Advanced investment appraisal techniques

Question 1

what are the main two tax effects to be dealt with regarding investment appraisal?

Answer 1

1. corporation tax - cash flows must be stated after tax and discounted at an after-tax discount rate - take care over the timing of the tax cash flows. usually slip one year, so tax in year one taken into cash flows for year two but this doesn’t always happen so take care.

general assumption that taxable profits = net cash flows from project less any tax depreciation.

2. tax depreciation allowances - take the place of income statement provisions for tax relief except where tax allowances are used for income statement calculations. represent cash savings/inflows in the DCF projections. not actual cashflows, and to calculate the tax impact have to multiply depreciation by tax rate. relevant cashflow is amount of tax payable

Question 2

what elements influence taxation effects?

Answer 2

the taxable profits and rate

the company’s accounting period and tax payment dates

whether asset qualify for tax depreciation

losses available for set off

Question 3

what is a capital allowance? how should it be treated for investment appraisal purposes?

Answer 3

tax depreciation allowances. not cash. affect the tax liability and therefore the payable/refundable tax. sometimes a first year allowance followed by allowances at lower rates in following years

Question 4

what is the main assumption when dealing with tax losses in investment appraisal?

Answer 4

where a tax loss arises there are sufficient taxable profits elsewhere in the org to allow the loss to reduce any relevant/subsequent tax payment (and may therefore be treated as a cash inflow) and that the company has sufficient taxable profits to gain full benefit from this.

Question 5

what timing assumptions are made regarding asset taxation in investment appraisal?

Answer 5

assume asset bought at start of accounting period and therefore first tax depreciation is offset against year 1 net cash flows.

Question 6

what is are balancing allowances/charges?

Answer 6

when plant eventually sold, may be different in reducing amount and selling price of asset. appropriate adjustment must be made to ensure company receives allowance equal to that allowed (purchase price - final value)

total tax relief = cost of asset - disposal value achieved. multiply by tax rate to find the reduction in tax payments over the years.

if sold for more than it has been depreciated to, there will be a balancing charge, and vice versa for an allowance.

Question 7

what discount rate is generally used in investment appraisal?

Answer 7

typically, discount rate = money cost of capital or nominal cost of capital (same thing), which = rate payable on borrowed money. this includes an allowance for inflation in sense that lender cannot expect any more than the interest rate - e.g. the lender may charge a 15% rate assuming inflation will be 8%, getting a 7% real return.

if a money cost of capital is employed, the cash flows on which the analysis is performed should also include expected inflation. if different rates of inflation are expected on revenue vs costs, this should also be considered.

Question 8

out of real, current, nominal and money - which cash flows include inflation?

Answer 8

real and current = no inflation

nominal or money = with inflation

Question 9

how are cash flows usually projected?

Answer 9

cash flows often projected in so called real terms, excluding inflation. given uncertain nature of future cash flows this isn’t surprising - inflating estimated future cash flows is a little worrying. since inflation may be expected to affect all entities equally, it can reasonably be assumed that if there are unexpected inflationary pressures they will be compensated by price adjustments.

arguable reasons for ‘real’ cash flows, but discount or cut off rate should then also be in real terms. any inflation element should then be excluded before proceeding with the analysis. this is often overlooked in practice

Question 10

how should you treat cash flows when you haven’t been told if they’re real or money?

Answer 10

assume cash flows in exam are money, unless told otherwise. be careful with being told ‘sales are x in one year and THEN will inflate by x%’

Question 11

what formula links nominal / real / inflation rates?

Answer 11

(1 + nominal rate) = (1 + real) * (1 + inflation)

or (1+N) = (1+R)*(1+I)

Question 12

what is the best way to adjust between real / money?

Answer 12

easier to adjust one rate than all the cash flows, particularly where they’re annuities. real method is only way for a perpetuity. theoretically possible to use real method in calculations involving tax, but very complex to try to use nominal method in all questions with tax.

