Q. Having calculated an NPV, if the question then asks you to “advise the Board” what do you talk about to get the marks other than whether the NPV is + or -?
A. Remember the an NPV is only a financial appraisal and there may be a host of other issues to consider such as the following:
- Risks – are there any significant risks associated with the project? What could go wrong?
- Ethics/Stakeholders – Are there any potential stakeholder conflicts?
- Strategy – Is the project a good fit with the organisations present strategy and objectives?
- Real options – Are there any choices or flexibility within the project?
- Alternatives – Any other uses for the capital?
In addition to the above, consider the numbers:
- How certain are the cashflows?
- Is the cost of capital suitable? (Risk?)
Q. What are the common topics that always come up?
A. Two key topics are always NPV appraisal and capital structure, particularly CAPM and Betas. You will not pass if that is all you know but you will struggle to pass if you do not know them!
Q. Where do I begin on a NPV question?
A. This area is frequently examined and you will be under extreme time pressure to do as many calculations as possible within the allotted time. Having read the question – you will either start on cash flows or the discount rate (see below). To maximise your mark earning potential group the cash flows under three headings, operating, capital and working capital – and deal with the tax accordingly – impacts on operating / capital flows but not working capital. If the question requires the calculation of an MIRR then when you use a proforma for your cash flows split them between the investment phase and return phase which will then allow you to use the MIRR formula or any other method recognised.
Q. How do I calculate a cost of capital?
A. If it is an NPV calculation and you are required to calculate a risk adjusted WACC then following four steps will be required:
- Ungear the equity beta of the proxy company supplied to find the asset beta
- Regear the asset beta to reflect the financial gearing of the investment
- Use the equity beta to find the Ke(g) using CAPM
- Feed Ke(g) into CAPM along with a post tax Kd
Q. How do I approach an APV question?
A Remember we use APV when we don’t know the post project gearing, typically because the finance has changed.
- We evaluate the investment decision at an ungeared Ke found be degearing an asset beta of the proxy co / industry we are investing in.
- We then calculate the present value of the finance flows using the pre tax cost of borrowing / debt – the main finance flows being the cost of raising the finance (tax relief on the debt) and the present value of the tax shield.
Q. How do I use currency futures to hedge against an adverse rate of exchange movement?
A. Remember the critical step is to identify the currency of the futures contract, and having established this, then what we do with that currency in the currency market, we do exactly the same in the futures market. So if we have a $ receivable and a $ futures contract, then we would be selling our $ from the customer in the currency market and therefore we would create the hedge by selling $ futures.
Q. Do I use an interest rate futures to hedge against an adverse movement in the rate of interest?
A. It is just a case of remembering that whenever we are concerned about rate rises because we are looking to borrow at some point in the future the we hedge by selling interest rate futures, or if we were looking to invest at some point in the future and we are concerned about rate falls then we hedge by buying interest rate futures.