W19- Investment appraisal

What is net present value?

the most widely used investment appraisal technique

Why do we not include financing costs as a relevant cash flow in our NPV calculations?

because the discount rate already includes the cost of financing the project

When the NPV is positive, do we accept or reject the project and why?

accept- it provides a return in excess of the cost of capital, the NPV is the estimated absolute gain that shareholders obtain if the project goes ahead

When the NPV is negaitive, do we accept or reject the project and why?

reject- it does not provide the required return, the NPV is the estimated absolute loss that shareholders would incur if the project went ahead

When deciding between 2 projects/investments, how can we use NPV to decide which to go ahead with?

choose the option with the highest NPV as this will give the greatest benefit to shareholders

What are the 4 steps to work out NPV (net present value)

1. identify revenant cash flows

2. estimate discount rate (provided)

3. calculate the present value for each cash flow

4. net the present values to calculate NPV

What is the formula for calculating NPV?

discounted cash inflows - discounted cash outflows - initial investment

When calculating NPV, what table should we draw to help work it out?

columns: year, relevant cash flow, discount factor, present value and then net present value at the bottom

What is meant by working capital?

it represents the financial resources used by the company in their operations

What is the formula for working capital?

current assets - current liabilities

What should we do when including the impact of working capital in our NPV calculations?

• include increases in working capital as cash outflow

• release working capital as a cash inflow at the end of the project

What is payback period?

• another investment appraisal method

• uses same relevant cash flows as NPV method to determine how long it takes an investment project to recover the initial cash invested a the start of the project (assume cashflow occurs evenly across the year)

• note they only assess relevant cash flows and are not discounted

What is the method for payback period?

1. estimate the cash flow for each year of project

2. calculate the cumulative cash flows for each year

3. the payback period occurs when the net cumulative cash flow is zero (if this occurs part way thru a year, it can be expressed as a decimal or in years & months)

How do we interpret payback periods? What does it mean if a project recovers quickly or slowly?

• the quicker the project recovers the initial cash invested (shorter the payback period) the better and less risky it is

• projects that take a long time to recover the cash invested are seen as riskier as they involve more uncertainty due to longer recovery period

Organisations need to set a max payback period for projects in order to decide whether to accept or reject an investment. How can they choose between investments?

choose the project with shortest payback period

What is accounting rate of return (ARR)?

• another investment appraisal method

• it focuses on profits rather than cash flows

• we include non cash expenses such as depreciation

• based on the return on capital employed (ROCE) ratio

What is the formula for ARR?

ARR = average operating profit / average investment

How do we calculate average operating profit?

total project profit before interest & tax / years of project

how do we calculate average investment?

initial investment + residual value / 2

• don’t include any investment in working capital only include capital equipment

How do you know whether to accept or reject using ARR?

If the ARR you calculate is above the threshold given in the question accept the project, if its below reject it

What are advantages and disadvantages of NPV?

advantages

• considers time value of money

• helps maximise shareholder wealth

disadvantages

• more difficult to explain to non accountants

• uses discount rates which involve significant estimation giving misleading results

What are advantages and disadvantages of payback period method?

advantages

• based on cash flows rather than profit

• focused on liquidity

disadvantages

• does not consider time value of money

• requires estimation of cash which may not be accurate

What are advantages and disadvantages of ARR method?

advantages

• easier for non accountants to understand

• expresses return in a % format that is easier to interpret

disadvantages

• reliant on accounting profits which may be distorted by accounting adjustments

• requires estimation of profit which may not be accurate