Projects (NPV) Flashcards
(31 cards)
How to deal with depreciation in cashflows?
Remove it
How to calculate money rate %?
1 + m = (1 + r) x (1+ i)
Advantages and disadvantages of using NPV to value projects?
Advantages:
- Takes into account the time value of money
- Show shareholder wealth created by project
- Can allow for risk (by adjusting cost of capital)
- Looks at entire project
Disadvantages:
- Requires the cost of capital to be estimated in the future
- Calculations can be time consuming and misunderstood
- Doesn’t factor in liquidity or time taken to generate funds
ARR calculation?
Average Annual Profit / Average Investment
Average investment calculation?
Initial outlay + Scrap value / 2
How to calculate IRR?
What does it show?
Use IRR function on all periods (including T0)
Actual % return on investment
How to calculate perpetuity?
What if the perpetuity grows annually?
Cashflow x 1/r
Cashflow x 1/(r-g)
How to calculate discount factor?
What does it show?
1 / (1 + r)^n
How much a cashflow in the future is worth right now.
What is an annuity?
How would you use it on a cashflow and what would it show?
Where to find formula?
Constant annual cashflow for a set amount of years.
Multiply the cashflow by the annuity to get PV of cashflow.
Given to us on sheet.
How is the annuity factor formula split?
Perpetuity x discount factor
When would you use replacement analysis/EAC and how is it calculated?
Deciding on the best replacement cycle of an asset/project.
1) Create cashflow for each scenario
2) Calculate NPV of each cycle and divide by annuity factor
3) Choose the cycle with the LOWEST negative EAC (Equivalent Annual Cost)
When is capital rationing used? How to calculate and make decision?
Situation when a company can’t invest in all positive NPV projects.
1) Calculate PI (profitability index) of each project = NPV / Initial investment
2) Order them by best to worst PIs
3) Choose projects to invest in within budget - if divisible, can invest in parts of projects
What are the seven driving factors to increase wealth?
- Sales growth rate
- Operating profit margin (increase sales price/reduce costs)
- Corporation tax rate
- Investment in non-current assets (reduce)
- Investment in working capital (reduce)
- Cost of capital (find cheaper)
- Life of projected cashflows (extend life)
What are the 5 ‘real options’ for projects?
Follow on options - ability to launch future projects off the back / extend life of current project
Abandonment options - ability to exit project early and sell assets
Timing options - ability to delay start of project until favourable market conditions
Growth options - ability to ‘dip your toes in the water’ with a small investment, then grow
Flexibility options - ability to change supplier/materials/location if a cheaper option becomes available
When may you choose to take a negative NPV project? (not in exam question)
For strategic reasons if the real options outweigh the negative NPV
How to calculate sensitivity of a cashflow?
NPV of project / NPV of impacted cashflow (inc. tax)
How to calculate sensitivity of cost of capital?
IRR - Cost / Cost
Strengths and weaknesses of sensitivity analysis?
Strengths:
- Helps decision making
- Identifies variables that should be closely monitored
- Simple to understand
Weaknesses:
- Ignores probability
- No clear answer - gives context rather than clear decision
What is simulation and what does it show?
Hundreds & thousands of simulations are run to calculate the NPVs of the project for different combinations of variables to identify the range of variables and the probability of these occuring.
Results show the expected NPV and the distribution of possible NPVs.
Strengths and weaknesses of using simulation?
Strengths:
- Gives more information about the spread of the possible outcome
- Useful for problems that can’t be solved analytically
Weaknesses:
- Doesn’t give a decision, provides additional context
- Time consuming without a computer
- Can be expensive to design and run
- Assumptions need to be made about probabilities
What is systematic and unsystematic risk?
Systematic - external environment
Unsystematic - specific to company
Examples of systematic risk?
- State of the economy, interest rates and inflation
- Impact by business sector and it’s level of gearing
- The beta figure in CAPM represents systematic risk
Examples of unsystematic risk?
- Variability in PBIT due to factors specific to the company
Examples: equipment failure, product faults and labour strikes - Investor’s exposure to this risk may diversified away
What is portfolio theory?
- By investing in several uncorrelated companies (15-20 random shares), where one company may be generating less profits due to risk, another will be generating more therefore offsetting the unsystematic risks.
- Simplified: the ups and downs of the uncorrelated companies will cancel each other out - therefore reducing UNSYSTEMATIC RISK.
- The more investments held, the more the risk is diversified.
