Revision Cards 2.0 Flashcards
(11 cards)
What are the 3 methods of investment appraisal?
1) Net Present Value
2) Payback
3) Accounting Rate of Return
What is Net Present Value
NPV is based upon discounting the value of cash received and paid to reflect the fact that money is worth more to a business today, as it’s available risk-free and it can be invested today to return a profit rather than at some point in the future.
Discounting uses the rate of interest paid on borrowings to convert future receipts into the current value of money. If there are 2 or more potential projects but only funds for one, the project with the highest NPV is selected as it will produce the biggest overall profit after the interest has been accounted for.
NPV does not take into account the profitability of projects. It can also be challenging to explain to non-experts such as line managers.
What is Payback?
Payback is a method of investment appraisal which calculates the time when a business will receive the return on its investment. It assumes the project will be financed by borrowings. The money made after the project reaches Payback is surplus/profit.
Packback takes no account of the time value of money or the size of the surplus. However, it is a good tool for small businesses as it focusses on repaying borrowings and clearly shows when the project has paid off so it will be able to move onto the next project.
What is Accounting Rate of Return?
The accounting rate of return measures the profit, or return on the amounts invested, in projects. It allows a business to see how much profit each project will make as a percentage of capital invested.
The accounting rate of return does not account for the time value of money, or the size of projects. There is a risk a small project with a small return but high profitability % could be chosen over a project with a higher overall return but a smaller profit %.
3 Cases for Acquisitions and Mergers
1) Synergies (2+2=5)
1. 1 - SAVED MANAGEMENT COSTS (remove layers of management)
1. 2. - SAVED ADMIN COSTS (IT systems etc.)
2) Economies of Scale!
2. 1 - BULK BUYING - Although, scope within aviation is limited as fuel and staff are the main costs and you’re unlikely to be able to negotiate a discount on them. However, it is possible on aircraft.
2. 2 - EASIER TO RAISE FINANCE - But only if you’re profitable in the first place. Also, larger amounts of finance are now likely to be necessary.
2. 3 - EASIER TO MARKET / BRAND - However, recent aviation mergers have retained both brands (eg, AF/KL and BA/IB)
2. 4 - GREATER SPECIALISATION - Eg, of managers, although there must be a point where further specialisation fails to yield any greater economies?
2. 5 - TECHNICAL ECONOMIES - Parts etc, although now you have a wider variety of aircraft to maintain.
3) REDUCES RISK by operating in a variety of markets and by reducing competition. However, whilst these points have face validity, why would you not diversify away from aviation to spread risk properly? Furthermore, how much should you pay to eliminate a competitor?
6 cases against acquisitions and mergers
1) Research suggests 80% of them don’t achieve the published goals. This may be because the goals are exaggerated to gain initial support.
2) It’s arguable they are just about the boss’ ego to build a massive empire.
3) Sometimes the idea is promoted by financial advisors who stand to gain income for themselves.
4) It’s difficult to know the right price to pay. If it seems a rival is also prepared to bid then the price may be inflated.
5) The cost and inconvenience of a merger may not outweigh the economic benefits.
6) If a company is abroad then FOREX issues/risks are present, specifically transaction risk.
7) How will they actually be financed?
8) Could be deemed anti-competitive by courts.
FOREX risk demonstration
A sale of $65k
£1 = $1.50 = £43k
£1 = $1.75 = £37k
Risk = loss (£6k)
WACC demonstration
Ordinary shares / retained earnings £200,000k 2% £4,000
Secured loans / finance leases £100,000 3% £3,000
Unsecured loans / operating leases £100,000 5% £5,000
TOTALS £400,000k £12,000
WACC 3%
6 methods of hedging a company can utilise to reduce FOREX risk
1) TAKE THE RISK - sometimes it may work in your favour!
2) Get paid in GBP - this transfers the risk to the customers which may be deemed unacceptable and renders you uncompetitive
3) Operate bank accounts abroad - transfer the funds when the rate is good again, whenever this may be
4) Buy a FORWARD - a contract to buy currency at a set rate on a set date. You may loose out if the market value improves.
5) Buy an OPTION - similar to a forward however you are not obliged to actually use it. However, even if you don’t use it then you’ve still had to pay for the forward.
6) MATCHING - take out loans in a foreign currency to pay in foreign currencies, eg, FR took out USD to pay Boeing
Where does the discount factor for NPV come from?
WACC
What tax advantage is there for interest paid on loans?
The interest paid on loans is seen as an expense and therefore is not subject to tax. This effectively means loans can be up to 30% cheaper for a company as dividends paid to shareholders comes from the company’s profits which are taxed.
