D Theory Flashcards
(143 cards)
1
Q
What is asset (“capital”) expenditure?
A
Incurred in the acquisition or improvement of non-current assets
2
Q
What are expenses (“revenue”) expenditure?
A
Incurred to maintain non-current assets (e.g. repairs)
3
Q
Superior investment appraisal technique if the company’s main financial objective is to maximise shareholder wealth?
A
Net Present Value (NPV). This is because NPV shows the theoretical absolute change in shareholder wealth due to a project
4
Q
What appraisal technique is needed for providers of finance?
A
May wish to know the project’s internal rate of return (IRR)
5
Q
The higher the project IRR over the proposed loan interest rate?
A
Lower the risk of default
6
Q
What is the payback period?
A
Time it takes for the undiscounted operating cash flows from a project to pay back the initial investment
7
Q
What if payback period is less than target?
A
Accept
8
Q
What if payback period is greater than target?
A
Reject
9
Q
Advantage of payback period (calculate and understand)
A
Simple to calculate and easy to understand
10
Q
Advantage of payback period (earlier)
A
Concentrates on earlier flows which are more certain
11
Q
Advantage of payback period (capital)
A
It focuses on recovering the original capital as soon as possible to exploit new investment options
12
Q
Disadvantage of payback period (cash flow)
A
It ignores cash flows after the payback period
13
Q
Disadvantage of payback period (TVM)
A
It ignores the time value of money
14
Q
Disadvantage of payback period (information)
A
It gives no information about the change in shareholder wealth
15
Q
What is discounted payback?
A
Requires cash flows to be discounted to present value first
16
Q
What is ROCE?
A
The average annual operating profit expressed as a percentage of the initial (or average) investment
17
Q
When ROCE is greater than target?
A
Accept
18
Q
When ROCE is less than arget?
A
Reject
19
Q
Does ROCE contain sunk costs and depreciation and amortisation?
A
Yes
20
Q
Advantage of ROCE (accounting)
A
It uses readily available accounting information
21
Q
Advantage of ROCE (calculate)
A
Simple to calculate and understand
22
Q
Advantage of ROCE (financial)
A
It is often used by financial analysts to appraise performance
23
Q
Disadvantage of ROCE (methods)
A
Different methods of calculation may confuse
24
Q
Disadvantage of ROCE (profits)
A
It is based on profits rather than cashflow. Profits are affected by accounting policy choices. It ignores the time value of money
25
Disadvantage of ROCE (relative)
As a relative (percentage) measure, it gives no information about the absolute change in shareholder wealth
26
When does interest accrue?
Only on the initial amount invested
27
How is interest reinvested in compound interest?
Interest is reinvested alongside the principal
28
When is it useful to know the EAIR?
Where interest is charged on a non-annual basis. Gives the true interest rate associated with an investment or loan
29
What is the reverse of discounting?
Compounding
30
What does discounting calculate?
The sum which must be invested now (at a fixed interest rate) to receive a given sum in the future
31
What does simple discount factor give?
The present value of $1 receivable at the end of n years at a discount rate
32
What is the time value of money concept?
It is based on the assumption that investors prefer to receive $1 today rather than $1 in one year
33
Liquidity preference for time value of money?
Money received today can be spent or reinvested to earn more. Therefore, investors have a preference for having cash/liquidity today
34
Risk for time value of money?
Cash received today is safe; future cash receipts may be uncertain
35
Inflation for time value of money?
Cash today can be spent at today's prices, but the value of future cash flows may be eroded by inflation
36
What are the DCF methods?
IRR and NPV
37
NPV an absolute or relative measure?
Absolute
38
IRR an absolute or relative measure?
Relative
39
Advantage of DCF methods (time)
Time value of money and all of a project's cash flows over its entire duration
40
Advantage of DCF methods (objectivity)
Provide a more objective basis for evaluating and selecting investment projects as they are unaffected by financial accounting policies (e.g. capitalisation)
41
Disadvantage of DCF methods (calculate)
The potentially complex and time-consuming process of calculating NPV or IRR
42
Disadvantage of DCF methods (explanation)
Difficulty in explaining DCF methods to non-financial managers
43
Disadvantage of DCF methods (discount)
The complexity of estimating an appropriate discount rate (i.e. the applicable interest rate), particularly for unquoted companies
44
Disadvantage of DCF methods (managers)
Managers may feel little connection between DCF methods and their reported performance and bonus systems
45
What does a project's NPV show?
The theoretical change in the dollar value of the company due to the project. Therefore shows the change in shareholder wealth due to the project
46
What is perpetuity?
A stream of identical cash flows arising each year to infinity
47
What is IRR?
The discount rate at which the present value of a project’s cash flows is zero
48
If IRR > Cost of capital?
Accept
49
If IRR < Cost of capital?
Reject
50
How to achieve an NPV of 0?
The present value of the cash inflows must equal the initial cash outflow
51
A situation where there are multiple IRRs?
