Lecture 9 - Investment Appraisal

What does ARR stand for in investment appraisal?

Accounting Rate of Return

What is a major pro of using ARR?

Managers understand profitability measures.

What is a major con of using ARR?

It ignores the timing of cash inflows.

What does PP stand for in investment appraisal?

Payback Period

What is a pro of using the Payback Period method?

It uses cash flows, so accounting decisions do not affect the outcome.

What is a con of the Payback Period method?

It ignores cash flows after the payback period.

What is the time value of money?

The concept that £1 in the future is not worth £1 today due to interest, inflation, and risk.

What is the NPV decision rule?

Accept the project if NPV is positive; reject if negative.

How do you calculate the Present Value (PV) of cash flows?

Actual cash flow of year n divided by (1 + r)^n.

What is the formula for NPV?

NPV = Total Present Value of cash inflows - Initial Investment.

What is a key advantage of the NPV method over ARR and PP?

It considers the time value of money.

What is the significance of the cost of capital in NPV calculations?

It is used to discount future cash flows to present value.

What does a positive NPV indicate?

The project is expected to generate value exceeding its cost.

What is the hurdle rate in the context of ARR?

The minimum acceptable return on an investment.

What is the risk premium in investment appraisal?

The additional return expected for taking on additional risk.

What are relevant cash flows in NPV analysis?

Cash flows that will occur as a direct result of the investment decision.

What is the impact of inflation on investment appraisal?

Inflation reduces the purchasing power of future cash flows.

How does NPV relate to shareholder wealth maximization?

NPV aims to maximize the value of the firm and shareholder wealth.

What is the formula to calculate the Present Value of £1 at a discount rate?

PV = £1 / (1 + r)^n.

What is the purpose of using Present Value tables?

To easily find the discount factors for various periods and rates.

What is an example of a cash flow for Project A in the Hosta Haulage example?

Expected cash inflows of £60,000 per annum.

What is the initial investment amount for the projects in the Hosta Haulage example?

£120,000.

What should be done if multiple projects have positive NPVs?

Select the project with the highest NPV.

What is a disadvantage of the Payback Period method regarding project selection?

It does not help in selecting between projects with the same payback period.

Why is the Payback Period considered a risk-averse decision model?

It favors projects that return cash quickly, minimizing risk.

What does the term 'cumulative cash flows' refer to?

The total cash inflows accumulated over time from an investment.

What is the importance of adjusting for opportunity cost in investment appraisal?

It recognizes the potential returns lost from alternative investments.

What is the primary focus of investment decision making?

To allocate large amounts of resources effectively for long-term gains.

What are the four methods of investment appraisal?

1. Accounting Rate of Return (ARR) 2. Payback Period (PP) 3. Net Present Value (NPV) 4. Internal Rate of Return (IRR)

What does the Accounting Rate of Return (ARR) measure?

The average accounting profit generated by an investment as a percentage of the average investment over the project's life.

What is the formula for calculating ARR?

ARR = (Average annual operating profit / Average investment) × 100%

What is the decision rule for ARR?

A project must achieve at least a minimum target ARR to be acceptable.

What is the Payback Period (PP)?

The time taken for the initial investment to be repaid from project net cash inflows.

What is the decision rule for Payback Period?

A project should have a shorter PP than the maximum PP set by the business.

What is the significance of the time value of money in investment decisions?

It accounts for the fact that money available today is worth more than the same amount in the future.

In the Billingsgate Battery Company example, what was the initial investment cost?

£100,000

What were the expected operating profits before depreciation for Year 1 to Year 5?

Year 1: £20k, Year 2: £40k, Year 3: £60k, Year 4: £60k, Year 5: £20k

What were the disposal proceeds from the machine at the end of Year 5?

£20,000

How is average annual operating profit calculated in the ARR example?

Average annual operating profit = (£20k + £40k + £60k + £60k + £20k) ÷ 5 = £40,000

What is the annual depreciation for the machine in the Billingsgate example?

Annual depreciation = (£100,000 - £20,000) ÷ 5 = £16,000

What is the average annual operating profit after depreciation in the example?

Average annual operating profit = £40,000 - £16,000 = £24,000

What is the average investment value for the machine in the example?

Average investment = (£100,000 + £20,000) / 2 = £60,000

What is the calculated ARR for the Billingsgate Batteries investment?

ARR = (£24,000 / £60,000) × 100% = 40%

What is the cumulative cash flow at the end of Year 3 in the Payback Period example?

Cumulative cash flow = £20,000

When does the project reach payback in the Billingsgate Batteries example?

After 2 years and 8 months.

What is a key advantage of using the ARR method?

It provides a clear percentage return on investment.

What is a disadvantage of the Payback Period method?

It does not consider cash flows that occur after the payback period.

What is a disadvantage of the ARR method?

It does not take into account the time value of money.

What is a key advantage of the Payback Period method?

It provides a quick assessment of how long it will take to recover the initial investment.

What is the primary purpose of investment decision-making?

To evaluate potential investment opportunities and maximize shareholder wealth.

What are the four main investment appraisal methods?

Net Present Value (NPV), Internal Rate of Return (IRR), Accounting Rate of Return (ARR), and Payback Period (PP).

What does NPV stand for?

Net Present Value.

What does IRR represent?

Internal Rate of Return, which is the discount rate that makes the NPV of a project zero.

How is NPV calculated?

By discounting future cash flows to their present value and subtracting the initial investment.

What is the significance of a positive NPV?

It indicates that the investment is expected to generate profit and is worth pursuing.

What is the NPV of Project A in the Hosta Haulage example?

£29,160.

What is the NPV of Project B in the Hosta Haulage example?

£(8,130).

What is the NPV of Project C in the Hosta Haulage example?

£25,250.

Which project has the highest NPV in the Hosta Haulage example?

Project A.

What does it mean if a project has a negative NPV?

The project is expected to result in a loss and should be rejected.

What is the IRR decision rule?

Accept the project if its IRR meets or exceeds the firm's minimum IRR requirement.

What are some problems associated with using IRR?

It does not directly address wealth maximization, ignores the scale of investment, and can be difficult with unconventional cash flows.

How can IRR be calculated?

By trial and error using two discount rates, one resulting in a positive NPV and the other in a negative NPV.

What is the relationship between NPV and IRR?

Both methods are used to evaluate investment opportunities, with NPV focusing on dollar value and IRR on percentage return.

What is the formula for calculating the present value of cash flows?

Cash Flow / (1 + r)^n, where r is the discount rate and n is the year.

What does the payback period measure?

The time it takes for an investment to generate enough cash flows to recover its initial cost.

Which investment appraisal method is considered the most effective?

Net Present Value (NPV).

What factors should be considered in investment appraisal?

Relevant costs, opportunity costs, and potential cash flows.

What is the typical cost of capital used in the Hosta Haulage example?

10%.

How do larger businesses typically approach investment appraisal?

They tend to rely more heavily on NPV and IRR compared to smaller businesses.

What is the total expected cash inflow for Project C over three years?

£180,000.

What is the significance of the discount rate in NPV calculations?

It reflects the opportunity cost of capital and affects the present value of future cash flows.

What does it mean for projects to be mutually exclusive?

Only one project can be accepted; if one is chosen, the others are rejected.

What is the cash flow for Year 1 of Project C?

£40,000.

What is the cash flow for Year 2 of Project C?

£50,000.

What is the cash flow for Year 3 of Project C?

£90,000.