Question 13

what is the real vs money/nominal method for dealing with inflation?

Answer 13

real method - don’t inflate cash flows, discount using the real rate

money method - inflate each cash flow by its specific inflation rate

discount using money rate

Question 14

how does taxation and real rates affect calculations?

Answer 14

in using real rates, taxation will be adjusted to exclude inflation so it will appear in real terms in the year in which it falls in the DCF projections. should check carefully for any specific requirement for treatments of tax cash flows in the questions. if there are taxation implications, not usually appropriate to leave the cash flows at the real cost of capital as it would understate the overall tax liability, because capital allowances are based on the original cost and do not change in line with changing prices. cash flows will have to be adjusted by the appropriate estimate of price change.

Question 15

what is a specific vs general inflation rate?

Answer 15

specific - impacts all individual cash flow items

general - impacts investors’ overall required rate of return. investors in the project need compensation for their lost purchasing power, which relates to their ability to buy a basket of all goods rather than any specific one.

Question 16

when should you use the money vs real method?

Answer 16

real method: if cash flows are in real terms

money method: if there is more than one rate of inflation or tax, OR cash flows are in money terms

to use the real method when cash flows inflate at different specific rates is very complex and involves a lot of workings. therefore, always use money method in this situation. this means inflating the cash flows at specific rates, and discounting using the money rate. very often money rate needs to be calculated, should be done using the real rate and general inflation rate

Question 17

what is deflation? how can if affect business decision making?

Answer 17

may apply to certain hi-tech materials which get considerably cheaper when they go into mass production. may affect business decision making in a few ways:

investing in projects with longer payback requires more courage

borrowing to finance purchase of assets that will fall in value - money rates will be low but real rates higher.

may be difficult to reduce some costs, especially wages, in line with deflation

consumers may defer purchasing if they think prices will fall

Question 18

how should working capital be incorporated into DCF analysis?

Answer 18

correct approach for incorporating working capital into DCF analysis = incremental approach.

Question 19

what should be included when identifying costs/benefits in investment appraisal?

Answer 19

tax allowances
working capital (but only the change, not the whole amount, and ignore in tax calcs)
incidental effects representing cash movement if they represent cash
operational project decisions
opportunity costs
avoidable costs
differential/incremental costs
cash inflows after tax (as concerned with benefits to shareholders not shareholders and HMRC)

cash flows should relate as far as possible to directly distinguishable cost elements

Question 20

what should be left out when identifying costs/benefits in investment appraisal?

Answer 20

depreciation
sunk costs
financing decisions (analyse separately)

Question 21

what is a relevant cash flow?

Answer 21

will be affected by decision being made. ‘future, incremental cash flow’.

incremental here = only extra cash flows that occur as a result of this decision. ignore fixed costs unless as a result of the decision.

remember:
cash flow is accepted - cash flow if rejected = relevant cash flow.

Question 22

what qualitative factors should be considered in terms of relevant costs?

Answer 22

qualitative factors

costs: increased noise level, lower morales if redundancies needed

benefits: reducing product development time, improved product quality and service, increase in manufacturing flexibility.

need to be pointed out and not ignored!!

Question 23

what is the monetary vs real approach to dealing with perpetuities?

Answer 23

monetary approach: annual cash flow * (1 / cost of capital)

if subject to inflation, not possible to use monetary approach and adjust cash flows in each year.

real approach:

A project will cost $42,000. It will earn returns of $7,000 (in current terms) in perpetuity, inflating in line with general inflation, at 5% per annum. The company has a monetary cost of capital of 15.5%.

real rate of return = 1.155/1.05 -1 = 0.1 = 10%
7000/0.1 = 70,000
-42000 +70000 = 28,000 NPV

Question 24

is a company’s cost of capital real or monetary?

Answer 24

monetary rate = includes an element of inflation

Question 25

how do you calculate a perpetuity that starts at T0 not T1?

