Chapter 13 - Project Appraisal Techniques Flashcards
What is investment appraisal
Project (investment) appraisal, is the financial and economic appraisal of a project or investment to assess its
viability and the value it may generate. Companies normally undertake investment appraisal to identify the attractiveness of an investment before committing to high levels of capital expenditure, such as investing in a new factory, buying new machinery or making investment portfolio decisions
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When analysing a project, what 5 questions need to be asked to ascertain if the project is viable?
- What for? The objectives of the project – such as launching a new product.
- How? The process and the internal and external resource requirements.
- Who? For whom, by whom – project partners, stakeholders.
- When? The time factor.
- Where? The location.
What relevant factors should be taken into account when making investment decisions?
- Future costs: an estimated quantification of the amount of a prospective expenditure.
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Incremental costs: additional costs incurred from undertaking an additional activity or increasing the level of
production. -
Cash flows or cash-based costs : any expenses or costs that are predicted to be paid in cash. Non-cash items
such as depreciation should be ignored. - Financing costs: opportunity costs. For example, a company bears an opportunity cost in the interest foregone on cash by investing it in £50,000 of new machinery.
- The timing of returns: early returns are preferred to later ones. Returns can be reinvested to generate a higher value at the later date.
- Working capital: new projects require additional working capital such as inventory and trade receivables in running the project, which must be taken into consideration.
- Taxation: the profits subject to taxation and tax relief from the capital cost of the project must be considered.
- Future inflation: future revenues and costs will be impacted by inflation to different degrees. For example, the cost of oil, gas and electricity is likely to be impacted more quickly than wages and salaries.
What factors are irrelevant for investment decision-making?
Non-relevant factors are those that are irrelevant for project appraisal decision making. They include the following.
* Sunk costs: past expenditure that cannot be recovered and hence cannot be influenced by the current decision.
* Committed costs: obligations that cannot be revoked.
* Non cash items: items such as depreciation which are just accounting entries with no impact on cash flows.
* Allocated costs: costs that are clearly assigned to specific projects, processes or departments, such as the
apportionment of overheads that would be incurred in any event.
Key Project appraisal methods (5)
Non-discounting methods
* Payback method
* Accounting rate of return (ARR)
Discounted cash flow methods
* Net present value
* Internal rate of return
* Discounted payback
What is the payback period method and how is it calculated?
Number of years for project to recover initial investment. Based on expected cash-flows rather than profits, so provides a measure of liqiduity
Original cost of investment or initial cash outflows ÷ annual cash inflows
If the cash flows are uneven - use cumulative cash flows over the project’s life to calculate the payback period.
Decision rules
* Accepted - pays back investment within a specified time period/target period (so one should be set)
* Where there are mutually exclusive projects - shortest payback period should be chosen
- Shorter/quicker = more certainty of making a surplus
- Longer = more uncertain cash-flows/forecases are likely to be
Advantages and disadvantages of payback period method
Advantages
* Uses cash flows, not profits - no chance of manipulation
* Simple
* Adaptable
* It encourages a quick return and faster growth.
* Useful in certain situations ex. those involving rapidly changing technology.
* Maximises liquidity.
Disadvantages
* Ignores cash-flows after the project’sd payback period
* Subjectivity - no definitive investment answer for managers
* Ignores timings of cash-flows - solution is to use the discounted payback period method as this takes TVM into account
* Ignores profitability
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What is accounting rate of return method and how is is calculated?
The accounting rate of return (ARR) method is also known as the return on capital employed (ROCE) method. It uses
accounting profits to estimate the average rate of return that a project is expected to yield over the life of the investment.
The ARR is measured as:
Average annual profits ÷ average capital investment × 100%
Where:
Average capital (investment) cost = (initial investment + scrap value) ÷ 2
And:
Average annual profits = total accounting profit over the investment period ÷ years of investment
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Decision rules
* The project is undertaken when ARR is equal to or greater than the target rate of return.
