Principles of Finance Notes
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
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