1.

Baumol model
This assumes that cashflows are predictable, and treats cash like inventory. In practice, cash
flows might not be predictable. In addition, in the Baumol model, no buffer level of cash is
allowed for, which means that using this model may result in costs associated with running out
of cash. Buffer stocks of cash can be builti into model, however, as they can with the Economic
Order Quantity approach to inventory management.

An advantage of the Baumol model is that it is straightforward to understand and operate.

2. Miller-Orr model
The Miller-Orr model is more realistic than the Baumol model in that it assumes random
fluctations in cashflows, which is often the case in practice.
In the Miller-Orr model, a lower limit for cash holding is set by management. Taking into acount
the interest rate and the trading costs of buying and selling marketable securities, and the
standard deviation of daily cash flows, an upper limit and return point are calculated.
When the cash balance hits the upper or lower limit, marketable securities are bought or sold
to bring the cash balance back to the return point.

The model is reasonably straightforward, so management time can be saved by using this
model, rather than spending time trying to predict uncertain cashflows.

3. Working capital ratios: AR, AP, Inventory (RM, WIP, FG), Sales/net working capital
4. Liquidity ratios: Current ratio, Quick ratio
5. EOQ model (re-order quantity)
Assumptions in EOQ Model:
The formula is based on the following assumptions. Without these assumptions, the EOQ model
cannot work to its optimal potential.
1. The demand rate for the year is known and evenly spread throughout the year.
2. There is no time gap between placing an order and receiving its supply.
3. Ordering cost very directly with the number of orders.
4. Carrying cost very directly with the average inventory.
5. There is no quantity discount.

Pros: The EOQ is very useful tool for inventory control it may be applied to finished goods
inventories, work-in-progress inventories and raw material inventories. It regulate of purchase
and storage of inventory in such a way so as to maintain an even flow of production at the
same time avoiding excessive investment in inventories.

Cons: The assumptions made in the EOQ formula restrict the use of the formula. In practice
cost per unit of purchase of an item change time to time and lead time are also uncertain. It is
necessary for the application of EOQ order that the demands remain constant throughout the
year which is not possible. Ordering cost per order can’t be constant because it’s including
transport cost.
 6. Re-order level, Maximum inventory level, Minimum inventory level, Buffer safe
inventory
7. Early settlement discounts
8. Bulk discounts
9. Cash operating cycle
10. JIT
11.Payback method

Pros:
Simple
Useful when rapidly changing technology; improving investment conditions.
If equipment is to be scrapped in a short period due to obsolescence, the company needs a
quick payback.
If the investment conditions is improving soon, the company needs a quick payback to take
advantage of the improving investment conditions.
Help company grow, minimise risk and maximise liquidity.
Have cash early
More certain earnings.
Use cash flows, not accounting profits.
Useful when used as a first screening device to eliminate clearly inappropriate projects before
using other investment appraisal methods.

Cons:
It ignores returns after the payback period → focus on liquidity.
It ignores the timing of cash flows.
It ignores project profits/ profitability.
Target payback is subjective.
It gives no clear decision advice.

12.ROCE (ARR)
Pros:
- It is simple, easy to understand. As it is expressed in percentage terms: managers and
accountants are familiar with.
- It links with other accounting measures.

Cons:
- It ignores the time value of money.
- It ignores the timing of cash flows.
- It ignores the project life.
- It ignores the size of the project.
- It uses profits, which are subject to accounting policies.
 - It ignores working capital requirement.
- It ignores absolute gain in shareholder wealth.
- It gives no clear investment advice.
- The target ROCE is subjective.

Cash:
- Better measure whether the investment is suitable.
- Lifeblood of the business.
- All claims of shareholders are settled by cash for example, dividends payments.
- More objective than profits.
Profits:
- Only a guide to cash availability.
- Subjective, depends on various accounting policies.

13.NPV
Pros:
Superior to all other methods of investment appraisal.
It considers the time value of money.
It considers the timing of cash flows.
It measures the absolute gains in shareholder wealth.
It uses cash flows (objective), not accounting profits (subjective, depends on various accounting
policies, unduly optimistic figure, distorted figure).
It considers the whole life of the project.
It considers the size of the project.
It considers the working capital requirement.
It gives clear investment advice. (clear decision rule).

Cons:
It is not easy to understand to managers.
It requires knowledge of cost of capital.
It is relatively complex.

