Beruflich Dokumente
Kultur Dokumente
N.B.
These notes are based on the capital investment appraisal questions set in many other Exams.
They are not therefore necessarily comprehensive different topics could be set in the Exams.
CONTENTS
1. MEANING OF RELEVANT CASH FLOWS
2. EXAMPLES OF RELEVANT CASH FLOWS
3. ITEMS WHICH ARE NOT RELEVANT CASH FLOWS
4. CAPITAL OUTLAYS AND CASH INFLOWS
5. CASH FLOW LAYOUT
6. THE MEANING OF: PAYBACK / NET PRESENT VALUE / IRR
7. CALCULATING DISCOUNT FACTORS
8. INTERPOLATING BETWEEN TWO DISCOUNT RATES
9. NPV v IRR
10. ADVANTAGES AND DISADVANTAGES OF NPV AND IRR
11. ADVANTAGES AND DISADVANTAGES OF THE ACCOUNTING RATE OF RETURN
12. ADVANTAGES AND DISADVANTAGES OF PAYBACK
13. SENSITIVITY ANALYSIS
GEOFF PAYNE
MARCH 2008
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Why is it important to distinguish between relevant and irrelevant costs in project evaluation?
It is important to distinguish between relevant and irrelevant costs in decision making because only relevant costs
should be included and all irrelevant costs should be excluded. If one fails to accurately distinguish between the two
ones decision will be based on the wrong data.
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(700)
50
160
(490)
Discount factors
Present Value
Net Present Value (NPV)
100
160
160
160
160
160
160
160
160
160
260
1.0
0.909
0.826
0.751
0.683
0.621
(490)
178.6
145.4
132.2
120.2
109.3
161.46
Payback
Payback is a commonly used method of appraising capital investment projects. It is seen as a useful
way of measuring the degree of risk involved in recovering the funds invested. The payback period
is the time that must elapse before the net cash flows from a project result in the initial outlay result
in the initial outlay being recovered in cash terms. It is argued that the shorter the payback period the
more attractive the project. It is a valid indicator for capital investment appraisal although it ignores
inflation. It also, perhaps more crucially, gives no indication of the overall cash flow benefits since it
ignores all cash flows after payback has been achieved, even when the later cash flows result in the
project never being paid back. It is for this reason that it should never be used in isolation.
IRR.
IRR is a means of appraising a project in financial terms. It takes into account the time value of
money i.e 1000 received today is worth more than 1000 received in a year's time. IRR refers to
the discount rate which, when applied to the project's cash flows, causes the cash inflows to equal
the cash outflows, with the result that the net present value of the project is equal to zero. If a project
has an IRR of,say, 15% this means that a project will be profitable if it can be financed at a rate less
than 15%. The IRR criterion is that a proposal with a return greater than the cost of capital (discount
rate) can be accepted. If there is more than one option, the option with the highest IRR should be
accepted.
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NPV V IRR
NPV is considered the superior method since in relation to mutually exclusive projects:
NPVs provision of financial returns (e.g. NPVs of say 1.6M and 1.0M) tells you how
much richer you would be in absolute terms and thus facilitates the choice of project to
pursue - assuming profit maximisation is your goal. IRR tells you only in relative terms
(e.g. 18% and 12%) which does not tell you how much richer you would be and is therefore
less useful to decision makers. In the example, the 18% IRR project could generate a very
modest NPV whilst the 12% IRR project could generate a very substantial NPV
NPVs are easier to base a decision upon (by choosing the project which gives the higher
NPV) in situations where IRR generates multiple yields that straddle the hurdle rate.
Disadvantages
Sensititivity to discount rate
The results are very sensitive to the rate of
discount chosen and in capital rationing, where
NPVs as % returns on investment are being
compared, a change in discount rates can
change the rankings of projects since the
impact of different rates can vary materially
from project to project according to the timing
of the cash flows.
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Disadvantages
Easy to interpret
A decision as to whether or not to invest can be
straightforward. If the IRR is higher than the
hurdle rate (the minimum rate acceptable to the
investor or the cost of capital) then the project can
be accepted
Target setting
Businesses can set target IRRs for project
appraisals these take the timing of earnings into
account, unlike say a target accounting rate of
return.
Perpetual cash flows
Where cash flows can be regarded as a perpetuity
the IRR is simple to work out. One simply divides
the annual cash flow (say 4,000) by the initial
outlay (say20,000) to give the IRR of 20%
Disadvantages
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Disadvantages
Ignores cash flows after payback
Payback ignores all cash flows after payback has
been achieved and hence gives no indication of the
overall cash flow benefits, even when the later cash
flows result in the project never being paid back.
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