Chapter 5 - Decision making and further steps Flashcards
Methods of economic evaluation
- capital investment
- budgeting
- appraisal techniques
Payback method
accepts the idea that pays the investment back quickest (is measured in years)
Accounting rate of return (ARR)/ the return on investment
compares investment possibilities by average accounting profit per annum to the investment
Internal rate of return (IRR)
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 %)
Net present value (NPV)/ Discounted Cash Flow
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).
Non economic evaluation methods
- Payback
- Accounting rate of return (ARR)
ARR Formula
ARR = (Cash in flow-investment)/ (No.of cash flow years • investment)
How to interpret ARR
• Decision is to select investment opportunities with the greatest rate of return
• results that are economically inadequate as accounting and economic values differ
Advantages of NPV
takes into account the time value of money, both before and after the payback perioc
Assumptions under NPV
• the financial market is perfectly competitive
• the risk in the financial market is the same for investment in ideas
How to interpret NPV
• 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
IRR rule
invest until marginal return on investment equals the interest rate in an equally risky financial market
Why is NPV is better than IRR?
- when borrowing we want the lowest hurdle rate, when lending we want the highest.
- IRR can have multiple solutions, which may lead to confusion.
- NPV maximises wealth whereas IRR maximises interest rates.
- The discount rate in NPV may be modified when interest rates are likely to change, whereas the IRR rate cannot be changed
Risk management tools
• 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
Weighted Average Cost of Capital (WACC)
— 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
Break-even analysis
— 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
The break-even output
where income is equal to costs, whereby no profit or loss occurs
Break-even formula
• 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
The separation theorem
• 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
Preference shares formula
• 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
Gordon growth model formula
Ks = D1/Po + g
where
Po - current share price,
D1- next expected dividend,
g - growth rate on share
CAPM model formula
Ks = RF + [b × (km - RF)]
where
RF - risk free rate of return,
km - return on market premium
Debt formula
• Ki= Kd(1 - T)
where
Ki- after tax cost of debt,
Kd - before tax cost of debt,
T - tax
Business plan
- Executive Summary
- Product
- Marketing
- Manufacture
- Finance
- Appendices
Slacks advantages
- Speed
- Dependability
- Flexibility
- Cost
- Quality
