Managing Finance and Budgets

Seminar 7

Follow-up Activities

Read Chapter 14 (including EPNV) Describe key concepts:

Purpose of Investment Appraisal

Accounting Rate of Return

Payback Period

Discounted Cash Flow

Internal Rate of Return

Cost-benefit analysis Exercises 14.1 and 14.2

Questions 1

What precisely is meant by ‘Investment’? Give the full names of the following tools for analysing the

value of an investment, ARR PP NPV IRR

Methods of investment appraisal

Four methods of evaluation:

Accounting rate of return (ARR)

Payback period (PP)

Net present value (NPV)

Internal rate of return (IRR)

Questions 2

Explain the difference between ARR and PP, Explain why ARR is thought to be the more useful

measure.

Average annual profit________ x 100% Average investment to earn that profit

ARR =

Accounting rate of return (ARR)

Payback period (PP)

Payback period (PP)

The payback period is the length of time it takes for the initial investment to be repaid

out of the net cash inflows from the project.

The cumulative cash flows of project with different types of yield

Project 1

Project 3

Project 2Yr 1

Cash flows (£000)

200 800600400 9000 500300100 700

Yr 2

Yr 3

Yr 5

Yr 4

Yr 1

Yr 2

Yr 3

Yr 5

Yr 4

Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Yr 1

Payback period

Questions 3

Explain why the value of £1000 invested and returned in five year’s time may not be equal to its present value.

State three factors which need to be taken into account in calculating the discount rate used to determine the Net Present Value.

Carry out the calculations to work out the net present value of £1 in 1 year, 2 years, 3 years, 4 years and 5 years time.

M & A Exercise 14.1

Interest foregone

InflationDiscount rate

Risk premium

The factors influencing the discount rate to be applied to a project

Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent

(1 + 0.2)0

(1 + 0.2)5

(1 + 0.2)4

(1 + 0.2)1

(1 + 0.2)2

(1 + 0.2)3

1.000

0.833

0.694

0.579

0.482

0.402

Year

1 2 3 4 5

Present value of £1

Questions 4

Why is NPV superior to ARR and PP? What factors affect the sensitivity of NPV calculations?

Why NPV is superior to ARR and PP

It addresses the following issues:

The timing of the cash flows

The whole of the relevant cash flows

The objectives of the business

Factors affecting the sensitivity of NPV calculations

Operating costs

Project NPV

Financing cost

Initial outlay

Sales price Annual sales volume

Project life

Questions 5

Explain what is meant by IRR. Explain the relationship between IRR and NPV. M & A 14.2

Internal rate of return (IRR)

Internal rate of return (IRR)

The internal rate of return is the discount rate, which, when

applied to the future cash flows of a project, will produce an NPV

of precisely zero.

The relationship between the NPV and IRR methods

NPV (£000)

Rate of return (%)

10

20

30

40

50

60

70

0 10 20 30 40

IRR

Finding the IRR of an investment by plotting the NPV against the discount rate

NPV(£000)

Discount rate (%)

£18,660 (positive)

+

-

0 G H

NPV £23,490 (negative)

6% 15%

FE

D

Questions 5

In addition to the IRR, PP, NPV and IRR analysis what other issues might affect a company’s decision to invest ?

What is the relationship between risk and expected return?

Dealing with questions relating to investment appraisal

Some practical points

Relevant costs

Opportunity costs

Taxation

Cash flows and profit flows

Relationship between risk and return

Return(%)

Risk

Risk premium

Risk-free rate

Questions 6

Describe the stages that you would expect to go through in managing an investment project.

Managing the investment decision

Stage 1

Stage 2

Stage 3

Stage 4

Stage 5

Determine investment funds available

Identify profitable project opportunities

Evaluate the proposed project

Approve the project

Monitor and control the project