Week 3 - Investment Appraisal Flashcards
How to adjust for inflation in an NPV model
Fishers equation: (1 + real rate of interest) x ( 1 + inflation rate)
Either (produces same NPV) forecast cash flows:
- At constant prices (‘real’ cash flows) and discount using real rate of interest or
- With the effect of inflation added (‘money’ cash flows) and discount using nominal rate of interest
Dealing with taxation in NPV models
Taxable profit = ?
taxable profit = Accounting profit + depreciation - capital allowances
Dealing with taxation in NPV models
pre-tax cash flows = ?
pre tax cash flows = accounting profit + depreciation
Dealing with taxation in NPV models
after tax cost of debt = ?
discount after-tax cash flows using after-tax WACC
pre tax debt cost x (1 - tax rate)
if projects are financed using equity:
existing shareholders may not be ready to fund the proposed project;
public share issue to raise funds for new project dilutes current shareholders’ control of company
if projects are financed using debt:
may affect gearing levels
lenders may require security (collateral)
what is the approach to asset allocation when there’s limited project funding?
for indivisible projects?
Capital rationing:
- rank projects using PI (from highest to lowest) and accept projects in that sequence until capital is used up
- CR limits firms capital expenditures to funds available during a given period of time
- CR does work well for divisible projects
- for indivisible project CR may result in unused funds or the firm undertaking projects inconsistent with NPV decision rules
Qualitative factors to consider when assessing projects?
- Strategic importance of the project
- value of real options of the project
- project risk attributes
- post-completion audit for projects
- sustainability performance of a project
Strategic importance qualitative factors:
- enhancing quality of the services you provide
- keeping up with competitors i.e investing in similar projects undertaken by best firms in industry (benchmarking) - ensuring you compete with other firms
- lowering of costs (cost leadership)
- enhance or create customer value
Value of real options qualitative factors to consider
- future expansion
- manufacturing flexibility - may want to produce a product at a later date
- future sale of project - creation of a subsidiary to facilitate future sale
Post completion audit for projects qualitative factors to consider
- lessons learned from current/past projects
- value chain analysis (where project value can be maximised) - where can you add value In the supply chain e.g. outsourcing
- used for selection and performance improvement of future projects - taking best practices and applying to future
legal factors to consider when assessing project risks:
- attitudes of host government to foreign investors e.g. currency repatriation restrictions
- restrictions of employment of expatriate staff - may have to employ local workers - knock on consequences for operations of business should be considered
- may have requirements for licensing
- host government may demand a stake in the project
economic factors to consider when assessing the risk of a project?:
- Stability or growth of the local economy
- potential demand for products in the local economy - disposable income levels
- import/export tariffs
- supply chain considerations
- depreciation/instability of local currency
social factors to consider when assessing risks of a project?:
- adverse motivation of staff
- risk of redundancies
- availability of suitably qualified personnel
- frequency of industrial strike action
Project risks - qualitative factors to consider when assessing projects
- projects may have different risks during life span
- use project specific discount rate - risk premium factor to use?
- sensitivity analysis
