ASSESSMENT 2

You are working as a Financial Analyst for a medium-sized Invest Firm from New Delhi that
specializes in technology startups. You have been asked to assess the returns on equity
investments made in two companies and make a recommendation on investment. Your
company wishes to exit the investment in 8 years.
(1) Explain the difference in the debt-to-equity ratio of both companies.
(2) Explain the role of tax rate in this information. Should the tax rate be included in capital
investment decisions?
(3) Calculate the returns on investments on both companies using the NPV formula. (Ignore
Income from Sale of Stock)
(4) Evaluate the NPV and Payback Periods for both companies and make a recommendation
to the Executive Committee for an investment.

ANSWER.

The Debt Ratio is a measure of the company’s leverage. Leverage is the amount of debt
borrowed as a result of financing and investing decisions. This provides an interpretation of
what proportion of assets are financed using debt. The higher the debt component, the higher
the financial risk faced by the company. This ratio is also referred to as the debt-to-assets
ratio and is calculated as follows.

Debt Ratio = Total Debt / Total Assets *100

Total Debt
This comprises short-term and long-term debt.

Short-term Debt
These are the current liabilities that are due within one year’s time.

E.g. Accounts payable, interest payable, and unearned revenue.

Long-term Debt
Long-term liabilities are payable within a period exceeding one year
E.g. Bank loan, deferred income tax, mortgage bonds.

Total Assets
Total assets comprise of short term and long term assets.
Short-term Assets- Generally referred to current assets, these can be converted to cash within
a one year period.
E.g. Accounts receivable, prepayments, inventory.

Long-term Assets
These are non-current assets that are not expected to be converted into cash within one year’s
time E.g. Land, buildings, machinery.

(2)Explain the role of the tax rate in this information.

The concept of taxation is vital to businesses in the economy, as the amount of tax taken
from each business is accumulated, one of the ways that tax is used to help businesses is
 through the government funding the money back into the economy as long-term loans
funding. The money could also be pumped back! into the economy by the government in
the event of an economic recession or turmoil. Another benefit of taxation to society, Is
that it helps develop the country as a whole, and the more developed the country is)
would therefore mean better prospects for business as it increases the well-being of the
country’s society.
The income tax usually has a significant impact on the cash flow of a company and
therefore needs to be taken into account while making capital budgeting decisions. An
investment that looks desirable without considering income tax may become unacceptable
after considering it.
Impact of income tax on capital budgeting decisions. The income tax usually has a
significant effect on the cash flow of a company and should be taken into account while
making capital budgeting decisions. An investment that looks desirable without
considering income tax may become unacceptable after considering income tax.
(1) Return on investment and NPV.
ROI % = Profit $ ÷ Spent $ × 100%
When an individual investor makes an investment or an organization enters into a
business endeavor, ROI helps them in understanding how much profit or loss has been
made from the same.
Return on investment (ROI) is:

 A metric that helps investors know the profitability of their investment.

 A calculation that compares the amount paid towards an investment against
how much earnings were made from the investment.
 helpful in evaluating the efficiency of the investment.

NET PRESENT VALUE

 Net present value (NPV) is used to calculate the current value of a future
stream of payments from a company, project, or investment.
 To calculate NPV, you need to estimate the timing and amount of future cash
flows and pick a discount rate equal to the minimum acceptable rate of return.
 The discount rate may reflect your cost of capital or the returns available on
alternative investments of comparable risk.
 If the NPV of a project or investment is positive, it means its rate of return will
be above the discount rate.
(4)
Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the
entire life of an investment discounted to the present. NPV analysis is a form of intrinsic
valuation and is used extensively across finance and accounting for determining the value of
a business, investment security, capital project, new venture, cost reduction program, and
anything that involves cash flow.
Positive NPV vs. Negative NPV
A positive NPV indicates that the projected earnings generated by a project or investment—
discounted for their present value—exceed the anticipated costs, also in today’s dollars. It is
assumed that an investment with a positive NPV will be profitable.

PAYBACK PERIOD.

 The payback period is the length of time it takes to recover the cost of an investment
or the length of time an investor needs to reach a breakeven point.
 Shorter paybacks mean more attractive investments, while longer payback periods
are less desirable.
 The payback period is calculated by dividing the amount of the investment by the
annual cash flow.
 Account and fund managers use the payback period to determine whether to go
through with an investment.
 One of the downsides of the payback period is that it disregards the time value of
money.

Capital Budgeting and the Payback Period. The payback period disregards the time
value of money. Simply, it is determined by counting the number of years it takes to
recover the funds invested. For example, if it takes five years to recover the cost of
the investment, the payback period is five years.