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ICAS - AFin > Module 4 > Flashcards

Module 4 Flashcards

1
Q

Payback period =

A

Time taken to recover initial outlay (recorded as X years, Y months)

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2
Q

Payback period advantages (2)

A
  • Good initial screening tool

- Easy to calculate and understand

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3
Q

Payback period disadvantages (2)

A
  • Ignores cashflows after the payback period

- Ignores the time value of money (no discounting of cash flows)

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4
Q

Accounting rate of return =

A

Expressing the average annual cashflows compared to the average capital investment as a %

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5
Q

ARR formula

A

Average annual profits / Average capital investment

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6
Q

Average annual profits =

A

Average pre tax cash flows less annual depreciation

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7
Q

Average capital investment =

A

1/2 x (cost + residual value)

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8
Q

Accounting rate of return advantage

A

Simple to understand

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9
Q

Accounting rate of return disadvantages (3)

A
  • Can’t meaningfully compare to cost of capital
  • Ignores the time value of money
  • Ignores the life of the project
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10
Q

Net Present Value (NPV) =

A

Discounting cashflows to their present value using WACC

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11
Q

If NPV > 0

A

Accept

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12
Q

If NPV < 0

A

Reject

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13
Q

NPV advantages (3)

A
  • Easy to calculate
  • Includes the time value of money
  • Considers all relevant cash flows
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14
Q

Internal rate of return (IRR)

A

Discount rate that gives us NPV = 0 as a percentage

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15
Q

If IRR > Cost of capital

A

Accept

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16
Q

If IRR < Cost of capital

A

Reject

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17
Q

IRR disadvantages (3)

A
  • Can be possible to get more than one IRR
  • Doesn’t provide the magnitude of the increase in wealth from the project (ignores the scale of any project)
  • Can prove misleading where projects are mutually exclusive or if capital is rationed
18
Q

Cost of preference shares =

A

% preference share / market value

19
Q

Disadvantages with WACC (2)

A
  • Difficult to estimate for unlisted companies

- Not possible to calculate for government organisations

20
Q

Only correct to use the WACC as the discount rate in NPV analysis if (3)

A
  • Project being assessed is small relative to the business
  • Existing capital structure will be maintained
  • Project has same risk profile as rest of business
21
Q

NPV is superior method of investment appraisal because

A

It measures the addition the shareholder’s wealth of accepting a new project

22
Q

Relevant cash flows

A

Those cash flows affected by the decision to invest

23
Q

Relevant cash flows > sunk costs

A

Ignore

24
Q

Relevant cash flows > opportunity costs

A

Include the lost contribution

25
Q

Relevant cash flows > overhead costs

A

Additional overheads > include

Central/ arbitrarily apportioned > exclude

26
Q

Relevant cash flows > Materials

A

If replaced > replacement cost
Not replaced > cost = 0
If could have been sold > lost revenue = cost`

27
Q

Relevant cash flows > Labour

A

Idle > cost = 0
Full capacity > cost = contribution lost on work they had to stop doing
Hired specifically for project > cost = salary paid

28
Q

Relevant cash flows > Machinery

A

Purchased outright > cost included

Acquired through loan/ lease > ignore interest payments

29
Q

Relevant cash flows > Working capital (stock)

A

Cash tied up (outflow) -> Cash release (inflow) -> Net effect (for NPV)

30
Q

Assumption > timing of cash flows

A

Unless told otherwise, assume all cash flows received at end of the year

31
Q

Two impacts of inflation on NPV

A
  • Cash flows rise > project more attractive

- Cost of capital (discount rate) rises > project less attractive

32
Q

Inflate from…

A

Following period eg if provided with Year 0/ current year prices, inflate from year 1

33
Q

Real terms/ current prices

A

Ignore inflation

34
Q

Nominal market

A

Include inflation

35
Q

If one rate of inflation

A

Ignore inflation > use real cash flows + real discount rate

36
Q

If multiple rates of inflation

A

Cash flows and cost of capital must be inflated > use nominal cash flows and nominal discount rate

37
Q

Complications arising when foreign projects are assessed (3)

A
  • Discount rates
  • Exchange rates
  • Inflation rates
38
Q

Approach to international investment appraisal > Approach 1

A

1) Forecast projected cash flows
2) Calculate expected forecast exchange rate
3) Convert foreign cash flows to sterling
4) Discount at sterling cost of capital

39
Q

Approach to international investment appraisal > Approach 2

A

1) Forecast projected cash flows
2) Estimate foreign adjusted discount rate
3) Discount foreign cash flows at foreign discount rate
4) Convert NPV into sterling at spot rate

40
Q

Sensitivity analysis variables (5)

A
  • Selling price
  • Sales volume
  • Cost of capital
  • Initial cost
  • Operating costs
41
Q

Weakness of sensitivity analysis

A
  • Can only have one variable > unrealistic
42
Q

Simulation

A

Generates the distributions of the NPVs for each project > the wider the distributions, the higher the risk

ICAS - AFin (21 decks)

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