Investment Appraisal

Front 1

Type of finance available for a project depends on

Back 1

Size, duration, risk, capital asset banking

Front 2

Free cash flow

Back 2

Cash that isn't retained or reinvested in a business

Front 3

What does free cash flow represent

Back 3

Cash flow available to:

All providers of capital of a company

To pay dividends or finance additional capital projects

Front 4

Free cash flow formula

Back 4

Revenue less costs less investments

Front 5

Relevant cash flows

Back 5

Those costs and revenues that are:

Future

Incremental

Front 6

Which NPV costs should be ignored

Back 6

Sunk

Committed

Non cash

Apportioned overheads

Front 7

TAD rules

Back 7

TAD is calculated on a reducing balance basis

Total TAD is dependent on the total fall in value over the period (cost less scrap)

TAD is claimed as really as possible

No TAD in year of disposal

In the year of sale or scrap a balancing charge arises

Front 8

IRR is sensitive to

Back 8

Increase in cost of finance

Increase in investors' perception of the potential risk

Any alterations to estimates used in NPV appraisal

Front 9

What can affect returns required by investors?

Back 9

Interest rates increases: increases returns required by investors

Company specific factors: actions of competitors affect viability of business model impacting the return.

Front 10

Problems with using IRR

Back 10

The assumptions are unrealistic i.e. reinvestment at IRR

Decision rule is not clear cut i.e. two IRRs possible

Choosing between projects

Doesn't account for changing cash flow patterns

Cost of financing and return are likely to be different

Front 11

Advantages of MIRR

Back 11

Is unique

Gives a measure of returns from a project

Is a simple percentage

Front 12

Interpretation of MIRR

Back 12

Measures economic yield under the assumption that cash surpluses are reinvested at the current CoC

Shows max CoC firm can sustain

Front 13

MIRR method

Back 13

Terminal value of cash inflows at the company's reinvestment rate

Present value of outflows discounted at company's cost of finance

MIRR found by taking nth root of (TV inflows/PV outflows) subtract one. Where n = length of the project in years.

Front 14

Discounted payback period

Back 14

Measures the length of time before the discounted cash returns from a project covers initial investment.

Front 15

Concept of duration

Back 15

Measures average time to recover present value of project. Indicates when the bulk of project value will be captured.

Front 16

Modified duration

Back 16

If discount rate changes what will be the impact on duration

Front 17

Profitability index

Back 17

NPV/PV of capital invested

Used to deal with single period capital rationing

Front 18

What does long term capital rationing indicate

Back 18

Form should expand its capital base through issue of new finance to the markets

Front 19

Linear programming

Back 19

A technique dealing with scarce or rationed resources. Solution shows optimum allocation of scarce resources between options being considered

Front 20

How to formulate linear program

Back 20

Define the unknowns

Formulate the objective function

Express constraints in terms of inequalities including non negatives

Front 21

Using risk adjusted WACC

Back 21

Assumes business risk of CQC and financial risk of company and I'd therefore appropriate for appraisal

Front 22

Limitations of using CQC

Back 22

Assumes debt is perpetual whereas debt is actually finite

Issue costs on equity are ignored

Front 23

APV calculation

Back 23

Base case NPV + financing impact = APV

Front 24

How to value base case investment element for APV

Back 24

Find project asset beta

Calculate base discount rate Keu by putting asset beta in formula to reflect just business risk

Calculate base case NPV

Front 25

How to value PV of financing package APV

Back 25

Financing cash flows: issue costs and tax relief

Discount at Kd or risk free rate

Front 26

Issue costs APV

Back 26

Usually added on top so gross up funds to be raised. e.g. if 3% issue costs then sum of debt/0.97 and take 3% of that as issue costs

Front 27

PV of debt and equity issue costs

Back 27

Equity issue costs (non tax deductible)

Debt issue costs are tax deductible

RTQ for timings of tax relief cash flows.

Front 28

PV of debt issue costs formula

Back 28

Issue costs at T0

Tax relief at CT rate

PV of tax relief (RTQ for timings of CFs)

Front 29

PV of the tax replied on interest payments

Back 29

Bonds - interest paid at fixed amount each year.

Annual tax relief = Total loan * interest rate*tax rate. X

Annuity factor for ten years. X

Year one discount factor (if tax is delayed one year) X

PV of the tax shield. X

Front 30

PV of interest payments made for bank loans

Back 30

Amount of repayment = (amount of loan/relevant annuity factor)

Calculate annual interest charge (annual amount*annual interest rate)

Front 31

APV formula

Back 31

Base case NPV plus NPV of tax shield less NPV of issue costs

Front 32

Subsidized loan

Back 32

PV of interest saved less PV of tax relief lost

Opportunity benefit of the subsidized loan

Front 33

Debt capacity APV

Back 33

If amount of debt raised is lower than total debt capacity increase of the project then use theoretical debt capacity to calculate APV

Front 34

Advantages of APV

Back 34

Steep by step approach gives clear understanding of the elements of the decision

Can evaluate any type of financing package

More straightforward than using adjusted APV

Front 35

Disadvantages of APV

Back 35

Based on Modogliani and Miller therefore:

Ignores bankruptcy risk, tax exhaustion and agency costs

Assumes debt is risk free and irredeemable