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Please write in your own words Q1. Explain net present value (NPV) as a capital budgeting...

Please write in your own words

Q1. Explain net present value (NPV) as a capital budgeting tool and how NPV is used for the evaluation of a capital project. Explain net present value (NPV) as a capital budgeting tool and how NPV is used for the evaluation of a capital project.

Q2. Identify the assumptions that are necessary to make the general dividend valuation model easier to use, and, in doing so, to be able to use the model to calculate the value of a company’s ordinary shares.

Q3. What is the Capital Asset Pricing Model (CAPM) and how is it used to evaluate whether the expected return on an asset is sufficient to compensate the investor for the inherent risk of the asset?

Expert Solution

1) Net Present Value:

By definition, Net Present Value is the Present Value of all the future cash flows expected to be generated from a project/asset in excess of the Initial Investment.

NPV = PV of Future cash flows - Initial Investment

NPV is one of the most common Capital Budgeting tools. When a company has multiple options of projects that it could invest it's capital in and they have to choose from those options, the projects with the highest NPV is selected.

It makes perfect sense because the company is interested in the amount of excess cash flow over the initial investment the project can generate over it's life.

2) General Dividend Valuation Model:

The formula for the Dividend Discount Model is:

, where

V₀ = Value of share at time 0

D₁ = Dividend paid at time 1

r = Required Rate of Return

g = Long Term growth rate of earnings

ASSUMPTIONS:

The firm is a going concern. Liquidating firms have different methods of valuation.
Dividend payout will remain consistent with the earnings growth.
The growth will continue without any changes.

3) Capital Asset Pricing Model:

The CAPM is a model used for the calculating the expected return on a company's stock.

The formula is as under-

, where

r = Expected Return

RF = Risk Free rate

= Beta, which is the measurement of the stock's sensitivity to market changes

ERP = Equity Risk Premium

The expected return is also sometimes called the Required Return which means that an Investor will require a minimum return equal to r for investing in this stock, given the stock's risk.

This return is sufficient for an investor because it is based on the risk that the stock carries and adequately compensates the investor for carrying that risk.

jeff jeffy answered 1 year ago

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