Module 4 Flashcards
Payback period =
Time taken to recover initial outlay (recorded as X years, Y months)
Payback period advantages (2)
- Good initial screening tool
- Easy to calculate and understand
Payback period disadvantages (2)
- Ignores cashflows after the payback period
- Ignores the time value of money (no discounting of cash flows)
Accounting rate of return =
Expressing the average annual cashflows compared to the average capital investment as a %
ARR formula
Average annual profits / Average capital investment
Average annual profits =
Average pre tax cash flows less annual depreciation
Average capital investment =
1/2 x (cost + residual value)
Accounting rate of return advantage
Simple to understand
Accounting rate of return disadvantages (3)
- Can’t meaningfully compare to cost of capital
- Ignores the time value of money
- Ignores the life of the project
Net Present Value (NPV) =
Discounting cashflows to their present value using WACC
If NPV > 0
Accept
If NPV < 0
Reject
NPV advantages (3)
- Easy to calculate
- Includes the time value of money
- Considers all relevant cash flows
Internal rate of return (IRR)
Discount rate that gives us NPV = 0 as a percentage
If IRR > Cost of capital
Accept
If IRR < Cost of capital
Reject
IRR disadvantages (3)
- 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
Cost of preference shares =
% preference share / market value
Disadvantages with WACC (2)
- Difficult to estimate for unlisted companies
- Not possible to calculate for government organisations
Only correct to use the WACC as the discount rate in NPV analysis if (3)
- Project being assessed is small relative to the business
- Existing capital structure will be maintained
- Project has same risk profile as rest of business
NPV is superior method of investment appraisal because
It measures the addition the shareholder’s wealth of accepting a new project
Relevant cash flows
Those cash flows affected by the decision to invest
Relevant cash flows > sunk costs
Ignore
Relevant cash flows > opportunity costs
Include the lost contribution
Relevant cash flows > overhead costs
Additional overheads > include
Central/ arbitrarily apportioned > exclude
Relevant cash flows > Materials
If replaced > replacement cost
Not replaced > cost = 0
If could have been sold > lost revenue = cost`
Relevant cash flows > Labour
Idle > cost = 0
Full capacity > cost = contribution lost on work they had to stop doing
Hired specifically for project > cost = salary paid
Relevant cash flows > Machinery
Purchased outright > cost included
Acquired through loan/ lease > ignore interest payments
Relevant cash flows > Working capital (stock)
Cash tied up (outflow) -> Cash release (inflow) -> Net effect (for NPV)
Assumption > timing of cash flows
Unless told otherwise, assume all cash flows received at end of the year
Two impacts of inflation on NPV
- Cash flows rise > project more attractive
- Cost of capital (discount rate) rises > project less attractive
Inflate from…
Following period eg if provided with Year 0/ current year prices, inflate from year 1
Real terms/ current prices
Ignore inflation
Nominal market
Include inflation
If one rate of inflation
Ignore inflation > use real cash flows + real discount rate
If multiple rates of inflation
Cash flows and cost of capital must be inflated > use nominal cash flows and nominal discount rate
Complications arising when foreign projects are assessed (3)
- Discount rates
- Exchange rates
- Inflation rates
Approach to international investment appraisal > Approach 1
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
Approach to international investment appraisal > Approach 2
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
Sensitivity analysis variables (5)
- Selling price
- Sales volume
- Cost of capital
- Initial cost
- Operating costs
Weakness of sensitivity analysis
- Can only have one variable > unrealistic
Simulation
Generates the distributions of the NPVs for each project > the wider the distributions, the higher the risk