Week 2- Investment Appraisal Techniques

Question 1

What is an interest rate?

Answer 1

An exchange rate of money between time

Question 2

What are the other names for interest rates and what situations are they used in?

Answer 2

1) Discount rate: when moving future values back to the present
2) Rate of Return: When looking at an investment from an lenders POV
3) Cost of Capital: from the borrowers perspective (eg. cost of equity, cost of debt, weighted average cost of capital)

Question 3

How many components of interest rates are there?

Answer 3

3

Question 4

What is the Pure Time Preference?

Answer 4

the exchange rate between present consumption and future consumption (rewards people for investing and being patient with their money)

Question 5

What is the Risk Premium component of an interest rate?

Answer 5

compensation to offset the component of risk in interest rates

Question 6

What is the inflation premium component of an interest rate?

Answer 6

compensation needed to offset the devaluation of money over time

Question 7

What are the three types of interest rate?

Answer 7

Risk free rate, real rate of interest, nominal (money) rate

Question 8

What component of interest rates do Risk free rates contain?

Answer 8

Pure Time Preference

Question 8

What is a Risk Free interest rate?

Answer 8

Interest rates that provide no risk (eg. government rates)

Question 9

What is a real rate of interest ?

Answer 9

Rate of interest that doesn’t include inflation but does reflect real purchasing power

Question 10

What component of interest rates do real interest rates contain?

Answer 10

Pure time preference and Risk Premium

Question 11

What is a nominal rate of interest ?

Answer 11

reflects change in inflation and also real purchasing power

Question 12

What component of interest rates do nominal interest rates contain?

Answer 12

Pure Time Preference, Risk Premium and Inflation Premium

Question 13

What does the fisher formula show?

Answer 13

The relationship between the real rate of interest and the nominal rate under the impact of inflation

Question 14

What is the fisher formula?

Answer 14

(1+r nominal) = (1+ r real ) x (1+r inflation)

Question 15

What is the investment trade-off from a firm perspective?

Answer 15

Shareholders receive dividends from the company’s profits. However, They will vote for the firm to invest the profits if the rate of return is higher than the rate of return than they can get on their own.

Question 16

What are the three main investment appraisal techniques?

Answer 16

Payback Period, Net Present Value, Internal rate of return

Question 17

What are the advantages of Payback Period technique? Name three

Answer 17

1) Easy to Calculate
2) Useful for certain situations for example when attention is needed to be given to releasing funds sooner to help cashflows
3) Favours projects with quick returns
- Minimizes risk and maximises liquidity
4) Uses cashflows rather than profits which means it relates to future incomes not past performance

Question 18

What are the disadvantages of Payback Period?

Answer 18

1) Not concerned with increases in wealth
- promotes liquidity rather than increased long term value
2)Ignores return after payback period
3) Ignores interest rates + TVM

Question 19

What is Net Present Value (NPV)?

Answer 19

the total present values of each of a projects cashflows less the initial investment

Question 20

What does the NPV rule state?

Answer 20

That managers should increase shareholders wealth by accepting projects that are worth more than they cost

Question 21

What is the NPV formula?

Answer 21

NPV= -CF0 + CF1/(1+r)^1 + CF2/(1+r)^2….

Question 22

Is deprication an allowable expense for tax purposes?

Answer 22

No

Question 22

What does a NPV of 0 mean?

Answer 22

The project has broken even

Question 23

How can depreciation be calculated? (two ways)

Answer 23

Reducing balance method Straight line method

Question 24

How do you calculate the straight line method?

Answer 24

(Cost-scrap value)/ number of years it will last for

Question 25

How do you calculate the reducing balance method?

Answer 25

A) cost/ number of years it will last for Remaining balance = cost- answer to A- scrap value

Question 26

what is the general inflation rate?

Answer 26

the inflation rate we need to apply to the nominal rate

Question 27

what are the advantages of the NPV method?

Answer 27

-Considers all cashflows of projects - Allows for TMV - Gives an absolute measure, allowing for comparison of projects - DIrectly related to the objective of maximising shareholder wealth

Question 28

What are the disadvantages of NPV?

Answer 28

- Difficulty obtaining all relevant costs/benefits - Difficult to calculate and explain to managers - Assumes cashflows occur at annual intervals - Needs you to estimate a cost of capital (interest rate)

Question 29

what does PCTCT stand for and what does it exclude?

Answer 29

Profits chargable to corporation tax Depreciation

Question 30

When is tax paid?

Answer 30

In arrears (1 year later)

Question 31

what is the internal rate of return?

Answer 31

The rate that gives an NPV of 0

Question 32

what are the advantages of IRR method?

Answer 32

- Represents a breakeven point -Takes into account TVM -Considers all project cash flows - A percentage and therefore easily understood

Question 32

what is the formula for IRR?

Answer 32

IRR = r1 + NPV1/ NPV1-NPV2 x (r2- r1) r= interest rate

Question 33

What are the disadvantages of IRR?

Answer 33

- Not a measure of absolute profitability - May conflict with the NPV result - Fails to recognise value, only concerned with percentage returns - Assumes cash invested at IRR - Not possible to compare projects if scales of their investments are different eg. small scale project may have high IRR but only increase wealth a little in absolute terms