Objectives & Investment Appraisal

Question 1

What might you need to use if deciding whether it is economically more desirable to pick one project or another?

Answer 1

Asses EACh project separately

EAC (Equivalent Annual Cost)
Esp. when projects are different lengths

NPV/Annuity factor

(Annuity factor is the long formula)

Question 2

Limitations of NPV/EAC

Answer 2

Assumes the present value of the fleece goats produce is always the same…

1. Flow: Cashflow
2. Goods: Change in goods
3. Price: Changes in price

Question 3

(When thinking about limitations of NPV)
Why might leasing be better than outright payment

Answer 3

Because if you haven’t paid outright, then you haven’t lost all your money when you get to the property and inside you find cheerful foxes chasing cats chanting round the fire

1. Cash Flow (Small & predicable)
2. Cost of Capital (Can be lower)
3. Capital rationing (Security on loan)
4. Tax (Benefits for leasing)
5. Flexibility

Question 4

Will there be running costs in T0?

Answer 4

NO!

Question 5

How do you work out the (money) discount factor when you have real and inflation rates?

Answer 5

Multiply them all together
The 1+…. rates
For the all the periods up to the one being discounted

(1 + m) = 1/( (1+I1)(1+D1) (1+I2)(1+D3) (1+I4)*(1+D4) ) …

Question 6

Sensitivity to change in factor

Answer 6

NPV of project / NPV of relevant factor including TAX

Whole project on top

Question 7

What are real options, in general?

Answer 7

‘strategic implications’ of taking on project

Question 8

Follow-on optoin

Answer 8

Opportunity to acquire even more later
(economies of scale/market share)

Question 9

Growth option

Answer 9

Range of services offered

Question 10

Systematic risk i.e.

Answer 10

market risk

I.e. the risk in the system as a whole

Question 11

What is beta?

Answer 11

The systematic risk of an investment vs the market

I.e. its sensitivity to market movements

Question 12

What is Rm - Rf

Answer 12

Equity risk premium

MIGHT GIVE THIS IN THE EXAM, NOT RF

Question 13

What to take into account for sensitivity to sales volume?

Answer 13

Sales price
Variable costs
(Tax)

Question 14

How to work out the sensitivity to discount rate?

Answer 14

IRR of undiscounted cashflows
(Because want to know the discount rate)

Question 15

How to work out the sensitivity to project life?

Answer 15

Easy one!

It is just the amount of time (months) from payback the project lasts

(Because sensitivity is the amount the factor can change before NPV becomes zero, so must be)

Question 16

What is the change in wealth for new shareholders after a share issue?

Answer 16

( No. new shares X TERP ) - Amount paid for shares

DON’T FORGET NEW SHAREHOLDERS PAY FOR THEIR SHARES!

Question 17

Why does inflation have to be accounted for in NPV?

Answer 17

So investor appropriately compensated for that loss in value

As negative impact on real value of money

Question 18

Other word for actual cash flows

Answer 18

Nominal cash flows

Question 19

Which is preferable: Matching real cash flows with real interest/rate, or matching nominal cash flows with an inflated discount rate?

Answer 19

Matching nominal to inflated discount rate

Because inflation assumptions don’t compound

Question 20

Why is calculating the wrong CoC detrimental to shareholder value?

Answer 20

Too high? Missing +ve project
Too low? Taking -ve projects

Question 21

How else can you describe real options?

Answer 21

Financially, (e.g. abandonment = put & growth = call)

Question 22

How to calculate NPV when given 2 (equally likely) scenarios?

Answer 22

Average them

Question 23

How to calculate taxable cashflow from contribution?

Answer 23

IT IS CONTRIBUTION

SELLING PRICE DOESN’T MATTER

Question 24

Using the ‘real @ effective’ method

Answer 24

This method is a short cut for the money method. It can be used for perpetuities or
long annuities.

Cash flows are left in real terms.

A specific ‘effective’ discount rate is calculated for each given cash flow.

With ‘1+’ rates:
Effective = Money / Specific inflation rate

Question 25

How to add the effect of inflation to an NPV calc?

Answer 25

Adjust discount rate to include inflation (i.e. * (1+inflation)

Include the effect of inflation in the cashflows

Question 26

What will happen to contribution in an inflationary environment

Answer 26

It will remain the same, as sales will increase by inflation and then loose value by the same amount of inflation

Question 27

What will happen to working capital in an inflationary environment?

Answer 27

It will increase

Because not linear cashflows (think of a graph)

Question 28

How to treat depreciation in an NPV calc?

Answer 28

IGNORE because NOT A CASH FLOW