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AFM_Study_Text_2024-25-2

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Bunthea
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© © All Rights Reserved
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Chapter 2

2 Investment appraisal

3 A key concept in investment appraisal – Free cash flow

Cash that is not retained and reinvested in the business is called free cash
flow.

It represents cash flow available:


 to all the providers of capital of a company
 to pay dividends or finance additional capital projects.

KAPLAN PUBLISHING 43
Investment appraisal

Uses of free cash flows

Free cash flows are used frequently in financial management:


 as a basis for evaluating potential investment projects – see below
 as an indicator of company performance – see Chapter 14: Corporate
failure and reconstruction
 to calculate the value of a firm and thus a potential share price – see
Chapter 13: Business valuation.

Calculating free cash flows for investment appraisal

Free cash flows can be calculated simply as:


Free cash flow = Revenue – Costs – Investments
The free cash flows used to evaluate investment projects are therefore
essentially the net relevant cash flows you will recall from your earlier studies.
Free cash flow to equity will also be discussed in future chapters. This is
essentially the cash available for distribution to shareholders, so in many cases
just the free cash flow already calculated, but with debt interest also deducted.

Use of free cash flows in investment appraisal

This chapter covers the following investment appraisal methods, all of which
incorporate the use of free cash flows:
 Net Present Value (NPV)
 Internal Rate Of Return (IRR)
 Modified Internal Rate Of Return (MIRR)
 Discounted Payback Period
 Duration (Macaulay Duration and Modified Duration).

4 Net Present Value


Capital investment projects are best evaluated using the net present value
(NPV) technique. You should recall from earlier studies that this involved
discounting the relevant cash flows for each year of the project at an
appropriate cost of capital.
As mentioned above the net relevant cash flows associated with the project are
the free cash flows it generates. The discounted free cash flows are totalled to
provide the NPV of the project.
Some basic NPV concepts (relevant cash flows, discounting, the impact of
inflation, the impact of taxation) are covered below.

44 KAPLAN PUBLISHING
Chapter 2

Relevant cash flows

Relevant costs and revenues

Relevant cash flows are those costs and revenues that are:
 future
 incremental.
You should therefore ignore:
 sunk costs
 committed costs
 non-cash items
 apportioned overheads.

Discounting

KAPLAN PUBLISHING 45
Investment appraisal

The impact of inflation


The treatment of inflation was introduced in the Financial Management
syllabus. A brief recap follows:
Inflation is a general increase in prices leading to a general decline in
the real value of money.
In times of inflation, the fund providers will require a return made up of
two elements:
 Real return for the use of their funds.
 Additional return to compensate for inflation.
The overall required return is called the money or nominal rate of
return.
Real and nominal rates are linked by the Fisher formula:
(1 + i) = (1 + r)(1 + h)
Or
(1 + r) = (1 + i)/(1 + h)
in which:
r = real rate
i = money/nominal interest rate
h = general inflation rate.
In investment appraisal two types of inflation need consideration:

46 KAPLAN PUBLISHING

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