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FM > NPV/IRR > Flashcards

NPV/IRR Flashcards

1
Q

What does the IRR show?

A

If it is more than the cost of capital of the business then this shows that the investment will enhance shareholder wealth. If the IRR % is lower than the current cost of capital then this shows that shareholder wealth would decline.

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2
Q

Do you include T0 in the IRR formula?

A

Yes

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3
Q

Do you include T0 in the NPV formula?

A

No, T0 is removed afterwards to give the final NPV

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4
Q

IRR vs NPV

A

IRR and NPV usually give the same result as to whether an investment should be made.
IRR is usually easier to understand in businesses as it is in percentage form.
The IRR however does not calculate the change in absolute shareholder wealth therefore it may provide the wrong result when alternative projects are being ranked.
Non-conventional cash flows can create more than one IRR.

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5
Q

How do we know whether to accept the IRR?

A

If it exceeds the COC

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6
Q

What do we do if the IRR is lower than the COC?

A

Reject the project as it implies shareholder wealth will decline

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7
Q

One advantage of the IRR in comparison to the NPV

A

It is in % form therefore managers and employees prefer this

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8
Q

Two disadvantages of the NPV

A

1 - it does not calculate the absolute change in shareholder wealth therefore may give the wrong conclusion when projects are being ranked

2 - Non conventional cash flows can have more than one IRR

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9
Q

What is the traditional view of D vs I

A

TRADITIONALLY it was believed that SH want dividends now rather than dividends or capital gains in the future as cash now in more certain than cash in the future.

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10
Q

What did MM argue with the D vs (dividend policy)

A

MM argued that share value is determined by future earnings and the level of risk.

They said that the amount of dividends paid would not affect SH wealth provided the retained earnings are invested in a project with a positive NPV and

any loss in dividend income will be offset by future gains in share price.

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11
Q

What are home made dividends? (MM - D vs I)

A

MM stated that SH can create home made dividends and do not have to rely on the dividends for income, if they want more income then they can sell shares.

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12
Q

What are the negatives to home made dividends? (3 costs)

A

Taxes, transaction costs, share issue costs

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13
Q

What were the assumptions MM made about the perfect market when creating the dividend policy? (2)

A

Dividend signalling and The clientele effect

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14
Q

Dividend signalling:

A

dividends suggest that management are confident on the future of the business. MM assumed that investors had perfect information about the company however a reduction in dividend may signal ‘bad news’ to SH.

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15
Q

Clientele effect:

A

The SH may have sought the company based on their dividend policy, if the dividend policy becomes inconsistent then the share price may drop as a result of no one wanting to buy them

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16
Q

What is the pecking order theory?

A

Raising equity in the specific order:
1 - retained profit (immediate and no costs)
2 - Rights issue (minimal costs but no control or value given away)
3 - new issue (expensive, difficult to price)

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17
Q

Why is it important to keep dividends lagging behind earnings?

A

So that in the case of the earnings falling, the div can still be paid

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18
Q

What other 2 ways can company distribute to their SH

A

Share buybacks
Scrip dividend - would you like the dividend in new shares rather than cash?

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19
Q

What is a Scrip Dividend?

A

Taking dividends as new shares rather than cash

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20
Q

What is the advantage to the SH of a Scrip Dividend?

A

No broker’s commission or stamp duty on their new shares - so easy to do

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21
Q

What is the advantage to the company of a Scrip Dividend?

A

Does not need to find the cash to fund a dividend and it has positive tax implications in some cases.

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22
Q

What is peer to peer lending?

A

This is a way of connecting established businesses who want to borrow with investors who want to lend through a specialised online platform.

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23
Q

What type of lending is P2P available for?

A

Long term
Short term
Unsecured
Secured
ALL lending

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24
Q

What type of lending is P2P usually used for?

