CFS ACA

What is the TCFD & what does it focus on?

Task-Force on Climate-related Financial Disclosure; Governance, Strategy, Risk Management & Metrics & Targets

What some examples of environmental - ESG Performance Indicators?

. Energy consumption

. Total water consumption

. Greenhouse Gas ("GHG") emissions, absolute emissions and intensity of emissions

. Waste generated

. Pollutants and effluents released

. Recycling: recycled materials used in production, recycled of end-of-life products

What some examples of social - ESG Performance Indicators?

. Employee turnover overall, by department, by age, by gender, by length of service

. Average training hours per employee split by gender, seniority and role

. Occupational Health & Safety. Fatalities, high consequence injuries, recordable injuries and recordable work-related ill health cases

. Fair working and pay conditions

. Child labour and forced labour policies

. Supply chain sustainability

What some examples of governance - ESG Performance Indicators?

. Diversity of board directors by age, gender, such as women on the board and management team

. Board member expertise

. Risk management policies and procedures, risk identification, evaluation and mitigation

. Bribery and corruption. Anti-bribery, money laundering and other corruption disclosures and training for employees

. Assurance. Disclose for each ESG metric whether sustainability report has undertaken external independent assurance, internal audit departments or if no assurance has been undertaken. Also, explained the scope of assurance if undertaken.

What is payback period?

The time taken for cash inflows from a project to EQUAL cash outflows

What are the 2 formulas for accounting rate of return?

ARR = Average annual profit from investment/Initial investment x 100

Or,

Average annual profit from investment/Average investment x 100

Where average investment =(Initial outlay + Scrap value)/2

What should we remember about profit for accounting rate of return?

Profit is after depreciation

What is the NPV?

The difference between the maximum an investor would pay for a given set of cash flows (at their cost of capital) and to the actual amount they are being asked to pay.

What does the NPV Excel function assume?

It assumes the first cell is a cash flow in year 1.

When can you not use the NPV spreadsheet function?

If the cost of capital changes during the life of the investment. Use discount tables

What is the internal rate of return?

A cost of capital (discount rate) at which the NPV of a project would be £0

Which of the appraisal techniques is most superior and give 4 reasons why?

NPV

1. Takes time value of money into account (ARR & payback do NOT)

2. It’s an ABSOLUTE measure of return (unlike IRR)

3. It’s based on cash flows, NOT profits (profits=subjective)

4. Considers the whole life of the project

Which accounting rate of return formula should I use if I am not told?

Initial investment

For payback period, how do I work out the time?

Use tn to count - e.g. if PBP is just past t5, the PBP is 5 years + x months

What must you remember for the average investment formula for ARR?

(every number including initial investment SHOULD be POSITIVE)

How does a higher discount rate affect the NPV?

A higher (more aggressive) discount rate lowers the NPV

What are the advantages of the payback method?

• Simple to understand

• quick for initial screening of projects

• and considers risk (very crudely).

What are the advantages of the accounting rate of return method (ARR)?

• The use of profit is consistent with ROCE and EPS

• Use the of SFP values (asset backing)

• Relative score is easy to understand

What are the advantages of net present value method for appraisal?

• Takes into account the time value of money;

• gives an absolute measure, allowing for comparison of projects;

• considers all cash flows of projects.

What are the advantages of internal rate of return (IRR) appraisal method?

• Takes into account the time value of money;

• represents a breakeven point so does not need an exact cost of capital;

• considers all cash flows of projects.

What are the disadvantages of the payback method?

• Unsophisticated,

• no account is taken of the time value of

  money

• cash flows received/paid after payback are

  ignored.

What are the disadvantages of the accounting rate of return method (ARR)?

• Not consistent with wealth maximisation;

• no account is taken of time value of money;

• investment decisions should be based on expected cash flows rather than accounting profits;

• percentage figure may give misleading advice when choosing between alternatives;

• profits can be manipulated.

