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D Spreadsheet Flashcards

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1
Q

Why NPV is better than IRR

A

NPV looks at absolute increases in wealth and thus can be used to compare projects of different sizes. IRR looks at relative rates of return and doesn’t take into account relative size of the project

In situations involving multiple reversals in project cash flows, it is possible that the IRR method may produce multiple IRRs (that is, there can be more than one interest rate which would produce an NPV of zero). Affects decision-making

NPV links to shareholder wealth whilst IRR only calculates the rate of return on projects

NPV can be used in situations where the cost of capital changes from year to year. In IRR, it’s difficult to know what to compare cost of capital with

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2
Q

How may capital rationing issues be overcome

A

Obtain information about available sources of finance, since SMEs may lack understanding in this area

Wealthy individuals or groups of investors who invest directly in the company and who are prepared to take higher risks in the hope of higher returns

Grant aid from a government, national or regional source which could be linked to a specific business area

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3
Q

When can real-terms inflation be used?

A

Must be a single rate of inflation affecting all of the project’s cash flows

The single rate of inflation affecting the cash flows must also be the same as the general rate of inflation suffered by investors

Apply the specific rates of inflation to sales, material costs and other cash flows and ensure the cash flows in the appraisal incorporate these

The uncertainty surrounding the rates of inflation that Crocket Co faces with this project will certainly make an appraisal in nominal-terms more difficult to prepare

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4
Q

Why is DCF better than non-DCF

A

They allow for TVM and recognise that a $ received today is worth than a $ received in one year’s time

DCF is cash flow based rather than profit based. So won’t be affected by accounting policies

DCF investment appraisal methods consider cash flows over the whole life of an investment project, whereas payback ignores cash flows after the payback period

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5
Q

DCF Disadvantages

A

The potentially complex and time-consuming process of calculating NPV or IRR

The complexity of estimating an appropriate discount rate (i.e. the applicable interest rate), particularly for unquoted companies

Difficulty in explaining DCF methods to non-financial managers

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6
Q

Issue with ARR

A

Based upon accounting profit and ignores cash flow

Arbitrarily set targets based upon internal corporate targets

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7
Q

Sensitivity Analysis Advantages

A

It gives an idea of how sensitive the project is to changes in each of the original estimates

It prompts management to check the quality of data for the most sensitive variables

It identifies thecritical success factorsfor the project and directs project management

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8
Q

Sensitivity Analysis Disadvantages

A

Doesn’t take into account probabilities occuring

Involves isolating the impact of each variable on the outcome

Doesn’t provide an indication of whether to undertake a project

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9
Q

Advantages Probability Analysis

A

How likely it is that outcomes will occur which will change the decision

Allow for more than one variable changing by combining their probabilities

Calculate the expected NPV of the project, which can provide the decision-maker with a simple decision to go ahead if the expected NPV is positive

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10
Q

Payback advantage

A

Advantage: Uses cash flows, indicates when the investment will break even and whether this is before projected cash flows become very uncertain

It is simple to calculate and it is easy to understand

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11
Q

Payback disadvantages

A

Disadvantage: Payback period ignores cash flows after the payback period. The payback target is subjective

Disadvantage: Using payback to compare investments may result in choosing shorter-term investments giving immediate returns, rather than investments offering greater returns in the longer term

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12
Q

ROCE advantages

A

Advantage: The ROCE method may reflect the wishes of shareholders that the company generates sufficient profits and does consider the entire life of the investment

Advantage: As ROCE is a percentage measure, it can be used to compare this investment with other options

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13
Q

ROCE disadvantages

A

Disadvantage: Doesn’t take into account the TVM

Disadvantage: An investment which increases company value will be rejected if its ROCE is below the target ROCE

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14
Q

Lease instead of Buy

A

Leases offer more flexibility than buying. If technology changes so the asset is out-of-date, the lessee does not have to keep on using it

Lessee may not have enough cash to pay for the vehicle and might have difficulty in obtaining a bank loan

The cash flows of leasing and buying generally last over the life of the project, discounted cash flow techniques should be used. Means TVM should be used

Cash flows of the lease that will be relevant are the lease payments themselves and the tax savings that these lease payments will lead to

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15
Q

NPV affect if real-term inflation used?

