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Financial Management

MBA- 511

Section- 04

Submitted To:

Dr. K.M. Zahidul Islam

Submitted By:

Date of Submission:

28th November, 2018

1

Integrative Problem (9-23)

a. What is capital budgeting? Are there any similarities between a firm's capital budgeting

decisions and an individual's investment decisions?

Capital Budgeting:

The process of planning, evaluating expenditures on assets whose cash flows are expected to

extend beyond one year.

On the other hand, Capital budgeting is the planning process used to determined whether an

organizations long term investments such as new machinery, replacement machinery, new plants,

new products and research development projects are worth the funding of cash through the firm's

capitalization structure (debt, equity or retained earnings)

Capital budgeting is the process of analyzing fixed asset additions. It is important because the

fixed asset decisions chart a company's course for future. In addition, Capital budgeting process

is very much same as those of individual investment decisions as they both involve these same

steps:-

3. Determined the discount rate based on the riskiness of the cash flows as well as interest rate.

This process is called the project cost of capital

5. If the inflows are greater than the outflows of the PV (meaning the NPV is greater than zero)

or if the IRR is higher than the project cost of capital, you would accept the project.

2

b. What is the difference between independent and mutually exclusive projects? Between

projects with conventional cash flows and projects with unconventional cash flows?

Projects are independent if the cash flows of one are not affected by the acceptance of the other.

Therefore, two projects are mutually exclusive if acceptance of one affects adversely the cash

flows of the other; that is, at most one of two or more such projects may be accepted.

Projects with a conventional cash flow pattern is when you see negative cash flows for the first

year (or longer) representing initial outlays, followed by a series of cash inflows. Unconventional

cash flows occur when inflows change to outflows again, or vice versa, if this happens two or

more times it is unconventional.

c. (1) what is payback period? Find the traditional payback periods for Project L and

Project S?

Payback period: The payback period is the length of time required to recover the cost of an

investment. The payback period of a given investment or project is an important determinant of

whether to undertake the position or project, as longer payback periods are typically not

desirable for investment positions. The payback period ignores the time value of money (TVM),

unlike other methods of capital budgeting such as net present value (NPV), internal rate of return

(IRR), and discounted cash flow.

The traditional payback period for Project L and Project S are shown below:

3

(2) What is the rationale for the payback measure? According to the criteria which project

or projects should be accepted if the firms’ maximum acceptable payback is two years and

Project L and S are independent? Mutually exclusive?

(2) The rationale for the payback measure: The rationale behind this is that the shorter

the payback period, the greater the liquidity, and the less risky the project. The payback period is

the ratio of the initial investment (cash outlay) to the annual cash inflows for the recovery period.

According to the payback criterion, Project S is accepted if both Project S and L are independent

because the PBP< cutoff period (2 years). For mutually exclusive projects, again Project S is

accepted because the PBP< cutoff period (2 years) and by choosing Project S the other projects

gets rejected automatically according to its rule.

(3) What is the difference between the traditional payback and discounted payback? What

is each projects discounted payback?

Difference between traditional payback and discount payback: Payback period and

discounted payback period are investment appraisal techniques that are used to evaluate

investment projects. The key difference between payback period and discounted payback period

is that payback period refers to the length of time required to recover the cost of an

investment whereas discounted payback period calculates the length of time required to recover the

cost of an investment taking the time value of money into account. Recovering the initial

investment is one of the major objectives of any investment project.

4

Each project Discounted Payback:

(4) What are the main disadvantages of the traditional payback? Is the payback method of

any real usefulness in capital budgeting decision?

This is amongst of the primary negative aspects of the payback length that it ignores the time

cost of money which is a very necessary business concept. As per the idea of the time value of

money, the money obtained sooner is worth greater than the one coming later because of its

manageable to earn an extra return if it is reinvested. The PBP technique doesn’t reflect on

consideration on such a thing, therefore distorting the genuine fee of the cash flows. Here, there

is a workaround. One can use Discounted Payback Period that can do away with this

disadvantage.