What are the disadvantages of net present value method for appraisal?

• The need to estimate a cost of capital;

• difficulty in obtaining all relevant costs/benefits;

• assumes cash flows occur at annual intervals.

What are the disadvantages of internal rate of return (IRR) appraisal method?

• May conflict with NPV decision for mutually exclusive projects - a project may have a lower NPV than another but a higher IRR;

• assumes cash reinvested at IRR.

What is the Excel spreadsheet formula for NPV?

=NPV(discount rate, cashflows to discount from T1 to tn)

What is the formula for the present value of a single cash flow

= Cash flow * (1+r)^-n

What is the formula for the present value of an annuity cash flow?

=Annuity cash flow *1/r *(1-(1+r)^-n)

What is the formula for the present value of a perpetuity cash flow?

= Perpetuity cash flow * 1/r

What is the formula for the present value of a growing perpetuity?

Cash flow at t1 × 1/(r-g)

How do I calculated present value if a annuity or perpetuity is delayed? (doesn’t start in year 1)

the discount factor must be adjusted for the delay.

How do I calculate present value if the discount rate changes over the period?

the formula for calculating the discount factor must be adapted

Which 2 adjustments must be made to get profits to cash flows?

1. Depreciation - ADD IT BACK

2. Working capital

What do we assume about working capital at the end of the project?

All working capital is resumed to be recovered at the end of the project

What should you do if they say working capital “required at the start of each year” in a Q?

That working capital cash flow should come out in the prior year (e.g. outflow in t0 for t1)

What is the definition of relevant cash flows?

The FUTURE, INCREMENTAL cash flows that arise from a decision being made

What is the formula for relevant cash flows?

Relevant cash flows = The difference between the cash flow if the action is taken & the cash flow if it is NOT

Which costs should be excluded & are not relevant cash flows?

1. Sunk costs - money already spent & irrecoverable

2. Committed costs - contracts already signed

3. Allocated & apportioned costs - You still have to pay regardless of project

4. Non-cash items - like depreciation

5. Book values

6. Finance costs - like interest & dividends

What is an opportunity cost?

The cash flow forgone if a unit of the resource is used on the project instead of in the best alternative way

What should we assume if we have a material in stock for a project that is used in normal work? (not project specific)

Assume that the extra units of material needed will be BOUGHT (to replenish stock)

What should we assume about capital allowance unless stated otherwise?

1. WDAs are at 18% on a reducing balance basis

2. There is NO WDA in year of sale - either balancing charge or allowance

3. That there are sufficient profits available elsewhere in business to utilise ALL tax benefits in full and at once

What are the tax assumptions for investment appraisals?

1. Assume whole tax payment is paid at end of year it relates to

2. Corporation tax paid at 25% unless stated otherwise

3. Tax rate is constant over life of project (unlikely in real life)

4. Working capital flows have NO tax effects

How are assets bought at the START of the accounting period treated for tax purposes?

First capital allowance will appear at time T1

How are assets bought at the END of the accounting period treated for tax purposes?

First capital allowance will appear at time T0

Which 2 distinct impacts does inflation have on the NPV calculation?

1. The effect of specific inflation on the cash flows

2. The effect of general inflation on the discount rate

What are current cash flows?

Cash flows that have not been increased for expected inflation (cash flows at today’s prices)

What are money cash flows?

Where cash flows have been increased to take account of expected inflation

What should be assumed about cash flows unless told otherwise?

They are money cash flows

What’s the difference between general and specific inflation rates?

The general inflation rate is a WEIGHTED average of many specific inflation rates (e.g. CPI) & a specific inflation rate is the expected rate of inflation for an individual item of revenue, savings or cost

What do you do if a question says “sales for next 3 years are £100 in CURRENT terms but are expected to inflate by 10%?”

It means year 1 is £100×1.1=£110, year 2 £110×1.1=£121 etc.