Answer 25

some regular cash flows start at T0 not T1. calculative PV by ignoring that first one and then adding one to the factor: 5 year $600 annuity starting today with interest rate at 10% PV = 600 + 600*3.17 = 2502 = 600*4.17 = 2502

Question 26

how do you calculated delayed perpetuities (e.g. in arrears?)

Answer 26

apply the appropriate factor as normal, then discount your answer back to T0 $200 each year for 4 years, starting in 3 years time at 5% 200 * 3.546 = 709.20 (annuity at T2) 709.2 * 2 year discount factor = 709.2 * .907 = 643.

Question 27

what is the best way to deal with changing discount rates?

Answer 27

in reality company discount rates change year to year. inflation affects discount rates, meaning they’re rarely constant. therefore, just use the formula instead of the tables. if costs of capital are 10%, 12%, 15%, 16% then the discount rates are: - year 1 = 1/1.1 = 0.909 - year 2 = 0.909/1.12 = .0812 - year 3 = 0.812/1.15 = 0.706 - year 4 = 0.706/1.16 = 0.608

Question 28

which method should be used to discount when there is tax and inflation involved? What are the steps?

Answer 28

questions with tax and inflation need the money method: inflate costs and revenues where necessary determine tax implications ensure cost and disposal value have been inflated if necessary before calculating tax depreciation always calculate working capital on inflated figures unless given use post tax money discount rate

Question 29

how do you change the discount rate to deal with non-annual periods?

Answer 29

quarterly: (1+i)^1/4 -1 6 months: (1+i)^1/2 -1 monthly: (1+i)^1/12 -1 every other year: (1+i)^2 -1

Question 30

how does capital budgeting change when considering investment in new products?

Answer 30

decision faced by entities is to identify range of projects that within capital funding available will maximise shareholder wealth. quantitative aspects of this process involve identifying the mix of projects that produce the highest NPV. in addition to investment, working capital must be made available through life of selected projects.

Question 31

what factors are important to consider during new product development?

Answer 31

industry type and technology pace often need significant cash investment, regardless of whether you take product to manufacture/implementation. minimum size of entity that can afford certain types of R&D activity. this will be determined by the nature of the industry and the pace of technological change. benefits vs investment decisions will have to be made at a number of stages in the development of a product or service on whether the expected future benefits justify the commitment of further investment. this applies to all new products/services, regardless of amount of design and development expenditure required. cash flows forecasting expected flows in and out through life of product/service, discounting for NPV.

Question 32

what are the reasons to develop new products?

Answer 32

- To meet changing customer demands - To take advantage of developing technology - To maintain or improve competitive position - To respond to emerging environmental or safety issues - To diversify the product range or geographical outreach - To attract new customers to the brand

Question 33

how can investment be seen as options?

Answer 33

when project is slipping behind forecast, mgrs can take action to achieve original target. they can therefore create options or take action to mitigate losses/exploit new opportunities. call options = buying the asset at a specific price on or before a certain date put = sell a specified asset at specific price on/before certain date

Question 34

how does flexibility in investment add value?

Answer 34

- if investments can be staggered, future costs can be avoided if market turn less attractive than expected. therefore, reduces downside risk while keeping upside open. - call allows you to ‘wait and see’

Question 35

what are the two assumptions in NPV analysis that may be questioned when looking at real options?

Answer 35

project is reversible - if true, implies if it doesn’t work out the investment can be recovered and applied to a new project. this is flawed as generally wholly or partly irreversible project cannot be delayed - not always possible to delay an investment decision, but in the majority of cases a delay is possible - although there may be costs associated with this. if irreversible to some degree, ability to delay investment decision in order to obtain new info is valuable. additional costs of delay should be assessed against benefits associated with new info

Question 36

why were NPV techniques initially developed and why may this be an issue?