The payback method considers the cash flows only till the time the initial investment is

recovered. It fails to consider the cash flows that come in the subsequent years. Such a limited

view of the cash flows might force you to overlook a project that could generate lucrative cash

flows in their later years.

NOT REALISTIC

The payback method is so simple that it does not consider normal business scenarios. Usually,

capital investments are not just one-time investments. Rather such projects need further

investments in the following years as well. Also, projects usually have irregular cash inflows.

5

IGNORES PROFITABILITY

A project with a shorter payback period is no guarantee that it will be profitable. What if the cash

flows from the project stop at the payback period, or reduce after the payback period. In both the

cases, the project would become unviable after the payback period ends.

Simplicity. The concept is extremely simple to understand and calculate. When engaged in

a rough analysis of a proposed project, the payback period can probably be calculated

without even using a calculator or electronic spreadsheet.

Risk focus. The analysis is focused on how quickly money can be returned from an

investment, which is essentially a measure of risk. Thus, the payback period can be used to

compare the relative risk of projects with varying payback periods.

d. (5) Define the term net present value (NPV). What is each project’s NPV?

NPV is the acronym for net present value is a calculation that compares the amount invested

today to the present value of the future cash receipts from the investment .In the words, the

amount invested is compared to the future cash amounts after they are discounted by a specified

rate of return.

Net Present value (NPV) is the difference between the present value of cash inflows and the

present value of cash out flows over a period of time. NPV is used in capital budgeting and

investment planning to analyze the profitability of a projected investment or project.

At 10% required rate of return, NPV for Project L is $18.78 and Project S $19.98. At proposed

rate of return at 15%, the new NPV for Project L is $6.67 and Project S $11.83.

(6) What is the rationale behind the NPV method? According to NPV which project or

projects should be accepted if they are independent? Mutually exclusive?

Businesses must observe proper procedures when undertaking long-term investments to ensure

the projected payoff is worth the resource allocation. Capital investments are costly and their

benefits are spread over several years. Employing appropriate decision-making models when

analyzing the costs and benefits of long-term investment plans are essential. The viability of

6

capital investments can be ascertained using the net present value method. NPV primarily seeks

to identify the most viable investment opportunities by comparing the present value of future

cash flows of projects. The rationale behind the NPV method is its focus on the maximization of

wealth for business owners or shareholders.

The NPV measures the opportunity costs between two or more projects. It is important to know

what you are giving up in order to make the decision. A higher NPV indicates a greater rate of

return, but is not always the best choice as at some times the financial risks associated with the

project may be unacceptable. Likewise a low NPV project may not be worthwhile because it

would simply be better to put your money into a savings account since the return is so low.

Mutually exclusive projects are projects in which acceptance of one project excludes the others

from consideration. In such a scenario the best project is accepted. Since NPV is an absolute

measure, it will rank a project adding more dollar value higher regardless of the original

investment required.

(7) Would the NPV change if the required rate of return changed?

The cost of capital or required rate of return from the investment is used to determine the present

value of future cash flows of the project Thus, the change in cost of capital will change the

present value of future cash flows, and eventually the NPV will change.

(8) Define the term Internal Rate of Return. What is each project’s IRR?

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows

(both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR

of a new project exceeds a company’s required rate of return, that project is desirable. If IRR

falls below the required rate of return, the project should be rejected.

7

e. (9) How is the IRR on project related to the YTM on a bond?

IRR is a capital project where the YTM is a bond. YTM is an expected rate of return for a

project and YTM is provide fixed rate of return on a bond.

(10) What is the logic behind the IRR method? According to IRR, which projects should

be accepted if they are independent? Mutually exclusive?

The logic behind the IRR is that the IRR is an estimate of the project’s rate of return. If this rate of

return exceeds the cost of the funds used to finance the project, then the difference in rates benefits

the company/ Stakeholders. An IRR more than rate of return implies an economic profit, which

accrues to the firm’s shareholders, while rate of return more than an IRR, indicates an economic

loss, so economic loss indicates a project that will not earn enough to cover its cost of capital.