If cash outflows are followed by cash inflows and then more cash outflows
52
Another way of saying cost of capital?
Target %
53
NPV vs IRR for decision-making?
NPV is always reliable
IRR isn't reliable
54
NPV vs IRR for shareholder wealth?
NPV shows $ change in shareholder wealth
IRR does not show an absolute change in wealth
55
What does IRR take no account of?
The relative size of a project
56
What are incremental cash flows?
Those that change because a project is undertaken (e.g. cash from sales, and operating costs such as materials and labour)
57
Are financing costs an incremental cash flow?
No
58
What is lost contribution?
An opportunity cost and should be shown as a cash outflow
59
Negative effect of taxation on investment appraisal
It is charged on operating results
60
Positive effect of taxation on investment appraisal
Tax relief is given on non-current assets via tax-allowable depreciation
61
Assumptions of tax (constant)
Tax rate is constant
62
Assumptions of tax (sufficient)
Sufficient taxable profits are available to use all tax deductions in full
63
Inflation problems for project appraisal (estimate)
It is hard to estimate, especially when rates are high
64
Inflation problems for project appraisal (inflate)
Different costs and revenues will inflate at different rates
65
Inflation problems for project appraisal (governments)
It causes governments to take actions which may affect businesses
66
Inflation problems for project appraisal (customers)
It creates uncertainty for customers, which may lead to lower demand
67
What does the real interest rate reflect?
The interest rate required in the absence of inflation
68
What does the nominal interest rate reflect?
Real interest rate adjusted for the effect of general inflation as measured
69
How does the specific inflation rate differ from the general inflation rate?
A specific inflation rate is the inflation rate on an individual item (e.g. wage inflation, materials price inflation). In comparison, the general inflation rate is a weighted average of many specific inflation rates.
70
Two possible approaches when there is inflation in the economy?
Discount nominal (money) cash flows at a nominal cost of capital
Discount real (today’s money) cash flows at a real cost of capital
71
Discounting cash flows using the nominal method?
Cash flows are inflated to future price levels using the specific inflation rate for each type of revenue/cost
72
Discounting cash flows using the real method?
Expressed at today's prices (i.e. before the effects of inflation). These are then discounted at a real rate (calculated using the Fisher formula)
73
When does the Real Method only work?
If all cash flows are inflating at the same general inflation rate
74
What has to be done to calculate NPV if selling prices and costs have different inflation rates?
To forecast each cash flow in nominal terms
75
How does a project usually start?
With a cash outflow for the investment in non-current assets
76
What can happen to accounts receivable in a project's life?
May increase, resulting in cash inflows less than sales revenues
77
What can happen to accounts payable in a project's life?
May also increase, reducing the investment in working capital and improving cash flows because payments to suppliers are less than purchases
78
What can happen at the end of a project?
Inventory may be reduced to zero and all receivables collected, creating a cash inflow
79
Increase in net working capital outflow or inflow?
Cash outflow
80
Decrease in net working capital outflow or inflow?
Cash inflow
81
How is scrap value treated in a project?
Must be included in the evaluation of a project as a cash inflow at the end of the project life
82
Problem with ignoring scrap value in a project?
Ignoring scrap value would reduce the NPV and may lead to rejecting an otherwise acceptable investment project
83
How is working capital recovery treated in a project?
Shown as a cash inflow at the end of the project
84
What happens to cash flow forecast if tax is paid one year in arrears?
The cash flow forecast is extended by a year
85
What is capital rationing?
situation in which there is not enough finance (capital) available to undertake all available positive NPV projects
86
What is hard capital rationing?
The capital markets limit the amount of finance available
87
What is soft capital rationing?
The company sets internal limits on finance availability
88
What is single-period capital rationing?
Capital is in short supply in only one period
89
What is multi-period capital rationing?
Capital is rationed in two or more periods
90
Why use hard capital rationing (business risk)
The company's operating cash flows are very sensitive to the economic cycle
91
Why use hard capital rationing (political risk)
Concerns about corporate governance or state appropriation of assets
92
Why use hard capital rationing (financial risk)
Company already has high debt levels
93
Why use soft capital rationing (equity)
Managers may wish to avoid raising further equity finance if this will dilute the control of existing shareholders
94
Why use soft capital rationing (organic)
A preference for slower organic growth to a sudden increase in size arising from accepting several large investment projects
95
Why use soft capital rationing (debt)
Managers may wish to avoid issuing new debt if their expectations of future economic conditions are such that an increased commitment to fixed interest payments would be unwise
96
What are mutually exclusive projects?
Two or more projects that cannot be undertaken simultaneously
97
Issue with replacement analysis (like-with-like)
It's rarely possible, even if desirable. Asset requirements may change over time
98
Issue with replacement analysis (technology)
Changing technology may also require earlier replacement
99
Issue with replacement analysis (non-financial)
Non-financial factors (e.g. employees may be more satisfied if their company cars are replaced more often.)