A

Personal unsecured loan

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25
Q

What do the P2P online platforms require from the business when P2P lending? (3)

A

Trading history
submit financial statements
credit checks

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26
Q

What do the P2P online platforms require from the business when P2P lending? (3)

A

Trading history
submit financial statements
credit checks

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27
Q

4 advantages of P2P lending

A

Cheaper than a bank loan
Convenient as online
Quick as waiting list of investors
Dividends can be paid with RE as its an external source of finance

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28
Q

2 disadvantages of P2P lending

A

Got to pass a credit check - requires low score though
Arrangement fee

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29
Q

What is the formula to work out EAC (equivalent annual cost) - replacement theory

A

NPV/Annuity factor

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30
Q

What is the process for replacement theory

A

Cost / sale proceeds
maintenance
- Tax
any other cash flows

net cash flow
NPV (DF, Cash flows 1-n)
Less T0

work out AF

Divide NPV by AF to find out EAC

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31
Q

What are the three issues related to replacement theory

A

> Ignores price changes
assets are not replaced for identical ones in the real work on a continuing basis
The timing of the cash flows - analysing between 2 or 3 years but what if our business cash flow only allows for 3 years?

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32
Q

What is capital rationing?

A

Capital rationing is where there are a number of positive NPV projects
available, but insufficient funds to take on all these projects.

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33
Q

What is the difference between hard capital rationing and soft capital rationing?

A

Hard is an actual shortage of funds whereas soft is an internally imposed limit on funds (budgeting)

34
Q

What does capital rationing show?

A

The optimal use of the limited capital - where you should put the funds

35
Q

In capital rationing what two types can the project be that will depend on what method is used

A

Infinitely divisible and Indivisible

36
Q

What does it mean for a project to be infinitely divisible?

A

We can do part of the project and gain part of the NPV

37
Q

What does it mean for a project to be indivisible?

A

The project must be done in full or not at all

38
Q

What is the first step before ranking the divisible projects?

A

NPV per £ invested by dividing the NPV by total investment

39
Q

are negative NPVs every considered when ranking projects?

A

Yes - when the cash flows have to be positive by a certain period aka by T1

40
Q

What are the 5 benefits of leasing over outright purchase?

A

1: Tax benefits
2: Capital rationing - using the asset as security to overcome difficulties in raising loan finance
3: cash flow - no big outlay and regular payments with lease (planning perks)
4: cost of capital - lease borrowing may be lower than a conventional bank loan
5: flexibility

41
Q

What are the problems with investment appraisal (NPV)

A

All decisions are based on forecasts which are subject to uncertainty that needs to be reflected in the financial evaluation

42
Q

What is the difference between risk and uncertainty?

A

Risk is quantifiable where the probabilities are known whereas uncertainty in unquantifiable where the outcomes can not be mathematically calculated

43
Q

What is risk averse

A

The investor who chooses the preservation of the capital over the potential for a higher return

44
Q

What is the best way to address this uncertainty?

A

Sensitivity analysis

45
Q

What are four other ways to address the uncertainty

A

minimum payback period
prudent estimates of cash flows
assessment of best and worst outcomes
higher discount rates

46
Q

How does the expected value apply to investment appraisal?

A

If a number of outcomes are all assigned a probability then the EV can be calculated to find the LONG RUN AVERAGE OUTCOME

47
Q

what is the formula for Expected Value

A

EV = (SUM)px

p = probability of the outcome
x = the value of the outcome

48
Q

Does the expected value give the most likely result?

A

No - it gives the long run average outcome

49
Q

When is a tree diagram helpful with EV?

A

If uncertain events occur progressively

50
Q

Tree diagram - how to work out the final EV

A

0.6 * 0.7 = 0.42
0.42 * 8800

51
Q

What does sensitivity analysis provide us with?

A

the % change in an estimate that gives the NPV of 0

52
Q

What two types of estimate (from the NPV calc) can we do sensitivity analysis on?

A

Sensitivity to factors affecting cash flows and sensitivity to other factors

53
Q

What type of things affect the cash flow that we do SA on?

A

price, volume, tax rate

54
Q

How do we do a sensitivity analysis over the discount rate?

A

Discount rate

The difference between the cost of capital and the IRR

55
Q

How do we do a sensitivity analysis over the project life?

