Week 6: Investment appraisal Flashcards
What are the two broad categories of capital investment decisions?
Two broad categories:
1) Screening decisions – is it acceptable & viable
2) Preference decisions – which one is the best?
what is the payback period?
The Payback period is the length of time required for a stream of cash proceeds from an investment to recover the original cash outlay required by the investment.
which is more desribale and why? a longer or shorter payabcl period?
Shorter payback period is more desirable:
Quicker recovery of initial investment
Longer time means greater chance of failure so more risk
Name four typical cash outflows?
four typical cash outflows are:
1) Working Capital
2) Repairs and maintenance
3) Initial Investment
4) Incremental operating cost
Name four typical cash inflows?
four typical cash inflows:
1) Release of working Capital
2) Salvage value
3) Reduction of cost
4) Incremental revenue
What does the rate of return represent?
The rate of return represents the opportunity cost of the investment.
e.g Money invested in shares or gilts cannot be invested elsewhere.
A firm should only invest in a project if it can achieve a higher return than this opportunity cost.
This is also known as the minimum required rate of return, cost of capital, discount rate or interest rate
If the NPV of a project is postive then what is the project?
If NPV is postive then project is acceptable as it promises a retrun greater than the required rate of return
If the NPV of a project is zero then what is the project?
If the NPV of a project is zero then the project is acceptable as it promises a retrun equal to the required rate of return
If the NPV of a project is negative then what is the project?
If the NPV of a project is negative then the project is not acceptable as it promises a retrun less than the required rate of return
What are the strengths of NPV?
the strengths of NPV are that it:
Considers time value of money
Accepting projects with a positive NPV should maximise shareholders wealth becaise it
Assists in decision making
Complements other methods such as payback
The most complete method – but not necessarily perfect!
What are the limitatuions of NPV?
Apart from the initial cash outlay to create the project, the cash flows for each year are assumed to occur all on the last day of the year. This is clearly unrealistic.
The cost of capital is assumed to remain constant over the whole lifetime of the project. This is very unlikely to be the case.
Use of estimates and projections – reliable?
What is the Internal rate of return (IRR)?
The IRR is the average annual rate of return of cash that the project is expected to produce (allowing for the time value of money). It is numerically equal to the discount rate, which gives the project an NPV of zero.
For the project to be acceptable, the IRR should be equal to, or greater than, the minimum rate of return set by the business (a.k.a. ‘hurdle rate’).
Where projects are mutually exclusive, the one with the greatest IRR is chosen.
If the IRR decision conflicts with the NPV, the NPV decision is used as it is expressed in £ rather than %.
If the NPV is postive what i sthe IRR?
If the NPV is positive, the IRR will be greater than the discount rate used. If the NPV is negative, the IRR will be lower than the discount rate.
What is risk? what factors infleunce risk?
Risk is evident when the future is unclear and there is a set of possible different outcomes.
Factors such as the:
-source of funding
-size of the investment
-timescales involved etc
add to the risk pressures faced by the choice of investment.
Are taxes included in the NPV calculation?
Tax payment constitutes additional cash outflow so must be considered in NPV calculation.
Is depreciation included in the NPV equation?
depreciation is a non cash expense so it isnt included unless it has effect on taxation.
How does inflation affect future cash flows?
Future cash flows can be expressed in the monetary units at a time when they are received (nominal values) whilst cash flows expressed in today’s purchasing power are reflected at real values.
Nominal cash flow = Real cash flow x (1+I)t.
However if the same rate of inflation applies to the future cash flows and the rate of return, then the project’s NPV will be unaffected.
