Question and Answer (Group Three – Chapter 11)

Financial Management
1. Question: What is capital budgeting and What is strategic business plan?
Answer: The process of planning expenditures on assets with cash flows that are expected to
extend beyond one year.
Answer: Strategic Business Plan means a long run plan that outlines in broad terms the firm’s
basic strategy for the next 5 to 10 years.

2. Question: How are project classifications used in the capital budgeting process?
Answer: Project classification schemes can be used to indicate how much analysis is required to
evaluate a given project, the level of the executive who must approve the project, and the cost of
the capital that should be used to calculate the project’s NPV(net present value). Thus,
classification schemes can increase the efficiency of the capital budgeting process.

3. Question: What is the difference between independent and mutually exclusive

projects?

Answer:
Characteristics Independent Mutually exclusive
Dependency No dependency over other Projects Dependent with relative projects
Acceptance of the If NPV exceeds zero, then project Accept the project with the
project will be accepted highest positive NPV
Rejection Criteria Two or more projects are running Two or more project run at a
parallely ,then calculate NPV and time, if one of the projects
reject which doesn’t exceed Zero. remains negative, then all project
will be rejected.

4. Question: Why is the NPV the primary capital budgeting decision criterion?

Answer: The net present value (NPV) tells us how much a project contributes to share-holder
wealth—the larger the NPV, the more value the project adds; and added value means a higher
stock price.

Net present value uses discounted cash flows in the analysis, which makes the net present value
more precise than of any of the capital budgeting methods as it considers both the risk and time
variables.
A net present value analysis involves several variables and assumptions and evaluates the cash
flows forecasted to be delivered by a project by discounting them back to the present using
information.

Thus, NPV is the best selection criterion.

5. Question: What do you mean by IRR ?

Answer: IRR stands for Internal Rate of Return. It is the discount rate that forces the Present
Value (PV) of the inflows to equal the cost. This is equivalent to forcing the Net Present Value
(NPV) to equal zero. The IRR is the estimate value of a project’s rate of return and it is
compatible to the Yield to Maturity (YTM) on a bond.

6. Question: Briefly explain, how the concept of YTM is same as IRR ?

Answer: We have discussed YTM on a bond in chapter 7. There if we hold the bond to maturity
then we can earn the YTM on investment. The YTM is found as the discount rate that forces the
PV of the cash inflows to equal the price of the bond. This same concept is involved in capital
budgeting when we calculate the IRR.

7. Question: What is Internal Rate of Return (IRR)

Answer: Internal Rate of Return (IRR) is the discount rate that forces the PV of the inflows to
equal the
cost. This is equivalent to forcing the NPV to equal zero. The IRR is an estimate
of the project’s rate of return, and it is comparable to the YTM on a bond.

8. Question: When we decide to accept and reject a project based on IRR?

Answer: For independent project If IRR exceeds the project’s Weighted Average Cost of Capital
(WACC), accept the project and if IRR is less than the project’s WACC, reject it.

For mutually exclusive projects accept the project with the highest IRR, provided that IRR is
greater than WACC. Reject all projects if the best IRR does not exceed WACC.
 9. Question: What is Financial Multiple Internal Rates of Return (MIRRs)?
Answer: Multiple IRRs occur when a project has two or more internal rate of return (IIRs). The
problem arises where a project has non-normal cash flow.

10. Question: What is non normal cash flows?

Answer: Non normal cash flow profile is a series of cash flows that, over time, don’t go in only
one direction. It is characterized by not just one, but several changes in the direction of the cash
flow. Directional changes are usually represented by the positive (+) and negative (–) signs. The
positive sign (+) denotes a cash inflow of cash, while the negative (–) sign denotes an outflow of
cash.

11. Question: How many ways the new common equity is raised and what are those?
Answer: The new common equity is raised in two ways
a. By retaining some of the current year’s earnings and
b. By issuing new common stock.

12. Question: What is called Discounted Cash Flow (DCF)?

Answer: Discounted cash flow (DCF) is a valuation method used to estimate the value of an
investment based on its future cash flows. DCF analysis attempts to figure out the value of an
investment today, based on projections of how much money it will generate in the future.

13. Question: What is Modified Internal Rate of Return (MIRR)?

Answer: Modified Internal Rate of Return(MIRR)" is a method used to find the attractiveness of
the investment. This method used in capital budgeting ranking the investment projects. This
method is the same like IRR (Internal Rate of Return)

14. Question: What is Financial Internal Rate of Return (IRR)?

Answer: The internal rate of return is a metric used in financial analysis to estimate the
profitability of potential investments. The internal rate of return is a discount rate that makes the
net present value (NPV) of all cash flows equal to zero.
 15. Question: What is crossover rate?
Answer: Crossover Rate is the rate of return at which the Net Present Values (NPV) of two
projects are equal.

16. Question: What make NPV profiles to cross and lead to conflicts?
Answer:
Timing differences.
. Project size differences.

17. Question: What is Playback Period and its Formula?

Answer: The length of time required for an investment’s net revenues to cover its cost. The
shorter the payback, the better the project.
NPV is the most commonly used method today; but historically, the first selection criterion was
the payback period, defined as the number of years required to recover the funds invested in a
project from its operating cash flows.
+Uncovered cost at start of year
Playback=¿Number of years prior to full recovery
Cashflow during full recovery year

18. Question: What is Discount Playback? Difference between Playback and Discount
Playback
Answer: The length of time required for an investment’s cash flows, discounted at the
investment’s cost of capital, to cover its cost.
To counter the criticism of Playback, analysts developed the discounted payback. Here cash
flows are discounted at the WACC; then those discounted cash flows are used to find the
payback.
The regular payback doesn’t consider the cost of capital; it doesn’t specify the true break-even
year. Where, the discounted payback does consider capital costs; but it still disregards cash flows
beyond the payback year, which is a serious flaw.

19. Question: Why NPV is the single best criterion?

Answer: Because the NPV method uses a reinvestment rate close to its current cost of capital,
the reinvestment assumptions of the NPV method are more realistic than those associated with
the IRR method. In conclusion, NPV is a better method for evaluating mutually exclusive
projects than the IRR method.

20. Question: What makes a long payback project riskier than one with a shorter
payback?

Answer: Payback and discounted payback provide indications of a project’s liquidity and risk. A
long payback means that investment dollars will be locked up for a long time; hence, the project
is relatively illiquid. In addition, a long payback means that cash flows must be forecasted far out
into the future, and that probably makes the project riskier than one with a shorter payback. A
good analogy for this is bond valuation.