Valuing An Investment

Question 1

What is the hurdle rate?

Answer 1

• the expected rate of return shareholders can earn by investing in financial markets at the same level of risk as the investment project
• also known as the opportunity cost of capital

Question 2

If the hurdle rate < project rate of return what should the financial manager do?

Answer 2

• financial manager should invest in real asset as in this case this would increase company value the most and this shareholder wealth

Question 3

If the hurdle rate > project rate of return what should the financial manager do?

Answer 3

• should pay cash as dividend so shareholders can invest into financial assets themselves

Question 4

What is PV?

Answer 4

PV = Ct x 1/(1+r)^t

Question 5

What is NPV?

Answer 5

NPV = PV - Initial Outlay

Question 6

What does it mean if NPV > 0?

Answer 6

• company should go ahead with investment
• company value would be increased by investment by same amount as NPV

Question 7

What happens when rate of return increases?

Answer 7

• discount rate is higher
• NPV is lower
• PV is smaller

Question 8

What is the rate of return rule?

Answer 8

• accept investments if the rate of return > opportunity cost of capital

Question 9

What is the NPV rule?

Answer 9

• accept investments if NPV > 0

Question 10

What are the key advantages of NPV rule?

Answer 10

1. NPV offers a clear standard to compare different projects
2. NPV rule recognised tile value of money
3. NPV depends on all forecast cash flows from the project
4. NPV rule depends solely on the forecasted cash flows from the project and the opportunity cost of capital
5. By using the opportunity cost of capital in the calculation the NPV rule takes into account the projects level of risk
6. NPV had an additive property
7. NPV rule is consistent with the goal of maximising shareholder wealth

Question 11

How does NPV take risk into account?

Answer 11

• sNPV rule uses opportunity cost of capital in its calculation
• greater return = higher discount rate
• greater return-increased risk
• greater discount rate - lower PV

Question 12

With regards to investment projects what should a financial manager do if they have unlimited resources?

Answer 12

• Accept all investments where NPV > 0

Question 13

With regards to investment projects what should a financial manager do if they have limited resources?

Answer 13

• Accept investment with highest NPV and profitability index (PI)

Question 14

What is the PI?

Answer 14

• NPV per pound of initial outlay

PI = NPV / Investment

Question 15

Why is PI not a full proof tool?

Answer 15

• it can be misleading when dealing with more than one constraint and mutually exclusive projects

Question 16

What is hard rationing?

Answer 16

• always reflects market imperfections
• a barrier between firm and capital markets
• restraints put on company by outside entities

Question 17

What is soft rationing?

Answer 17

• reflect no imperfections in capital markets
• self-imposed limits as a means of financial planning and control