Week 3 - Investment Appraisal Flashcards
How to adjust for inflation in an NPV model
Fishers equation: (1 + real rate of interest) x ( 1 + inflation rate)
Either (produces same NPV) forecast cash flows:
- At constant prices (‘real’ cash flows) and discount using real rate of interest or
- With the effect of inflation added (‘money’ cash flows) and discount using nominal rate of interest
Dealing with taxation in NPV models
Taxable profit = ?
taxable profit = Accounting profit + depreciation - capital allowances
Dealing with taxation in NPV models
pre-tax cash flows = ?
pre tax cash flows = accounting profit + depreciation
Dealing with taxation in NPV models
after tax cost of debt = ?
discount after-tax cash flows using after-tax WACC
pre tax debt cost x (1 - tax rate)
if projects are financed using equity:
existing shareholders may not be ready to fund the proposed project;
public share issue to raise funds for new project dilutes current shareholders’ control of company
if projects are financed using debt:
may affect gearing levels
lenders may require security (collateral)
what is the approach to asset allocation when there’s limited project funding?
for indivisible projects?
Capital rationing:
- rank projects using PI (from highest to lowest) and accept projects in that sequence until capital is used up
- CR limits firms capital expenditures to funds available during a given period of time
- CR does work well for divisible projects
- for indivisible project CR may result in unused funds or the firm undertaking projects inconsistent with NPV decision rules
Qualitative factors to consider when assessing projects?
- Strategic importance of the project
- value of real options of the project
- project risk attributes
- post-completion audit for projects
- sustainability performance of a project
Strategic importance qualitative factors:
- enhancing quality of the services you provide
- keeping up with competitors i.e investing in similar projects undertaken by best firms in industry (benchmarking) - ensuring you compete with other firms
- lowering of costs (cost leadership)
- enhance or create customer value
Value of real options qualitative factors to consider
- future expansion
- manufacturing flexibility - may want to produce a product at a later date
- future sale of project - creation of a subsidiary to facilitate future sale
Post completion audit for projects qualitative factors to consider
- lessons learned from current/past projects
- value chain analysis (where project value can be maximised) - where can you add value In the supply chain e.g. outsourcing
- used for selection and performance improvement of future projects - taking best practices and applying to future
legal factors to consider when assessing project risks:
- attitudes of host government to foreign investors e.g. currency repatriation restrictions
- restrictions of employment of expatriate staff - may have to employ local workers - knock on consequences for operations of business should be considered
- may have requirements for licensing
- host government may demand a stake in the project
economic factors to consider when assessing the risk of a project?:
- Stability or growth of the local economy
- potential demand for products in the local economy - disposable income levels
- import/export tariffs
- supply chain considerations
- depreciation/instability of local currency
social factors to consider when assessing risks of a project?:
- adverse motivation of staff
- risk of redundancies
- availability of suitably qualified personnel
- frequency of industrial strike action
Project risks - qualitative factors to consider when assessing projects
- projects may have different risks during life span
- use project specific discount rate - risk premium factor to use?
- sensitivity analysis
Sustainability performance- qualitative factors to consider when assessing projects
- impact of the project on the environment
- stakeholder (society, pressure groups, gov) concerns and their reaction on project failures: decommissioning and restoration costs to be considered in appraisal
- social impact of project
- adverse effect of redundancies on project
- positives to be considered too
How to address project risks in an NPV model? (2 ways)
- using a sensitivity analysis which addresses the issue and tests certain factors sensitivity to change
- using a project specific discount rate
what is payback period and how to calculate?
decision rule?
Payback period is the time the projects cash inflows take to recover the initial investment
decision rule to go with projects with earlier payback time
What is discounted payback period and how to calculate?
same as payback but with discounted cash flows
what is ARR and how to calculate?
ARR = (Average annual profits / average capital employed) x 100%
Decision rule:
- higher ARR preferred
- projects with ARR > RRR (yardstick) undertaken
What is the IRR and how to find it?
IRR is discount rate if used to discount project cash flows gives a NIL NPV
Decision rule:
- Yardstick: IRR > RRR
- Project with IRR > RRR is viable
- Projects with high IRR preferred
What question does profitability index (PI) address?
how to calculate PI?
What is the PI decision rule?
- PI = NPV / Investment required
- only accept if the ratio is positive (+ve NPV)
- projects with higher PI preferred
what is a sensitivity analysis?
when to conduct a SA?
- Sensitivity analysis is the practice of analysing the economics of a project or operation in order to determine the extent to which overall outcome responds to variation in individual elements
- accuracy of appraisal techniques depend on accuracy of cash flow estimates
- conduct SA to see how NPV is affected by changes to key inputs
