Corporate Finance

Question 1

What is NPV

Answer 1

The net benefit or loss of benefit in present value terms from an investment opportunity.
Positive NPV = Accept project
Negative NPV = Reject Project

Question 2

Advantages of NPV

Answer 2

Advantages: Considers time value of money, considers cashflows, it considers the whole life of a project

Question 3

Disadvantages of NPV

Answer 3

Disadvantages: Relatively complex to calculate, not well understood by non-financial managers, it may be difficult to determine the cost of capital.

Question 4

What is Internal Rate of Return (IRR)

Answer 4

The rate of return (discount factor) at which the project has an NPV of zero. To calculate IRR you first need to have calculated 2 NPVs Using 2 Discount rates.

Question 5

Formula for IRR

Answer 5

IRR= Ldf + (Hdf - Ldf) x (NPVLdf / (NPVLdf - NPVHdf))

Question 6

when to accept IRR

Answer 6

If the IRR is greater than the cost of capital the project should be accepted

Question 7

Advantages of IRR

Answer 7

Advantages: Considers the time value of money, as a percentage return it is easily understood by non-financial managers, considers cashflows, considers the whole life of the project, can be calculated without reference to the cost of capital.

Question 8

Disadvantages of IRR

Answer 8

Disadvantages: It is not a measure of absolute profitability ( it is a percentage return), fairly complicated to calculate, interpolation only provides an estimate of the true IRR, the IRR of projects may conflict with the NPV if so the NPV takes precedence.

Question 9

What is The Payback Period?

Answer 9

This is the time which elapses until the invested capital is recovered. Unlike DCF techniques it is assumed that cashflows occur evenly throughout the year.

Question 10

When to accept The Payback Period

Answer 10

Compare the payback period to the company’s maximum return time allowed and if the Payback is quicker the project should be accepted.

Question 11

Formula for The Payback Period

Answer 11

Payback Period= Amount to be invested / estimated annual net cashflow

Question 12

Advantages of Payback Period

Answer 12

Advantages: Simple to understand, a project period with a longer payback period is riskier than one with a short payback period, simple measure of risk, uses cashflows not subjective accounting profits, emphasises the cashflows from earlier years, firms selecting projects on the basis of payback periods may avoid liquidity problems.

Question 13

Disadvantages of Payback period

Answer 13

Disadvantages: Ignores the time value of money, it is not an absolute measure (not a cash amount), does not take into account cashflows beyond the payback period.

Question 14

What is the Accounting Rate of Return (ARR) ?

Answer 14

ARR = Average annual profit / Average investment x100

The ARR method also known as ROI or ROCE reflects the percentage rate of return expected on an investment or asset.

Question 15

When to accept the ARR

Answer 15

The ARR for a project may be compared with the companies target return from an investment if it meets the target or exceeds it then accept.

Question 16

Formula for ARR

Answer 16

ARR= (Average annual profit / Average value of investment ) x 100

Average annual profit = Net cashflow less depreciation (before tax) / No. of years
Average value of investment = Initial investment plus residual value / 2

Question 17

Advantages of ARR

Answer 17

Advantages: Simple to understand, widely used and accepted, it can be obtained through readily available financial accounting data, it considers the whole life of the project.

Question 18

Disadvantages of ARR

Answer 18

Disadvantages: Ignores the time value of money, not a measure of absolute profitability, measures profit not cashflows which includes depreciation and other accounting adjustments.

Question 19

Working capital formula

Answer 19

Defined as: Current assets - current liabilities

Current assets = inventory, receivables and cash
Current liabilities = Payables

Question 20

Working Capital

Answer 20

Treated at the start of the project.
Only the change in WC is treated as a cashflow.
WC does not qualify for tax relief - so is ignored in capital allowance calculations
At the end of project WC is ‘released’ this is treated as a cashflow at the end of the project.

Question 21

NPV and Inflation

Answer 21

Consistency, Either:
Discount money (nominal) cashflows at the money discount rate ie. inflate the cashflow then discount the money (nominal) cost of capital.
Terminology: Money/nominal = inflation is adjusted for
OR
Discount real (current) cashflows at the real discount rate ie. do not inflate the cashflows (leave them expressed in real or current terms) and then discount at the real rate.
Terminology: Real/current = inflation is not adjusted for

Question 22

Working Capital and Inflation Formula

Answer 22

To find the real rate of return : ( 1 + r ) = ( 1 + m ) / ( 1 + i )
Where : r = the real rate
m = the money rate (ie. the interest rate)
i = the inflation rate
This may be arranged as : ( 1 + m ) = (1 + i ) x ( 1 + r )

