L1 Introduction and Review of Capital Budgeting

Question 1

What is the primary goal of the firm?

Answer 1

To maximise shareholder’s value/wealth.

Question 2

What are the different types of Investment Decision Rules ? (5)

Answer 2

1. NPV
2. IRR
3. Payback Rule
4. Incremental IRR
5. Profitability Index

Question 3

NPV Facts

Answer 3

• most accurate and reliable
• invest in projects with (+)I’ve NPV
• takes into account… (1) the primary goal of the firm (if projects create wealth for SH), (2) time value of money, (3) risk

Question 4

What is Capital Budgeting?

Answer 4

The process, through which firms analyse alternative projects and decide which ones to accept.

Question 5

Dealing with Mutually Exclusive Projects?

Answer 5

• Pick the ones with the HIGHEST NPV
• They have to have the same life
• If they have different lives use EAB

Question 6

Dealing with Limited Resources Available?

Answer 6

• use the PI rule

- used when there are resource constraints

Question 7

Further Analysis: Accidentally accepting (-)ive NPV Projects (2)

Answer 7

1. Over-estimation of FCF

2. Under-estimating the Risk i.e. Lower d/c rate.

Question 8

Further Analysis: How to be accurate.

Answer 8

1. Break-Even Analysis
2. Sensitivity Analysis
3. Scenario Analysis

Question 9

Break-Even Analysis

Answer 9

The BE level of an input is the level that causes the NPV = 0

Question 10

Sensitivity Analysis

Answer 10

Shows how the NPV varies with a change in one of the assumptions, holding other assumptions constant.

i.e. change 1 input and see how drastic the change.

Question 11

Scenario Analysis

Answer 11

Considers the effect on the NPV of simultaneously changing multiple assumptions

i.e. we change a no. of inputs..