Chapter 7 - investment appraisals - methods

Question 1

What is discounted cash flows ?

Answer 1

This approach looks at the expected cash flows from the investment in question, if over life of investment there is a cash surplus they accept, if deficit they reject

To account for money being tied up in project of years (resulting in interest being incurred or owed) the cash flows are discounted at the cost of money (or cost of capital) to the company before calculating the net surplus or deficit and making the decision

So for example if a purchase expects to bring in revenue of 20,000 in two years time and interest (or inflation) is 10% what is that worth today, therefore 20,000 x 1/1.1 to the power of 2 = 16,528

Therefore we can see if the investment is worth it using todays money

Question 2

What is investment appraisal

Answer 2

Looking at investments in new machines to see if it is worth it

Question 3

What does net operating cash inflows means

Answer 3

The profits each year in cash terms

Question 4

What is the internal rate of the return ? (IRR)

Answer 4

The rate of interest where the net present value = zero

For example imagine after 4 years we have calculated that by purchasing something for £80k, the present value receipts we receive over the 4 years is £75k based on an interest rate of 10%, how much more can the % increase by so that the current £5k is nil so we know the maximum rate we can accept

Question 5

How to work out the internal rate of return

Answer 5

If we know that 10% rate of return gives up +£6,660 then rather than trying every % variance until we get to zero, we do one more, @ 15% the IRR is -£2,160 that that we know that a 5 % increase gave a drop of - £8,820 and we want it to drop by only £6,660 therefore to know where between 10% and 15% the zero lies you do 10 % + 6,660/8,820 X 5% = 13.78%

Question 6

What are the two problems with internal rate of return ?

Answer 6

1. There can be more than one. This happens when the receipts each year fluctuate from positive cash in one year to negative in another.
2. Cannot use to compare investments.

Question 7

What is an annuity

Answer 7

Equal cash flow each year

The discount factor for an annuity can be calculated using this formula

Annuity discount factor = 1- (1+r) -n / r

Where
r = discount rate
n = number of periods

If we want you can use npv but as the amount we want each year is the same we can use the annuity table as it can be quicker

Question 8

What is the perpetuity

Answer 8

An equal cash flow each year, forever!

Unlike with annuity we can’t use discount tables at it is for ever so need to use formula

1 / r where r = the rate of interest

For example is we wanted to make 12000 per year and interest is 10% then it would be

12000 x 1 / 0.1 = 120,000

Question 9

What are other alternative approaches to net present value

Answer 9

99% of time questions will be on npv but there are another two;

1. Accounting rate of return - this is a profits measure. Unlike with npv it looks at cash flows but not profits which is what shareholders are interested in. It is defined as

The average profits from an investment / the average book value of the investment x 100

To get average profits take the total cash flows less total depreciation.

Average book value refers to what the value of the asset is in the sfp = purchase price + scrap value / 2

Question 10

What is another alternative to the net present value

Answer 10

2. Payback period - looking back at cash flows, but the number of years it takes to get back the original investment