money is ignored - we do not discount cash flows.
• There is no objective cut off point - the cut off period is arbitrary and decided by the management team. There is no definitive investment signal or formula. It is based on skills and experience.
• It concentrates on liquidity and cash flows, but investors and shareholders may find it difficult to calculate or understand this. The payback rule ignores project profitability.
• It does not consider cash flows after the payback period. It ignores cash flows that occur at the end of the project. The payback rule might bias the firm against accepting long term but profitable projects. There may be excessive investment in short term projects.

Question 22

In practice, payback is most commonly used when the…

Answer 22

Capital investment is small or when the merits (or demerits) of the projects are so obvious that more formula analysis is necessary.