A

Real cash flows would need to be discounted using real cost of capital not nominal cost of capital
The effects of general inflation are excluded

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16
Q

Simulation Benefits

A

Specify the variables, specify the relationship between the variables, run the siimulation, analyse the results

More real-world, as it is unlikely a single variable will change in isolation

Shows the full range of possible outcomes, enabling further mathematical analysis

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17
Q

Simulation Disadvantages

A

It can be very time-consuming without a computer

Monte Carlo simulation is not a technique for making a decision, only for obtaining more information about the possible outcomes

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18
Q

Limitation of Probability Analysis

A

Probability estimation requires historic data of the event frequency to give any unreliability to the figures

A company’s attitude to risk is ignored in its decision

An expected value is essentially a long-run average over a sufficiently high number of repetitions and consequently may not be a possible outcome

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19
Q

Projects with Significantly different Business Risk to Current Operations

A

Proposed investment project has business risk that is significantly different from current operations, it is no longer appropriate to use theweighted average cost of capital (WACC)

Where business risk changes significantly, the capital asset pricing model should be used to calculate a project-specific discount rate

WACC can only be used as a discount ratewhere business risk and financial risk are not significantly affected by undertaking an investment project

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20
Q

CAPM (use)

A

The capital asset pricing model (CAPM) can provide a project-specific discount rate

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21
Q

CAPM (beta)

A

CAPM uses a beta that represents the systematic risk of a project and of the company undertaking the project to find a risk-adjusted cost of equity for use in discounting

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22
Q

CAPM (proxy company)

A

selecting a proxy company with similar business activities to a proposed investment project

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23
Q

CAPM (ungearing)

A

ungearing the proxy company equity beta to give an asset beta which does not reflect the proxy company financial risk

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24
Q

CAPM (regearing)

A

regearing the asset beta to give an equity beta which reflects the financial risk of the investing company

