Lecture 3-Project appraisal Flashcards
What is project appraisal?
- Also called investment appraisal or capital budgeting
- Are projects that involve making capital outlays in the hope of adding extra ‘value’ in the future
- Examples include the launch of new products or enter new markets e/g/ purchase new assets, upgrade company IT, hiring new staff, R n D projects
What are the two stages of cash flows?
-1.) Estimation of future cash flows from the project
How much does it initially cost?
How long will it last?
What do you get back?
-Analyse the cash flows
Given the cash flows, is project worth doing?
What are relevant cash flows?
-All incremental cash flows, i.e. any cash flow that is added, removed, or altered as a result of doing the project is relevant.
Examples of relevant cash flows
Direct cash flows associated with the project (initial cost, new sales revenues, wages for new staff, etc.)
Increased overheads due to the project
Changes in revenues on other projects
Opportunity costs of taking the project e.g. factory space could be rented out
- Inflation: Nominal cash flows and nominal discount rate or real cash flows and real discount rate
- Taxation
What are non relevant cash flows?
- Any cash flow that will not change because of the project is not relevant
- Overheads that have already been allocated.
Costs already incurred that cannot be recovered, these are known as Sunk Costs
Costs that will be incurred irrespective of whether the project goes ahead
Depreciation – this is not a cash flow!
Interest on borrowing, this is already allowed for by discounting the cash flows
What are conventional projects?
-A simple project starts with an immediate net cash outflow, followed by a series of net cash inflows
What are unconventional projects?
-Some projects may have several net outflows during the project, or have a single outflow in the middle
Four main techniques to calculate project appraisal
- Accounting rate of return (ARR)
- Payback period
- NPV=discounted cash flow techniques
- Internal rate of return (IRR)
What is ARR in relation to project appraisal?
-Uses accounting data to decide
What does the payback period suggest?
-How quickly costs are recouped
What does the NPV calculate in relation to project appraisal?
-Calculates added value
What does IRR calculate in relation to project appraisal?
-Estimates the return on the project
What are the advantages of using ARR as an investment appraisal method?
- ARR provides a percentage return which can be compared with a target return
- Focuses on profitability – a key issue for shareholders
- This method recognizes the concept of net earnings i.e. earnings after tax and depreciation. This is a vital factor in the appraisal of a investment proposal.
What are the disadvantages of ARR?
- Does not consider time value of money
- Profit is subjective and does not equal cash
- Treats profits arising late in the project in the same way as those which might arise early
- Does not take into account cash flows – only profits (they may not be the same thing)
What is the time value of money?
The time value of money (TVM) is the concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity.
-This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received
What is the payback period?
- Number of years until the initial cost of the project is recovered
- Requires conventional cash flows
- Accept projects if the project is <=
- Reject projects that take too long to pay back
What to remember when working out the payback period?
include the cumulative inflows
What are the advantages of payback?
- Easy to calculate and to communicate to others
- Focusses attention on liquidity and analyse projects that obtain immediate cash flows, as investors want to obtain their initial outlay as soon as possible by focussing on the value of money now rather than in the future
- Projects that payback quickly tend to be less risky
What are the disadvantages of payback period?
- Time value of money is ignored
- Cash flows after the cut-off period are ignored
- The cut-off period is arbitrary, base on personal choice without reason
What is the NPV?
- Is the present value of all future cash flows
- Represents the value added by the project
- Only accept projects where it is is positive i.e. NPV>0
What are the disadvantages of NPV?
Hidden costs as it considers cash inflows and outflows of the project i.e sunk costs. Therefore project might not be highly accurate
-Assume cash flows are ‘fixed’
What are the advantages of NPV?
NPV takes into account each and every cash flow you define. It’s not like payback period method or discounted payback period method which ignores cash flows beyond the payback period.
-Includes the time value of money
What is an advantage of NPV over the payback period
An advantage of NPV over payback is it includes the time value of money
We can adjust payback to include this and calculated the Discounted Payback Period
What are the advantages of IRR?
- Time value of money, timing of future cash flows is considered, therefore each cash flow is given an equal weight
- he IRR is an easy measure to calculate and provides a simple means by which to compare the worth of various projects under consideration. The IRR provides any small business owner with a quick snapshot of what capital projects would provide the greatest potential cash flow. Just a percentage
What are the disadvantages of IRR?
Ignore reinvestment rates:Although the IRR allows you to calculate the value of future cash flows, it makes an implicit assumption that those cash flows can be reinvested at the same rate as the IRR. Few opportunities as the yield is too large
-Not be used to rate mutually exclusive porjects.In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders ‘ wealth) and should thus be accepted over the second project
Key facts about the NPV
£1 today is worth more than £1 tomorrow
- When all projects can be accepted it maximises shareholder utility. Positive NPV projects should be accepted since they increase shareholder wealth
- It takes into account investment size-absolute amounts of wealth change
- Can handle non-conventional cash flows
- Additivity can be possible as PVs are all measured in today’s £
- Cash inflows arising during the life a project are reinvested at the opportunity cost of capital
Key lecture points for IRR
- Takes into account the time value of money
- In non-mutual exclusivity, shareholder wealth is maximised if all projects with a yield hihger than the opportunity cost of capital are accepted, those with a return less than the time value of money are rejected
- Measures percentage returns and this may cause ranking problems in conditions of mutual exclusivity
- Easier to communicate a percentage return than NPV
- Non-conventional cash flows cause problems
- Additivity not possible
- Financing decisions may result in misinterpretation of IRR results
What does the IRR implicitly assume?
Cash flows received can be invested elsewhere at a rate equal to the IRR until the end of the projects life
What are mutually exclusive projects?
-Where we have a choice of many projects, but can only do one of them they are known as can only do one of them
Decision rule for mutually exclusive projects
- Calculate the NPV for each project
- Discard all projects with a negative NPV
- Choose one with the highest NPV
What is capital rationing?
- Is where limits are set on the amount of funds available for investment
- Soft rationing: limits imposed by management
- Hard rationing-Limits imposed by the markets
How to rank when under capital rationing?
Using the profitability index to rank the project when funds are limited
What happens if the projects are indivisible?
- Find NPV of each project
- Discard all negative NPVs
- List all possible combinations of projects that can be achieved given the prevailing projects
- Choose the combination that yields the highest combined NPV
- If there is no capital rationing, we can still just use NPV
Different variables that affect the net cash flows
Sales price
Sales price
Sales volumes
Wages
Oil prices
What is sensitivity analysis?
-way of seeing how important errors in the initial forecasts are
What are the limits of sensitivity analysis?
-Doesn’t tell us how likely changes in that variable are
Usually if one variable changes so will others
How to overcome the problems with sensitivity analysis?
Scenario Analysis
Estimate NPV based on a Best-case scenario
High sales, high price, long-life, low costs, etc.
Estimate NPV based on a
Worst-case scenario
Low sales, low price, short life, high costs, etc.
