17 Investment Appraisal Flashcards
How useful is payback period?
The usefulness of payback as an investment appraisal method is:
It is simple to calculate
It is easy to understand, especially for non-accountants
It uses relevant cash flows
It can be used as an initial screening tool on projects before undertaking a more detailed review
It (rather crudely) allows for risk
What are: Payback period (and discounted payback)
This measures the length of time it takes to recoup the initial investment. Discounted payback considers the time taken to recoup the initial investment if all future cash flows are discounted to present value
There is an example showing how it works.
Accounting rate of return (ARR)
What is it?
There are a few different ways of calculating it but broadly it is the profit from an investment divided by the amount of the investment.
How useful is ARR?
The ARR usefulness as an investment appraisal method is:
It is simple to calculate
As a percentage the measure is familiar to non-accountants
It looks at the entire project
It reflects the way external investors judge the organisation
Net present value (NPV)
How useful is it?
The net present value’s usefulness as an investment appraisal method is:
It allows for the time value of money
It shows the change in shareholders’ wealth
It can allow for risk via the cost of capital
It looks at the entire project
NPV Issues – inflation and taxation
Inflation
The relationship between money rate of return, real rate of return and inflation rate is:
And taxation?
(1 + m) = (1 + r)(1 + i)
If cash flows are stated in money terms, they should be discounted at the money rate; if cash flows are stated in real terms, they should be discounted at the real rate.
Tax writing-down allowances (WDA) are available on non-current assets which allows a company’s tax bill to be reduced
Annuities
An annuity is a constant periodic cash flow for a defined period, such as a lease where the same payment must be made each year for 5 years. Annuities are assumed to have the first payment in one year unless otherwise stated
Perpetuities
A perpetuity is a constant periodic cash flow for an indefinite period, such as receipt of an annual dividend on a preference share.
Perpetuities are assumed to have the first payment in one year unless
otherwise stated.
Adjusted present value
If a project being considered is expected to change the long term financial gearing of a company, the existing WACC cannot be used as a discount rate in calculating the project’s NPV. Instead an APV must
be used in evaluating the potential project.
(1) Estimate the value of the project with no gearing, by discounting project cash flows at the ungeared cost of equity.
(2) Calculate the present value of the interest tax savings generated by borrowing.
(3) Add the two NPVs from steps 1 and 2 and deduct any issue costs of new debt finance to get the project’s APV. If it is positive, then the project should be accepted.
What is the internal rate of return?
The Internal Rate of Return (IRR) is the discount factor which gives a zero NPV. As the discount factor increases, the NPV reduces. As can be seen on the diagram (in the study manual), this forms a curved relationship
Due to this curved relationship, finding the precise IRR would be very time consuming, so instead we find an approximate IRR by finding two points on the curve and then assuming that there is a straight line between them.
For normal projects (that is, initial investment followed by a series of cash inflows), the project is feasible if IRR > cost of capital.
Internal rate of return usefulness?
The internal rate of return’s usefulness as an investment appraisal method is:
It does not require the exact cost of funds to be known
As a percentage the measure is familiar to non-accountants
It looks at the entire project
It provides a relative measure of performance
What is the modified internal rate of return?
The main problem with IRR is that it assumes that cash flows will be reinvested at the IRR. A way to resolve this problem is to allow the specification of the reinvestment rate. This modification is known as the modified internal rate of return.
it’s basically terminal value of inflows divided by terminal value of outflows discounted. There’s an example in the manual.
What is a sensitivity analysis?P
Sensitivity analysis measures the percentage by which a variable can change before NPV moves from its current level to zero.
The NPV could depend on a number of uncertain independent variables.
Selling price
Sales volume
Cost of capital
Initial cost
Operating costs
Cost savings
Residual value
A simple approach to deciding which variables the NPV is particularly sensitive to is to calculate the sensitivity of each variable.
The following formula can be used to calculate the sensitivity of any variable which affects project cash flows:
NPV / PV of the variable
The lower the percentage, the more sensitive is NPV to that project variable as the variable would need to change by a smaller amount to make the project’s NPV zero.
Weaknesses of this approach to sensitivity analysis
Each variable has to be considered individually.
Sensitivity analysis does not examine the probability that any particular variation in costs or revenues might occur.
Critical factors may be those over which managers have no control.
It does not give a definite decision rule
