Topic 8 - Investment Appraisal Techniques Flashcards
What are the distinct stages of the investment decision-making process? 4
- Origination of proposals (comes up with ideas)
- Project screening (does ths project satisfy our stratergy (ARR)
- Analysis and acceptance (investment appraisal)
- Monitoring and review (ongoing checks)
What is the definition of the payback period?
The payback period is the time required for the cash inflows from a capital investment project to equal the initial cash outflows.
How is the payback period commonly used in investment decision-making?
It is often used as a first screening method. If a project passes the payback test, it should then be evaluated with a more sophisticated project appraisal technique.
When calculating the payback period using profits, what adjustment is made?
Profits before depreciation are used instead of profits after depreciation, as this provides a rough approximation of cash flows. Profit + dep = cash flow
When usIng payback period when should we accept a project?
Accept project if payback period is less than the target set by the company.
What is the decision rule for accepting a project based on the payback period?
A) Accept the project if the payback period is greater than the target set by the company.
B) Reject the project regardless of the payback period.
C) Accept the project if the payback period is less than the target set by the company.
D) Accept the project only if it has the shortest payback period compared to all other options.
C) Accept the project if the payback period is less than the target set by the company.
What is a potential problem when choosing between projects based on payback period alone?
The payback method ignores cash flows that occur after the payback period, which means it does not consider the total profitability of a project.
What are some disadvantages of the payback method? 6
- Short terms as cash flows after the payback period are ignored.
- It ignores the timing of cash flows.
- It does not account for the time value of money.
- The choice of payback period is arbitrary.
- Can lead to excessive investment in short-term projects.
- All estimates
What are some advantages of the payback method? 6
- Quick to calculate and easy to understand.
- Short-term forecasts are more reliable.
- Focus on short-term liquidity can be beneficial.
- Simple
- Useful for initial screening
- Can be useful if future is uncertain
What is the definition of the Accounting Rate of Return (ARR)?
ARR is the amount of profit, or return, that a business can expect to make based on an investment made.
What are the two formulas for calculating ARR?
- ARR = (Average annual accounting profit / Initial investment) × 100%
- ARR = (Average annual accounting profit / Average investment) × 100%
How is the average investment calculated for ARR?
It is calculated as ½ × (initial investment + final or scrap value).
What is the decision rule for accepting a project based on ARR?
A) Accept if the ARR exceeds a target set by the company.
B) Accept if ARR is higher than the payback period.
C) Accept only if ARR is greater than 50%.
D) Accept if ARR is equal to or greater than net present value (NPV).
A) Accept if the ARR exceeds a target set by the company.
What are some advantages of the ARR method? 4
- Able to compare as its a relative measure
- Quick to calculate and easy to understand.
- Considers the entire project life.
- Accounting profits are easy to identify. So can be comparable to targets (ROI)
What are some disadvantages of the ARR method? 6
- Accounting profit can be manipulated. e.g. depreciation
- Ignores the time value of money.
- Does not consider the size of the project.
- Does not consider the timing of cash flows.
- It is a relative measure so can ignore absolute value, profit so can choose small value project
- Uses average profits - ignores timing and spread of profits
What is the time value of money?
The time value of money is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
What are the key reasons why money today is worth more than the same amount in the future? 4
- Uncertainty
- Inflation
- Preference for current consumption over future consumption
- Money can be invested to earn returns in the future
What is compounding in finance?
Compounding is the process of calculating the future value of an investment by applying interest over time, where interest accumulates on both the initial investment and previously earned interest.
What is the formula for calculating the future value of an investment using compounding?
V = X(1 + r)^n or V = CF x (1+r)^n
where:
- V is the future value or terminal value of the investment
- X is the initial or present value of the investment
- r is the compound rate of return per time period (expressed as a decimal)
- n is the number of time periods (usually years)
What is discounting in finance?
Discounting is the process of converting a future sum of money into its present value by accounting for the time value of money. It is the reverse of compounding.
What is the formula for calculating the present value (X) of a future sum of money (V)?
