Principles of Finance Notes

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Principles of Finance Notes
Theory Questions
Explain why the NPV approach is preferred to the IRR approach (2006)

The NPV approach takes into account the timing of cash flows and the IRR does not. For example if you took 2 projects that required the same initial outlay and had the same cash inflows for the same period of time but one project was deferred for one year, using the NPV we would have different values but the IRR would give us the same.

The NPV approach takes into account the scale of the project and the IRR does not. For example

The NPV approach can include multiple positive and negative cash flows in its calculations whereas the IRR cannot. The IRR is the discount rate that makes a project break even. If market conditions change over the years, this project can have two or more IRRs which would be ineffective.

The IRR takes into account the capital required

The IRR is thought the be easier to understand than the NPV as it is thought to be the % return on the project.

Explain soft and hard capital rationing with examples of both (2007/2011) In a perfect market, investments funds are freely available. However this is not true in reality as investment funds are not freely available. Therefore firms need to set limits on their capital expenditure when capital is scarce, known as capital rationing. There are 2 forms capital rationing: Hard capital rationing occurs when companies face problems in raising finance due to external conditions imposed. For example lenders such as banks may limit the amount a firm can borrow if the firm is under financial distress. Soft capital rationing occurs when companies face problems in raising finance due to internally imposed conditions. For example company directors may decide that investments will not be made in such projects that result in a return on investment of less that 10%. Another example would be if directors refuse to issue new shares as it will lead to a dilution of EPS. Explain relevant and irrelevant cash flows with examples of both (2006/2009/2011) Not all costs are of equal importance in decision making which is why the concept of ‘relevance’ is key to decision making. Determining whether a cost is relevant or irrelevant will depend upon the specific circumstance of the decision to be made. It is perfectly possible for a particular cost item to be relevant to one decision but irrelevant to another. Relevant costs are future costs that will be changed by a particular decision. There are 2 main types: Opportunity cost is the potential benefit that is given up when one alternative is selected over another. For example if an employee has a part-time job that pays her £100 per week while attending university and she would like to take a week of during the Easter holidays to go on holiday, and her employer has agreed to give her the time off, but without pay. The £100 in lost wages would be an opportunity cost of taking the week off to go on holiday. Replacement cost is the current cost to replace the asset a business already owns. The older the asset the more likely its current replacement cost will be higher. For example if a car company wants to increase their sales revenue, they will have to increase the number of cars they sell. However if the cost of tires increased the company would have to take the current cost of tires into account. Irrelevant costs (also known as sunk costs) are past costs that has already been incurred that cannot be changed by any decision made now or in future. For example… Explain operation and pricing efficiency in terms of stock markets (2007/2011) Pricing efficiency refers to the idea that prices reflect rapidly in an unbiased way all available information. Pricing efficiency emerges because the price of assets are adjusted to reflect expected future cash flows.

Operational efficiency refers to the level of costs of carrying out transactions in capital markets.

Explain Fisher’s separation theorem (2010/2011)...
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