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Year 1 Semester 2 > Finance Topic 1 > Flashcards

Finance Topic 1 Flashcards

1
Q

Financial management

A

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

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2
Q

Financial strategy:

A
  1. Financing strategy - raise funds needs in appropriate manner
  2. Inv strategy - managing employment of funds, decision to reinvest/distribute profits generated
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3
Q

Capital investment decisions
3 things

A

long horizon
substantial
Capital budgeting decisions or investment appraisals

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4
Q

Inv appraisal technique

A

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

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

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5
Q

Accounting rate of return formulae

A
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6
Q

Cash flows vs profit

A

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

Profit (ARR)
-annual depreciation

av inv (ARR)

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7
Q

Payback period

A

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

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8
Q

Decision rules for inv appraisal

A
  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
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9
Q

Discounting formulae

A
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10
Q

Time value of money - discounting

A

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

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11
Q

Opportunity cost of investment

A

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

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12
Q

NPV

A

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

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13
Q

NPV - capital rationing

A

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

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14
Q

Profitability index

A

NPV per £ of initial capital outlay

Calculated - NPV divided by initial investment

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15
Q

Types of discount rates

A

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

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16
Q

Internal rate of return

A

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

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17
Q

IRR formulae

A

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

18
Q

3 Components of a rate of return

A
  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
19
Q

ARR ADV & DIS

A

Adv
-simple and easy to calculate
-similar to ROCE

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

20
Q

Payback ADV & DIS

A

Adv
- simple and easy
- Good for rapid recovery

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

21
Q

NPV ADV& DIS

A

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

Dis
Complex explanation

22
Q

IRR ADV & DIS

A

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

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

23
Q

Annuity

A

Same cash flow every period
Finite number

24
Q

Perpetuities

A

Same cash flow each period
Forever

25
Q

Single future cash flow

A
26
Q

Inflation nominal vs real

A

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

27
Q

Formulae linking nominal and real inflation rates

A
28
Q

Conversion of inflation nominal vs real

A
29
Q

Discounting and compounding

A

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

30
Q

International capital budgeting

A

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

31
Q

6 added complexities from international capital budgeting

A
  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
32
Q

Exchange controls (EC)

A

-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

33
Q

Intercompany transfer of assets & profits

A
34
Q

Exchange rate fluctuation

A

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

35
Q

Differential tax rates

A

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

36
Q

Political risk
2 ways to deal with it:

A

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

37
Q

Cannibalisation

A
  • 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

38
Q

Parent cash flows

A
39
Q

International capital budgeting - simplified valuation model

A

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

40
Q

Effective annual interest rate - delete

A

EAR = (1+ i/n)n – 1

i = stated annual interest rate
n = no. Of compounding periods

Year 1 Semester 2 (10 decks)

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