Ch 2 - Investment Appraisal

Question 1

key decisions of fin manager

Answer 1

Inv - what projects should be undertaken by the company?
Finance - how should necessary funds raised?
Div - how much should be allocated to be paid as return to shareholders? How much should be retained to meet the cash needs of the business

Question 2

free cash flow

Answer 2

Rev-Costs-Investments
cash that is not retained and reinvested in the business. it is available to
1. all providers of capital of a company
2. to pay dividends or finance additional capital projects
used as a basis for evaluating potential inv project
as an indicator of company performance
to calc value of a firm and thus potential share price
Free CF to equity = Free CF-debt interest (for disctrib to shareholders)

Question 3

relevant CF (Rev and costs)

Answer 3

relevant Rev and costs
- future
- incremental

Ignore the following
- sunk costs
- committed costs
- non-cash items
- apportioned OH

Question 4

inflation

Answer 4

increase in prices leading to a general decline in the real value of money
fund providers require
real retrun for the money and
additional return to compensate inflation

Question 5

real rate of return (cost of capital)

Answer 5

(1+i)=(1+r)(1+h)
(1+r)=(1+i)/(1+h)
r- real rate
i - money/nominal rate
h = general inflation rate

Question 6

specific inflation rate

Answer 6

impact all the individual CF items - each CF is affected by specific rate (different rate of infl?)

Question 7

general rate of inflation

Answer 7

impacts investors’ overall required rate of return

Investors need compensation for their lost purchasing power, which relates to their ability to buy a basket of all goods, rather than any specific one

Question 8

real method of reflecting inflation

Answer 8

1. do not inflate CF - leave them in real terms, i,e in today’s prices - To
2. Discount using the real rate

Only used when general inflation rate - all cash flows are inflating at general rate

Question 9

money/nominal method

Answer 9

1. Inflate each CF by its specific inf rate, i.e convert into money flow
2. Discount using the money rate

It is ok in q-s involving specific inflation rates, taxation or working capital

Question 10

PV factor

Answer 10

cost of capital = (1+r)(1+h)

Question 11

tax impact

Answer 11

charged on operating CF
tax allowable depreciation (capital allowances or writing down allowances) can be claimed, = generate tax relief
company is earning net taxable profits

Question 11

IRR

Answer 11

• discount rate at which NPV of an investment is Zero
• standard projects (outflows followed by inflows) should be accepted if IRR is greater than the firm’s cost of capital
• can be found by linear interpolation

Question 12

Linear interpolation

Answer 12

1. Calculate 2 NPVs at 2 different costs of capital
2. Find IRR
   IRR = L (lower rate of interest) + (NL /(NL-NH))*(H-L)

NL - NPV at lower rate of interest
H - higher rate of interest
3. Compare IRR with company’s cost of borrowing

Question 13

problems with IRR

Answer 13

Assumption. it is not project specific - not return from the project. It is so only if the funds can be reinvested at the IRR for the duration of the project
Decision rule is not always clear cut espe when many projects with all greater than cost of capital
choosing bn projects. Since projects can have multiple IRRs (or none at all) it is difficult to usefully compare projects using IRR.
for unconven-l projects w/o structured inflow, no IRR, more than 1 IRR, so greater than CC doesn’t work
IRR is unrealiable bc project with high IRR may not necessarily be the one with highest return in NPV terms it is unreliable for choosing bn ME projects

Question 14

MIRR

Answer 14

MIRR=Project’s return
MIRR or PR > company’s cost of finance - accept the project

Question 15

MIRR interp

Answer 15

yield of the investment under the assumption that any surplus will be reinvested at the firm’s current cost of capital
It does not give a measure of the max cost of finance that the firm could sustain and allow the project to be worhtwhile
it gives margin of error or room for negotiation

Question 16

MIRR formula

Answer 16

(PVR/PVI)^1/n*(1+re)-1

PVR - PV of ‘return phase’ of the project
PVI - PV of ‘investment phase’ of the project
Re - firm’s cost of capital