16.2 Interaction of Finance and Investment Decisions

Question 1

What are involve in investment decisions

Answer 1

• Appraising an investment to see if it is worthwhile
• Is it financially worthwhile

Question 2

Graphical interactions

Question 3

Need to know and be able to explain the graphs

Answer 3

Cannot add pictures so just look at main notes

Question 4

Issues with CAPM and WACC

Answer 4

• CAPM tells us we should only be concerned with systematic risk and not with total risk of the project.
  o Assumes unsystematic risk is diversified
  o Need to point out in answers when this might not be the case
• The WACC criterion will only lead to the correct decision (cut off rate) where the project under consideration is in the same risk class as that of the company

Question 5

What are the implications of financing decisions

Answer 5

• A question that arises when you consider financing decisions is what effect does gearing have on the cost of equity and overall cost of capital.
• Equity holders will expect a higher rate when additional debt is introduced -to compensate for the financial risk.
• This financial risk can be reflected in the beta coefficient of a security and the ß as a consequence will be larger.
• Therefore, the observed beta coefficient incorporates both the business risk and the financial risk attaching to a security