Chapter 4: Financial Management Flashcards
(16 cards)
Appraisal method and Basis of method
Return on Capital Employed (Accounting rate of return) - Profits
Payback - Cash flows
Net Present Value - Discounted cash flows
Internal rate of return - Discounted cash flows
The Return On Capital Employed (ROCE), or Accounting Rate of Return (ARR) as it is also known, is calculated as follows:
ROCE = Average annual profit of the project / Average investment × 100
Where:
Average annual profit of the project = (Total net cash flows – Total depreciation)Length of project
Average investment = (Initial investment + Scrap value) / 2
Adv and disadv of ROCE
Advantages
-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
Disadvantages
-No account is taken of the project life
-No account is taken of the timing of the cashflows/it ignores the time value of money
-The result may vary according to the accounting policy used
-It may ignore working capital
-It does not measure absolute gain
-It does not give a definite decision
What are relevant cashflows
‘Future Incremental CashFlow’
Future - A decision being made today cannot change the past and so only future costs are considered
Past costs are sometimes referred to as sunk costs and so are ignored
Incremental - Only costs that are affected by the decision are incremental and therefore relevant
Costs that are sometimes referred to as committed costs and are not relevant and so are ignored eg. unavoidable fixed costs
Businesses need to consider opportunity cost
Relevant cash flows - Deprival value
Lower of:
Replacement cost and the higher of NRV and Value In Use
Payback period Adv and disadv
Adv
-Simple to calc
-Easy to understand
-uses relevant cash flows
disadv
-Ignores returns after payback
-timings of cash flows
-does not give definite decision
Present value formula
given in exam
FV x (1+r)^-n
What are annuities
Some investments generate a constant return, called an annuity
What are delayed annuities
Annuity formula and factors from annuity table assume cash flows will occur in one years time
Calculate the value as at one year before the start of the annuity then a discount factor may be used to find the present value
Advanced annuity
Cash flow starts at T0 rather than one years time
Add ‘1’ to the annuity formula to take into account the present value of the cashflow
perpetutities and formula
Annuity which lasts forever
PV = A x 1/r
Learn: Cashflow / interest rate
NPV Adv disadv
Adv
- time value of money
- cash flows rather than profits
- allows for risk via cost of capital
- looks at entire project
-shows changes in shareholder wealth / absolute measure of return
disadv
- difficult to understand
- requires knowledge of cost of capital
- relatively complex
IRR and formula
discount factor that gives a zero NPV
L + (NPVL / (NPVL-NPVH)) x (H-L)
L = Lower discount factor
H = Higher discount factor
Adv / disadv or IRR
Adv
-Time value of money
-Cash flows not profits
-does not require exact cost of funds
-As a %
-entire project
-relative measure of performance
disadv
-not an absolute measure
-interpolation provides only an estimate
-fairly complex
-non conventional cash flows give rise to multiple IRRs
-inherent assumptions that cash flows from the project are reinvested at projects IRR
NPV allowing for inflation
What is the nominal rate / money rate?
What is the real rate?
Formula is given in the exam, what is i, r and h
Nominal rate - interest rate set by bank of england (sometimes called money rate) - includes inflation
Real rate - cash flows exclude inflation so must the discount factor
i=nominal interest rate
r=real rate
h=general inflation rate
Sensitivity analysis
formula for a variable and cost of capital
Variable = NPV/PV of variable x 100
Cost of capital
=(IRR-Cost of capital)/ Cost of capital *100
