Chapter 2

Question 1

What is the payback period and how do you calculate it?

Answer 1

How many years a project cash flows are needed to recover the initial investment

Calculate when cumulative cash flow on the project hits zero.

Question 2

What is the AROR and how to calculate?

Answer 2

Represents annual % return on the project based on accounting profits

Average annual profit/ average initial investment

Avg investment = initial outlay +scrap value/2

Question 3

What is the NPV? What does it represent?

Answer 3

Summing present value of future cash flows (discounted at COC) on a project by deducting upfront cost gives BPV

Represents the present value of the excess return on the project over and above the financing costs

Question 4

How do you calculate PV of each cash flow?

Answer 4

Multiply it by discount factor:

1/(1+r)^n

R is the COC
N is the no of periods into the future

Question 5

What is an annuity and how do you value it?

Answer 5

Constant annual cash flow (with cash flow at end of each year and first cash flow in years time)

PV of annuity: A/R x ((1-1/(1+r)^n)

Question 6

What is a perpetuity and how do you calculate it?

Answer 6

Never ending constant annual cash flow (cash flow at end of each year and first cash flow in years time)

Use formula A/R

R is COC
A is annuity

Question 7

How to calculate NPV using spreadsheet?

Answer 7

NPV(discount, cell range)

Question 8

What is IRR? When is IRR good?

How do you calculate?

Answer 8

Internal rate of return: actual annual % return on the project (based on discounted future cash flows)

Good is IRR> COC

IRR(cell range)
Cell range is cash flows

Question 9

Pros and cons of payback period?

Answer 9

Pros:

Simple easy to understand
Use as initial screening tool
Recognises importance of liquidity
Focuses on nearest more certain cash flows

Cons

Ignored time value of money
Only considers the cash flows up to payback date
Encourages short term decision making
No clear decision rule

Question 10

Pros and cons of AROR

Answer 10

Pros
Simple to calculate and understand
Looks at entire life of project
Reflects way that external investors judge the organisation

Cons:

Ignores time value of money
Based on profits, not relevant cash flows
Doesn’t consider length of project
No clear decision rule

Question 11

Pros and cons of NPV

Answer 11

Pros:

Takes into consideration TV of money
Shows the shareholders wealth created by project
Can allow for risk by adjusting COC
Clear decision
Looks at entire project life

Cons:

Requires COC to be estimated several years into future

Calculations can be time consuming and easily misunderstood

Doesn’t factor in liquidity or time taken to generate return

Assumes you can reinvest proceeds at COC

Question 12

Pros and cons of IRR

Answer 12

Pros

Allows for TV if money

Does not require an exact cost of funds to be estimated

Easy to interpret (% return of project)

Looks at entire project life

Cons

Ignored size of investment require and total cash inflows

Can give conflicting answer to NPV when evaluating mutually exclusive projects

Assumes you can reinvest proceeds at the IRR

Question 13

What are 5 non-financial factors associated with a decision?

Answer 13

Compliance with current or future legislation

Impact on staff morale

Impact on suppliers and customers

Reputation of organisation

Sustainability

Question 14

What is the definition of relevant costs?

Answer 14

Incremental: costs and revenues impacted by decision, include lost opportunity costs (cash flows foregone if we proceed with project), exclude committed costs (overheads that will not be impacted by project)

Future: only consider cash flows arising in future and ignore past, sunken costs

Cash flows: ignore non cash items such as depreciation

Question 15

Define opportunity costs

Answer 15

The cash flow foregone if a unit of the resource is used on the project instead of in the best alternative way

Question 16

What is working capital?
How do we treat it in our calculation?
When does it need to be in place in our calculation?

Answer 16

Liquidity of the business

Increase in working capital investment ties up cash and so needs to be treated as cash outflow. Decrease in working capital is a cash inflow

At T0

Question 17

What are the two impacts of taxation in investment appraisal?

Answer 17

Taxation of operating cash flows: operating cash flows are subject to corporation tax either in the year cash flows are generated or the following year

Capital allowances:

Lease to reduction in tax outflows and these savings should be included in our NPV as cash inflows

Question 18

What is a balancing allowance and balancing charge?

Answer 18

Balancing allowance: TWDV>didposal value you get extra cap allowance

Charge: TWDV< disposal value you get negative capital allowance e

Question 19

What are specific and general inflation rates?

Answer 19

Specific: rate of inflation on individual item or service

General: weighted avg of many specific inflation rates (CPI) and is applied to the real rate of interest in order to determine money rate

Question 20

What are money and real cash flows

Answer 20

Money (nominal cash flows): where any inflationary effects have already been taken into account (2yr cash flow would need to be multiplied by (1+i)^2) to get it into money terms

Real: cash flows expressed in todays terms and have not been adjusted for future inflation

Question 21

What are real and money (nominal rates)

Answer 21

Real: rates of interest that would be required in the absence of inflation in economy

Money(nominal): achieved by adjusting real rates of interest for the effect of general inflation

Question 22

What is the calculation linking money rates, real rates and general inflation?

Answer 22

(1+m) = (1+r) (1+i)

M is money rate
R js real rate
I is general inflation

Question 23

When performing NPV calcs you either need to use money cash flows and money rate of interest or real cash flows and real rate of interest. How do you deal with this?

Answer 23

Money method:
Adjust invidivhsl cash flows to incorporate specific inflation
Discount cash flows using money rate

Real method:

Remove effects of gen inflation from money cash flows to generate real cash flows
Discount using real rate

Question 24

What is the effective rate?

