13. Project appraisal techniques

Question 1

Project Appraisal Non discounted Methods

Answer 1

Payback Period
ARR

Question 2

Payback Period

Answer 2

• Time takes to repay initial investment
• If between mutually exclusive projects choose the one with a shorter payback period

Advantages
* Cash flow not profit
* Simple to calculate
* Maximise liquidity
* Encourage growth

Disadvantages
- Ignores cash flow after PBP
- Ignores time value of money
- Ignores profitability and risk
- Subjective

Question 3

ARR

Answer 3

ARR
* Aka ROCE
* Measures profits to establish Rate of Return

Advantages
* Based on profits
* Management performance
* Financials audited
* Profitability of project

Disadvantages
- Profits vary depending on accounting policies
- Ignores time value of money
- Ignores factors e.g. project life and work capital

Question 4

NPV

Answer 4

• Net value of capital investment
• NPV = PV Inflow – PV outflow

Advantages
* Theoretically superior
* Time value of money considered
* Cash flow not profit
* Maximise SH wealth

Disadvantages
- Difficult to explain
- Complex

Question 5

IRR

Answer 5

• Rate of return of NPV = 0
• Same concepts as NPV

Advantages
*Cash flow not profit
*Time value of money considered
*Evaluates potential returns
*Evaluates potential attractiveness

Disadvantages
- Most complex
- Not lead to value max compare 2 mut excl
- Not lead to value max when capital rationing
- Assume + CF reinvested same rate as IRR

Question 6

Project Appraisal Discounted Methods

Answer 6

NPV
IRR
Discounted payback period

Question 7

Impact of inflation on interest or discount rates

Answer 7

Inflation = increase in money price decline in real value

Lenders will require:
real return to compensate for use of funds
additional return compensate for loss of purchasing power

Question 8

Impact of inflation on cash flows

Answer 8

Affects CF and discounted rate

Inflation incorporated into NPV calculations

Question 9

Tax effects

Answer 9

Corp tax on profits for most companies

Must therefore be included in project appraisal

Payable one year in arrears
Included in NPV calculation with a one year delay

Question 10

Capital rationing (why)

Answer 10

Strategy implemented co has more acceptable projects than can be financed from existing funds

Hard - lending institutions impose limit

Soft - company imposes voluntary restrictions (policies, limit exposure to external financing)

Question 11

Single period capital rationing (how)

Answer 11

Shortage of funds for one period.
If projects are divisible, assumption = returns generated in exact proportion to the amount of investment undertaken

Company would use a profitability index (PI) or benefit-cost ratio

A profitability index calculates the PV of cash flows generated by the project per unit of capital outlay, or

PI = NPV / initial investment

If PI is greater than 1 it adds value to the co and the project should be accepted.
Projects should be ranked by greatest PI, and funds allocated to those with the greatest PI.
If projects are indivisible, they have to be undertaken in their entirety or not at all.

A trial-and-error approach must be used to determine the optimum use of capital available for investment.

Question 12

PI formulae

Answer 12

PI = NPV/ II