Financial Management Session 7

Muhammad Mohsin Ayub

24010036

Q1.

Ans

• Assumes the sales to increase immediately to 100000.

• Assumes COGS of 58/unit to be achieved immediately.
• Assumes consistent marketing expenses.
• Adds book value of old equipment (it is sunk cost so no need).
• Disregards taxes.
• Disregards investments into working capital.
• Does not offer any comparative alternative assessment of doing nothing.
• Disregards TVM.
• Disregards any salvage value for the project.

Q2.

Ans

Cash flows are important because the accrual of capital costs in accounting disregards for TVM, and hence
cash flows are needed for investment decision analysis. Moreover, bulk payments are considered at the
time of payment and its matching has no relevance and taking these flows would essentially cause a
replication error.

Q3.

Ans

It is preferable to focus on the difference of both as it is the only thing of relevance with respect to a
decision that what additional value is the project adding. Looking in isolation causes the numerical
indicators to change dramatically on behest of the already existing performers (In this case NPV goes from
$266k to $4.9M and IRR from 19% to 162%). Hence it causes the project to look more or less lucrative
than it already is based on the past and current cash flows without the project.

Q4.

Ans

Payback period is one of the criteria and has the advantage being fairly simple but if used in isolation it
can cause incorrect or ill-informed decision making because it disregards TVM, it does not tell any picture
beyond the breakeven and it causes companies to be risk-averse and not to invest in long term projects,
tunneling their vision. Discounted payback, NPV and IRR are good measures to use in complement to
Payback period.

Q5.

Ans

The additional cash requirements of first 3 years would have to be funded through debt or equity and
since greater positive cash flows would start to come in later it would cause the Return on assets to
decrease and based on whether it was funded using debt or equity it would cause return on equity or
leverage to deteriorate.

Implications would be entirely different for a new company as it would not be complementing its
existing business and its do nothing alternative would have a 0 NPV.

It can only invest as much as the free cash available if capital markets are not to be considered. It would
cause companies to invest in quick return projects because they would seldom have enough free cash to
fund long term projects.

Q6.

Ans

Done on next page.

Q7.

Ans

Based on the comparative IRR, NPV and payback periods, Linda Hudson should expand the syrup facility.