Investment Appraisal and Valuation
What you must understand
Core tools: discounted cash flow using a project-specific cost of capital, NPV as the primary decision rule, IRR with its reinvestment assumption, payback and discounted payback, and the treatment of inflation (real versus money terms - never mix them). You must handle tax (capital allowances, tax-allowable depreciation), working capital, opportunity costs and sunk costs correctly. For valuation, know the free cash flow to firm model, dividend valuation models (including the growth model), and relative valuation using P/E and earnings yields. Synergy, control premiums and the difference between asset, earnings and cash-flow-based values are examinable.
Traps in questions
- Discounting real cash flows at a money (nominal) rate, or vice versa - a classic error.
- Including sunk costs or allocated fixed overheads that are not incremental.
- Forgetting working capital recovery at the end of the project.
- Using the company's WACC for a project in a different risk class; use a proxy beta (asset beta re-geared).
- In valuation, treating the growth model as valid when growth exceeds the cost of equity.
Worked rule of thumb
For a project in a new sector: ungear a proxy company's equity beta, re-gear at the target gearing, then use CAPM for the project discount rate. Only then discount incremental, after-tax, money-terms cash flows.
Example
A project returns £2m a year for five years, cost £7m, project cost of capital 10%. Annuity factor 3.791 gives PV £7.582m; NPV £0.582m - accept. If the company WACC were 8% but the project beta were higher, using 8% would overstate NPV.