FIN 401 Lecture Notes - Lecture 2: Accounts Receivable, Systematic Risk, Sunk Costs

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danotehustla

26 Jan 2018

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The difference between the market value of a project and its cost. Steps to finding npv: estimate the expected future cash flows, estimate the required return for projects of this risk level, find the present value of the cash flows and subtract the initial investment. If the npv is positive, accept the project. You are looking at a new project and you have estimated the following cash flows: your required return for assets of this risk is 15%. Ans: npv = initial cost + pv (cfs) = l000000 + (250000/1. 15) + (375000/1. 152) + (900000/1. 153) Calculation: estimate the cash flows, subtract the future cash flows from the initial cost until the initial investment has been recovered. Two possibilities to assume: cash flows occur at the end of the year, cash flows occur evenly throughout the year. Decision rule: accept if the payback period is less than some preset limit. Note: when using calculator, discount rate must be zero!

Related Questions

Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.

The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.

For example, consider the two mutually exclusive projects below.

Investments	Cost	Cash Flow 1	Cash Flow 2
Project A	$ 50	$ -	$ 100
Project B	$ 50	$ 50	$ 25

According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.

Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.

This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?

It may be that the project stakeholder is requesting a quicker return in cash.

For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?

bluelizard621

You are a financial analyst for the Waffle Company. The director of capital budgeting has asked you to analyze two proposed capital investments, Projects A and B. Each project has a cost of $50,000, and the cost of capital for each is 10%.

The projects’ expected net cash flows are as follows:

	Expected Net Cash Flows
Year	Project A	Project B
0	($50,000)	($50,000)
1	25,000	15,000
2	20,000	15,000
3	10,000	15,000
4	5,000	15,000
5	5,000	15,000

Calculate each project’s payback period, net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index (PI).

peachturtle69

Q6) Assume yourself as a financial analyst for the Great Land Company. Then, the director of capital budgeting asks you to analyse two proposed capital investments named Project A and Project B. Each project has a cost of 900,000 birr, and the cost of capital (the required rate of return) for each project is 10%. The information on the projects’ expected net cash flows are as follows with the present value of 1 birr at 10%.

Year	Cash flow of the projects in Birr		PV of 1birr at 10%
Year	Project A	Project B	PV of 1birr at 10%
0	- 900,000	- 900,000	1
1	400,000	245,000	0.909
2	350,000	245,000	0.826
3	250,000	245,000	0.751
4	150,000	245,000	0.683
5	100,000	245,000	0.621

Required:

Calculate each project’s payback period (PBP) and determine which project is preferable as per PBP results. (2 pts)
Calculate each project’s net present value (NPV). (2 Pts)
Determine and justify which project or projects should be accepted as per NPV results if they are independent projects. (2Pts).
Determine and justify which project or projects should be accepted as per NPV if they are mutually exclusive projects. (2Pts).
Calculate the internal rate of return (IRR) for each project and determine whether the projects are accepted or rejected as per IRR result and also determine which project is preferable based on IRR. (2Pts)
Discuss the relative strengths and limitations of the capital budgeting decision criteria that you have used above (Payback period, NPV and IRR).( 3Pts)

goldcoyote821

FIN 401 Lecture Notes - Lecture 2: Accounts Receivable, Systematic Risk, Sunk Costs

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