Investment Appraisal & Financing

Question 1

Follow on options

Answer 1

That the project allows to happen in the future e.g. launch of new product.

Question 2

Abandonment options

Answer 2

The initial investment can be recovered for the most part e.g. project requires investment in land which doesn’t lose value vs investment in machinery which has a low resale value.

Question 3

Timing options

Answer 3

When the project has to be started e.g. now vs any point in the next 5 years.

Question 4

Growth options

Answer 4

Whether a project requires full commitment now or it can be started in a small capacity and expanded later in the future.

Question 5

Operational gearing

Answer 5

The extent to which a firm’s operating costs are fixed rather than variable.

=FC / VC or,
=FC / Total costs

Question 6

Financial gearing

Answer 6

The extent to which debt is used in the capital structure.

=Debt / Equity or,
= Debt / (Debt + Equity)

Preference shares treated as debt finance and therefore the dividends as interest.

Question 7

Assumptions for Modigliani and Miller (M&M) effect of gearing on WACC

Answer 7

Perfect capital market:

• No transaction costs
• No individual dominates the market
• Full information efficiency
• All investors are rationale and risk averse
• No taxes, WACC is constant.
• With taxes, Kd lowers as it is tax deductible therefore WACC decreases as gearing increases.

Question 8

Equity Beta Formula

Beta reflecting systematic business risk (Asset Beta) and firm’s level of gearing.

Answer 8

= Asset Beta x (D(1 - T) / E)

E: MV of equity
D: MV of debt
T: Tax rate