Finance Topic 1 Flashcards
Financial management
Firms inv and financing decision interactions
Firm level economics of time and risk (both dimensions in decisions)
Financial strategy:
- Financing strategy - raise funds needs in appropriate manner
- Inv strategy - managing employment of funds, decision to reinvest/distribute profits generated
Capital investment decisions
3 things
long horizon
substantial
Capital budgeting decisions or investment appraisals
Inv appraisal technique
Ignore time value of money & RISK
- ARR (accounting profits - manipulate/varies)
- Payback
Account for time value of money & RISK (2 best)
- NPV
- IRR
Accounting rate of return formulae
Cash flows vs profit
Cash flows - PP, NPV, IRR
-initial spend on assets
-residual value (sale proceeds) of assets
Profit (ARR)
-annual depreciation
av inv (ARR)
Payback period
Method can be modified to accept discounted cash flows = discounted payback period
Decision rules for inv appraisal
- ARR = higher than company target & highest = best
- Payback = within target & shortest = best
- NPV >0 and highest = best
- IRR > or equal to company cost of capital - want the highest
Discounting formulae
Time value of money - discounting
Future cf = discount accounting the opp cost of inv (OCI)
- all uncertain = risk = compensated with sufficient returns
-invest only if yield return in excess of OCI
Opportunity cost of investment
OCI
Minimum required rate of return
Project cost of capital
Discount rate
Simplicity = often assumed constant
NPV
Discounted cash flow method, discount all relevant cash flows to present value
NPV - capital rationing
-funding limitations preventing undertaking all positive NPV projects
Calculate profitability index (may be conservative)
Accuracy - timing and calculating appropriate discount rate
Profitability index
NPV per £ of initial capital outlay
Calculated - NPV divided by initial investment
Types of discount rates
Nominal discount rate - discount nominal cash flows
Real discount rate - discount real cash flows (cash flows at todays prices)
Both give same answer
Internal rate of return
IRR
Yield earned on an inv over course of its economic life
Discount rate that causes NPV to be zero
IRR formulae
Rule:
R1> 0
R2-r1 , or equal to 10%
3 Components of a rate of return
- Pure time preference (ALWAYS)
- (price of item & risk free) - Inflation premium (nominal rate, not real)
-purchasing power - Risk premium (all non risk free assets
-volatility
-risk return trade off
ARR ADV & DIS
Adv
-simple and easy to calculate
-similar to ROCE
Dis
-time value of money
-accounting profit
-relative measure (%) ignores competitors
Payback ADV & DIS
Adv
- simple and easy
- Good for rapid recovery
Dis
-no time value (other than discounting)
-ignore c.f past point
-provide little other info
NPV ADV& DIS
Adv
-time value
Consider all c.f (not accounting profit)
Project in absolute terms (NPV - effect on SH wealth
Dis
Complex explanation
IRR ADV & DIS
Adv
time value
All c.f (not accounting profit)
Dis
Relative measure ignore absolute
Possible to have multiple IRR
Difficult explanation
Annuity
Same cash flow every period
Finite number
Perpetuities
Same cash flow each period
Forever
Single future cash flow
Inflation nominal vs real
Real cf projection - project future volume, at current prices
Real cf = todays price (ignore inflation) discounted by real discount rate
Nominal cf projection - project future volume, at expected future prices (current increased for inflation)
Nominal cash flow (include inflation) = discounted by nominal rate
Formulae linking nominal and real inflation rates
Conversion of inflation nominal vs real
Discounting and compounding
More frequently than annually (r/2 or r/4 or r/12)
Sums grow faster is compounded more frequently than annually
Sums diminish faster if discounted more frequently than annually
International capital budgeting
E.g. FDi & joint ventures
Added complexities but same decisions
invest if foreign project increases SHs wealth
NPV (properly discounted) >0
-international projects evaluated based parent c flows
6 added complexities from international capital budgeting
- Exchange controls
- Inter company transfer of assets and profits
- Exchange rate fluctuation (cash flows in foreign currency)
- Differential tax rates
- Political risk
- Cannibalisation
Exchange controls (EC)
-restrictions placed by host countries on foreign opened local companies to remit profit/fund to their parents
-absence of EC - parent CF = project CF
-presence of EC - parent CF doesn’t equal project CF
Parent = extract profits from foreign subsidiaries/operations through management fees/royalties/dividends/asset transfer, interest etc
CFs used for NPV calculation = include these items
Intercompany transfer of assets & profits
Exchange rate fluctuation
Cash flows are in foreign currency
ER between parent country and project country = will fluctuate during project life
Incorporate these exchange rates into NPV calculation
Differential tax rates
Taxation from project profit subjected to different tax treatments (home & foreign gov)
Sometimes additional tax = payable to home gov even though foreign project profit taxed once by foreign gov
All relevant tax charges should be incorporated into NPV calculation
Project tax outflows doesn’t equal parent tax outflows
Political risk
2 ways to deal with it:
Inv in foreign countries attract additional political risk = alter ultimate payoffs from inv
2 ways to deal with political risk
1. Increase discount rate applied
2. Incorporate risks into CF forecasts
Cannibalisation
- new project taking revenue away from an investing firms existing projects
Any potential cannibalisation effects must be considered in inv appraisals
Applies to both domestic & internatiaonl capital budgeting - more common in international
Parent cash flows
International capital budgeting - simplified valuation model
Acquisition of foreign companies shares
Use simple NPV approach
Free cash flows = revenue - COS - operations expenses - tax + depreciation - change in inv in working capital/capital expenditure
R = cost of capital
Effective annual interest rate - delete
EAR = (1+ i/n)n – 1
i = stated annual interest rate
n = no. Of compounding periods
