Chapter 12: Project appraisal

Question 1

Role of financial managers

Answer 1

1. The financing decision - how should the company raise the funds that it needs
2. The investment decision - which projects should the company invest in?

Question 2

Goal of financial managers

Answer 2

Maximise shareholder wealth in other words maximise share price
as we assume the market is accesible and competitive and shareholders can freely choose from a wide range of appropriately priced shares

Question 3

How do financial managers achieve their goals?

Answer 3

1. Raising the finance in the most efficient (cost-effective way)
2. Investing in profitable projects

Question 4

Opportunity cost

Answer 4

The opportunity cost of an item or an activity is the cost in terms of the best alternative item or activity that is foregone

Question 5

When is a project profitable

Answer 5

When it earns at least the opportunity cost of the capital, ie the rate of return foregone by investing in the project rather than in other similarly risky investment opportunities.

Question 6

NPV

Answer 6

Net Present Value.
Forecast all relevant net cashflows from the project and then discount them using an appropriate discount rate.
The interest rate is the (opportunity) cost of the capital ie the rate of return that shareholders coulod have eearned on a similarly risky project.
Called the risk discount rate (this is an i, not a d)

Question 7

IRR

Answer 7

The internal rate of return or yield is the interest rate for which the NPV is 0

Question 8

Compate the following Projects
Initial Outlay: Higher for B
NPV (@6%): Higher for B
IRR: Higher for A

Answer 8

• B has a greater initial outlay, the compnay might have difficulty raising finance for this.
• B has a higher NPV @ 6% and so is more profitable a that risk discount rate, thus will create more shareholder wealth if that is the opportunity cost for both.
• A will be more profitable up to a higher risk discount rate, therefore if the 6% is likely to change eg interest rates in the economy will rise then A may be better
• Also it is unknow the time until break even for each project.

Question 9

Accumulated profit

Answer 9

Accumulates all the cashflows to the end of the projects life

Question 10

Why could market value of a fund change?

Answer 10

• Income generated by the fund, such as interest on bonds and dividends on shares
• changes in market value of the assets purchased
• addition to and withdrawals from the fund, such as inflows from the contributions and outflows to those people who have retired

Question 11

How can we evaluate the performace of a fund over a particular period?

Answer 11

We need info on:
* The initial value of the fund
* any external cashflows that take place, such as inflows from contributions and outflows to thos epeople who reture, and
* the final value of the fund
* and the value of the fund at intermediate time period

We then can d o one of three calculations:
1. the money weighted rate of return:
2. the time-weighted rate of return
3. the linked internal rate of return

Question 12

Money weighted rate of return

Answer 12

Solve i such that
accumulated value of initial fund + accumulated value of cashflows = final fund value

influenced by timings and amounts of cashflows
To get a good first guess replace (1+i)^n with 1+ni. (Good for 1 year or less, gets bad for more than 1.25 years)

Question 13

TWRR

Answer 13

Time wighted rate of return. removes the influence of the timing and the size of cashflows and is only concerned with the growth rates of the fund so is a better measure of performacne of a manager