Investment Appraisal Short Answer Type Questions
Question 1.
What is investment appraisal? List the various capital investment appraisal techniques.
Answer:
An evaluation of the attractiveness of an investment proposal, using methods such as average rate of return, internal rate of return (IRR), net present value (NPV), or payback period. Investment appraisal is an integral part of capital budgeting (see capital budget), and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training. The capital investment appraisal techniques used to measure capital investment appraisal of a business project include:
- Net present value.
- Accounting rate of return.
- Internal rate of return.
- Modified internal rate of return.
- Adjected present value.
- Profitability index.
- Equivalent annuity.
- Pay back period
Question 2.
How allowing for inflation and Taxation in investment appraisal?
Answer:
Inflation in investment:
It is important that whichever technique is used, inflation is considered in a consistent manner. For instance, in both the internal rate of return and the net present value techniques, present and future cash flows will be identified as nominal amounts and will use a nominal interest rate to discount them to a present value. The impact of future inflation is ignored, except to the extent it is reflected in the interest rate used.
However, sometimes a company will want to compare the return on a potential future- project with a completed or ongoing one. Alternatively, the company will want to compare the returns from two countries with different rates of inflation. In these cases, real rates of return, which account for inflation, should be calculated for the completed projects. Real rates of return, even when inflation is low, will always be lower than a nominal return for the same period.
When discounting cash flows, they must be discounted using the appropriate rate of return. So, if real cash flows are used, then they must be discounted using a real rate of return. Similarly, a nominal rate of return must be used to discount nominal cash flows. The conventional method is to use nominal values.
Taxation in investment:
Tax will also have an impact on the discount rate used. Again, the issue is consistency. In most cases, the cash flows identified will be after-tax flows. To give a fairer reflection of the relative returns from prospective projects, companies should use an after-tax rate of return to discount any after-tax cash flows.
The after-tax discount rate can be calculated using the following formula:
R = r x 1 – trn where R equals the after-tax discount rate, r is the pre-tax discount rate and tm is the marginal tax rate.
The marginal tax rate is important as it reflects, as close as possible, the tax which will be payable on additional positive cash flows. As can be seen, the after-tax discount rate will be lower than the pre-tax equivalent.
Applying the correct discount rate is important when projects in different tax regimens are being assessed. For example, tax-is often an important consideration when a company is deciding to develop a new production facility. Using a pre-tax discount rate would distort the potential return from a project based in a low tax regimen when compared with one based in a location where a higher rate applies.
Question 3.
Explain the technique of assets replacement.
Answer:
Calculating periodic cash flows of existing asset is straight forward. Since the existing asset is already purchased, the initial investment outlay is zero and the periodic net cash flows are calculated based on the following formula:
Net cash flows = (revenue – operating expenses – depreciation) * (1 – tax rate) + depreciation
If the asset is replaced, it involves investment is the new asset and sale or disposal of the existing asset. Disposal of exiting asset has some income tax implications which need to be reflected in the calculation of initial investment as follows:
Initial investment after replacement = cost of new asset – sale proceeds of old asset +/- tax on disposal
Tax on disposed asset = (sale proceeds of old assets – book value of old asset) * tax rate
As evident from the equation above, if the old asset is sold at an amount higher than its book value, the company bears a related tax cost which is added to the initial investment. Similarly, if the sale proceeds are lower than the book value of the asset sold, there is a resulting tax shield which is subtracted from sum of cost of new asset and sale proceeds of the old asset.
Question 4.
Explain the various types of Capital rationing.
Answer:
1. Soft Rationing:
Soft rationing is when the firm itself limits the amount of capital that is going to be used for investment decisions in a given time period. This could happen because of a variety of reasons:
(a) The promoters may be of the opinion that if they raise too much capital too soon, they may lose control of the firm’s operations. Rather, they may want to raise capital slowly over a longer period of time and retain control. Besides if the firm is constantly demonstrating a high level of proficiency in generating returns it may get a better valuation when it raises capital in the future.
(b) Also, the management may be worried that if too much debt is raised it may exponentially increase the risk raising the opportunity cost of capital. Most firms have written guidelines regarding the amount of debt and capital that they plan to raise to keep their liquidity and solvency ratios intact and these guidelines are usually adhered to.
(c) Thirdly, many managers believe that they are taking decisions under imperfect market conditions i.e. they do not know about the opportunities available in the future. Maybe a project with a better rate of return can be found in the future or maybe the cost of capital may decline in the future. Either way, the firm must conserve some capital for the opportunities that may arise in the future. After all raising capital takes time and this may lead to a missed opportunity.
2. Hard Rationing:
Hard rationing, on the other hand, is the limitation on capital that is forced by factors external to the firm. This could also be due to a variety of reasons:
(a) For instance, a young startup firm may not be able to raise capital no matter how lucrative their project looks on paper and how high the projected returns may be.
(b) Even medium sized companies are dependent on banks and institutional investors for their capital as many of them are not listed on the stock exchange or do not have enough credibility to sell debt to the common people.
(c) Lastly, large sized companies may face restrictions by existing investors such as banks who place an upper limit on the amount of debt that can be issued before they make a loan. Such covenants are laid down to ensure that the company does not borrow excessively increasing risk, and jeopardizing the investments of old lenders.