BFF1001 Lecture Notes - Lecture 5: Cash Flow, Weighted Arithmetic Mean, Net Present Value
Week 5: Capital Budgeting
1. Risk and return
2. NPV
3. IRR
What is the risk in the context of finance and investment?
Ans: Uncertainty of cash flows; in timing and magnitude of cash flow
What is risk/ uncertainty qualified and measured?
Ans: typically, through the standard deviation of cash flows
What is considered to have risk?
Ans: Both assets and liabilities can have risk. For asset holders, risk is
uncertainty in earnings (cash inflow)
For liability holders, risk is uncertainty in cost (cash outflow)
When risk increases, a greater return is needed to compensate for the risk
burden.
A foundational relationship in Finance =
“High Risk – High Return”
“Low Risker – Low Return”
What is the implication, increased or decreased risk, of a value and
subsequently price?
Ans: Holding all else equal, when future cash flows become more
uncertain (risk increases), the present value of their worth today falls.
Greater Risk = Less Value
This place down pressure on its prices, as buyers should rationally pay
less for lower value.
Capital Budgeting: is the process by which organisations determine whether
their long term investments such as new machinery, replacement machinery,
new plants, new products, and research development projects are worth
pursuing. It is the investment of corporates and institutions
OBJECTIVE
The objective of capital budgeting decisions is to select investments in assets
that will increase the value of the company. It is said that the corporate
objective is to maximise shareholder‟s wealth.
IMPORTANCE
Capital budgeting is important because these investment involve large cash
outlays, they create value when the cash flows they generate are worth more
than they cost and once made these investments are not easily reversed.
Document Summary
Week 5: capital budgeting: risk and return, npv, irr. Ans: uncertainty of cash flows; in timing and magnitude of cash flow. Ans: typically, through the standard deviation of cash flows. Ans: both assets and liabilities can have risk. For asset holders, risk is uncertainty in earnings (cash inflow) For liability holders, risk is uncertainty in cost (cash outflow) When risk increases, a greater return is needed to compensate for the risk burden. Ans: holding all else equal, when future cash flows become more uncertain (risk increases), the present value of their worth today falls. This place down pressure on its prices, as buyers should rationally pay less for lower value. Capital budgeting: is the process by which organisations determine whether their long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is the investment of corporates and institutions.
