Investment Decisions and Valuation (pink)

Question 0

WHAT IS THE DEPRIVAL VALUE?

Answer 0

The relevant cost of using a currently owned asset.

                       DEPRIVAL VALUE
                              (lower of)
                                 /        \
                               /            \
          Replacement            Recoverable
                 Cost                       Amount
                                              (higher of)
                                                 /        \
                                             VIU       NPV

Question 1

WHAT ARE THE ADVANTAGES OF USING NPV?

Answer 1

• takes account of the time value of money
• absolute measure of return
• based on future cash flows not profits
• considers whole life of a project
• should lead to maximisation of shareholder wealth

Question 2

WHAT ARE THE ASSUMPTIONS AND LIMITATIONS OF REPLACEMENT ANALYSIS?

Answer 2

• cost of asset is not subject to inflation
• operating efficiency of assets at different ages will be
  similar
• asset will be replaced in perpetuity or at least for the
  foreseeable future

Question 3

WHAT ARE THE 7 VALUE DRIVERS?

Answer 3

SLOWCAT:

Sales growth
Length
Operating profit margin
Working capital
Cost of capital
Asset investment
Tax

Question 4

WHAT ARE THE REAL OPTIONS TO CONSIDER WITH NPV ANALYSIS?

Answer 4

1) follow on options
2) abandonment options
3) timing options
4) growth options

[see pages 24 - 25 in the workbook for more detail]

Question 5

WHAT ARE THE PROBLEMS THAT INVESTMENT APPRAISAL FACES?

Answer 5

• decisions are based on forecast
• forecasts are subject to uncertainty
• uncertainty needs to be reflected in the financial evaluation

Question 6

WHAT ARE THE STRENGTHS OF EXPECTED VALUES?

Answer 6

• deals with multiple outcome
• quantifies probabilities
• simple
• straight forward decision rule

Question 7

WHAT ARE THE WEAKNESSES OF EXPECTED VALUES?

Answer 7

• subjective probabilities
• answer is only a long run average, so not practice to
  one off projects
• ignore variability payoffs
• risk neutral decision

Question 8

HOW DO WE CALCULATE SENSITIVITY?

Answer 8

FACTORS EFFECTING CASH FLOWS:
(NPV of whole project)/(NPV of cash flow affected by change)

SENSITIVITY DUE TO OTHER FACTORS:

• difference between cost of capital and IRR
• discounted payback

Question 9

WHAT ARE THE STRENGTH OF SENSITIVITY ANALYSIS?

Answer 9

• simple
• allows subjective judgements
• identifies critical estimates

Question 10

WHAT ARE THE WEAKNESSES OF SENSITIVITY ANALYSIS?

Answer 10

• assumes variable change independently of each other
• does not assess the likelihood of a variable changing
• does not identify a correct decision

Question 11

WHAT IS THE CAPM MODEL?

Answer 11

The Capital Asset Pricing Model

A way of estimating the rate of return that a fully diversified equity shareholder would require from a particular investment.

It considers the level of systematic risk of the investment compared to the average.

The level of systematic risk is measured by a beta factor.

It is commonly used to find the required rate of return from a project in situations where the project has a different risk profile from the company’s current business operations.

Question 12

WHAT ARE THE PROBLEMS OF CAPM?

Answer 12

• estimating rm (usually done with historic data)
• estimating rf (gilts are not risk free, returns vary)
• calculating beta (too simplistic)

Question 13

NAME 3 ALTERNATIVES TO CAPM

Answer 13

1) Arbitrage Pricing Theory (APT)
2) Bond yield plus premium approach
3) Dividend valuation model