Module 3 Flashcards
IRR formula (internal rate of return)
IRR = A + ((B-A) x Na/Na-Nb))
A- lower discount rate
B- higher discount rate
Na - NPV at lower rate
Nb - NPV at higher rate
ARR calculation?
ARR = average annual profits/ average capital investment. X 100
AAP/ACI x 100
Accounting rate of return
AAP calculation
Annual cash flows generate from investment - depreciation / number of years of investment
Average annual profit
ACI calculation
1/2 (investment + residual value)
Average capital investment
What is market capitalisation?
The value of the business
How is market capitalisation calculated?
Share price x number of shares
What are examples of positive purpose expenditure?
Expansion Replacement New subsidiary, JV R and D License or payment for know-how Costs of tech Losses in learning to establish reputation Major contracts
What are examples of negative purpose expenditure?
Redundancy Plant closure costs, severance Plant mothballing expenses Compensation payment Losses form market withdrawal
What does mutually exclusive mean?
One to another (not both)
Choice of one precludes the choice of the other
What does Independent mean?
May chose any single project or a combination
What does dependent or contingent mean?
A project may depend on the outcome of another project
What does the value additivity principle mean?
If the value to the firm of separate projects accepted by management is known, then simple addition will give the overall value
Capital investment appraisal criteria
All cash flows considered (remove deprecation as not cash flow)
Appropriate rate
Value additivity
Selection must result in choice which maximises shareholder wealth
What is the superior appraisal technique?
Net present value
What are the 4 methods of investment appraisal?
Payback
Accounting rate of return
Net present value
Internal rate of return
What does payback represent?
Time taken by a project to recover the initial capital outlay
Best used as an initial screening tool
What are the advantages of payback?
Simplicity involved
Length of time that the capital is at risk is known
What are the disadvantages of payback?
The time value of money is not taken into account
Cash flows after the payback period are ignored
What does ARR express?
The profits from a project as a percentage of the capital cost
If no information is given on depreciation assume what?
Straight line basis p
What are he advantages if ARR?
One of the simpler and more easily understood techniques
What are the disadvantages of ARR?
Decision to invest or not remains subjective since companies set their target ARR subjectively
Not reliable as:
Ignores life of project
Doesn’t account for time value of money
Doesn’t measure absolute gain in wealth of shareholders
What is net present value?
Inflows - outflows
To be acceptable, the project must exhibit a positive net present value (inflows>outflows)
What is the impact of tax on NPV calculation?
Only consider on revenue cash flows (not on initial capital investment)
After tax cash flows calculated cash flow x (1-t)
Ignore tax on outflows
Ignore if q doesn’t mention tax
What are the advantages of NPV?
Relatively easily to calculate despite complexity of time value
Discount rate ensures exactly measures the increase in shareholders wealth
Disadvantages of NPV?
Using firms overall cost of capital (WACC) as d.f is only okay if the potential project has the same risk exposure as the company
Difficulty in predicting future cash flows accurately
Difficulty non-financial accountants may have in understanding
What is the internal rate of return? IRR%
The rate of return that brings the net present value of all inflows and outflows to zero
If IRR > cost of capital
We will increase shareholder wealth and the project should be accepted
If IRR < cost of capital
We will not increase shareholder wealth and the project should be rejected
The IRR method is also known as what?
The yield method
