This content introduces the crucial concept of investment appraisal within financial management, emphasizing its interconnectedness with financing and dividend decisions, and highlighting the importance of free cash flow for evaluating investment opportunities.
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We are moving to part B of the syllabus
and that is talking about investment appraisal.
appraisal.
Uh you recall that there are three core
decisions that a senior financial
executive must be able to take and there
we're talking about investment decision,
financing decision and dividend policy.
So we're taking the first one now which
is the investment decision.
You know what is all about investment
decision is you being able to select the
right investment for the company because
you want to maximize shareholders worth
and at the same time you want to achieve
the target which is the secondary
objective uh secondary financial
objective of every company. Yeah. But
before I go into the investment decision
itself, it's also good that I emphasize
on importance of knowing the linkages
between these three core decisions.
Remember we said you must be able to
make investment decision, financing
decision and dividend policy. So as we
as you move on in the study, you must be
able to understand how these three
decisions can be interlin.
Take for instance if you take investment
decision. Yes you want to pick the best
investment that will maximize return but
at the same time you have to finance
this investment. So financing is needed
to be able to do any investment because
if you don't have the fund you cannot do
the investment. Yeah. So and you must be
able to select the right financing
appropriate financing.
So which means your investment
can actually determine
the type of financing that you should be
talking about and how can investment
determine how they should be financed.
So what factors do you need to consider?
Yeah, how can investment determine the financing?
financing?
There are factors that you need to
consider. The first one is asking
yourself what is the nature of this investment
investment
because take for instance if the
investment has to be grain investment
which means net zero emission then you
want to match that investment with green
fund. So you can't just go to any bank
or go to any fund for investing. So you
should be matching this with green fund
because there are banks that would have
said they have dedicated fund for such
investment and you might be able to get
it at a cheaper rate right. So very
important to note that likewise apart
from the nature of the investment the
size of the investment also matters
because if you have a small size
investment then no problem you can
finance it internally with retain
earnings. You can even use credit line
maybe line of credit or something. But
if you are talking of large investment
then you might be talking of going to
even in stock market to raise fund
through public offer or you might be
selling bonds so that you can raise a
lot of money for such huge investment.
So apart from size as well the duration
of the investment also matters. If you
are talking of short-term investment,
you want to able to match it with
short-term funding. And if it's a
long-term investment, you want to match
with long-term funding. So, this is
about asset liability matching.
So, that can also influence what type of
investment you should be, what type of
funding you should be looking for. The
risk is also quite important because if
the investment is high risk, take for
instance, maybe you want to invest in a startup.
startup.
Yeah. Eg a startup business or maybe a
new product that has not been tested
before. So this is high risk investment.
This kind of investment you have to
match it with a funding that is less
risky. And the less risky funding for a
company is equity because when a company
finances his investment with equity, it
doesn't have any obligation to pay back.
So remember is the opposite from the
investor's part. For investor that is
why it is very risky. Equity is very
risky. So don't get it confused from the
company part. It is actually what they
want. They want a less risky investment
which is equity to finance high-risk
investment because it might not turn out
good. And with that case, they won't
have to worry too much about paying the
fund providers. But if there's a lowrisk investment,
investment,
then yeah, you know that definitely
returns and principles are guaranteed,
then you can finance it with debt.
You can do debt financing because you
know you are definitely going to make
money and you'll be able to pay back the
debt providers. Yeah. So that's a way to
think about investment
versus financing. They are very well
linked together because all of these
factors determines the type of funding
that you should use for that particular
investment. Likewise, even for financing
and dividend policy, they are also
linked together.
This is very straightforward because
remember if a company is financed with debt
debt
that means you will pay interest. When
you pay interest what happens to profit
after tax? Profit after tax will reduce.
And what happens to dividend? Dividend
will have to reduce. Even might reduce
to a point whereby you can't even pay
any dividend. So
more debt means less dividend. More debt
means high risk. and shareholders
definitely will be asking for more
returns. Yeah. So please make sure that
you are able to link everything
together. The more the returns you get
on investment as well, the more dividend
you're able to pay. So that's also a
link. So that linkage is extremely
important and please take note and
always think about it as you progress in
this uh part of the syllabus and even
the entire syllabus. Now let's go into
investment appraisal. Now, so I just
quickly did that refresher for you. So
let's talk about investment appraiser
from past study on FM. You know,
investment appraiser is simply you being
able to choose the right investment. And
for you to be able to do that, we are
always working with free cash flow.
Very important free cash flow because
your assessment
has to be done using those free cash
flows. Yeah. What is free cash flow?
We're just talking about the cash flow
that is available to all providers of capital.
of capital. So we're talking of both
equity providers
and debt providers.
So we're talking about both of them.
So all the cash flows available for them
is what we are talking about when we say
free cash flow. So simply to put in a
formula we're just talking of your
revenue which is all inflows
minus cost that you're incurring minus
initial outlay
which is what you learned in FM. So
So
that is your free cash flow. But it's
good I also mention to you because you
can see something like free cash flow to equity.
equity.
Now this is different. Free cash flow is
simply all the cash flows minus all the
out all the inflows minus all the outflows.
outflows.
What if you hear free cash flow to
equity it is different because now this
is only the cash flow that is available
to equity provider. This is available to
both equity providers and debt
providers. But when you say free cash
flow to equity, you are talking about
the cash flow that is available to
equity providers alone. And how do you
calculate that? you're just going to deduct
deduct
your interest expense because it's
interest expense that is available to
debt provider. So once you take that out
from the total free cash flow then the
remaining cash flow is left for the
equity providers to share and that is
talking about your shareholders.
I hope that is very clear. Yeah. So now
what are the method that we have to
learn in investment appraisal for this
There about five methods that you have
to be very comfortable with. Some of
them you've done before in FM. talking
about the likes of NPV, IRRa,
the discounted payback period.
If you remember during FM we've dealt
with this very well. Likewise this one
and this one.
And what I will advise you to do is if
you struggle with any of these three,
please just quickly go back to my recording
recording
the FM playlist. Please refer to FM
playlist and that will be lectures
I think lectures 22 to lectures 25. I
dealt with all these methods in detail.
Then after lecture 25 you will still see
a lot of practice questions on this NPV
IRL discounted payback period lecture 26
27 28. So comprehensively you'll be fine
if you go to those lectures. Please make
sure that you know it if you have
forgotten your NPV, IRRa and discounted
payback method. Especially if you have
done FM maybe not this year, maybe last
year or two years ago. Please go and
have a refresh. Yeah, it won't take you
so long to get them back on track. So
which means for this video, my focus
will be on modified IR and duration. So
these are totally new concept that you
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