Corporate Finance: Course Notes

Topics: Net present value, Internal rate of return, Discounted cash flow Pages: 26 (2404 words) Published: October 29, 2013
Having studied this chapter you will be able to:
Evaluate the potential value added to a firm arising from a
specified capital investment project or portfolio using the net present value model. Project modelling should include explicit treatment of:
(a) Inflation & specific price variation
(b) Taxation including capital allowances and tax exhaustion (c) Single & multi-period capital rationing to include the
formulation of programming methods and the interpretation
of their output
(d) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in investment appraisal
(e) Risk adjusted discount rates (covered in chapter 7)
Outline the application of Monte Carlo simulation to investment appraisal. Candidates will not be expected to undertake
simulations in the exam but will be expected to demonstrate
understanding of
(a) simple model design
(b) the different types of distribution controlling the key variables in the simulation
(c) the significance of the simulation output and the assessment of the likelihood of project success
(d) the measurement and interpretation of project value at risk Establish the potential economic return using IRR and modified IRR & advise on a project’s return margin. Discuss merits of NPV & IRR.

Discounted cash flow
techniques are also
extensively examined
in the context of
business valuations
(business valuations
are covered in
chapters 9-12).

Slow Fashions
- 20 marks, June 09
Your business
- 28 marks, June 09
Seal island
- 24 marks, June
2010 Q1i,ii,iii

Seal island - 4
marks, June 2010
Q1iv
Tisa Co- 4 marks,
June 2012 Q4c

Tisa Co- 8 marks,
June 2012 Q4b
Neptune- 6 marks,
June 2008 Q5b

5: DCF TECHNIQUES AND THE USE OF FREE CASH FLOWS

Maximisation of
shareholder wealth

Investment decision

DCF techniques & the use of free
cash flows

Estimating the potential value
added to a firm from a capital
investment project

Financing decision

Dividend decision

Impact of capital rationing on
project appraisal

Impact of a capital investment
project on dividend capacity

5: DCF TECHNIQUES AND THE USE OF FREE CASH FLOWS

Lecture example 2 (from day 1)
Avanti plc is considering a major investment programme which will involve the creation of a chain of retail outlets throughout the United Kingdom. The following cash flows are expected. Time
Land and Buildings
Fittings and Equipment
Gross Turnover
Direct Costs
Marketing
Office Overheads

0
£’000
3,250
700

1
£’000

2
£’000

3
£’000

4
£’000

1,800
750
170
125

2,500
1,100
250
125

2,800
1,500
200
125

3,000
1,600
200
125

(a)

60% of office overhead is an allocation of head office operating costs.

(b)

The cost of land and buildings includes £80,000 which has been spent on surveyors’ fees.

(c)

Avanti plc expects to be able to sell the chain at the end of year 4 for £4,000,000.

Avanti plc is paying corporate tax at 30% and is expected to do so for the foreseeable future. Tax is paid one year in arrears.
The company will claim capital allowances on fittings and equipment at 25% on a reducing balance basis. Capital allowances are not available on land and buildings. Estimated resale proceeds of £100,000 for the fittings and equipment have been included in the total figure of £4,000,000 given above.

Avanti plc expects the working capital requirements to be 15% of turnover during each of the four years of the investment programme.
Avanti’s real cost of capital is 7.7% p.a. Inflation at 4% p.a. has been ignored in the above information. This inflation will not apply to the resale value of the business which is given in nominal terms.

Solution to NPV
Net Present Value working (All figures £'000s)
Year
1
Sales
1800
Direct Costs
(750)
Marketing
(170)
(50)
Office overheads (40%)
Net Real Operating flows
830
Inflated at 4% (rounded)
863
Taxation at 30% in arrears
0
Tax relief from capital...
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