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
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A firm's choice of investments are separate from its owner's attitudes towards the investments.

2. It is possible to separate a firm's investment decisions from the firm's financial decisions.

The first point means that the primary goal of any firm is to maximise its value, regardless of the attitudes of the firms owners. The second point means that a firm's value is not determined by the way it is financed or the dividends paid to the firm's owners.

Explain the concepts of business risk and financial risk. (/2010)

Business risk is the possibility that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit. Business risk is influenced by competition, economic climate, government regulation amongst others. A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure that it can meet its financial obligations at all times. The ratios used to evaluate business risk include the contribution margin ratio, operating leverage ratio, financial leverage ratio and total leverage ratio.
Financial risk is the possibility that shareholders will lose money when they invest in a company that has debt, if the company's cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors will be repaid before its shareholders if the company becomes insolvent. Investors can use a number of ratios to evaluate financial

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