14.IRR

Pros:
It is simple, easy to understand. As it is expressed in percentage terms: managers and
accountants are familiar with.
It considers the time value of money.
It considers the timing of cash flows.
It uses cash flows (objective), not profits (subjective, unduly optimistic figure, distorted figure,
depends on various accounting policies).
It considers the whole life of the project.
It gives clear investment advice ie. Choosing a project with IRR higher than the company’s cost
of capital could increase the shareholder wealth.

Cons:
It does not measure the absolute gain in shareholder wealth. For example, a project could be
invested $1,000 now and forecasted to pay back $1,100 in one year’s time. It has an IRR of 10%.
If the company’s cost of capital (required return) is 6%, then the project is acceptable under IRR
decision rule but the absolute gain of $100 is considered to be too small for an investment.
Interpolation (IRR formula) only gives an estimate IRR not the accurate figure.
It is relatively complex.
In situations of non-conventional cash flows where cash flows changes signs over the life of the
project, this produces multiple IRRs where NPV is of zero. It is hard to decide which IRR to
compare with the company’s cost of capital.
In situations where cost of capital changes from time to time, making an accept or reject
decision using IRR method is difficult as it is difficult to choose which cost of capital to compare
the IRR with.
In situations of mutually exclusive projects, IRR ranks projects in a different rather incorrect
order compared with NPV method. This is due to the inbuilt reinvestment assumption within
IRR method ie. Any cash inflows generated from the project during its life will be reinvested at
the project’s IRR, which is unrealistic. Meanwhile, NPV assumes the reinvestment rate is the
company’s cost of capital, which is more realistic and allows the NPV method to rank projects
more precisely.

15.EAC

Cons:
- It assumes when asset is replaced, the replacement, in all practical respects, is identical
to the last one. The like with like assets. This process will continue for the foreseeable
future. But this is not true in reality as it ignores changing technology (replaced with a
better more efficient version not a like with like asset), inflation (cost changes so the
optimal replacement cycle changes), and changing production plans (company may not
need that type of asset in the future, they cannot predict the exact future).
16. Profitability index
17. Postponability index
18.Sensitivity analysis
Pros:
- It is simple.
- It indicates the key or critical variable for management to make decisions.

Cons:
- It assumes one variable changes at a time while others remain constant. (sales price
changes but it is not sensible to ignore the knock-on effects it has on the sales volume).
- It does not assess the probability of a variable changing.
 - It does not give a clear decision.

19. Probability analysis

20. Expected value (EV)

Pros:
- It is the average pay-off per occasion if the project were repeated many times. (a long-
run average)
- It handles a range of outcomes.
- It assigns each outcome a probability.
- It is relatively simple.
- It assists decision making.
- Useful for a project that is repetitive and involves small investments.
Cons:
- The project may be undertaken once, not many times. Using EV could result in large loss
and no chance to recover money.
- Probabilities are determined subjectively, based on expert judgments or past
experience, limited data.
- EV is only a long-run average, may not actually happen.
- It ignores variability of payoffs, the dispersion of possible outcomes → ignore risk.
- It ignores the investor’s attitude to risk (risk neutral).

21.Simulation

22. Adjusted payback

23. Discounted payback
24. Risk-adjusted discount rate
25. DVM
26.DGM
ke = d0(1+g)/P0 + g
P0 = d0(1+g)/(ke-g)

P0: current market value per share

D0: current dividend per share
G: constant growth rate of the company
K: cost of capital of the company

Pros

Cons:
 - It assumes constant dividend growth rate. However, in reality, dividends should depend
on earnings which is not considered in the DGM. Dividends do not grow at a constant
rate as company managers make dividend decisions in which profitability, liquidity, tax
positions, previous year dividend policy, legal and contractual restraints are factored.
- As finding the accurate value for future dividend growth rate is difficult, the common
approach is to calculate the average historical dividend growth rate as substitute for the
future dividend growth rate. However, this is based on a risky assumption that the
future will repeat the past.
- The company uses their own cost of capital as the discount rate or it assumes that all
shareholders of the company have the same required rate of return.
- The growth rate of the company must exceed its cost of capital (g>k). This is not true for
companies with low growth.
- DGM assumes cost of equity remains constant in the future. In reality, ke changes as
economic circumstances change. CAPM suggests ke varies with changes in systematic
risk whether business risk or financial risk. CAPM can calculate ke but it uses historical
information and does not reflect the expectations about the future.
- DGM does not apply to companies who do not pay dividends. DGM can only apply to
companies who are expected to pay dividends. The dividends to be paid from a future
date which will be discounted to give the current ex-div share price.
https://core.ac.uk/download/pdf/234629562.pdf

