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Year 2 Managerial Economics (AUT EXAM) > Investment Decisions > Flashcards

Investment Decisions Flashcards

Week 7 & 8

1
Q

What are the two horizons of managerial decision-making?

A
  • ST operational decisions (Pricing, Advertising, Output)
  • LT strategic decisions (Growth, Investment decisions, Financing)
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2
Q

What are some examples of Long-term strategic decisions?

A
  • Capital Investment, new products, market-entry, technological adaptation, Expenditure on R&D and HC, M&A
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3
Q

What is Capital Budgeting? How does it differ from Capital Expenditure?

A
  • Capital Budgeting is the process of planning for/evaluating capital expenditure
  • Capital Expenditure is the cash outflow designed to generate a flow of future cash benefit
  • Capital expenditure is costly and tough to reverse
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4
Q

When should a firm choose whether to invest?

A
  • If future return > MCk, this means that the firm should invest
  • It is important to compare the Investment Opportunity Curve (downward) VS MCk Curve (upward)
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5
Q

What are the steps of Capital Budgeting?

A
  • Generate alternative capital investment project
  • Estimate cash flows for project proposal
  • Evaluate and choose investment projects to implement
  • Review investment project and check said assumptions
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6
Q

Elaborate on generating alternative capital investment project

A
  • Proposals come from management/workers/shareholders
  • All investment projects are Long-Term
  • Proposal screening from chiefs/managers/presidents
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7
Q

Elaborate on estimating cash flow for the proposed project

A
  • Basic calculation of what to include/exclude (all measured in opportunity cost)
  • INCLUDE: incremental cash flow, externalities, CFAT
  • EXCLUDE: sunk-costs, Non-incremental overheads
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8
Q

Elaborate on evaluating and choosing investment projects to implement

A
  • Typically, the project initially outflows and then inflows incremental
  • Need to compare cash at different times which is tough
  • Two methods of NPV and IRR
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9
Q

What is the NPV? Give the equation for NPV and PV and when firms know when to accept/reject the project

A
  • NPV is the present value, discounted at the cost of capital (K) [differs between firms] of the streams of Net Cash Flow minus the net investment
  • PV = Σ[At / (1+K)^t] where At is an unequal payment
  • NPV = Σ[NCF / (1+K)^t] - NINV
  • If NPV >0, accept the project
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10
Q

What is the IRR? Give the equation for IRR and when firms know when to accept/reject the project

A
  • IRR is the discount rate that equates the PV with the Net Investment i.e. NPV = 0
  • Using NPV = 0, the IRR is the r in the equation
  • If IRR>k, Accept the project
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11
Q

What is the comparison between NPV and IRR?

A
  • Come to the same conclusion (NPV>0 and r>k are the same thing)
  • In the case of mutually exclusive projects, they may give different values
  • NPV > IRR because IRR doesn’t account for magnitudes of projects
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12
Q

What is the equation for ARR and when firms know when to accept/reject the project

A
  • ARR = [Average annual profits after tax] / [initial investment of projects]
  • Accept if ARR>k
  • Based on accounting income, not cashflows
  • Doesn’t take into account inflow & outflow timing
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13
Q

What is the Payback Period? Give the equation and when firms know when to accept/reject the project

A
  • Payback Period is based on the length of time required to recover the cost of an investment
  • PP = [Initial Investment of a Project] / [Annual Cashflow]
  • Accept if PP < Maximum Acceptable PP (Defined by the firm)
  • Popular but it doesn’t consider cashflows or timings of flows
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14
Q

What is Capital Rationing? What is used to rank bundles within the Capital budget?

A
  • How to ration available capital among competing potentially successful projects
  • These can be ranked using the profitability ratio
  • PR = 1 + NPV/NINV
  • You cannot exceed capital funds constraints
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15
Q

What is the Cost of Capital?

A
  • How much a firm has to pay for the capital it uses to finance new investment
  • The minimum rate of return that must be earned for new investment
  • This is determined by the capital market
  • Related to risk of new investment, existing assets and firm’s capital structure
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16
Q

What are the two major sources of investment? How are these financed?

A
  • EXTERNAL: Debt and Equity
  • INTERNAL: Cash flow
17
Q

What is the equation for the cost of debt?

A
  • Ki = Kd(1-T)
    Ki is after tax K, Kd is before tax K and T is MRT
18
Q

What are the equations for cost of equity? What does it depend on?

A
  • The type of Model (DVM Vs CAPM)
    1. Ke = D1/V0 + g
      D1 is the shareholders dividends at the end, V0 is the value of the stock at the start, g is the growth rate
  • This comes from the sum of a geometric progression, where D1 = A, Ke = ‘1’ and g = r
    1. Ke = rf + β(Rm-rf)
19
Q

What is the equation for the Weighted average cost of Capital (WACC)?

A
  • Kc = [E/D+E] Ke + [D/D+E] Kd
20
Q

What is Capital Structure?

A
  • The composition of debt & equity in total investment financing
21
Q

What is leverage? How can leverage be calculated and what are the other names it can be called?

A
  • Leverage is the combination of debt & equity is used to maximise the firm’s value
  • AKA Debt-to-Equity ratio, Capital Gearing
  • Leverage = D/E
22
Q

What are the advantages of financing with debt?