100
How can use of an asset be obtained?
an outright purchase (e.g. by borrowing to buy)
a lease agreement
101
What is the lease or buy decision?
Assumes that the preferred financing decision is the one with the lower present value (PV) of cost and that the purchased asset is financed with a bank loa
102
Relevant cash flows to buy an asset?
Purchase cost
Tax benefit of TAD
Scrap proceeds
103
Relevant cash flows to lease an asset?
Lease payments (assume all to be tax-allowable deductions)
Tax benefit of lease payments
104
When the PV of cost of best finance source < PV of operating cash flows?
Project should be undertaken
105
If a business is not in a tax-paying position, what are the implications for a lease vs buy decision? (TAD)
No tax benefit from TAD if the asset was bought
106
If a business is not in a tax-paying position, what are the implications for a lease vs buy decision? (lease)
No tax benefit arises from the lease payments
107
If a business is not in a tax-paying position, what are the implications for a lease vs buy decision? (debt)
There would be no tax shield on debt
108
Situations where a business is not in a tax-paying position?
Losses in current year
Losses are brought forward from prior years
Incorporation in a tax-free special economic zone
109
Implications of borrow to buy (bank loan)
Bank loan (or loan notes) will be recorded in non-current liabilities, increasing the reported level of financial gearing
110
Implications of borrow to buy (interest)
Interest on the debt will reduce interest cover
111
Implications of lease (liability)
Both the asset and a related liability would be recognised in the statement of financial position
112
Implications of lease (expense)
Interest expense in early years would be relatively high, tending to reduce interest cover, but lower in later years due to amortisation
113
When buying an asset is appropriate (fundamental)
The asset is of fundamental importance to the business and is in constant use
114
When buying an asset is appropriate (upgrade)
To update or upgrade the asset to scale up capacity is relatively easy
115
When buying an asset is appropriate (maintained)
The asset is easily maintained
116
When leasing an asset is appropriate (short time)
The asset may only be needed for a short time or there is significant uncertainty about how long it may be used
117
When leasing an asset is appropriate (upgraded)
The asset needs to be regularly updated or upgraded for any reason
118
When leasing an asset is appropriate (specialist)
The asset requires specialist support or maintenance that is provided by the lessor
119
What is a risk?
A condition in which several possible outcomes exist, the probabilities of which can be quantified from historical data
120
What is an uncertainty?
The inability to predict possible outcomes due to a lack of historical data (i.e. information) being available for quantification
121
Sensitivity analysis?
The analysis of changes made to significant variables to determine their effect on a planned course of action
122
Benefit of sensitivity analysis (sensitive)
It gives an idea of how sensitive the project is to changes in each of the original estimates.
123
Benefit of sensitivity analysis (management)
It prompts management to check the quality of data for the most sensitive variables
124
Benefit of sensitivity analysis (spreadsheet)
It is easily adapted for use in spreadsheet packages
125
Limitations of sensitivity analysis (data)
It assumes data for all other variables is accurate
126
Limitations of sensitivity analysis (decision)
It does not provide a decision rule. Management must decide the level of sensitivity that is acceptable
127
Limitations of sensitivity analysis (computer)
Without a computer, it can be time-consuming
128
What is a simulation?
A technique that allows more than one variable to change simultaneously
129
Advantages of simulation (Monte)
Monte Carlo simulation provides more information about the possible outcomes and their relative probabilities
130
Advantages of simulation (NPV)
This data can be used to calculate an expected NPV
131
Limitations of simulation (Monte)
Monte Carlo simulation is not a technique for making a decision, only for obtaining more information about the possible outcomes.
132
Limitations of simulation (Expensive)
It could prove expensive in designing and running the simulation, even on a computer
133
What is an expected value?
The quantitative result of weighting uncertain events by the probability of their occurrence
134
Advantage of expected value (one)
Expected value reduces the information to one value for each choice
135
Advantage of expected value (average)
The idea of an average is readily understood
136
Disadvantage of expected value (probabilities)
The probabilities of possible outcomes may be difficult to estimate
137
Disadvantage of expected value (average)
The average may not correspond to any of the possible outcomes
138
What is discounted payback period?
Length of time it takes the discounted net cash revenue/cost savings of a project to payback the initial investment
139
Benefit of discounted payback period?
Allows for the time value of money
140
Criticism of discounted payback period?
Still ignores cash flows after the payback period
141
Methods of keeping project risk within acceptable levels (payback)
Setting a maximum adjusted payback period in the initial screening process of potential projects
142
Methods of keeping project risk within acceptable levels (NPV)
Selecting projects with a combination of an acceptable expected NPV and a relatively low standard deviation of NPV
143
Methods of keeping project risk within acceptable levels (Risk-adjusted)
Using risk-adjusted discount rates for both NPV and adjusted payback. A higher discount rate should be applied to higher-risk projects, reducing the influence of more distant cash flows
