Investment & Finance

Assignment Brief

5105LBSBW Investment & Finance

Question 1

A firm is considering an investment opportunity which has a 10 year life. It will cost £500,000 and is expected to generate annual profits of £100,000 (assuming zero debt finance). The company is considering how to raise the £500,000 and has the following data regarding the proportion to be raised through equity and debt

Gearing (%)              Cost of Equity (%)              Cost of Debt after tax (%)

0                                            3                                  1

10                                          3.1                               1.1

20                                          3.2                               1.2

30                                          3.3                               1.3

40                                          3.5                               1.5

50                                          3.9                               1.8

60                                          4.5                               2.1

1. Calculate the weighted average cost of capital for the company at each of the different levels of gearing and identify the optimal capital structure from your answer. (20 marks)

2. Calculate the Payback, NPV and IRR using the optimal capital structure identified in Part a (20 marks) 

3. Evaluate the opportunity highlighting the risks and stating whether you would proceed with the investment (20 marks)

Question 2

Select ONE of the following:

• Outline and illustrate the Utility Function of someone who is Risk Averse; Risk Neutral and a Risk Taker and explain how this may impact on their decisions to insure against risk

• Evaluate the Role of Portfolio Theory and the Capital Asset Pricing Model in assessing and pricing risk.

• Outline and evaluate Option Pricing Theory with reference to the Black & Scholes Option Pricing Model

• To what extent are financial markets efficient ? Support you answer with (40 marks)

(Total 100 MARKS)

Sample Answer

Investment & Finance

Introduction

Investment and financing decisions are crucial in shaping a company’s value and sustainability. This report analyses an investment opportunity by calculating the firm’s Weighted Average Cost of Capital (WACC) under different gearing levels, identifying the optimal capital structure, and evaluating the project using Payback, Net Present Value (NPV), and Internal Rate of Return (IRR). It also discusses Portfolio Theory and the Capital Asset Pricing Model (CAPM) to understand how risk is assessed and priced in financial markets.

Question 1: Investment Appraisal and Capital Structure

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital represents the company’s average cost of financing from both equity and debt. It can be calculated using this formula:

WACC = (E/V × Re) + (D/V × Rd)

Where:

• E/V = proportion of equity

• D/V = proportion of debt

• Re = cost of equity

• Rd = cost of debt (after tax)

The lowest WACC occurs at 30% gearing (2.76%), meaning that is the optimal capital structure. Beyond this level, the higher cost of debt and equity outweighs the benefits of leverage.

Continued...