Long term decision making Flashcards
What is the capital budgeting/ investment appraisal?
An evaluation of proposed long-range projects which addresses two problems: which projects should be undertaken and how much should be spent on projects.
Why use appraisal?
1) Decisions involve large amounts of cash
2) Resources are limited
3) Opportunity cost
4) Not easy to reverse decision
ARR formula
Average Annual Profit/ Average Capital Employed
Average Capital Employed formula
(Initial investment + residual value) / 2
How to interpret ARR
If it is above the RRR then accept the project.
Factors to be considered in the choice of appraisal technique
1) Future focus
2) Profit or Cash flow focus
3) Incorporate time value of money
4) Unambiguous decision rule
5) Consistency with wealth creation objective
Why is ARR used?
1) Easy to understand
2) Approximates ROCE which is a widely used KPI.
Why is payback used?
1) Good signal of liquidity
2) It can be argued that projects that recover cash outflows more quickly are less risky
How is IRR found?
1) Interpolation after finding two rates
2) Plot a graph
3) Trial and error
IRR formula
lower discount rate + (NPV of low)/ (NPV of low - NPV of high) x (higher - lower)
Negatives of IRR
1) With unconventional cashflows, IRR will either give no sensible figure or multiple IRR’s.
2) If discount rates change over the project then IRR will give incorrect decisions.
3) Overstates returns as it assumes reinvestment at the IRR.
4) Relative measure
What are things that can impact investment appraisal?
1) Impact of Inflation
2) Impact of Tax
3) Capital Rationing
4) Qualitative Factors
Nominal rate of interest: Fisher Equation
(1 + nominal rate of interest) = (1+ real rate of interest) x (1 + inflation rate)
How to adjust for inflation?
1) Use the fisher equation and find an adjusted discount rate.
2) Use real cash flows and discount them using real rate of interest.
How to deal with taxation in the NPV model?
Taxable profit = accounting profit + depreciation - capital allowances
How to deal with capital rationing?
1) Allocate the capital to maximise the NPV
2) Rank investment opportunities to maximise NPV
3) Profitability index
Formula for profitability index
PI= PV of cash flows/ investment
PI > 1 means positive NPV
Qualitative Factors for Appraisal
1) Strategic importance- consistency with corporate strategy
2) Value of real options- flexible projects are less risky and have greater value as projects can be deferred, expanded or suspended.
3) Project risks (PESTEL)
4) Sustainability- economic, social and environmental
5) Post-completion audit
How to address project risks in NPV model?
1) Sensitivity analysis
2) Use of project-specific discount rate
How to find after-tax cost of capital?
Pre-tax capital cost x (1-tax rate)
How to find profit from cash flow?
Deduct depreciation
What is post completion audit?
The evaluation of actual results from investment appraisal with the original estimates
