Module 7: Cash Flow Valuation And Investment Flashcards
What is capital budgetting?
Capital budgeting is the process of identifying, analysing and selecting investment
opportunities in non-current assets whose returns are expected to extend beyond one year.
Name three different investment appraisal techniques
The payback period. This method of investment appraisal calculates the length of time a project will take to recoup the initial investment (i.e. how long a project will take to pay for itself). A project might not be undertaken unless it achieves payback within a given period of time. Based on the anticipated cash flows.
Discounted cash flow (DCF) appraisal. There are three methods of project appraisal using DCF.
– The net present value (NPV) method. This takes into consideration all the relevant cash flows associated with a project over the whole of its life, and also the timing of the cash flows. Cash flows occurring in future years are then discounted to a ‘present value’. The process of
re-valuing all project cash flows to a ‘present value’ is known as discounting. The present value of benefits (revenues or savings) are then compared with the outlay including any initial costs or
investments (present value of expenditure). The difference is the net present value. If the present value of benefits exceeds the present value of costs, the project is financially justified. If the present value of benefits is less than the present value of costs, the project is not justified
financially. The NPV method is the recommended method of project appraisal, since it is consistent with the objective of maximizing shareholder wealth.
– The internal rate of return (IRR) method. This method uses discounting mathematics to calculate the return expected from the project calculated on a discounted cash flow basis. This ‘internal rate of return’ for the project is then compared with the target rate of return. The project is justified financially if the IRR of the project exceeds the target rate of return.
– The discounted payback method. This method converts all the expected cash flows from a
project to a present value, and calculates how long it will take for the project to payback the
capital outlay on a discounted cash flow basis. It is similar to the non-discounted payback
method, except that it uses discounted cash flows.
What is return on investment, and how is it used in investment appraisal?
The return on investment (ROI) method, also known as the accounting rate of return (ARR) or return on capital employed (ROCE). This method calculates the profits that will be earned by a project and expresses these as a percentage return on the capital invested in the project. The higher the rate of return, the higher a project is ranked. A project might be undertaken if its expected return on investment exceeds a minimum target rate of return.
This method of project appraisal is based on accounting results rather than cash flows.
What is payback period?
The payback period is the length of time required before the total of the cash inflows received from a
project is equal to the cash outflows, and is usually expressed in years. In other words, it is the length
of time the investment takes to pay itself back.
What is sensitivity analysis?
Sensitivity analysis is one method of analysing the risk surrounding a capital expenditure project and
enables an assessment to be made of how responsive the project’s NPV is to changes in the variables
that are used to calculate that NPV.
Explain hard and soft capital rationing
Soft capital rationing may arise for one of the following reasons:
Management may be reluctant to issue additional share capital because of concern that this may
lead to outsiders gaining control of the business.
Management may be unwilling to issue additional share capital if it will lead to a dilution of
earnings per share.
Management may not want to raise additional debt capital because they do not wish to be
committed to large fixed interest payments.
Management may wish to limit investment to a level that can be financed solely from retained
earnings.
The Board may restrict the capital expenditure budget available to individual business units as a
means of management control.
If an organisation restricts funds available for investment for internal reasons (soft capital rationing),
this may not be optimal. Limitations in soft capital rationing tends to be due to the split of the capital
budget amongst business units. Problems that arise are typically driven by the potentially subjective nature of the distribution. The organisation may reject projects with a positive net present value and forgo opportunities that would have enhanced the market value of the organisation.
Hard capital rationing may arise for one of the following reasons:
Raising money through the stock market may not be possible if share prices are depressed.
There may be restrictions on banks’ lending due to government control.
Lending institutions may consider an organisation to be too risky to be granted further loan
facilities.
The costs associated with making small issues of capital may be too great.
What is the marginal cost of capital approach?
The additional cost to the company of obtaining specific funds to
invest in a specific project.
What is Net Present Value (NPV)?
Net present value or NPV is the value obtained by discounting all cash outflows and inflows of a capital investment project by a chosen target rate of return or cost of capital. The sum of the present
value of all expected benefits from the project and the present value of all expected cash outlays is
the ‘net’ present value amount.
If the NPV is positive, it means that the cash inflows from a capital investment will yield a return in
excess of the cost of capital, and so the project should be undertaken.
If the NPV is negative, it means that the cash inflows from a capital investment will yield a return
below the cost of capital, and so the project should not be undertaken.
If the NPV is exactly zero, the cash inflows from a capital investment will yield a return which is
exactly the same as the cost of capital, and so the organisation will be indifferent about whether it
undertakes the project or not.
What is profitability index?
The profitability index is an index that identifies the relationship between the costs and benefits of a
proposed project. The ratio is calculated as the present value of the project’s future cash flows (not
including the capital investment) divided by the present value of the total capital investment.
What are the stages for investment decision making model
-Origin of proposals
-Project screening
-Analysis and acceptance
-Monitoring and review