What do you do if a question says “sales in the first year will be £100 but are going to inflate by 10% for next 2 years?”

Year 1: £100, Year 2: £100×1.1=£110

What is the formula for real & money returns?

(1 + money rate) = (1+ real rate) * (1+ inflation rate)

Which method should we use for the impact of inflation?

Money @ money:

1. Inflate each cash flow by its specific inflation rate

2. Discount using the money rate

What is the formula for the real @ effective method? & what can it be used for?

(1+ effective rate) = (1+ money rate)/(1+specific inflation rate)

Can be used for annuities and perpetuities

What are the 4 environmental cost types?

1. Conventional costs – the costs of using raw materials, utilities, capital goods

   and supplies

2. Potentially hidden costs – these costs tend to be ‘hidden’ in general overheads

   rather than separately classified

3. Contingent costs – costs to be incurred at a future date, due to their uncertainty

   a prediction may be required using probabilities

4. Image and relationship costs – costs incurred to improve corporate image.

What are the benefits of understanding environmental costs?

1. better pricing decisions

2. Managing and controlling these costs may avoid fines and save money

3. Regulatory compliance

What is replacement analysis?

Replacement analysis (aka optimum economic life) helps us decide how often to replace an asset

How to calculate the optimum economic life for replacement analysis?

1. For each possible economic life, calculate the NPV of a single asset cycle.

2. The NPV of each option is then converted into an 'Equivalent Annual Cost' (EAC)

This is the equal annual cash flow (annuity) to which a series of uneven cash

flows is equivalent in PV terms.

It is calculated as:

Equivalent annual cost = PV of cash flows / Annuity factor

3. Choose the strategy with the lowest EAC.

What is the formula for equivalent annual cost?

Equivalent annual cost = PV of cash flows / Annuity factor

What are the 3 assumptions of replacement analysis?

1. the cost of the asset will not be subject to inflation

2. the operating efficiency of assets different ages will be similar

3. The asset will be replaced in perpetuity or at least into the foreseeable future

What are the limitations of replacement analysis?

1. Changing technology, which can quickly make machines obsolete and shorten replacement cycles.

2. Inflation, which by altering the costs of assets means that the optimal replacement cycle can vary over time.

3. The fact that use of the machines is unlikely to continue in perpetuity.

What is capital rationing?

Where there are insufficient funds to undertake ALL positive NPV projects, so a choice must be made between projects

What are the 2 types of capital rationing?

1. Hard rationing - when the EXTERNAL capital market (e.g. banks) limits the supply of funds

2. Soft rationing - When the firm INTERNALLY imposes its own restraint on funds

What does it mean if a project is indivisible?

the project must be done in full or not at all

What does it mean if a project is infinitely divisible?

we can do part of the project and gain part of the NPV.

1. Projects should be ranked according to the NPV earned per £1 invested in the

   cash-restricted period.

2. Funds applied in the ranking order (highest to lowest) - highest first

How do we choose from infinitely divisible projects with synergies?

1. Work out the projects independently first

2. Work out the joint projects with synergies & compare

What is SVA?

Process of analysis activities of a business to identify how they will result in increasing shareholder wealth?

What are the seven drivers of value (SVA) using mnemonic?

Sales

Length (of cashflows)

Operating profit margin

Working capital

Cost of capital (discount rate)

Asset cost

Tax

What are real options?

The strategic value of a project that NPV does not consider

Worth of a project = Traditional NPV + Value of associated options

What are the 6 options available for real options?

1. Follow on options

2. Abandonment options

3. Contraction options (reducing output, not abandoning)

4. Timing options (e.g. starting now or in 5 years)

5. Growth options - (e.g. new technology)

6. Flexibility options

What the examples of political risks?

1. Quotas

2. Tariffs

3. Non-tariff barriers

4. Restrictions

5. Nationalism

6. Minimum shareholding

What is the difference between risk & uncertainty?