* Where projects are mutually exclusive, the project with highest ARR (that also meets the target rate) is selected.
Advantages and disadvantages of ARR method
Advantages
* ARR is widely accepted and simple to calculate.
* It uses profits which are readily recognised by most managers. Managers’ performance may be evaluated using
ROCE. As profit figures are audited, it can be relied on to some degree.
* It focuses on profitability for the entire project period.
* It is easy to compare with other projects as it is linked with other accounting measures.
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Disadvantages
* ARR ignores factors such as project life (the longer the project, the greater the risk), working capital and other
economic factors which may affect the profitability of the project.
* It is based on accounting profits that vary depending on accounting policies (such as depreciation policy).
* It does not take into account the time value of money.
* The return calculated via ARR can be calculated using different formulas. For example, the return can be calculated
using profit after interest and tax, or profit before tax – thus leading to different outcomes. It is important to ensure
that returns calculated via ARR are calculated on a consistent basis when comparing investments.
* It is not useful for evaluating projects where investment is made in stages at different times.
* It does not take into account any profits that are reinvested during the project period.
Caculating annual depreciation figure
(Initial Investment amount - scrap value) / useful years
Calculating average annual profit
annual cashflow - annual depreciation
What is the time value of money and what are the 3 instances related
The time value of money is the concept that money received today is worth more than the same sum received in the
future.
This occurs for three reasons.
* The potential for earning interest and savings on the costof finance: if money is received today it can either be spent or reinvested to earn more in future. Hence, investors have a preference for having cash/liquidity today. Savings now can also be used to repay debts, saving on cost of finance.
* Impact of inflation: the value of future cash flows can be eroded by inflation.
* Effect of risk: Future cash receipts may be uncertain, unlike cash received today.
What is compounding and how is it calculated?
Money invested today will earn interest in future. Compounding calculates the future value (FV) of a given sum invested
today for a number of years.
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FV = PV(1 + r) ^n
Where:
FV = future value
PV = present value
r = rate of compound interest
n = number of years
What is discounting and how can it be calculated?
The timing of cash flows is taken into account by discounting. This is the opposite of compounding: it starts with a future
value (FV) to reach a present value (PV).
This provides a ‘discounted value’ of a future sum of money or stream of cash flows using a specified rate of return.
Present value means a current cash equivalent of a discounted sum of money receivable or payable at a future date.
A discount rate is the rate of return used in discounted cash flow analysis to determine the present value of future cash
flows. The discount rate will give the current worth of the future value. For example, at any discount rate, £1 earned after
one year will have a current worth or present value of less than £1.
In a discounted cash flow analysis, the sum of all cash flows at FV over the holding period (n), is discounted back to PV
using a rate of return (r).
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The formula is:
PV = FV ÷ (1 + r) n
Where:
FV = future value
PV = present value
r = rate of compound interest
n = number of years
The present value factor (PV factor) is calculated as:
1 ÷ (1 + r) n
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The PV factor is the current value today per £1 received at a future date. The future value can be calculated by
multiplying the present value factor by the amount received at a future date.
Negative interest rates - what are they/when used - effect on formulae of compounding and discounting
Negative interest rates are an unconventional and seemingly counterintuitive, monetary policy tool.
Central banks impose the drastic measure of negative interest rates when they fear their national economies are slipping
into a deflationary spiral, in which there is no spending – which results in dropping prices, no profits and no growth.
With negative interest rates, cash deposited at a bank yields a storage charge, rather than the opportunity to earn
interest income; the idea is to incentivise lending and spending, rather than saving and hoarding.
In recent years, several European and Asian central banks have imposed negative interest rates on commercial banks.
The time value of money says that money received today is worth more than the same sum received in the future. This
is reversed if the interest rate is negative. Money received today is worth less than the same sum received in the future.
This is calculated using the formula for compounding, as follows:
FV = PV(1 + r) n
If r is negative then 1 + r will be less than 1. As we compound it by n, the value will get smaller, rather than larger.
