Investment Decisions

Question 1

Main objective for a profit making company is

Answer 1

maxmisation of shareholder wealth

Question 2

Agency theory

Answer 2

~ separation of mgt and S/H can lead to sub-optimal decisions
~ agency costs are born by S/H
~ div paymts can decrease agency costs

Question 3

Ethical considerations for increasing profit

Answer 3

~ exploitation of child labour
~ polluting the environment
~ insider information

Question 4

Investment appraisal techniques

Answer 4

~ payback
~ accoutning rate of return (ARR)
~ NPV
~ IRR

Question 5

Payback

Answer 5

time taken for cash inflows to equal cash outflows

Question 6

ARR

Answer 6

(Av yrly profit from investment/ Initial investment) x100
or
(Av yrly profit from investment/ Av investment) x100
Decision: accept if ARR > target

Question 7

Average investment

Answer 7

(initial outlay + scrap value)/2

Question 8

IRR

Answer 8

a + (b-a) x NPVa/(NPVa - NPVb)

Decision: accpet if IRR > cost of cpaital

Question 9

Money rates, real rates and general inflaction (CPI) - formula

Answer 9

(1 + m) = (1 + r) x (1 + i)
m = money/nominal rate
r = real/effective rate
i = inflation rate

Question 10

Asset replacement: EAC

Answer 10

a.k.a. Equaivalent Annual Cost
= NPV of one replacement cycle/ AF for cycle length
Decision: select lower annuity (result)

Question 11

Capital rationing: Divisible projects

Answer 11

1) calcualte profitability index (PI) of each project
2) rank projects from high to low
3) allocate funds a/c to ranking

Question 12

Capital rationing: Indivisible projects

Answer 12

a. k.a. trial and error
1) combine projects w/ requirement equal to or closer to amount available
2) choose combination with highest NPV

Question 13

Profitbaility index (PI)

Answer 13

= NPV/ funds required

Question 14

Shareholder value analysis (SVA): key value drivers

Answer 14

SLOW CAT
Sales growth
Life of product
Operating margin
WC investment

Cost of cpaital
Asset investment
Tax liability

Question 15

List the Real options (5)

Answer 15

~ follow on options
~ abandonment options
~ timing options (wait and see, flexibility = value)
~ growth options
~ flexibility options

Question 16

Real options

Answer 16

Uncertainty surrounding an investment that is hard to quantify but may impact decision

Question 17

Follow on options

Answer 17

although NPV is -ve, the experience gained gives the option to make future profits
e.g. R&D

Question 18

Abandonment options

Answer 18

adds value through having a ‘back-up’ plan

e.g. resale value or alternative use

Question 19

Growth options

Answer 19

Uncertain growth oppotunities that allow the firm to delay, complete only a part or follow on can be valuble

Question 20

Flexibility options

Answer 20

investing in items which have different uses (future-proofing)
e.g. hybrid cars, dual fuel power stations

Question 21

Shareholder Value Analysis (SVA)

Answer 21

process of analysing biz activities to identify how they will result in increased S/H wealth