Risk is quantifiable (probabilities are known) & uncertainty is unquantifiable (outcomes cannot be mathematically predicted)

What does the expected value?

The long run average outcome, NOT the most likely result

What are the 4 limitations of expected values?

1. requires discrete outcomes

2. subjective probabilities

3. ignores risk

4. not a possible outcome, so less applicable to one-off projects.

What is sensitivity?

The percentage change required in an estimate for the NPV to fall to 0

How do you calculate the sensitivity to discount rate?

Difference between the cost of capital and the IRR

How do you calculate the sensitivity to project life?

Discounted payback

What are the strengths of sensitivity analysis?

1. Provides more information to make a judgement

2. Identifies areas that critical to the project’s success

What are the limitations of sensitivity analysis?

1. assumes variables change independently of each other

2. doesn’t assess the likelihood of a variable changing

3. doesn’t identify a correct decision.

What is big data?

datasets whose size is beyond the ability of typical database software to capture, store, manage and analyse.

What is data analytics?

the process of interpreting, organising and analysing big data to generate insights and support for business decisions.

What is data mining?

the process of extracting valuable information from big data using AI and statistical algorithms.

What are predictive analytics?

Predictive analytics use historical and current data to create predictions about the future.

What are 4 common examples of predictive analytics?

1. Linear regression models

2. Decision trees

3. Scenario analysis

4. Simulations.

What is a linear regression model?

Linear regression quantifies the relationship between the dependent variable (y) and the independent variable (x)

What are the independent and dependent variables for linear regression?

The variable that the business is trying to predict is called the dependent variable (e.g. sales growth), and the factors that have an impact are called the independent variables (e.g. time/seasonality).

What does multiple regression analysis do?

It involves exploring whether identifying more than one independent variable reduces the error term & identifies the most important variables that reduce the error term as low as possible

What are the advantages of a linear regression model?

1. Simple to use and easily explained to non-financial managers

2. Models can be used to predict the impact from changes in estimates (e.g. sales volumes being higher than predicted).

What are the disadvantages of a linear regression model?

1. There will not always be a linear relationship between variables and outcomes

2. Linear models may identify spurious relationships as they do not consider the difference between correlation and causation

3. Will be less meaningful if the data collected is inaccurate or if the error term is large

What is correlation?

Correlation measures the strength of the connection between two or more variables.

What is the Excel formula for correlation?

= CORREL(cell range for array 1, cell range for array 2)

What are 3 types of correlation coefficient & what values can it take?

values between –1 and +1

1. r = +1 indicates perfect positive correlation

2. r = 0 indicates no correlation

3. r = –1 indicates perfect negative correlation

What are decision trees?

Decision trees are a predictive analytics technique that can be used to identify the impact of different decisions on the outcome of an investment.

What are the advantages of decision trees?

1. Simple to explain and logical

2. Can be used to consider multiple decisions

3. Can be used to consider the different outcomes that occur based on changes in a number of variables

What are the disadvantages of decision trees?

1. Large decision trees, or many possible outcomes can become difficult to interpret

What is scenario analysis?

A technique which allows the effect of multiple variables changing simultaneously to be assessed by creating a limited number of plausible future scenarios

What is the Monte Carlo simulation?

Monte Carlo simulation uses mathematical modelling to produce a distribution of the possible outcomes from the project.

What are the 3 stages of the Monte Carlo simulation?

1 Specify major variables, and their probabilities.

2 Specify the relationships between the variables.

3 Simulate the environment.

What are the advantages of simulation?

1. Provides more information about the possible outcomes and their sensitivities

2. Useful for problems that cannot be solved analytically.

What are the disadvantages of simulation?

1. Does not identify a correct decision

2. Time-consuming and complex without specific software

3. Can be expensive

4. Monte Carlo techniques requires assumptions to be made, which may be unreliable.

What are physical risks?

physical effects of climate change, such as wildfires and flooding