Finance Topic 1

Question 1

Financial management

Answer 1

Firms inv and financing decision interactions
Firm level economics of time and risk (both dimensions in decisions)

Question 2

Financial strategy:

Answer 2

1. Financing strategy - raise funds needs in appropriate manner
2. Inv strategy - managing employment of funds, decision to reinvest/distribute profits generated

Question 3

Capital investment decisions
3 things

Answer 3

long horizon
substantial
Capital budgeting decisions or investment appraisals

Question 4

Inv appraisal technique

Answer 4

Ignore time value of money & RISK
- ARR (accounting profits - manipulate/varies)
- Payback

Account for time value of money & RISK (2 best)
- NPV
- IRR

Question 5

Accounting rate of return formulae

Answer 5

Question 6

Cash flows vs profit

Answer 6

Cash flows - PP, NPV, IRR
-initial spend on assets
-residual value (sale proceeds) of assets

Profit (ARR)
-annual depreciation

av inv (ARR)

Question 7

Payback period

Answer 7

Method can be modified to accept discounted cash flows = discounted payback period

Question 8

Decision rules for inv appraisal

Answer 8

1. ARR = higher than company target & highest = best
2. Payback = within target & shortest = best
3. NPV >0 and highest = best
4. IRR > or equal to company cost of capital - want the highest

Question 9

Discounting formulae

Answer 9

Question 10

Time value of money - discounting

Answer 10

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

Question 11

Opportunity cost of investment

Answer 11

OCI
Minimum required rate of return
Project cost of capital
Discount rate
Simplicity = often assumed constant

Question 12

NPV

Answer 12

Discounted cash flow method, discount all relevant cash flows to present value

Question 13

NPV - capital rationing

Answer 13

-funding limitations preventing undertaking all positive NPV projects
Calculate profitability index (may be conservative)
Accuracy - timing and calculating appropriate discount rate

Question 14

Profitability index

Answer 14

NPV per £ of initial capital outlay

Calculated - NPV divided by initial investment

Question 15

Types of discount rates

Answer 15

Nominal discount rate - discount nominal cash flows
Real discount rate - discount real cash flows (cash flows at todays prices)
Both give same answer

Question 16

Internal rate of return

Answer 16

IRR
Yield earned on an inv over course of its economic life
Discount rate that causes NPV to be zero

Question 17

IRR formulae

Answer 17

Rule:
R1> 0
R2-r1 , or equal to 10%

Question 18

3 Components of a rate of return

Answer 18

1. Pure time preference (ALWAYS)
   - (price of item & risk free)
2. Inflation premium (nominal rate, not real)
   -purchasing power
3. Risk premium (all non risk free assets
   -volatility
   -risk return trade off

Question 19

ARR ADV & DIS

Answer 19

Adv
-simple and easy to calculate
-similar to ROCE

Dis
-time value of money
-accounting profit
-relative measure (%) ignores competitors

Question 20

Payback ADV & DIS

Answer 20

Adv
- simple and easy
- Good for rapid recovery

Dis
-no time value (other than discounting)
-ignore c.f past point
-provide little other info

Question 21

NPV ADV& DIS

Answer 21

Adv
-time value
Consider all c.f (not accounting profit)
Project in absolute terms (NPV - effect on SH wealth

Dis
Complex explanation

Question 22

IRR ADV & DIS

Answer 22

Adv
time value
All c.f (not accounting profit)

Dis
Relative measure ignore absolute
Possible to have multiple IRR
Difficult explanation

Question 23

Annuity

Answer 23

Same cash flow every period
Finite number

Question 24

Perpetuities

Answer 24

Same cash flow each period
Forever

Question 25

Single future cash flow

Answer 25

Question 26

Inflation nominal vs real

Answer 26

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

Question 27

Formulae linking nominal and real inflation rates

Answer 27

Question 28

Conversion of inflation nominal vs real

Answer 28

Question 29

Discounting and compounding

Answer 29

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

Question 30

International capital budgeting

Answer 30

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

Question 31

6 added complexities from international capital budgeting

Answer 31

1. Exchange controls 2. Inter company transfer of assets and profits 3. Exchange rate fluctuation (cash flows in foreign currency) 4. Differential tax rates 5. Political risk 6. Cannibalisation

Question 32

Exchange controls (EC)

Answer 32

-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

Question 33

Intercompany transfer of assets & profits

Question 34

Exchange rate fluctuation

Answer 34

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

Question 35

Differential tax rates

Answer 35

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

Question 36

Political risk 2 ways to deal with it:

Answer 36

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

Question 37

Cannibalisation

Answer 37

- 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

Question 38

Parent cash flows

Answer 38

Question 39

International capital budgeting - simplified valuation model

Answer 39

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

Question 40

Effective annual interest rate - delete

Answer 40

EAR = (1+ i/n)n – 1 i = stated annual interest rate n = no. Of compounding periods