X = V × 1 / (1 + r)^n or X=CF x 1 / (1 + r)^n
where:
- X is the present value
- V is the future value
- r is the discount rate
- n is the number of time periods
How does discounting account for the timing of cash flows?
Discounting assigns a higher present value to cash flows that occur earlier and a lower present value to cash flows that occur later.
What is the Net Present Value (NPV) method?
NPV is the present value of cash inflows minus the present value of cash outflows. It measures the absolute change in shareholder wealth as a result of accepting a project.
Net Present Value (NPV) formula
NPV = Present value of cash inflows - the present value of cash outflows
What is the decision rule for accepting a project based on NPV?
A) Accept the project if NPV is negative.
B) Accept the project if NPV is positive.
C) Accept the project if NPV is equal to zero.
D) Accept the project if NPV is less than the required rate of return.
B) Accept the project if NPV is positive.
Why are cash flows used in discounted cash flow (DCF) techniques instead of accounting profits?
DCF techniques are based on cash flows rather than accounting profits because cash flows reflect actual money movement, while accounting profits can be affected by non-cash items such as depreciation.
What are some advantages of the NPV method? 4
- Helps to determine if investment is worth it
- Considers the time value of money.
- Accounts for all cash flows over the project’s life.
- Provides a direct measure of the increase in shareholder value. Absolute measure
What are some challenges in determining the correct discount rate for NPV calculations? 3
- Different discount rates may be needed at different points in the project’s life.
- The discount rate should reflect the cost of capital or required return of the investment.
- Market conditions and risk levels can impact the choice of discount rate.
How is NPV calculated when the discount rate changes over time?
NPV = Outflow + Inflow / (1 + r1) + Inflow / (1 + r1)(1 + r2) + …
where:
- r1 is the discount rate for year 1
- r2 is the discount rate for year 2
What is an annuity?
An annuity is a series of identical cash flows for a number of years.
How is the present value of an annuity calculated efficiently?
The present value of an annuity is calculated by adding together the discount factors for the individual years. These total factors are known as ‘cumulative present value’ factors or ‘annuity’ factors.
What adjustment needs to be made for annuities in advance or delayed annuities?
The annuity factor tables assume that the first cash flow occurs in one year’s time. If the first payment is not at this point, an adjustment must be made.
What is a perpetuity?
A perpetuity is a series of identical annual cash flows that continue forever.
What is the formula for calculating the present value of a perpetuity?
Present Value = Cash Flow / r
where r is the annual discount rate.
What is net terminal value (NTV)?
NTV is the cash surplus remaining at the end of a project after taking account of interest and capital repayments.
How is net terminal value (NTV) used in project appraisal?
The NTV, when discounted at the cost of capital, gives the NPV of the project.
What is the discounted payback period (DPP)?
The DPP is the time it takes for a project’s cumulative NPV to turn from negative to positive.
What is the decision rule for accepting a project based on the discounted payback period?
A) Accept the project if DPP is longer than the target set by the company.
B) Accept the project if DPP is equal to the project’s total duration.
C) Accept the project if DPP is less than the target set by the company.
D) Accept the project if DPP is greater than the required rate of return.
C) Accept the project if DPP is less than the target set by the company.
What are some advantages of the discounted payback period (DPP)? 2
- Easy to understand.
- Considers the time value of money.
What are some disadvantages of the discounted payback period (DPP)? 2
- Cash flows after the payback period are ignored.
- Not ideal for comparing projects.
What is the internal rate of return (IRR)?
The IRR is the discount rate at which the NPV is zero, or the annual return (in present value terms) that a project is expected to achieve. It is a relatve measure (%) whereas NPV is absolute. NPV is zero this s the ‘breakeven’ discount rat making 0 returns on shareholder value
What is the decision rule for accepting a project based on IRR?
A) Accept if IRR is lower than the target rate of return.
B) Accept if IRR exceeds a target rate of return set by the company.
C) Accept if IRR equals the required discount rate.
D) Accept if IRR is equal to zero.
