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Lecture10 - FIN2101 FIN2101 Business Finance II Module 9...

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FIN2101 FIN2101 Business Finance II Business Finance II
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Module 9 Module 9 Investment and Investment and Financing Decisions Financing Decisions
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Student Activities Student Activities Reading Study Book , Module 9 Selected Reading 9.1 Tutorial Activities Tutorial Workbook , Self Assessment Activity 9.1
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Introduction Introduction The cost of capital is used to discount after- tax cash flows expected from a firm’s investment decision. This, in turn, determines whether the investment should be accepted or rejected according to the value it is expected to create. Cost of capital is thought of as the rate of return required by the market suppliers of capital in order to attract their funds to the firm.
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Introduction Introduction Does the financing mix affect the firm’s overall cost of funds, either favourably or unfavourably? MM say NO - financing decisions are irrelevant. Firms should therefore concentrate on the investment decisions.
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Introduction Introduction In reality, the cost of capital may decrease with financial leverage, resulting in some negative NPV projects becoming acceptable (positive NPV). This factor therefore needs to be incorporated into our investment decision analysis!
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Introduction Introduction Under MM assumptions, investment decisions can be separated from the financing decisions. In reality, these decisions can’t be separated! The effects of financing decisions must be included in the analysis.
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Valuation Methods Valuation Methods WACC method – adjusts the discount rate. Adjusted present value (APV) method – adjusts the NPV for the impact of the financing decision. Flow-to-equity (FTE) method combination of the other 2 methods.
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WACC WACC ( 29 V D T - 1 k V S k k d s a × + × =
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WACC WACC Reflects, on average, the firm’s cost of long-term financing. Recognises the mix of different financing sources that fund the firm’s long-term assets. Is the average of the rates of return that providers of capital require, with each source’s contribution being weighted according to the proportion of capital it provided.
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