Semester 2: Lecture 2: Investment Appraisal applications.

Question 1

If 2 projects both return the same amount why are they not equally as good …

Answer 1

• Timing
• Risk

Question 2

Why do we need a discount rate?

Answer 2

• Needed for decision making.
• Reflect on the return investors require for the risk they take.

Question 3

2 different methods to set a discount rate:

Answer 3

WACC Method: Weighted Average cost of capital.

and

CAPM Method: Capital Asset Pricing Model

Question 4

Weighted Average cost of capital (WACC):

Answer 4

The average return expected by both the lenders (debt) and shareholders (equity).

Question 5

CAPM: Capital Asset Pricing Model

Answer 5

Estimates the return needed based on the investment risk compared to the market.

Question 6

Relevant cashflows:

Answer 6

DCF focuses on cashflows which impact decision making.

Include: Tick.
- Future & incremental cashflows (caused by the decision).
- Opportunity costs (next best investment).

Exclude: Cross
- Sunk costs (past expenses which have already been paid).
- Committed costs ( fixed overheads, ongoing expenses).
- Depreciation.

Question 7

What is Capital Rationing?

Answer 7

• Companies do not have unlimited capital so must decide between different projects.
• Even if positive NPV, project may not be taken due to capital constraints.

Question 8

2 different types of capital rationing?

Answer 8

Hard - capital markets will only supply a given level of capital.

Soft - company has chosen to restrict its capital investment.

Question 9

How do companies allocate limited capital (Capital rationing)?

Answer 9

• Allocate capital which will maximise shareholders returns.
• Rank projects based on their NPV per unit of capital invested (NPV/capital ratio).

Question 10

Strategic context of investment appraisal: Considering strategic factors factors ensures long term success with methods such as…

Answer 10

• Real Options
• Value Chain Analysis
• Cost Driver Analysis
  Competitive Advantage.

Question 11

Real options…

Answer 11

Building flexibility into options.

Taking a narrow financial focus could result in a negative NPV.

e.g a construction firm buying land, but only starting to build the houses when the demand increases in the housing market.

Question 12

Value Chain Analysis…

Answer 12

“Value Chain” - a set of activities which link from basic raw materials through to the ultimate end product.

Companies analyse which part of the value chain needs investment to gain a competitive edge.

Question 13

Cost Driver Analysis:

Answer 13

• These are the factors which influence total costs in business operations.
• Investment decisions should focus on high cost areas to improve efficiency.
• Analysing cost drivers, helps a company to decide where to invest for long-term savings.

Question 14

Competitive Advantage Analysis:

Answer 14

• USP factor.
• Differentiate to build a long-term competitive advantage.