B) Accept if IRR exceeds a target rate of return set by the company.
How can the IRR of a project be estimated using a graphical approach?
The IRR can be estimated by calculating the project’s NPV at different costs of capital and plotting a graph of NPV against discount rate. The IRR is the discount rate at which the NPV curve cuts the axis (NPV = 0).
How can the IRR be estimated using the interpolation method?
The IRR can be estimated by calculating the NPV at two different discount rates and drawing a straight line between the two points on the NPV vs. discount rate graph. The IRR is where this line crosses the x-axis (NPV = 0).
What is the formula for IRR interpolation?
IRR = a + (NPVa / (NPVa - NPVb)) * (b - a)
or
IRR = a + (b+a) (NPVa / (NPVa - NPVb)) ‘A BANANA’
where:
a is the first discount rate giving NPVa (lower discount rate giving the higher NPV)
b is the second discount rate giving NPVb
What are some advantages of the IRR method? 3
Provides a percentage return, which is easy to understand and compare. Relative measure
Does not require an external discount rate or cost of capital
Takes into account the time value of money.
What are some disadvantages of the IRR method? 7
Can give multiple IRRs if there are unconventional cash flows.
Does not consider the scale of the investment.
Assumes reinvestment at the IRR at same rate of return, which may not be realistic.
More complex to calculate compared to NPV.
Relative measure, so doesn’t not look at amount of pay out as ignores absolute value: size of NPV and investment ignored.
Might get confused with ARR (profit based) as it sounds similar
Tends to give optimistic results
What are conventional cash flows in capital projects?
Conventional cash flows consist of an initial cash outflow followed by a series of cash inflows. In such cases, the NPV and IRR methods typically give the same accept/reject decision.
What are non-conventional cash flows?
Non-conventional cash flows occur when there are multiple changes in cash flow direction (e.g., inflows followed by outflows or alternating inflows and outflows), which can result in multiple IRRs.
What is a mutually exclusive project?
A mutually exclusive project is one where selecting one project means that another project cannot be undertaken.
Why can the NPV and IRR methods give conflicting rankings for mutually exclusive projects? 3
- The NPV method focuses on maximizing shareholder wealth, while the IRR method provides a percentage return.
- Differences in project scale can lead to conflicting recommendations.
- IRR may not always align with the cost of capital when ranking projects.
What are some disadvantages of the IRR method compared to NPV? 4
- Ignores the size of the investment.
- Does not work well with unconventional cash flows.
- Can be confused with the Accounting Rate of Return (ARR).
- Overestimates the real return.
When should we be using NPV? 4
Use NPV When:
✅ Maximizing Shareholder Value → NPV directly measures how much value an investment adds to the firm in absolute terms (£).
✅ Projects Are Mutually Exclusive → If you can only choose one project from multiple options, NPV is better because it ranks projects based on actual monetary gain.
✅ The Cost of Capital is Uncertain → IRR assumes reinvestment at the IRR itself, which is often unrealistic. NPV allows you to set a more realistic discount rate.
✅ Project Scale Varies → NPV correctly accounts for project size, whereas IRR can be misleading if projects are of different scales.
📌 Decision Rule → Accept the project if NPV is positive (i.e., it adds value to the company).
When should we be using IRR? 4
Use IRR When:
✅ You Need a Quick Percentage Return → IRR is easier to communicate because it provides a rate of return instead of an absolute value.
✅ No Specific Discount Rate Available → If you’re unsure about the correct cost of capital, IRR gives a benchmark return required for the project to break even.
✅ Project Cash Flows Are Conventional → IRR works well when there is one initial outflow followed by inflows but fails with multiple cash flow direction changes.
✅ Assessing Standalone Feasibility → If you’re not comparing multiple projects, IRR can help decide if a single project is worthwhile.
📌 Decision Rule → Accept the project if IRR exceeds the required rate of return (cost of capital).
When NPV and IRR Give Conflicting Results what should be used? 3
When NPV and IRR Give Conflicting Results
Scale Differences: If one project is much larger than another, IRR can be misleading. NPV should be used.