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25
Advantages of CAPM
It considers only systematic risk (i.e. is relevant for listed companies whose institutional investors have diversified portfolios from which unsystematic risk has been eliminated) CAPM has been subject to frequent empirical research and testing It is a much better method of calculating the cost of equity than the dividend growth model in that it explicitly allows for a company's level of systematic risk relative to the stock market as a whole
26
Limitations of CAPM
It is a single-period model – whereas company projects are often for multiple periods Lack of data for the model – particularly in developing markets CAPM tends to overstate the required return on high-risk companies and understate the returns on low-risk companies Assumptions in calculation - a complete risk-free asset isn't possible
27
Risk
Risk refers to the situation where an investment project has several outcomes, all of which are known and to which probabilities can be attached
28
Uncertainty
Uncertainty refers to the situation where an investment project has several possible outcomes but it is not possible to assign probabilities to their occurrence.
29
Risk-adjusted discount rate
Investment projects with higher risk should therefore be discounted with a higher discount rate than lower risk investment projects capital asset pricing model (CAPM) can be used to determine a project-specific discount rate that reflects an investment project’s systematic risk.
30
Adjusted Payback (considering risk)
If uncertainty and risk are seen as being the same, payback can consider risk by shortening the payback period Discounted payback can also be seen as considering risk because future cash flows can be converted into present values using a risk-adjusted discount rate
31
Ways to Encourage Stakeholder Objectives (codes)
Codes of best practice have developed over time into recognised methods of encouraging managers to achieve stakeholder objective Managers can be encouraged to achieve stakeholder objectives by bringing their own objectives more in line with the objectives of stakeholders such as shareholders Performance related pay - pay is determined based on meeting specific performance targets Reduce information asymmetry by monitoring the decisions and performance of managers
32
Nominal Approach
Cash flows are inflated to future price levels using the specific inflation rate for each type of revenue/cost Nominal leads to uncertainty surrounding the rates of inflation. How to determine the inflation rate accurately?
33
Real rate
Cash flows are expressed at today's prices (i.e. before the effects of inflation). These are then discounted at a real rate (i.e. excluding general inflation The only situation in which the real method is valid is when revenues and costs all increase at the general inflation rate
34
IRR
IRR takes into account the time value of money, cash flows and the whole life of the investment IRR is being used for comparison, it does not indicate which investment will generatemore wealth for shareholders
35
NPV
NPV uses cash flows rather than subjective profits. It takes into account the time value of money and the whole investment life The results of the NPV calculation will depend on whether the cost of capital has been accurately estimated
36
TVM Assumptions
Money received today can be spent or reinvested to earn more. Therefore, investors have a preference for having cash/liquidity today Cash received today is safe; future cash receipts may be uncertain Cash today can be spent at today's prices, but the value of future cash flows may be eroded by inflation
37
Taxation Assumptions
Tax rate is constant Sufficient taxable profits are available to use all tax deductions in full
38
Inflation Problems
Hard to estimate, especially when rates are high It causes governments to take actions which may affect businesses It makes historical costs irrelevant and causes return on capital employed (ROCE) to be overstated Different costs and revenues will inflate at different rates
39
Replacement Analysis Limitations
Like-with-like replacement (in perpetuity) is rarely possible, even if desirable. Asset requirements may change over time Changing technology may also require earlier replacement (e.g. IT equipment) than the optimal solution suggests Non-financial factors (e.g. employees may be more satisfied if their company cars are replaced more often
40
When Business is not in a Tax-Paying Position
Losses in current year Losses are broguht forward from prior years Tax exempt charitable status
41
Non-Financial Factors for Buying an Asset
The asset is of fundamental importance to the business and is in constant use Management wants to have absolute control over the asset To update or upgrade the asset to scale up capacity is relatively easy
42
Non-Financial Factors for Leasing an Asset
The asset may only be needed for a short time or there is significant uncertainty about how long it may be used The asset requires specialist support or maintenance that is provided by the lessor The asset needs to be regularly updated or upgraded for any reason
43
Benefits of EAC
NPV earned needs to be related to the period of time required to earn it Choose the optimal replacement interval, NPV of each possible replacement interval forms part of an infinite chain of replacement intervals EACs for different lengths of replacement interval can be compared meaningfully to find the optimal replacement interval
44
Reasons for Soft-Capital Rationing
Management aversion to issuing new equity (company may want to avoid dilution of EPS) Managers wish to finance new investments using retained earnings Managers want investment projects to compete for funds, in the belief that these funds will result in stronger investment projects
45
Reasons for Hard-Capital Rationing
High business risk (i.e. the company's operating cash flows are very sensitive to the economic cycle) High country/political risk (i.e. concerns about corporate governance or state appropriation of assets) High financial risk (i.e. the company already has high debt levels, banks don't want to lend)
46
Methods for Risk
Probability analysis Sensitivity analysis Discounted payback
47
What should investors rely on?
NPV
48
What does discounted payback method overcome?
Failure of simple payback to take account of the time value of money, it still fails to consider cash flows outside the payback period
49
Divisble Project (Profitability)
A profitability index can be calculated (NPV / initial investment)
50
Divisble Project (ranking)
The limited investment funds can then be invested in the projects in the order of their profitability indexes
51
Indivisble Project (PI)
Ranking by profitability index will not necessarily indicate the optimum investment schedule, since it will not be possible to invest in part of a project
52
Indivisble Project (NPV)
NPV of possible combinations of projects must be calculated Combination of projects with the highest aggregate NPV will then be the optimum investment schedule
53
If NPV > 0
Accept
54
If NPV < 0
Reject
55
If IRR > target %
Accept
56
If IRR < target %
Reject
57
When making a judgment using EAC
The lowest EAC should be chosen
58
NPV in numerator or denominator in project?
Numerator
59
What discount factor is used in EAC?
Only negative cash flows
60
When inflows increase (effect on IRR)?
Increase in IRR
61
When outflows increase (effect on IRR)?
Decrease in IRR
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