Chapter 5 - Decision making and further steps

Question 1

Methods of economic evaluation

Answer 1

1. capital investment
2. budgeting
3. appraisal techniques

Question 2

Payback method

Answer 2

accepts the idea that pays the investment back quickest (is measured in years)

Question 3

Accounting rate of return (ARR)/ the return on investment

Answer 3

compares investment possibilities by average accounting profit per annum to the investment

Question 4

Internal rate of return (IRR)

Answer 4

measures the return on investment using cash inflows and outflows derived from the idea. It compares the return on investment against the hurdle rate. Investments that exceed the hurdle rate may be accepted (measured as a %)

Question 5

Net present value (NPV)/ Discounted Cash Flow

Answer 5

the difference between the present values of the future cash inflows and outflows. Rule is to invest where the NPV is positive (measured in Rands).

Question 6

Non economic evaluation methods

Answer 6

1. Payback
2. Accounting rate of return (ARR)

Question 7

ARR Formula

Answer 7

ARR = (Cash in flow-investment)/ (No.of cash flow years • investment)

Question 8

How to interpret ARR

Answer 8

• Decision is to select investment opportunities with the greatest rate of return
• results that are economically inadequate as accounting and economic values differ

Question 9

Advantages of NPV

Answer 9

takes into account the time value of money, both before and after the payback perioc

Question 10

Assumptions under NPV

Answer 10

• the financial market is perfectly competitive
• the risk in the financial market is the same for investment in ideas

Question 11

How to interpret NPV

Answer 11

• If NPV > 0, invest in idea, as present benefits exceed present costs - choose most positive change
• If NPV < 0, place cash in the financial market
• If NPV = 0, both investments and financial markets are the same

Question 12

IRR rule

Answer 12

invest until marginal return on investment equals the interest rate in an equally risky financial market

Question 13

Why is NPV is better than IRR?

Answer 13

1. when borrowing we want the lowest hurdle rate, when lending we want the highest.
2. IRR can have multiple solutions, which may lead to confusion.
3. NPV maximises wealth whereas IRR maximises interest rates.
4. The discount rate in NPV may be modified when interest rates are likely to change, whereas the IRR rate cannot be changed

Question 14

Risk management tools

Answer 14

• Decision trees are useful for showing risky decisions by adjusting present values
• Adjust the discount rate for risk
• the Capital Asset Pricing Model (CAPM)- different risks of investments are made equal by adjusting the discount rate
• a risk premium is added to a risk-free rate

Question 15

Weighted Average Cost of Capital (WACC)

Answer 15

— the relative contribution of owners and loans to the cost of capital
— WACC = (E/V)(re) + (D/V)(rd)*(1-t)
• E- equity
• V- value of the firm
• D- debt
• re- Owners are paid after the firm has paid tax at a rate
• rd- Loans are paid before tax at a rate
• t- tax rate

Question 16

Break-even analysis

Answer 16

— predicts profit as a function of output (it excludes returns to owners)
— tries to find the level of output at which a firm starts to make a profit

Question 17

The break-even output

Answer 17

where income is equal to costs, whereby no profit or loss occurs

Question 18

Break-even formula

Answer 18

• Break-even = fixed costs/ Contribution per unit
• Contribution per unit = Selling price per unit - Variable cost per unit
• the contribution - the area between the total revenue and variable cost lines

Question 19

The separation theorem

Answer 19

• Separation of ownership and management
• Authority is delegated from shareholders to managers with one instruction -maximise NPV
—> Separation of ownership and management allows growth of firms
—> Separation allows firms to have many shareholders each with differing backgrounds

Question 20

Preference shares formula

Answer 20

• Kp = Dp/Np
Where:
Kp - cost of preference shares,
Dp - rand value of preference dividend,
Np - net proceeds from sale of a preference share

• Dp = Annual dividend x Par value
• Np = Sale price - Floatation cost

Question 21

Gordon growth model formula

Answer 21

Ks = D1/Po + g
where
Po - current share price,
D1- next expected dividend,
g - growth rate on share

Question 22

CAPM model formula

Answer 22

Ks = RF + [b × (km - RF)]
where
RF - risk free rate of return,
km - return on market premium

Question 23

Debt formula

Answer 23

• Ki= Kd(1 - T)
where
Ki- after tax cost of debt,
Kd - before tax cost of debt,
T - tax

Question 24

Business plan

Answer 24

1. Executive Summary
2. Product
3. Marketing
4. Manufacture
5. Finance
6. Appendices

Question 25

Slacks advantages

Answer 25

1. Speed
2. Dependability
3. Flexibility
4. Cost
5. Quality