Answer 36

NPV techniques were first developed to value bonds. There is little investors in bonds can do to alter the coupons they receive or the final principal paid (the future cash flows), or the yield rate (the appropriate discount rate). Companies, however, are not passive investors: managers have the flexibility to sell the asset, invest further, wait and see or abandon the project entirely.

Question 37

what is a real option?

Answer 37

It is the right - but not the obligation - to acquire the gross present value of expected cash flows by making an irreversible investment on or before the date the opportunity ceases to be available. Although this sounds similar to NPV, real options only have value when investment involves an irreversible cost in an uncertain environment. And the beneficial asymmetry between the right and the obligation to invest under these conditions is what generates the option's value.

Question 38

what are the strategic forms of real options?

Answer 38

Using real options values the ability to invest now and make follow-up investments later if the original project is a success (a growth option). These kinds of options characterise pharmaceutical R&D rather well, for example. Real options can also value the ability to abandon the project if it is unsuccessful (an exit option). A North Sea oil company has had much well-publicised success valuing its 5-year oil and gas exploration licenses in this way. scale options - expand or contract the investment And real options can value the ability to wait and learn, resolving uncertainty, before investing (a timing option). Eurotunnel has a statutory option on a second tunnel under the English Channel, to be opened not earlier than 2020 (its lease on the first tunnel expires in 2052). The current fixed link came in one year late and 11 billion over budget. What price the ability to resolve uncertainty this time? switching options - switch inputs or outputs in a production process

Question 39

what is dynamic complexity in real options?

Answer 39

the evolution of a few complex factors over time that determine the value of investment and cash flows. These are factors about which decisions can be taken at any time over a period.

Question 40

what type of real options are puts/calls?

Answer 40

abandonment - financial put timing - financial call strategic investment options - financial call

Question 41

what are the relevant costs in an abandonment option?

Answer 41

still the only relevant costs are future costs. things to consider: future cash outflows and inflows revenues and costs that would arise if abandoned other alternative projects or more profitable use of funds than a project at all these factors should be consciously assessed at each stage in project life.

Question 42

what is a strategic investment option?

Answer 42

'toe in the door' options where you may have a follow-on opportunity later on.

Question 43

how can the black-scholes model be applied to valuing real options?

Answer 43

current market price of share = PV of future cash flows from investment exercise/strike price = initial outlay on investment time to expiry of the option = time until investment opportunity disappears (i.e. can defer without losing opportunity) variability of share price over period of time = variability of project returns risk free rate = risk free rate

Question 44

what is the post completion appraisal/audit?

Answer 44

post completion appraisal of a project provides a mechanism whereby experience gained from current and past projects can be fed into org’s decision-making process to aid decisions on future projects. aids org’s learning. reviews all aspects of an ongoing project and assesses if it has fulfilled expectations. forward-looking rather than backward. often carried out by capital expenditure committee or appointed sub committee

Question 45

what are the benefits of a post completion audit?

Answer 45

can improve accuracy of projects if mgrs know they’ll be audited after if appraisal carried out before life ends, steps can be taken to improve efficiency if needed might identify weaknesses in forecasting techniques and estimating techniques used to evaluate project. discipline and quality of forecasting for future investments can be improved mgrs may be motivated to achieve forecast results if they know post completion audit will happen reveals reliability and quality of contractors/suppliers involved in project may highlight reasons for success/failure in previous projects and provide learning experience to aid better decision making in future

Question 46

what are the problems with a post completion audit?

Answer 46

may not be possible to identify separately the costs and benefits of any particular project can be time consuming and costly applied punitively, may lead mgrs to becoming over-cautious and risk averse the strategic effects of a capital investment project may take years to materialise and it may never be possible to identify and quantify them correctly there may be uncontrollable factors in long-term investments. post completion appraisal will not help managers chase these factors in the future

Question 47

what is the role of appraisal in abandonment?

Answer 47

checks on continuing validity of forecast cash and revenue, and gives a third party review of whether problems encountered are likely to continue into the future.