IRR are compared to their required rate of return or costs of capital. While Projects L and S

equally have a rate of return 10%, and as both have IRRs greater than that rate of return, both

should be accepted because they are independent.

IRR are greater than two projects, so these projects are mutually exclusive. So Project S would

be selected, because it has the higher IRR.

(11) Would the projects’ IRRs change if the required rate of return changed? Explain.

IRR are independent of the required rate of return. Therefore, neither IRRS nor IRRL would

change if cash flows do not change. Though, the acceptability of the projects could change,

project L would be rejected if required rate of return were greater than IRR L 18.13%, and

project S would be rejected required rate of return were greater than IRR S 23.56%.

f. (12) Construct the NPV profiles for Projects L and S. At what discount rate do the

profiles cross?

8

NPV ($)

50

Project L

40

Crossover Rate 9%

30

Project S

20

IRRS 23.56%

10

0

5 10 15 20 25

Re (%)

IRRL 18.13%

1. The Y-intercept is the project’s NPV when return = 0%. This is $50 for L and $40 for S.

2. The X-intercept is the project’s IRR. This is 18.13% for project L and 23.56% for project S.

3. NPV profiles are curves rather than straight lines. To see this, note that these profiles approach

4. From the figure below, it appears that the crossover rate is between 9%.

(13) Look at your NPV profile graph without referring to the actual NPVs and IRRs.

Which project(s) should be accepted if they are independent? Mutually exclusive? Explain.

Do you answers differ depending on the discount rate used? Explain.

The IRR and NPV profiles explain that the criteria lead to the same accept/reject choice for any

independent project. Project L and S, it intersects the X-axis at its IRRL 18.13% and IRRS

23.56%. According to the IRR rule project S and L is acceptable but Project S IRR is greater

than Project L IRR also required rate of return is less than IRR 23.56%, project S is accepted.

Also, at any rate of return less than 18.13%, project L’s NPV profile will be above the X-axis, so

its NPV will be greater than $0. Thus, for any independent project, NPV and IRR lead to the

same accept/reject decision.

9

Now assume that project L and S is mutually exclusive. In this case, a conflict might arise. First,

note that IRR S 23.56% > 18.13% IRR L. Therefore, regardless of the size of rate of return,

Project S would be ranked higher by the IRR criterion. However, the NPV profiles show that

NPV L > NPV S. if rate of return is less than the crossover rate. Therefore, for any rate of return

less than the crossover rate, say re = 8%, the NPV rule says choose L, but the IRR rule says

choose S. Thus, if rate of return is less than the crossover rate, a ranking conflict occurs.

g. (14) What is the underlying cause of raking conflicts between NPV and IRR?

There are three reasons why NPV and IRR conflict. They are due to:

The magnitude of cash flows

The timing of cash flows

It might happen that in some mutually exclusive projects the NPV of one project will be ranked

first whereas in case of IRR the other project would be ranked first. If there is a conflict, about

which method would be used to accept a project then NPV would be preferred over IRR. This is

because IRR considers that cash flows from the project will be reinvested at the same rate of

financing. However, in reality the reinvestment rate depends upon market and will not be certain

throughout the life of the project.

(15) What is the reinvestment rate assumption, and how does it affect the NPV versus IRR

conflict?

The reinvestment assumption is a sufficient condition, not an implicit assumption, for solving the

problems of conflicting ranking and multiple IRRs. The notion that the internal rate of return

(IRR) and net present value (NPV) have reinvestment rate assumptions built into them has long

been settled in the academic finance literature. Specifically, there are no reinvestment rate

assumptions built into, or implicit to, the computation and use of either the IRR or NPV. Once an

investment’s cash flows are received they can be distributed to the firm’s creditors or

shareholders without any necessity to reinvest them. However, there persists the notion that IRR

and NPV have implicit “reinvestment rate assumptions” embedded in them. For example, few

definitions states that

10

“the traditional internal rate of return (IRR) assumes the cash flows from a project are

“The IRR rule assumes that intermediate cash flows from the project get reinvested at

the IRR. Implicit is the assumption that the firm has an infinite stream of projects

“NPV and PI assume reinvestment at the discount rate. IRR assumes reinvestment at the

All discounting cash flow methods implicitly assume that cash flows can be

reinvested at some rate, regardless of what is actually done with the cash flows.

