Investment Appraisal Flashcards

Flashcards about Investment Appraisal Methods

What is the rationale behind investment appraisal decisions?

Firms will only wish to invest in projects that provide an adequate return on their investment. Decisions are characterised by the commitment of large amounts of funds, for the long term.

Define investment in a business context.

A decision that involves the firm making a cash outlay with the aim of receiving, in return, future cash inflows.

In terms of relevant cash flows, when estimating cash flows what do we need to know?

• The capital cost of the project and the timing of expenditure

• The anticipated life of the asset and its terminal value

• The sales and income and operational expenditure arising from the

project and the periods in which it will occur

• The working capital required during the life of the project

• The effect of tax

• The effect of the project in the cash flows of other projects

Name four investment appraisal methods.

The Payback Method, Return on Capital Employed (ROCE), The Net Present Value (NPV), and The Internal Rate of Return (IRR).

Define the Payback Method.

How quickly the incremental benefits that accrue to a company from an investment project ‘pay back’ the initial capital invested, with benefits normally defined in terms of after-tax cash flows. Simply: when do we get our money back?

The 2 main ways payback method is used.

Set a specific time threshold over which projects

are rejected

• Provides a “speed of payback” rule, in case of more

than one, mutually exclusive investments are

assessed; the fastest is the most favored.

What are the advantages of the payback method?

Easy to understand the logic, quick and simple to calculate, thought to lead to automatic selection of the less risky project, saves management the trouble of having to forecast cash flows over the whole of a project’s life, convenient method to use in capital rationing situations.

What are the disadvantages of the payback method?

The decision is concentrated purely on the cash flows that arise within the payback period, and flows that arise outside this period are ignored. The option not to invest is generally one of the options open to the decision maker. An investment of zero will always produce an immediate payback. It does not allow for the ‘time value of money’.

How do you calculate the Return on Capital Employed (ROCE)?

ROCE = (Profit / Capital Outlay) * 100%

2 ways the return on capital employed (ROCE) is used.

1. Set a minimum acceptable level under which projects are rejected

2. In case of mutually exclusive projects, the best of the alternatives is that with the

highest ROCE (assuming they are over the minimum acceptable level)

What are the advantages of using ROCE?

Evaluating the project on the basis of a percentage rate of return is a familiar concept, the method evaluates the project on the basis of its profitability, which many managers believe should be the focus of the appraisal, managers’ own performance is often evaluated by shareholders in terms of the company’s overall return on capital employed so it is logical to evaluate individual capital investment in the same way.

What are the disadvantages of using ROCE?

It is an ambiguous concept. There are so many variants that no general agreement exists on how capital employed should be calculated. Because the method shows percentages, it is unable to take into account the financial size of a project when alternatives are compared. But the most important disadvantages are: the method uses profits, not cash flows. It also ignores the time value of money

What is the formula for Net Present Value (NPV)?

NPV = Σ [At / (1+r)^t] where At = the project’s cash flow in time t, n = the point of time where the project comes to an end, r = the annual discount rate

What is the NPV decision rule?

If the expression has a zero or positive value, the company should invest in the project. If it has a negative value, it should not invest.

What are the advantages of using NPV?

It is directly related to shareholder wealth, it recognises the time value of money, all relevant information is considered, gives clear, unambiguous signals.

What are the disadvantages of using NPV?

Does not relate the return to the size of the investment, the discount rate must be provided.

Define the Internal Rate of Return (IRR).

The rate of return (in percentage) that the project carries. Mathematically, the IRR of a project can be defined as the rate of discount which, when applied to the project’s cash flows, produces a zero NPV.

What is the IRR decision rule?

Only projects with an IRR greater than or equal to some predetermined ‘cut-off’ rate should be accepted. This cut-off rate is usually the market rate of interest (i.e the rate that we would have applied if we used the NPV method)

What are the advantages of using IRR?

Recognises the time value of money, relates the return to the size of the investment, gives the marginal discount rate at which the project ceases to be worthwhile.

What are the disadvantages of using IRR?

Does not relate to shareholder wealth maximisation; does not give the worth of the investment to the company, difficult to calculate, many unrealistic assumptions, can produce multiple solutions when large negative cash outflows occur.