Topic 2 & 3 - Investment Appraisal

Question 1

What is the Accounting Rate of Return? and the other name for ARR?

Answer 1

The ARR is to calculate the average pre tax profit comapred to either initial investment or average investment to give an indication of expected return. The other name is Return on Capital employed.

Question 2

What does average pre-tax profit actually mean? and What is average investment?

Answer 2

The average pre tax profit is the total profit over the life time of the project before tax is deducted and then divided by the the amount of years the project is operational.
Average investment is Initial investment + Residual Value divided by 2.

Question 3

What are the positives and negatives of ARR

Answer 3

Postives:
1.) Ease - Easy to calculate and understand
2.) Percentage measure - easily use to comapre to other measures.
3.) Life time of project - Take into account whole life of project.

Negatives:
1.) Profit based - Can be influenced be accounting policies and estimates.
2.) Percentage measure - its not an absoulte measure.
3.) Time value of money - It doesn’t take in to account the time value of money.

Question 4

What is payback period and what are the benefits and drawbacks?

Answer 4

Positives:
1.) Ease - Easy to calculate and understand.
2.) Cash based - not altered by accounting policies and more objective.
3.) Focus on early cashflows - being liquidity conscious is important.

Negative:
1.) Time value of Money - it is ignored.
2.) Time measure - doesnt help with knowing if it will maximse shareholder wealth.
3.) Later cashflow - Cashflows could be negative after payback period and the calculation doesnt show that.

Question 5

What is an Annuity?

Answer 5

This is when cashflows are consecutive of a number years

Question 6

What is a Perpetuity?

Answer 6

This is when cashflows are continious “forever”.

Question 7

How to calculate advanced annuities and perpetuities?

Answer 7

This is when the cashflow starts at T0 so we add 1 to the annuity rate and for perpetuity when calculate as usual and then add an extra amount of the annual casflow to the calculation.

Question 8

How to calculate delayed annuity and perpetuity?

Answer 8

Calculate as normal as if starting from T1 and then multiply by the discount factor the year directly before the first cashflow.

Question 9

How to calculate NPV?

Answer 9

Total sum of the present values (Cashflows x discount factors) + the initial investment.

Question 10

What is the formula used to calculate NPV on a spreadsheet?

Answer 10

=NPV(Number%,Present values)+(Initial Investment)

Question 11

What are the benefits and drawbacks of NPV?

Answer 11

Positives:
1.) Time value of money - Takes into account the devaluation of money by infaltion.
2.) Cash based - Uses cashflows
3.) Life of project - takes into account whole life of project.
4.) Required return - Uses present value which should reflect required returns.
Shareholder wealth - It is an absoulte measure, represent the change in shareholder wealth.

Question 12

What is the internal rate of return? explain formula.

Answer 12

IRR represents the discount rate that would be required to make the NPV of a project to be nil.
The formula is IRR = L + (NPVL/(NPVL-NPVH))x(H-L)
NPVL= The net present value when the lower rate was used.
NPVH= The net present value when the higher rate was used.
L = Lower rate
H= Higher rate

Question 13

In relation to IRR, If NPV is positive or negative, what do we do?

Answer 13

When calculating use any rate, if NPV is positive use higher rate if its negative use lower rate for the second option.

Question 14

What are the postives and neagtives of IRR

Answer 14

Positives:
1.) Time value of money.
2.) Cash based
3.) Life of project.
4.) Percentage measure
Negatives:
1.) Assumptions - Assumes the cashflows are reinvested at the same IRR
2.) Unusual cash flows - you can have more than one.
3.) Mutually Exclusive - it can conflict with NPV as the highest IRR may not be the best NPV as it does take into consideration size of investment.
4.) Not an absoute measure - its a percentage measure.

Question 15

What costs are not included in relavant cashflows?

Answer 15

Sunk cost - Costs before investment has be decided e.g Market research.
Commited costs - Costs that occur even if the investment is taken or not.
Non cash items - Depreciation should be taken out.
Allocated costs - commited costs but they have be assigned to investment e.g research into project.

Question 16

How are interest payments treated in cashflows?

Answer 16

Never include as they are part of the discount rate

Question 17

How is depreciation treated in cashflows?

Answer 17

add back as they are now cash items.

Question 18

What are the different types of inflation and what are the differences between them?

Answer 18

General Inflation - affects the required rate of return e.g the discount rate.
Specific Inflation - Affect individual cash flows.

Question 19

What are the differences between Money and Real cost of capital and when do we use either of them?

Answer 19

Money rate includes specific inflation and an element to compensate investors
Real Rate excluded general inflation
If Specific and general are the same Money and real are the same.

Question 20

What is the Fisher formula and what do the individual sections mean?

Answer 20

(1+i)=(1+R)x(1+H)
i=Money rate
R= Real rate
H=General inflation

Question 21

What do we assume if the question does not meantion which cost of capital to use?

Answer 21

Always money

Question 22

How do we calculate TAD? Both ways

Answer 22

Calculate the depreciation of the asset each year then multiply the depreciation by the tax rate to calculate how much can be claimed back.

Question 23

Explain how we get a balancing allowance and a balancing charge?

Answer 23

Initial investment x (Percentage of reducing balance ^ Number of years of investment) - The residual value.
if its negative its a balance charge, if positive its a balance allowance.

Question 24

How do you calculate TAD benefit?

Answer 24

Whatever the balance charge or or balance allowance is, we multiply it by tax rate to calculate the benefit of TADs

Question 25

What order does the NPV proforma go in?

Answer 25

T amounts
Contribution items - sales, purchases
Fixed costs
Operational Profit
Initial Investment
Tax benefit of TADs
Working capital
Residual Value
Total Cashflow
Present value
NPV