Question 23

Proforma for IA Project evaluation

Answer 23

Time 0 1 2 3 4 5 6
Cash flows ($000)
Cost of equipment (xxx)
Residual Value xxx
Working capital (W2) (xxx) (xxx) (xxx) (xxxx) (xxxx) xxxxx
Operating CFs (+4%) 390 405.6 421.8 438.7 456.2
Tax on cash flows (128.7) (133.8) (139.2) (144.8) (150.5)
Tax relief on CAs (W1) 99.0 74.3 55.7 41.8 31.3

                               (1,300)  285   259.4   246.8   220.    1,223.0  (119.2)

16% DF 1 0.862 0.743 0.641 0.552 0.476 0.410
PV (1,300) 243.1 192.7 151.8 121.6 582.1 (48.9)
NPV = (57.6) $000

Question 24

Return On Capital Employed (ROCE) %

Answer 24

ROCE = ( PBIT / Capital employed ) x 100

Capital employed = Debt + Equity

Question 25

Return On Equity (ROE) %

Answer 25

ROE = ( PAT / Equity funds ) x 100

PAT = Earnings

Question 26

Earnings Per Share (EPS) £

Answer 26

EPS = ( PAT - Preference shares ) / No. ordinary shares

No. of ordinary shares = value of equity / par value of that share

Question 27

Dividends Per Share (DPS) £

Answer 27

DPS = ( Ordinary dividends / No. ordinary shares )

Question 28

Dividend Cover

Answer 28

Dividend Cover = ( PAT / Ordinary dividends )

Question 29

Dividend Yield %

Answer 29

Dividend Yield = ( Dividend / Share price at the beginning of the period ) x 100

Question 30

Price Earnings per Share (P/E ratio)

Answer 30

P/E = Current share price / EPS

EPS = Earnings per share

Question 31

Total Stakeholder Return (TSR)

Answer 31

TSR =

( Dividend + Change in share price ) / Share price at the beginning of the period x 100

Question 32

Financial Gearing (Using Book values OR Market values)

Answer 32

Financial Gearing = Debt / ( Debt + Equity ) x 100

OR

Financial Gearing = Debt / Equity x 100

Book value = Figures from SoFP
Market values = Currently trading at

Question 33

Interest Cover

Answer 33

Interest Cover = ( PBIT / Interest )

Question 34

Liquidity Ratio (Current Ratio)

Answer 34

Current ratio ( Liquidity ratio ) = Current assets / Current liabilities

Question 35

Quick ratio (Acid Test ratio)

Answer 35

Acid test ratio ( Quick ratio ) = ( Current assets - Inventory ) / Current liabilities

Question 36

Capital allowances (tax depriciation)

Answer 36

Government allows companies to write-off the cost of their assets in order to reduce company tax. Capital allowance is allowed on the cost of plant and machinery at the rate of 25% on a reducing balance basis unless told otherwise.

Question 37

Balancing Allowance (or Charge)

Answer 37

When the plant is eventually sold there may be a difference in the reducing balance amount and the selling price of the asset. ( Purchase price - final value )

Question 38

Timing of tax saving associated with capital allowance

Answer 38

Corporation tax is often paid one year in arrears (after), therefore the benefit of tax saved from capital allowances is only received when the corporation tax should have been paid.

Question 39

Proforma for IA dealing with Taxation

Answer 39

Year WDV Tax saved
yr 1 CA 25% XXX x Tax % = XXX
Balance XXX
Y2 2 CA 25% XXX x Tax % = XXX
Balance

Question 40

Working Capital formula

Answer 40

Working Capital = Current assets - Current liabilities
Where:
Current assets = Inventory, receivables and cash
Current liabilities = Payables

Question 41

Working Capital

Answer 41

Treated at the start of a project , any additional WC requirements are invested when required, only the change in WC is treated as a cashflow i.e incremental cashflow. WC does not qualify for tax relief - so ignored in the capital allowance calculations. WC ‘released’ and treated as a cashflow at the end of the project.

Question 42

Inflation

Answer 42

If money is invested in an account it will earn interest. However inflation will have the effect of reducing the value of the return.
Note: Inflation reduced the value of future cash.

Question 43

Inflation Rate of Return formula

Answer 43

( 1 + r ) = ( 1 + m ) / ( 1 + i )
Where :
r = the real rate
m = the money rate ( i.e the interest rate)
i = the inflation rate
This may be arranged as : ( 1 + m ) = ( 1 + i ) x ( 1 + r )

Question 44

NPV and inflation

Answer 44

Be Consistent, Either :
1. Discount money ( nominal ) cashflows at the money discount rate i.e inflate the cashflow then discount st the money ( nominal ) cost of capital.
Terminology: Money/Nominal = inflation is adjusted for !
OR
2. Discount real ( Current ) cashflows at the real discount rate i.e do not inflate the cashflows ( leave them expressed in real or current terms ) and then discount at the real rate.
Terminology: Real/Current = inflation is not adjusted for !