27.CAPM

Re or ke = Rf + (Rm-Rf) x Beta

Re or ke: the required rate of return on security

Rf: the risk-free rate of return
Rm: the market risk.
Rm-Rf: the market risk premium
Beta: systematic risk of security compared to the market

Beta < 1: the security is less sensitive to systematic risk than the market average.
Beta > 1: the security is more sensitive to systematic risk than the market average.
Beta = 1: the security’s exposure to systematic risk exactly matches the market average.

Pros:
- It assess the risk of the security and rates of return given that risk.
- It shows systematic risk is the important risk.
- It is one of the best method in estimating a company’s cost of equity.
- It gives risk-adjusted discount rates for new project appraisal (if the project is equity
financed).
 - It gives risk-adjusted cost of equity (if the project is financed by both debt and equity)
which is then combined with cost of debt to find WACC (the discount rate for new
project appraisal).

 It considers only systematic risk, reflecting a reality in which most investors have
diversified portfolios from which unsystematic risk has been essentially eliminated.
 It is a theoretically-derived relationship between required return and systematic risk
which has been subject to frequent empirical research and testing.
 It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model (DGM) in that it explicitly considers a company’s level of
systematic risk relative to the stock market as a whole.
 It is clearly superior to the WACC in providing discount rates for use in investment
appraisal.

Cons:
1) From a practical point of view:
It is difficult for investors to find values for the variables contained in the CAPM model to use it.

a) Rf (risk-free rate of return):

In reality, there is no risk-free asset. Short-term government debts such as Treasury bills are
used as substitute for the risk-free asset. However, government debts of different time periods
have different returns and make it hard to find which rate of return to use in CAPM.

b) Rm (Market rate of return):

It is hard to find as market is volatile.
c) (Rm-Rf) Market risk premium (aka Equity risk premium):
It is the difference between average market rate of return and the risk-free rate of return.
It is the extra return required for investing in equity not risk-free assets.
In reality, short-term share prices can fall and rise (not constant), leading to negative average
return. Time-smoothed moving average analysis can be used over longer periods of time to
smooth out such short-term changes.

d) Beta:
It is found by regression analysis which is subject to statistical error, the presence of
unsystematic risk and the effects of not having a perfect capital market.

If the business risk of the new project is different from the business risk of the company, CAPM
can be used in new project appraisal to calculate a risk-adjusted discount rate.

It is hard to find appropriate proxy companies ie. Quoted companies having the same business
risk as the new project and the proxy betas of the proxy companies.
In reality, as proxy companies could have a range of business operations, their proxy betas do
not only reflect the desired level and type of business risk.
CAPM does not generate accurate forecasts of returns for companies with low betas, low P/E
or seasonal business.

2) From a theoretical point of view:

a) All investors hold well-diversified portfolio of shares (market portfolio)

Unsystematic risk is diversified away so investors only want return to compensate for the
systematic risk.
In reality, investor do not really hold the market portfolio. However, a limited diversification
can produce a portfolio that is almost like a market portfolio. Hence, this assumption is feasible.

Also, the CAPM model only considers the systematic risk while portfolio theory considers both
the systematic risk and the unsystematic risk, or total risk. However, unsystematic risk is
important to investors who are undiversified, managers and employees.

b) Perfect capital market

No taxes, no transaction costs.

Perfect information are freely available to all investors.
All investors are rational, risk-averse.
They are a large number of buyers and sellers in the market.
In reality, capital markets are not perfect. They are only semi-strong form efficient at best.

c) All investors can borrow and lend at the risk-free rate of return.

It is the minimum level of return required by investors.

It is a variable in CAPM model.
In reality, the risk faced by individual investors is much higher than that faced by the
government. => Rf is higher in reality than in theory => (Rm – Rf) is higher => the slope of SML is
shallower.

d) All forecasts are made in the context of a single-period transaction horizon.

This assumption is reasonable as returns on securities are usually quoted on an annual basis.
However, it should be used cautiously in the appraisal of multi-period projects.

A standardised holding period is assumed by the CAPM in order to make comparable the
returns on different securities. A return over six months, for example, cannot be compared to a
return over 12 months. A holding period of one year is usually used.
28. WACC