Financial Questions and Client Investments in Business Finance

BUSINESS FINANCE
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Introduction
The objective of the given report is to answer the financial questions with regards to different
aspects of NPV coupled with risk and return related discussion. In this regards, reference has
been given to the portfolio theory and theoretical underpinnings related to capital budgeting.
Additionally, the client investments have also been critically analysed in order to provide
advice to the client with regards to the appropriate choice so as to maximise returns on the
investments at hand. A key limitation is that the analysis has been based on standard
assumptions related to NPV and other valuation models such as dividend discount model
which may not be true.
Financial Questions
1) The central tenet of portfolio theory is that the risk and return tend to be correlated. It is
based on the assumption that investors are risk averse and therefore to invest in a risky asset
class, compensation is required in the form of higher returns. The stock market investments
need to be viewed in the backdrop of portfolio theory. The average returns of the stock
market tend to exceed the average returns of lower risk class assets such as bonds. This
indicates towards higher risk being present which need to be properly managed to reduce
exposure (Damodaran, 2015).
With regards to stocks, there are two types of risks namely systematic risk and unsystematic
risk. Systematic risk is also called as non-diversifiable risk as it is a general risk associated
with market investment and cannot be mitigated using portfolio or diversification. On the
other hand, unsystematic risk is the diversifiable risk and therefore can be managed by
diversification of the portfolio. In this regards, it is noticeable that the risk associated with the
stock is captured by the standard deviation of the stock returns. Through diversification, there
tends to some natural hedge and hence the deviations from mean is lowered which enables
lowering of risk (Northington, 2015).
In order to maximise the benefits of diversification, it is essential that the portfolio must
contain of stocks that are negative correlated since this tends to reduce the diversifiable risk
component to almost zero. For example, comprising the portfolio of a company which
exports goods and one which imports goods would make the portfolio stable in time of
volatile currency. However, through perfect diversification also, risk cannot be made zero
since systematic risk would still be present which would be captured using beta. This term

represents the underlying risk associated with the portfolio or stock and is used to deriving
expected returns (Petty et. al., 2015).
2) There are two main conditions which ought to be fulfilled in order to ensure that WACC of
the firm is used for assessing new projects. One key requirement is that the new project
should have similar risk profile in comparison to the firm as a whole. If the project has higher
or lower risk in comparison to the average risk of the firm, then the WACC also needs to be
revised upwards or downwards respectively. This is because the underlying returns expected
on funding would be dependent on the perceived risk of the project (Parrino and Kidwell,
2014).
Another key aspect is that the capital structure related to funding the project should match the
existing capital structure of the firm. IF there is any significant difference in this regards, then
the firm WACC cannot be used for the project (Brealey, Myers and Allen, 2014).
3) a) The decision rule for NPV is that the project which has a positive NPV must be
selected. However, in case of mutually exclusive projects, even if a project has positive NPV,
it may not be selected as the alternative project may have a higher positive NPV. Thus, for a
project with positive NPV to be selected, it is imperative that the company should have
enough resources particularly finance for implementing the project. In case of shortage of
finance, projects having the highest positive NPV are selected and those at the lower end are
ignored (Arnold, 2015).
b) Depreciation is essentially an accounting cost which is not actually incurred thereby
implying that there is no cash implication as it is not paid in cash by the company.
Depreciation essentially captures the wear and tear in the fixed assets which causes a decline
in their book value. However, with regards to NPV, depreciation is considered owing to the
tax shield that it provides which is relevant considering the fact that NPV considers the post-
tax cashflows (Damodaran, 2015).
c) The tax savings on interest payments are excluded as the cost of debt taken into
consideration for the computation of WACC is already post tax and hence the tax savings are
already reflected in the form of lower cost of debt which essentially leads to lower value of
cost of capital (Parrino and Kidwell, 2014).
d) Sunk costs are not taken into consideration for the purpose of NPV analysis as irrespective
of the decision made regarding the project, these costs cannot be recovered. Hence, these