Investment appraisal and WACC

Question 1

What is payback?

Answer 1

• simplest and commonly used tool for investment appraisal.
• if only one project can be accepted, project yielding earliest payback will be selected.
• payback method assumes cash flows are received in equal amounts.

Question 2

What are the benefits of payback?

Answer 2

• assumes that cash flows after payback are risks so of no value, therefore not considered in decision-making.
• easy to understand

Question 3

what are the drawbacks?

Answer 3

• ignore cashflows beyond the payback period (unknown how much shareholder wealth will be generated)
• no consideration of the profile of cash flows within the payback period. (what if firm cant survive the lack of cash before payback period)
• ignores time value of money.

Question 4

What is Net Present Value?

Answer 4

the investment rule to invest in any project that generate a NPV > 0.

as anything with a NPV of above zero will increase shareholder wealth and firms value.

Question 5

Capital constraints and NPV?

Answer 5

• assume that all firms are not capital constrained. Therefore, the investment decision if all projects can be taken is to invest in all with NPV > 0.
• if they are capital constrained. then calculate NPV of all feasible combination of possible projects and choose the combination with maximum NPV.

Question 6

What about tax?

Answer 6

• firms must pay corporation tax. we can account for tax as incremental cash flows when undertaking NPV analysis.
• usually assume Tax is payable in one year arrears.
• depreciation costs are allowable against taxable profits.

Question 7

what is internal rate of return, IRR?

Answer 7

For a project this is the discount rate at which when applied to cash flows, produces NPV of 0.

Question 8

what is the investment decision rule?

Answer 8

• invest in any project which has an IRR bigger or the same as the predetermined cost of capital.
• comparison or hurdle rate is usually the discount rate at which we use to calculate the NPV of project.
• you can’t have a negative IRR.

Question 9

What are the drawbacks of IRR?

Answer 9

• IRR may say to invest when NPV shows a negative number.
• if only calculate IRR may wrongly accept a project (important to focus on NPV)
• Can’t only make a decision on IRR, as cashflows may change sign.

Question 10

What is the weighted average cost of capital?

Answer 10

• need to use an appropriate discount rates in investment appraisals.
• if erroneous discount rate is used, can lead to acceptance/rejection of projects.
• firms consist of a mixed capital structure. Necessary to determine both cost of equity and debt capital.
• Cost of capital is the return demanded by the investor.
• positive function of risk.
• not risk free rate. it is the compensation rate for forgone consumption and expected loss of purchasing power.
• equity holders face additional risks due to the existence of financing obligations, which make earnings attributable to equity holders more variable.

Question 11

The cost of Debt Capital?

Answer 11

• interest payments on debt are tax deductible. A firm’s ability to receive tax credit is a function of its marginal corporation tax rate.