Answer 24

Shortcut to use when trying to use the money method to discount perpetuity cash flows which are inflating at a steady rate:

(1+m)/(1+i) -1

Question 25

What are the key components of a NPV formula?

Answer 25

Revenue Variable costs Contribution Fixed costs Net operating cash flow Tax @ x% Cap expenditure Scrap value Tax saving on cap allowance (W) Working cap Net cash flow

Question 26

How do you lay out a capital allowance working

Answer 26

Time across top Opening TWDV CLOSIGN TWDV capital allowance % WDA on opening TWDV Tax saving (included on proforma)

Question 27

What is replacement analysis and what technique should you use? What EAC should be chosen and what does it represent

Answer 27

Involves choosing between two alternatives where the benefits are unequal (if over different number of years) Use equivalent annual cost PV of annuity = annuity cash flow x annuity factor EAC= NPV/ annuity factor for project life Represents constant annual cash flow that has the same present value as the actual cash flows Proposal with lowest EAC should be chosen

Question 28

What is capital rationing and what are the two types? What could they be the result of ?

Answer 28

Capital rationing describes the situation where a company does not have sufficient funds to invest in all positive NPVs Hard capital rationing: where an organisation would like to raise more funds but no stakeholder is prepared to invest. May result from potential returns not being high enough to compensate for risks involved Soft: Where an organisation could raise more funds but has decided not to. May result from a concern that the available finance is too expensive or may result in a loss of control

Question 29

What is single period rationin? How do you calculate profitability index

Answer 29

When funds are scarce in one year only and projects are divisible: If investment projects are divisible, then investing only a proportion of the initial investment required would result in the same proportion of the project NPV being achieved In such situations, we need to rank projects by identifying the NPV generated from each £1 of the initial investment, known as profitability index NPV/ initial investment

Question 30

What happens if you have indivisible projects in relation to capital rationing?

Answer 30

Can only accept projects as a whole and must find optimal combination

Question 31

What is shareholder value analysis?

Answer 31

Process of analysing the activities of a business to identify how they will result in increasing shareholder wealth

Question 32

What are the principles of SVA?

Answer 32

Business has a particular value at a particular time as determined by the present value of the project future cash flows from its activities There are seven factors known as value drivers

Question 33

What are the seven value drivers of SVA and how do you positively impact on the value drivers?

Answer 33

Sales growth rate: inc rate / prevent decline (using marketing, new products, changes) Operating profit margin: inc in margin by inc prices and or reducing operating costs (using marketing, product improvements, cost control) Corp tax rate: reduce effective rate using careful tax planning Investment in non current assets: reduce investment without impacting business (try to inc useful life of business) Investment in working capital: reduce investment without impacting business (reduce stock levels using careful inventory management) Cost of capifal (reduce cost of capital (by finding cheaper sources of finance) Life of projected cash flows (face lifting older products to increase life of cash flows)

Question 34

What are real options and what are the five real options?

Answer 34

One problem with NPV: only considers cash flows related directly to project. Negative NPV project may be accepted for strategic reasons. There may be options with the project: Follow on options: ability to launch future products off the back of this one or extend life of project Abandonment options: the ability to exit the project early and sell assets Timing options: ability to delay the start of the project to wait for favourable market conditions Growth options: ability to dip your toe in the water with small initial investment and then grow Flexibilitt: ability to change suppliers, materials, locations in the future if a cheaper project becomes available

Question 35

What is political risk and what are the 5 measures and descriptions?

Answer 35

Is the risk that action by a foreign government will affect the position and value of the company Quotas: limits on quantities of goods a subsidiary may buy from its parent for domestic sale Tariffs: extra tax or duty sooolier to imports in order to make domestic goods more competitive Non tariff barriers: extra quality or safety checks applied to imported goods Restrictions: foreign companies prevented from buying domestic companies in certain industries Nationalisation: of foreign owned companies and their assets Minimum shareholding: insistence of a minimum shareholding in companies by residents

Question 36

What are the four ways of dealing with political risks?

Answer 36

Negotiations with host government Insurance: export credit guarantee department provide protection against nationalisation, currency problems, war or revolution Production strategies: contract out some production to local sources or locate key parts of production and distribution overseas Management structure: use of joint ventures with domestic companies or ceding control to local investors

Question 37

What are the four benefits of understanding environmental costs?

Answer 37

Determine the correct cost and price of products and services Reduce chances of incurring fines and liability Ensure regulatory compliance Reduce costs (saving energy generally leads to cost savinds)

Question 38

What are the four types of conventional environmental costs?

Answer 38

Conventional: addressed in traditional cost accounting and inv appraisal but not usually considered environmental: cost of raw materials and utilities Potentially hidden costs: costs captured by accounting systems which lose their identity in general overheads: cost of complying with environmental laws or costs incurred going beyond compliance Contingent costs: costs to be incurred at a future date given their uncertain nature. Expected values could be used to build these costs into investment appraisal process. Such as cost of remedying and coenosbarinf future accidental releases of contaminents Image and relationship costs: costs incurred to affect perceptions of managements, customers, employees etc: costs of preparing environmental reports, or to improve companies image

Question 39

What are the three benefits of identifying key social impacts?

Answer 39

It affects an organisations relationship with key stakeholders It affects an organisations reputation It can assist in ESG reporting