Financing A Business And Investment Appraisal

Question 1

Long term finance sources

Answer 1

• share issues
• retained earnings
• long-term borrowings e.g. pref shares

Question 2

Types of debt financing

Answer 2

• preference shares: Named because they contain the right to receive a dividend before an ordinary shareholder i.e. they take preference. Is a fixed percentage every year.
• Debentures: When a company issues a debenture, it essentially owes the holder a specified sum of money, repayable with interest at a future date
• loans

Question 3

Weighted average cost of capital (WACC)

Answer 3

• method used by companies to work out their cost of capital if they are financed through a mix of debt and equity

Question 4

WACC formula calculation

Answer 4

WACC = (E/V x Re) + (D/V X Rd X (1 - Tc) )
E = market value of the firms equity
D = Market value of the firms debt
V = E + D
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate

Question 5

Investment appraisal

Answer 5

• A process of analysis whether an investment project is worthwhile or not
• It justifies the investment in a project providing the rationale for spending limited resources

Question 6

Investment appraisal methods

Answer 6

• Accounting rate return: the average accounting operation profit that the investment will generate as a percentage of capital investment
• Pay back period: the time the initial investment will be repaid
• Internal rate of return: the yield from a particular investment. Internal refers to the fact that the calculation excludes external factor such as inflation
• Net present value: looking at the cash inflows and outflows of an investment project

Question 7

Net present value

Answer 7

• It represents the different between the present value of cash inflows and the present value of cash outflows over a period
• need to use the discount factor formula to work out what something would be worth in the future

Question 8

Discount factor formula

Answer 8

Dn = 1/ (1 + r)^n

Question 9

Cost of capital

Answer 9

• plays a role in decision making process of financial management
• represents the minimum return a compay needs to achieve in order to justify cost of capital project
• they need to cover the cost of capital in heir expected return on investment