Chapter 10 review questions:
- What is the financial manager’s goal in selecting investment projects for the firm? Define the capital budgeting process, and explain how it helps managers achieve their goal?
Sol:
Financial manager’s goal in selecting investment projects is as same as the firm’s goal i.e. to maximize owner’s wealth by selecting those projects which must be profitable for the firm in terms of efficiency and profitability.
capital budgeting process
- Identification of Potential Investment Opportunities
- Assembling of Investment Proposals
- Decision Making
- Preparation of Capital Budget and Appropriations
- Implementation
- Performance Review
capital budgeting process helps managers in following perspective:
For the growth & prosperity of the business, long-term goals are very important for any organization.
As the companies have limited resources, the company has to make a wise & correct investment decision
The capital budgeting process facilitates the transfer of information to appropriate decision makers within a company
Liquidity of funds in making investment decisions so it must consider each proposal very thoroughly.
- What is the payback period? How is it calculated?
Sol:
Payback period is the time in which the initial outlay of an investment is expected to be recovered through the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
Since cash flow estimates are quite accurate for periods in the near future and relatively inaccurate for periods in distant future due to economic and operational uncertainties, payback period is an indicator of risk inherent in a project because it takes initial inflows into account and ignores the cash flows after the point at which the initial investment is recovered.
| Payback Period = | Initial Investment |
| Net Cash Flow per Period |
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula:
| Payback Period = | A + | B |
| C |
Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end of the period A; and
C is the total cash inflow during the period following period A
- What weaknesses are commonly associated with the use of the payback period to evaluate a proposed investment?
Payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions. A variation of payback method that attempts to address this drawback is called discounted payback period method.
It does not take into account, the cash flows that occur after the payback period. This means that a project having very good cash inflows but beyond its payback period may be ignored.
- How is the net present value (NPV) calculated for a project with a conventional cash flow pattern?
Conventional cash flow means that a project or investment has an initial cash outlay followed by a series of positive cash flows generated from the project.
The important steps for calculating NPV are given below .
Cash flows of the investment project should be forecasted based on realistic assumptions. These cash flows are the incremental cash inflow after taxes and are inclusive of depreciation (CFAT) which is assumed to be received at the end of each year. CFAT should take into account salvage value and working capital released at the end.
Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the firm’s opportunity cost of capital which is equal to the required rate of return expected by investors on investments of equivalent risk.
Present value (PV) of cash flows should be calculated using opportunity cost of capital as the discount rate.
NPV should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive (i.e. NPV >0)
NPV = Present value of cash inflows – Initial investment
- What are the acceptance criteria for NPV? How are they related to the firm’s market value?
Sol:
The present value method can be used as an accept-reject criterion. The present value of the future cash streams or inflows would be compared with present value of outlays. The present value outlays are the same as the initial investment.
If the NPV is greater than 0, accept the project.
If the NPV is less than 0, reject the project.
- Explain the similarities and differences between NPV, PI and EVA.
Sol:
Similarities
The NPV and PI both consider the time value of money and result in the same accept or reject decision when considering an independent project.
EVA is closely related to NPV in both valuation should result with the same estimate for the value of a firm. In their full forms, the information that is required for both approaches is exactly the same – expected cash flows over time and costs of capital over time
Differences
The main difference between the two is that the PI may be useful in determining which projects to accept if funds are limited.
A project can have same profitability index with different investments and vast difference in absolute dollar return. NPV has an upper hand in this case.
However EVA makes top managers responsible for a measure that they have more control over – the return on capital and the cost of capital are affected by their decisions – rather than one that they feel they cannot control as well – the market price per share.
- What is the internal rate of return (IRR) on an investment? How is it determined?
Sol:
The Internal Rate of Return (IRR) is the discount rate that makes the net present value
Calculating the internal rate of return can be done in three ways:
Using the IRR or XIRR function in Excel or other spreadsheet programs.
Using a financial calculator
Using an iterative process where the analyst tries different discount rates until the NPV equals to zero
- What are the acceptance criteria for IRR? How are they related to the firm’s market value?
Sol:
Rule states that a project should be pursued if the internal rate of return is greater than the minimum required rate of return
- Do the net present value (NPV) and internal rate of return (IRR) always agree with respect to accept-reject decisions? With respect to ranking decisions? Explain.
Sol:
If future cash flows are in series, and if cash flows are not in series, initial investment followed by cash inflows, then IRR and NPV would have different recommendations.
Therefore, the IRR and the NPV do not always agree to accept or reject a project.
- How is a net present value profile used to compare projects? What causes conflicts in the ranking of projects via net present value and internal rate of return?
Sol:
NPV is an absolute measure. It is the dollar amount of value added or lost by undertaking a project.
cause of the NPV and IRR conflict is the
nature of cash flows
nature of project (independent vs mutually-exclusive)
size of the project.
- Does the assumption concerning the reinvestment of intermediate cash inflow tend to favor NPV or IRR? In practice, which technique is preferred and why?
Sol:
NPV analysis makes the more realistic assumption that reinvestments will be made at an organization’s discount rate or cost of capital.
If the IRR method’s reinvestment assumption is untenable, it can introduce an unintended bias in favor of short-term projects or projects with proportionally more short-term cash inflow. Practically cost of capital must be used to analyzed the project