Flashcards in The ability to demonstrate this gearing effect numerically Deck (3)
How does modelling help in deciding on an investment?
Helps to look at overall financial impact and obligations over investment period
How do you model the effects of debt and equity?
Firstly collate all required info, then build financial model to look at the financial obligations and potential returns
Sometimes ‘sensitivity analysis’ = helps to look at various scenarios /situations that could occur over a specified period and how this effects the IRR and NPV (i.e. if we change the time discount rate, how does this effect the IRR)?
Most common type of model = DCF, which looks at future / expected income and cost projections over set period and discounts them back to today to get a PV
Internal rate of return (IRR) = used to work out percentage return over period with assumed capital costs, income and discount rate
The NPV = today’s capital value of the cash flows after applying a required rate of return
Level of debt /leverage can have significant effect on outcome
When using IRR as performance measure, positive value addition along with leverage creates a higher return percentage than that of all equity
This is due to the investor being able to access positive returns with less of their own capital, i.e. making more money with putting less in
The counter to this is when negative values are experienced the downside is also amplified and further capital may be required to avoid foreclosure from the lender = greater risk