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MB0029 Financial Management Set2

MB0029 Financial Management Set2

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Published by Saurabh MIshra12

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Published by: Saurabh MIshra12 on Nov 21, 2009
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SET 2 MB0029Page 1
Financial ManagementCODE: MB0029SEMESTER:I / II / III / IV
SET 2 MB0029Page 2
1. Compare and contrast NPV with IRR .ANS.
Net present value method
The cash inflow in different years are discounted (reduced) to their  present value by applying the appropriate discount factor or rate and thegross or total present value of cash flows of different years are ascertained.The total present value of cash inflows are compared with present value of cash outflows (cost of project) and the net present value or the excess present value of the project and the difference between total present value of cash inflow and present value of cash outflow is ascertained and on this basis, the various investments proposals are ranked.Cash inflow = earnings / profits of an investment after taxes but before depreciationThe present value of cash outflows = initial cost of investment and thecomment of project at various points of time ^
Decision rule
After ranking various investments proposals on basis on net present value, projects with negative net present value (net present value of cash inflowsless than their original costs) are rejected and projects with positive NPV areconsidered acceptable. In case of mutually exclusive alternative projects, projects with higher net present value are selected. Net present value methodis suitable for evaluating projects where cash flows are uneven.
1.The most significant advantage is that it explicitly recognizes thetime value of money, e.g., total cash flows pertaining to two machines areequal but the net present value are different because of differences of patternof cash streams. The need for recognizing the total value of money is thussatisfied.2.It also fulfills the second attribute of a sound method of appraisal.In that it considers the total benefits arising out of proposal over its life time.3.It is particularly useful for selection of mutually exclusive projects.4.This method of asset selection is instrumental for achieving theobjective of financial management, which is the maximization of theshareholder's wealth. In brief the present value method is a theoreticallycorrect technique in the selection of investment proposals.
SET 2 MB0029Page 3
1. It is difficult to calculate as well as to understand and use, incomparison with payback method or average return method.2.The second and more serious problem associated with present valuemethod is that it involves calculations of the required rate of return todiscount the cash flows. The discount rate is the most important elementused in the calculation of the present value because different discount rateswill give different present values. The relative desirability of a proposal willchange with the change of discount rate. The importance of the discount rateis thus obvious. But the calculation of required rate of return pursuits serious problem. The cost of capital is generally the basis of the firm's discount rate.The calculation of cost of capital is very complicated. In fact there is adifference of opinion even regarding the exact method of calculating it.3.Another shortcoming is that it is an absolute measure. This methodwill accept the project which has higher present value. But it is likely thatthis project may also involve a larger initial outlay. Thus, in case of projectsinvolving different outlays, the present value may not give dependableresults.4.The present value method may also give satisfactory results in caseof two projects having different effective lives. The project with a shorter economic lifeis preferable, other things being equal. It may be that, a projectwhich has a higher present value may also have a larger economic life, sothat the funds will remain invested for longer period while the alternative proposal may have shorter life but smaller present value. In such situationsthe present value method may not reflect the true worth of alternative proposals. This method is suitable for evaluating projects whose capitaloutlays or costs differ significantly.
Internal rate of return method
The technique is also known as yield on investment, marginal efficiencyvalue of capital, marginal productivity of capital, rate of return, timeadjusted rate of return and so on. Like net present value, internal rate of return method also considers the timevalue of money for discounting thecash streams. The basis of the discount factor however, is difficult in both

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