banking

• Opportunity cost of capital

  rate of return used to discount the expected cash inflows has to be the rate of return offered by equivalent investment alternatives in the capital market. This discount rate is termed opportunity cost of capital.
• Determinant of discount rate in the NPV method

  1.  Opportunity cost of capital, i.e. next best use of funds (what is being given up if the project is invested in).
  2. Firm's cost of capital (WACC}.Risk of project { if the project is riskier than projects normally invested in then may need to increase discountrate.
• ttype of cash flows discounted in the NPV method 


  ‘incremental cash flows’, which are the additional cash flows from the project.Sunk costs have to be excluded from the above calculation, because they are incurred whether or not the project is accepted. The implicit assumption about cash flows associated with the investment project is that they can be estimated without error. However, in the real world, the cash flows associated with investment projects represent forecasts, and not real values. Therefore the cash flows have to be estimated in an uncertain framework.
• .Discuss the limitations of this method when compared to the NPV technique.

  (i) When ranking projects (e.g. when choosing between mutually exclusive projects) the IRR method may give a ranking that is inconsistent with wealth maximization. (ii) The implicit assumption that a firm can re-invest the proceeds from the project at the projects IRR. This may be inconsistent with the market determined rate of return.

  (iii) Can give multiple or no solutions in some circumstances.
• Describe the IRR method.

  The IRR is the discount rate that gives an NPV = 0.

  The calculation of the IRR involves an iterative process, which can be viewed as a trial and error procedure.

  The choice of projects is made by comparing the IRR to a required rate ofreturn termed hurdle rate (R*). If the IRR is higher than the hurdle rate, the project has to be accepted.
• How can we appraise a set of investment projects when funds to finance those investments are constrained?

  The concept of limited funds refers to a situation where the amount of money available is less than the total investment cost of all the projects.

  When there are limited funds, the NPV additivity property enables firms to choose the best project.
• Describe the techniques used to value financial assets.

  the discounted cash flow model: P = C1 / (1+i) + C2 / (1+i)2 + .... Cn /(1+i)n
• Compare and contrast the methods used in the pricing of bonds and common stocks.

  For bonds, valuation is a simple matter of applying the above formula. All the terms are known. For stocks, we do not know the future cash flows (dividends). Assumptions therefore have to be made about the evolution of dividend payments to infinity.

  The two main assumptions made are:

  (i) constant dividends(ii) constant growth of dividends (the Gordon growth model).