A

Discounted payback

56
Q

How do we do a sensitivity analysis to those things that affect the cash flow?

A

NPV of the whole project / NPV of the cash flows affected by the change

57
Q

What are three limitations of sensitivity analysis?

A
  • Assumes variables change independently – they don’t!
  • Does not assess the likelihood of a variable changing
  • Does not identify a correct decision
58
Q

What are predictive analytics

A

they use historical and current data to create predictions about the future

59
Q

Three types of predictive analytics

A

Linear regression models
Decision trees
Simulations

60
Q

What is a linear regression model?

A

a stat technique that attempts to identify the factors that are associated with the change in the value of a key variable (aka the NPV of a project)

61
Q

2 advantages of a linear regression model

A

models easy to use and explain to non finance people
models an be used to predict the impact from changes in estimates

62
Q

3 Disadvantages of a linear regression model

A

> Non always a linear relationship between the variables and the outcomes!
do not consider the difference between correlation and causation
if the data is inaccurate then it will be wrong

63
Q

What is the correlation?

A

The strength of the relationship between two variables (aka a positive correlation between gas use for heating and sale of wooly gloves AND gas use for heating and the temperate outside) one has a cause and effect relationship WHICH IS GOOD but the positive correlation between gloves and gas isn’t really relevant because they dont depend on each other!

64
Q

What is not considered with a correlation?

A

Whether and cause and effect relationship exists!

65
Q

How do we find the correlation?

A

We use the correlation co efficient (+1/-1) with +1 being a positive correlation.
=CORREL(

66
Q

2 advantages of a decision tree

A

simple to explain and logical
can be used to consider multiple decisions

67
Q

Limitation to a decision tree

A

May be difficult to interpret if there are multiple outcomes

68
Q

How does the monte carlo simulation compare to sensitivity analysis?

A

Sensitivity analysis considers the effect of changing one variable at a time.

The monte carlo simulation considers multiple variables changing at the same time

69
Q

What will usually be the result of a simulation?

A

a probability distribution

70
Q

2 advantages of a simulation

A

provides more information about the possible outcomes and their sensitivities and its useful for problems that can not be solved analytically

71
Q

4 limitations of a simulation

A

does not identify a correct decision
time consuming and complex software to do
expensive
requires assumptions to be made which may be unreliable

72
Q

What are prescriptive analytics

A

when you combine predictive analytics with AI and algorithms they can be used to calculate the optimum outcome

73
Q

Advantage of prescriptive analytics

A

can consider multiple decisions and variables to identify optimum investment decisions

74
Q

2 disadvantages of prescriptive analytics

A

complex to create a reliable model and specialist
reliability depends on reliability of the data and the ability it has to predict the future from past events

75
Q

What is data bias

A

is the data representative of the population? Bias in many forms can cause data bias

76
Q

Types of bias that cause bias in a data set (6)

A

Selection bias - does the sample selection represent the population?

Observer bias - researcher allows their assumptions to influence the observation

Omitted variable bias - key data is not included in the analysis

Cognitive bias - presentation of the data may be misleading

Confirmation bias - people see date that confirms their beliefs and ignore anything else

Survivorship bias - the sample only include items that survived a previous event

77
Q

What does the standard deviation show

A

how far on average each result lies from the mean. Lower the SD, lower the risk

How much the data fluctuates around the mean!

We want this to be low!

=STDEV(cell range)

78
Q

If a football stadium have an average daily of 50,000 visitors and a standard deviation of 20,000 theen what is the range of the visitors?

A

30,000 - 70,000

79
Q

What is the coefficient of variation?

A

SD/MEAN * 100 gives the SD as a percentage of the mean to show how dispersed the data is. the higher the percentage the wider it is

How much does the data fluctuate around the mean!

80
Q

2 ways to calculate the WACC

A

CAPM and Gordon Growth Model

81
Q

What is CAPM

A

Capital Asset Pricing Model - a way of estimating the rate of return that a fully diversified equity shareholder would require from a particular investment

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