A
  • Cheaper (r<D), especially when r is low
  • Less risky for investors (lenders)- debt holders get paid first in the event of default
  • Low effective costs, interest payments are tax-deductible
  • Lower costs of issuing & administration
  • Allows company to retain ownership (no stocks/shares)
23
Q

What are the disadvantages of financing with debt?

A
  • High borrowing can risk inability to meet repayments
  • Shareholders are exposed to more risk than just business
  • Rational shareholders will expect greater compensation
24
Q

What are the five theories of Capital Structure?

A
  • Modigliani-Miller Theory
  • Traditional Theory
  • Trade-off Theory
  • Pecking order Theory
  • Agency costs Theory
25
Q

What is the Modigliani-Miller Theory? What are some of the drawbacks and assumptions? How does this come to the conclusion?

A
  • There are no ‘frictions’ [transactional costs, taxes, costless info, symmetric info]
  • This means that Kc and the value of the firm remain constant, regardless of the degree of leverage
  • This is because total investment value depends on its underlying profitability and risk; if leverage increases, risk moves between D and E
  • The model is unrealistic and was refuted by empirical evidence (was then used to include tax)
  • Debt is seen as better
26
Q

What is Traditional Theory? What are some of the drawbacks and assumptions?

A
  • Assumes there is an optimal capital structure and that the firm can increase its value through leverage
  • If CS is only equity, Ke=Kc
  • When debt increases, Ke increases, but Kc falls until point x
  • However, when leverage increases, this brings greater risk-> investors need Ke because Ke and Ki rise, Kc rises and a firm’s value declines
  • Firms want to be at x (optimal level) where Kc is minimised and Vg [Company Value] is maximised
27
Q

What is Trade-Off Theory? What ar ethe conclusions that can be drawn?

A
  • Assumes that a firm trades off between benefits and costs of debt and equity financing to optimise capital structure
  • BENEFITS: Tax benefits of Debt
  • COSTS: Bankruptcy costs and stress of cost of debt
  • Trade-off between benefits and costs (rewards vs risk)
28
Q

What is Pecking Order Theory? What are some of the drawbacks and assumptions?

A
  • Based on asymmetric information between managers and shareholders
  • Firms prefer internal financing to external
  • In the necessity case of external financing, debt is prefered to equity (no divorce of ownership)
  • Myers (1984) counteracted this:
  • Managers are assumed to know better than investors
  • Investors believe managers think the firm is overvalued- managers take advantage
  • Investors may place a lower value to equity
29
Q

What is Agency Costs Theory?

A
  • Based on the principle/agent theory, where the shareholder can abuse the manager because of asymmetric information
  • Agency cost= financial loss due to asymmetric information
  • As debt:equity ratio increases, so does manager risk
  • Management has the incentive to destroy a firms value through empire building & perks- increased leverage imposes financial discipline
30
Q

What is Country Risk Analysis? Who measures it?

A
  • CRA is the risk of investing/lending in a country
  • This could be from changes in business environment that may adversely affect profits
  • CRA is included in the risk-premium of required rate of return and is connected to cross-border investment
  • Credit risk rating agencies (e.g. Moody’s) and Political risk agencies (e.g. Economist Intelligence Unit) can measure these things
31
Q

How do you account for Country Risk?

A
  • Insurance against the risk
  • Detailed analysis of risk factor
  • Scenario Planning
32
Q

What is Cost Benefit Analysis? How should the project be evaluated?

A
  • Used to assess the consequences of a particular program expenditure or policy change
  • Objective to maximise social welfare
  • Issues arise as to how to measure costs/benefits and how to determine the discount rate
  • Accept the programme if the PVbenefits/PVcosts > 1 [can use NPV/IRR]
  • For expansion, look if MB>MC
33
Q

What is the decision-making process for Cost-Benefit analysis?

A
  • Determine the objective to be maximised
  • Consider constraints on decisions
  • Costs & Benefits that should be considered
  • Select criterion to determine acception
  • Select appropriate discount rate
34
Q

What does CBA say about Pareto efficiency?

A
  • Assumes ‘Potential’ Pareto improvement
  • Kaldor-Hicks criterion: A change is desirable if those better off in principle compensate those who are made worse-off
  • Hence there is a net fain
35
Q

What are some of the Constraints for CBA?

A
  • Physical- land, technology
  • Legal/administrative- laws, hiring quality people
  • Political/Social- Culture, Moderation of what is the best
  • Financial/Distributional- Losers cannot be too harmed
36
Q

How can Costs/Benefits be categorised?

A
  • Direct Benefits (Crops from a new irrigation system)
  • Direct Costs (Capital Costs)
  • Indirect Costs/Benefits (Affects 2nd parties)
  • Intangibles (QoL, aesthetics)
  • Tough to measure, so approximations are used
37
Q

What is the social rate of discounting?

A
  • The discount rate to be used when evaluating a project
  • Potential for bias, objectors want a high rate
  • The discount rate is the function of allocation of resources between public & private sectors
38
Q

What is Cost-Effective analysis? What are the two theories?

A
  • Due to difficulty estimating, this asks what are the alternatives to reach the goal
  • How can the goal be reached most efficiently?
  • Least cost: Identify least expensive method
  • Objective-level: Estimate the cost of achieving several performance level of the same objective

Year 2 Managerial Economics (AUT EXAM) (5 decks)

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