Week 2 Flashcards
(18 cards)
ROCE (Accounting Rate of Return) Formula
Average Annual Profit / Average Value of Investment
Average Annual Profit = net cash flow - depreciation
Average Value of Investment = initial value + residual value/2
Advantages & Disadvantages of ROCE (Accounting Rate of Return)
Advantages
- Simple to understand and calculate as it is based on widely reported measures of return and assets.
- It is widely used and accepted, linked to other accounting methods such as calculating the annual ROCE of the whole organisation
- Considers the whole life of the project
Disadvantages
- Although considers the whole life, it does ignores the time value of money and wouldnt differ from other projeects of different lengths if cash flows remain the same
- Uses profits and ignores cash flows, profits are subjective and will vary dependent on accounting policies
- There is no definite investment signal, the decision to invest or not remains subjective.
Accounting Profit vs Relevant Cash Flows
*Financial managers make better decisions when they use cash flows instead of profits because:
Profits can be spent
Profits are subjective
Cash is required to pay dividends
Payback Method Advantages & Disadvantages
Advantages
- Simple to calculate and understand by managers
- It uses cash flows, not subjective to accounting profits
- Favours projects with the fastest returns which helps company growth and minimises risk.
Disadvantages
- It only looks at cashflows in the payback period, future cash flows are ignored - a project with a greater cash flow over life could be denied
- Ignores the time value of money but can overcome this by using the discounted payback technique
- No definite investment signal, what should the accepted length of time be - subjective.
Time Value of Money concept
Money received today is worth more than the same sum receivedd in the future and therefore has a time value.
this occurs for three reasons:
- Potential for earning interest/cost of finance
- Impact of inflation
- Effect of risk
Compounding and Formula
A sum invested today will earn interest. Compounding calculates the future value of a given sum invested today for a number of years
F= (1+r)n
Discounting and Formula
What is NPV
Discounting performs the opposite calculation to compounding - the present valye is the cash equivalent of money receivable/payable at some future date.
PV = F x (1+r)-n
The NPV is the net benefit or net loss of beneift in present valye terms of an investment opportunity.
NPV advantages & disadvantages
Superior to all other methods of appraisal
Advanatges
- Considers the time value of money, the discount rate considers the impact of inflation over time which is ignored by other appraisal techniques
- It is an absolute measure of return and tells us whether a project will add value to the business and generate SH wealth - allows a business to plan better
- Considers CFs and therefore is a more reliable tool for decision making
- Considers the whole life of a project as opposed to methods such as payback which only looks at earlier CFs
- Should lead to maximisation of SH wealth. If the cost of capital reflects the SH’s required return - then the NPV reflects the theoretical increase in business wealth
Disadvantages
- Not always well understood by managers - to understand need an undertanding of discounting and projects like payback can be preferred
- It requires knowledge of the cost of capital which can be complex but without this the NPV could be distorted
- NPV only considers the long term which may lead to short term demotivation
Discount Factor Formula
DF = PV x (1+r)-n
Discounting Annuities
- Definition
- What is an annuity factor?
- AF Formula
An annuity is a constant annual CF for a number of years.
The annuity factor is the name given to the sum of the individual DF.
AF = 1-(1+r)-n / r
Discounting Perpetuities
- Definition
- Formula for PV of a perpetuity and growing Perpetuity
A perpetuity is an annual cash flow that occurs forever.
PV = Cash Flow/R
Growing Perpetuity PV = Cash flow at T1 x 1/r-g
Calculating Advanced and Delayed Annuities and Perpetuities
Advanced - add 1 to the AF or Perpetuity calculation
Delayed
- apply the apporpriate factor to the cash flow as nomrla and then discount back to T0 eg. if cash flows begin in 3 years time this is because of activity in year 2 therefore discount back 2 years.
Internal Rate of Return (IRR)
Definition and Decision Rule
The IRR represents the discount rate at which the NPV of an investment is zero. It represents the breakeven cost of capital.
Decision rule: projects should be accepted if their IRR is greater than the cost of capital.
IRR Formula
Excel formula
IRR = L + (NL/NL-NH) x (H-L)
=IRR(sum of values)
IRR with even CFs (Annuities)
1) Find the cumulative DF as initial invesment/annual inflow
2) Find the life of the project (n) and look for nearest DF
3) The column which it is found is the IRR
IRR of a Perpetuity
IRR = (Annual inflow/Initial investment) x 100
Advantages and Disadvantages of IRR
Advantages
- Considers the time value of money through discounting cash flows to present values unlike payback
- Quite easy to understand because it is a percentage value - can be compared to the required rate of return easily which helps with decision making
- Uses cash flows rather than profits which can be subjective or manipulated
- If a project is accepted where the IRR is higher than the cost of capital then it will contribute to shareholder wealth
Disadvantages
Interpolation only provides an estimate and an accurate estimate requires the use of a spreadsheet program - if the margin between IRR and cost of capital is small - could lead to wrong decision being made
*Non conventional cash flows may give rise to multiple IRR’s which means the interpolation method cant be used
*Use of IRR has an inherent assumption that once cash inflows begin it will be reinvested at the same level as the projects IRR but its more likely for cash to be invested in projects that return at or above the cost of capital.
NPV vs IRR
*Both use discounted cash flows and are superior to basic techniques however, only the NPV can be used to distinguish between two projects. A project with a higher NPV might have a lower IRR and might be favourable but projects with a higher NPV should always be chosen because it tells us the absolute increase in shareholder wealth resulting from the project at the current cost of capital.
The IRR simply tells us how far the cost of capital could increase before the project would not be worth accepting.
