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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
What do the P2P online platforms require from the business when P2P lending? (3)
Trading history submit financial statements credit checks
26
What do the P2P online platforms require from the business when P2P lending? (3)
Trading history submit financial statements credit checks
27
4 advantages of P2P lending
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
28
2 disadvantages of P2P lending
Got to pass a credit check - requires low score though Arrangement fee
29
What is the formula to work out EAC (equivalent annual cost) - replacement theory
NPV/Annuity factor
30
What is the process for replacement theory
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
31
What are the three issues related to replacement theory
> 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?
32
What is capital rationing?
Capital rationing is where there are a number of positive NPV projects available, but insufficient funds to take on all these projects.
33
What is the difference between hard capital rationing and soft capital rationing?
Hard is an actual shortage of funds whereas soft is an internally imposed limit on funds (budgeting)
34
What does capital rationing show?
The optimal use of the limited capital - where you should put the funds
35
In capital rationing what two types can the project be that will depend on what method is used
Infinitely divisible and Indivisible
36
What does it mean for a project to be infinitely divisible?
We can do part of the project and gain part of the NPV
37
What does it mean for a project to be indivisible?
The project must be done in full or not at all
38
What is the first step before ranking the divisible projects?
NPV per £ invested by dividing the NPV by total investment
39
are negative NPVs every considered when ranking projects?
Yes - when the cash flows have to be positive by a certain period aka by T1
40
What are the 5 benefits of leasing over outright purchase?
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
What are the problems with investment appraisal (NPV)
All decisions are based on forecasts which are subject to uncertainty that needs to be reflected in the financial evaluation
42
What is the difference between risk and uncertainty?
Risk is quantifiable where the probabilities are known whereas uncertainty in unquantifiable where the outcomes can not be mathematically calculated
43
What is risk averse
The investor who chooses the preservation of the capital over the potential for a higher return
44
What is the best way to address this uncertainty?
Sensitivity analysis
45
What are four other ways to address the uncertainty
minimum payback period prudent estimates of cash flows assessment of best and worst outcomes higher discount rates
46
How does the expected value apply to investment appraisal?
If a number of outcomes are all assigned a probability then the EV can be calculated to find the LONG RUN AVERAGE OUTCOME
47
what is the formula for Expected Value
EV = (SUM)px p = probability of the outcome x = the value of the outcome
48
Does the expected value give the most likely result?
No - it gives the long run average outcome
49
When is a tree diagram helpful with EV?
If uncertain events occur progressively
50
Tree diagram - how to work out the final EV
0.6 * 0.7 = 0.42 0.42 * 8800
51
What does sensitivity analysis provide us with?
the % change in an estimate that gives the NPV of 0
52
What two types of estimate (from the NPV calc) can we do sensitivity analysis on?
Sensitivity to factors affecting cash flows and sensitivity to other factors
53
What type of things affect the cash flow that we do SA on?
price, volume, tax rate
54
How do we do a sensitivity analysis over the discount rate?
Discount rate The difference between the cost of capital and the IRR
55
How do we do a sensitivity analysis over the project life?
Discounted payback
56
How do we do a sensitivity analysis to those things that affect the cash flow?
NPV of the whole project / NPV of the cash flows affected by the change
57
What are three limitations of sensitivity analysis?
* Assumes variables change independently – they don’t! * Does not assess the likelihood of a variable changing * Does not identify a correct decision
58
What are predictive analytics
they use historical and current data to create predictions about the future
59
Three types of predictive analytics
Linear regression models Decision trees Simulations
60
What is a linear regression model?
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
2 advantages of a linear regression model
models easy to use and explain to non finance people models an be used to predict the impact from changes in estimates
62
3 Disadvantages of a linear regression model
>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
What is the correlation?
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
What is not considered with a correlation?
Whether and cause and effect relationship exists!
65
How do we find the correlation?
We use the correlation co efficient (+1/-1) with +1 being a positive correlation. =CORREL(
66
2 advantages of a decision tree
simple to explain and logical can be used to consider multiple decisions
67
Limitation to a decision tree
May be difficult to interpret if there are multiple outcomes
68
How does the monte carlo simulation compare to sensitivity analysis?
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
What will usually be the result of a simulation?
a probability distribution
70
2 advantages of a simulation
provides more information about the possible outcomes and their sensitivities and its useful for problems that can not be solved analytically
71
4 limitations of a simulation
does not identify a correct decision time consuming and complex software to do expensive requires assumptions to be made which may be unreliable
72
What are prescriptive analytics
when you combine predictive analytics with AI and algorithms they can be used to calculate the optimum outcome
73
Advantage of prescriptive analytics
can consider multiple decisions and variables to identify optimum investment decisions
74
2 disadvantages of prescriptive analytics
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
What is data bias
is the data representative of the population? Bias in many forms can cause data bias
76
Types of bias that cause bias in a data set (6)
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
What does the standard deviation show
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
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?
30,000 - 70,000
79
What is the coefficient of variation?
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
2 ways to calculate the WACC
CAPM and Gordon Growth Model
81
What is CAPM
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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