M9: Capital Investment Appraisal Flashcards
What is payback?
Payback represents an assessment of the time taken by a project to recover the initial capital outlay.
How do you calculate payback to appraise an investment?
Cumulative cash flow/initial expense of next year = additional months on that year
e.g. 3 years and 8 months.
What are the advantages and dis-advantages of PBP?
Advantages of payback:
- Simple method to calculate.
- It is easy to see the length of time that the capital is at risk.
Disadvantages of payback:
* The time value of money is not taken into account.
* There is a built-in discrimination in favour of short-term investments.
* Cash flows after the payback period are ignored.
* It does not provide a measurement of absolute gain in wealth of the shareholders.
What is the accounting rate of return?
ARR provides insights into the profitability of potential investments.
How do you calculate the ARR to appraise an investment?
ARR = Avg. Annual profits/ Avg. Capital investment x 100
where:
π΄π΄π = π΄πππ’ππ πππ β ππππ€π πππππππ‘ππ ππππ π‘βπ πππ£ππ π‘ππππ‘ β πππππππππ‘πππ) / ππ’ππππ ππ π¦ππππ ππ πππ£ππ π‘ππππ‘
and
π΄πΆπΌ =1/2 x (πππ£ππ π‘ππππ‘ + πππ ππ’ππ π£πππ’π)
What are the advantages and dis-advantages of ARR?
Advantages of ARR:
* The calculation is relatively straightforward.
* It is one of the more easily understood techniques.
Disadvantages of ARR:
* The life of the project is ignored.
* ARR does not account for the time value of money.
* It does not provide a measurement of absolute gain in wealth of the shareholders.
What is NPV?
Net Present Value (NPV) involves the time value of money, discounting future cash flows of a capital project/investment to their present values.
- Positive NPV indicates an increase in shareholder
wealth, making the project viable, whereas - A negative NPV, the investment return/cash flow from the project is less than the original capital costs incurred for the project.
How do you calculate the NPV to appraise an investment without tax?
Forecast inflows and outflows over project life. Discount using the Firms WACC to Present value. Sum them and then minus investment outlay to get nPV
How do you calculate the NPV to appraise an investment including tax?
Multiply cash flows by (1-Tax rate)
Sum of discounted post-tax cash flows minus investment = NPV
What is the IRR?
the IRR is expressed as a percentage, representing the discount rate that equates the net present value of an investmentβs cash inflows and outflows to zero.
How might you choose which discount factors to use for the IRR calculation?
Step 1: First Discount Factor of 10%, to apply to cash flows, avoiding excessively high rates.
Step 2: Second Discount Factor: Based on the first NPV outcome, select a second rate. If the first NPV is positive, suggesting project
viability, a higher second rate is chosen to achieve an NPV closer to or below zero.
Calculate the IRR of an investment.
πΌπ π = π΄ + ((π΅ β π΄)π₯ π π΄ / π π΄β ππ΅)
where:
A = lower discount rate chosen
B = higher discount rate chosen
NA = NPV at the lower discount rate
NB = NPV at the higher discount rate
How do you choose between different projects using NPV techniques?
If projects are divisible:
- work through from best to worst until the funds run out.
If projects are non-divisible:
- Trial and error
What is the difference between specific risk and non-specific risk?
- Systematic Risk (Non-specific risk) : Also known as market risk, systematic risk refers to the risk inherent in the entire market or market segment, influenced by factors like economic and political changes. This type of risk is unavoidable and affects all companies.
- Specific Risk: Also known as unsystematic or unique risk, it includes risks specific to a company, such as demand for its products, asset nature, capital structure, and management quality.
What are specific risk and non-specific risk otherwise known as?
Specific risk - unsystematic/unique risk
Non-specific - market risk/systematic risk