Non-Conventional Cash Flows: If cash flows change direction multiple times, IRR can give multiple values, making NPV more reliable.
Different Cost of Capital Assumptions: IRR assumes reinvestment at the IRR itself, which may not be realistic. NPV, which assumes reinvestment at the cost of capital, is often preferred.
Why does NPV Takes Priority Over IRR in Ranking Projects? 4
Why NPV Takes Priority Over IRR in Ranking Projects
✅ NPV Measures Actual Value Added (£)
NPV tells you the absolute monetary gain from a project. A higher NPV means a greater increase in shareholder wealth.
IRR, on the other hand, only gives a percentage return, which can be misleading if projects differ in size.
✅ NPV Works for Mutually Exclusive Projects
If you must choose one project from several, NPV gives the best ranking.
IRR might favor projects with higher percentage returns but lower absolute profits.
✅ NPV Accounts for Cost of Capital Properly
IRR assumes reinvestment at the IRR itself, which may not be realistic.
NPV assumes reinvestment at the firm’s cost of capital, which is more accurate for decision-making.
✅ NPV Handles Non-Conventional Cash Flows Better
IRR struggles when cash flows change direction multiple times, sometimes producing multiple IRRs or none at all.
NPV remains reliable in all cases.
When Might IRR Be Useful for Ranking?
If all projects have the same scale and duration, IRR can be used to compare efficiency.
If there is uncertainty about the discount rate, IRR provides a benchmark return.
If stakeholders prefer percentage returns over absolute values, IRR is more intuitive.
Final Rule for Ranking Projects
1 First priority → NPV (maximize value creation).
2 Use IRR only if projects are similar in scale and you need a percentage return benchmark.
3 If NPV and IRR conflict, always trust NPV for decision-making.
If NPV and IRR conflict whch shuld be used for decision-making.
If NPV and IRR conflict, always trust NPV for decision-making.
What is the purpose of ICAEW ethical guidance for professional accountants?
To ensure accountants prepare and report information fairly, honestly, and in accordance with professional standards.
Which key principles should ICAEW members demonstrate? 5
Professional Competence and Due Care, Integrity, Professional Behaviour, Confidentiality, and Objectivity (PIPCO).
What are the key responsibilities of an accountant under ICAEW ethical guidance? 3
- Describe clearly the true nature of business transactions, assets, or liabilities.
- Classify and record information in a timely and proper manner.
- Represent the facts accurately and completely in all material respects.
What are some threats to compliance with fundamental ethical principles?
Threats arise when there is pressure (externally or personal gain) to produce or become associated with misleading information.
Which actions should be taken to ensure information is not misleading? 3
- Ensure information does not contain materially false or misleading statements.
- Avoid statements or information furnished recklessly.
- Do not omit or obscure information rendering it misleading.
Which of the following is NOT a step to deal with a threat to independence?
A) Consider the degree or source of misleading information.
B) Ignore the misleading information to avoid conflict.
C) Apply safeguards and consult with superiors.
D) Refuse to be associated with misleading information if necessary.
B) Ignore the misleading information to avoid conflict.
What should an accountant do if unknowingly associated with misleading information?
Take steps to disassociate upon becoming aware of the misleading information.
When should an accountant consider obtaining legal advice?
If there is a requirement to report potentially misleading information.
Which of the following is a correct step to deal with a threat to independence?
A) Resign immediately without assessment.
B) Do nothing if unsure.
C) Consult with governance or the audit committee.
D) Falsify information to protect confidentiality.
C) Consult with governance or the audit committee.
Steps to deal with a threat to independence 5
- 1 Consider the degree or source to which the information is, or may be, misleading.
- 2 Apply safeguards such as consultation with superiors, and speak to those charged with governance of the organisation (audit committee).
- 3 Where it is not possible to reduce the threat to an acceptable level, refuse to be associated with any information they determine to be misleading.
- 4 If unknowingly associated with misleading information, take steps to disassociate on becoming aware.