Discounting is the reverse of compounding. As compounding assume reinvestment, so does

discounting. NPV and IRR are both found by discounting, so they both implicitly assume some

discount rate. The fundamental assumption in the NPV calculation is that cash

flows can be rei nvest ed at t h e proj e ct 's cost of capi t a l , whi l e t he IR R

cal cul at i ons assum e s reinvestment at the IRR rate.

(16) Which capital budgeting method should be used when NPV and IRR give conflicting

rankings? Why?

The process for selecting capital projects can require much thought and analysis. Many financial

evaluation methods have been employed to determine whether to accept or reject a

project. Choosing the correct method for ranking projects can be complicated when a choice

must be made between mutually exclusive projects because in case of independent projects

ranking is not important since all the profitable projects will be selected. The choice in the case

of mutually exclusive projects must be made based on the ranking of projects in order of

increasing shareholder wealth. NPV is a better method for evaluating mutually exclusive projects

than the IRR method. The NPV method employs more realistic reinvestment rate assumptions, is

a better indicator of profitability and shareholder wealth, and mathematically will return the

correct accept-or-reject decision regardless of whether the project experiences non-normal cash

flows or if differences in project size or timing of cash flows exist.

11

(17) Define the term Modified Internal rate of Return (MIRR). What is each project’s

MIRR?

The modified internal rate of return (MIRR) is a modification of the internal rate of return (IRR)

and is used in capital budgeting as a ranking criterion for mutually exclusive projects. The idea

behind the MIRR method is that all project cash outflows are discounted at the cost of capital,

and all cash inflows are reinvested at the reinvestment rate. MIRR is that discount rate which

equates the present value of the terminal value of the inflows, compounded at the cost of capital,

to the present value of the costs. The MIRR for Project L is 16.50% and for Project S 16.89%

(shown in the excel file).

(18) What is the rationale behind the MIRR method? According to MIRR, which project

or projects should be accepted if they are independent? Mutually exclusive?

Modified Internal Rate of Return, shortly referred to as MIRR, is the internal rate of return of

an investment that is modified to account for the difference between re-investment rate

and investment return.

The calculation of IRR implicitly assumes that the positive cash flows earned during the life of a

project are re-invested at the rate of the IRR until the end of the investment period. This could

cause the IRR to be overly optimistic. MIRR was developed to counter this assumption.

MIRR calculates the return on investment based on the more prudent assumption that the cash

inflows from a project shall be re-invested at the rate of the cost of capital. As a

result, MIRR usually tends to be lower than IRR.

The decision rule for MIRR is very similar to IRR, i.e. an investment should be accepted if

the MIRR is greater than the cost of capital. However, when evaluating multiple investments that

are mutually exclusive (i.e. where selection of one investment would result in the abandonment

of another investment), it is preferable to select investments with the highest NPV rather than the

highest MIRR because NPV analysis offers a better measure of the impact of an investment on

the wealth of the investor. Like IRR, MIRR should still be used to assess the sensitivity of the

proposed investments in such cases.

12

(19) Would the MIRRs change if the required rate of return changed?

The Modified Internal Rate of Return (MIRR) would definitely change if the required rate of

return changed. This is because to find MIRR we need to calculate the terminal value which

requires the required rate of return to be multiplied with the cash inflows to get the Terminal

Value. Thus, the MIRRs will change. With a required rate of return of 10% the MIRRs for

Project L is 16.50% and for Project S 16.89% (shown in the excel file). If we increase the

required rate of return to 15%, the MIRRs will be increased to 18% for Project L and 19% for

Project S and vice versa.

13

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