Lecture 2 - Investment appraisal applications

Question 1

If both investments return £500,000 why are they not equally as good as one another?

Answer 1

1) Timing - £500,000 today is not the same as £500,000 in 10 years.

2) Risk - not all investments are equally safe.

Question 2

Why do we need a discount rate?

Answer 2

• Bring future cashflows back to today’s value.
• Reflect on the return investors require for the risk they take.
• For decision making

Question 3

Establishing a discount rate:

Answer 3

Premium for risk + Risk free rate of return

Question 4

2 different methods to set a discount rate are…

Answer 4

Weighted average cost of capital (WACC)

Capital Asset Pricing Model (CAPM)

Question 5

Weighted average cost of capital (WACC):

Answer 5

• The average return expected by both lenders (debt) and shareholders (equity).

Question 6

Capital Asset Pricing Model (CAPM):

Answer 6

• Estimates the return needed based on investment risk compared to the market.

Question 7

Relevant cashflows: Discounted Cashflows

Answer 7

DCF focuses on cashflows which impact decision making:

Include:
- Future and incremental cashflows, caused by the decision.
- Opportunity costs.

Exclude:
- Sunk costs (past expenses which have already been paid).
- Committed costs (fixed overheads and ongoing expenses)
- Depreciation

Question 8

What is Capital rationing?

Answer 8

• Companies do not have unlimited capital, so they must choose between competing projects.
• Even if a project has a positive NPV, then it may not be taken due to capital constraints

Question 9

2 types of capital rationing are:

Answer 9

Hard - Capital markets will only supply a given level of capital.

Soft - Company has chosen to restrict its capital investment.

Question 10

Capital rationing: How do companies allocate Limited Capital?

Answer 10

• Company’s objective is to allocate available capital so as to maximise shareholder returns.
• They rank projects based on their NPV per unit of capital invested.

(NPV/capital required) - when ranking

Question 11

Beyond NPV: The strategic context of investment appraisal.

Answer 11

• Investment decisions go beyond financial calculations.
• Also consider strategic factors which ensure long-term success such as:
• Real options
• Value chain analysis
• Cost driver analysis
• Competitive Advantage

Question 12

Strategic factors: Real options…

Answer 12

• Traditional techniques take a very narrow financial focus.
• Therefore, may take a wider strategic focus such as building flexibility into investments.

Question 13

Strategic factors: Value chain analysis

Answer 13

• “value chain” is that set of activities which link from basic raw materials through to the ultimate end product.
• Companies will analyse which part of the value chain needs investment to gain that competitive edge.
• Investments should strengthen key areas that improve efficiency, lower costs or differentiate the business.

Question 14

Strategic factors: Cost driver analysis

Answer 14

• These are the factors that influence total costs in business operations.
• Investment decisions should focus on reducing high cost areas to improve efficiency.
• Analysing cost drivers helps a company to decide where to invest for long term savings.

Question 15

Strategic factors: Competitive advantage analysis.

Answer 15

• Unique factors which make a company stand out
• companies use investment to differentiate themselves and build long term competitive advantages.