- 5 If there is a requirement to report potentially misleading information, then consider obtaining legal advice. In addition, the professional accountant may consider whether or not to resign.
You report to the financial controller, who has asked you to report only the favourable variances in the executive summary. Do you:
* A Follow this advice.
* B Resign immediately.
* C Consider the balance of adverse and favourable variances and consider whether it may be misleading. If so, discuss issue with the financial controller.
* D Refuse to comply on the grounds that it is unethical.
C Consider the balance of adverse and favourable variances and consider whether it may be misleading. If so, discuss issue with the financial controller.
You are required to appraise an investment using a NPV and you are told by the finance director to apply a discount rate of 10%. The finance director is out of the country. You have been party to recent refinancing discussions and you believe the cost of finance will fall in the future. Do you:
* A Complete the investment appraisal as per the finance director’s instructions
* B Complete the investment appraisal as per the finance director’s instructions and state your reservations on the assumptions used
* C Complete the investment appraisal using your estimate of the new discount rate
* D Refuse to complete the report on the grounds that it will be misleading
B Complete the investment appraisal as per the finance director’s instructions and state your reservations on the assumptions used
What does ESG stand for?
Environmental, Social, and Governance.
Which aspects are included in the Environmental criteria of ESG?
Greenhouse gas emissions, energy consumption, water consumption, and waste generation.
Which factors are considered under the Social criteria of ESG?
Gender diversity, age-based diversity, employment, development and training, health and safety.
What are key Governance factors in ESG?
Board composition, management diversity, ethical behaviour, certifications, assurance.
Which two of the following key performance indicators (KPIs) would be suitable for measuring elements of ESG in a holiday park?
A The average price charged for a holiday.
B Percentage of people employed over the age of 50.
C The number of customers per week.D The percentage of waste recycled
B Percentage of people employed over the age of 50.
D The percentage of waste recycled
Why is management information and data analytics important for sustainability?
They help meet the requirements of sustainable development monitoring, reporting, and evaluation.
Which of the following is NOT a component of ESG?
A) Environmental
B) Social
C) Governance
D) Financial
D) Financial
Which ESG factor focuses on board composition and management diversity?
Governance
Which ESG factor includes gender diversity and health & safety?
Social
How can an organisation ensure sustainability reporting meets standards?
By developing management information and data analytics systems.
What are the four classifications of environmental costs? 4
- Environmental prevention costs
- Environmental appraisal costs
- Environmental internal failure costs
- Environmental external failure costs
What are environmental prevention costs?
Costs required to eliminate environmental impacts before they occur, such as forming environmental policies, performing site feasibility studies, and staff training.
What are environmental appraisal costs?
Costs involved in ensuring activities comply with environmental standards and policies, such as performance measures, monitoring, testing, and inspection costs.
What are environmental internal failure costs?
Costs incurred when contaminants and waste have been created but not released into the environment, such as maintaining pollution equipment and recycling scrap.
What are environmental external failure costs?
Costs arising when a business releases harmful waste into the environment, potentially harming its reputation, such as cleaning oil spills or decontaminating land.
Which of the following is an example of environmental prevention cost?
A) Cleaning up an oil spill
B) Performing site feasibility studies
C) Maintaining pollution equipment
D) Testing environmental compliance
B) Performing site feasibility studies
Which of the following best describes environmental appraisal costs?
A) Costs related to monitoring and testing compliance with environmental policies
B) Costs incurred to clean up pollution after it occurs
C) Costs associated with recycling scrap material
D) Costs of legal fines for environmental damage
A) Costs related to monitoring and testing compliance with environmental policies
Which of the following is an example of an environmental internal failure cost?
A) Developing environmental policies
B) Recycling scrap material
C) Cleaning contaminated land
D) Conducting feasibility studies
B) Recycling scrap material
Which of the following is an environmental external failure cost?
A) Training employees on environmental standards
B) Cleaning up oil spills
C) Inspecting environmental compliance
D) Monitoring energy consumption
B) Cleaning up oil spills
