A: Financial Modeling, Projections, and Analysis

Question 1

The payback period computes the length of time required to recover the initial cash investment (i.e., pay yourself back).

Answer 1

When the annual cash flows are equal, the payback period is computed by dividing the initial investment by the annual cash flow.

The payback computation does not consider present value, salvage value, or depreciation.

Question 2

For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management:

Answer 2

wants to factor risk into its consideration of projects.

Question 3

Capital budgeting is the analysis of investment decisions concerning plant facilities and equipment that have a useful life of more than one year, the allocation of resources to investment opportunities in an attempt to obtain the maximum return to the firm, and long-term planning decisions regarding the acquisition and financing of investments.

Answer 3

Capital budgeting attempts to answer questions like the following:

Is this machine profitable?
Which of these machines is most profitable?
Is it profitable to add a product, segment, or new market?
Should a research and development (or advertising, etc.) project be implemented?
Should existing debt be extinguished?

Question 4

Relevant data for capital budgeting is cash-flow (future) oriented. Past (sunk) costs are irrelevant. Accrual accounting (i.e., depreciation) is irrelevant, although the tax effect of depreciation is relevant.

Answer 4

Relevant data includes:

・initial investment required,
・future net cash inflows or net savings in cash outflows, and
・gain or loss on the disposal of old equipment.

Approaches to capital budgeting commonly used include:

・net present value,
・time-adjusted rate of return,
・payback period,
・accounting rate of return, and
・internal rate of return.

Question 5

Internal rate of return (IRR) is the method used to determine the rate of return that causes the present value of the net cash flows to equal the initial investment. It is a way of evaluating an investment as the present value of the net future cash flows from the investment, expressed as:

Answer 5

Investment = PV (i,t)
…where i (the rate at which the cash flows are discounted) is unknown.

An acceptable or beneficial proposal is one for which the IRR is equal to or greater than the firm’s predetermined minimum acceptable rate of return on the investment.

Question 6

The Profitability Index is calculated by dividing the present values of the cash flows after the initial investment by that investment. It takes both the size of the original investment and the value of the discounted cash flows into account.

Present Value of Cash Flows
After Initial Investment
————————— = Profitability Index
Initial Investment

Answer 6

This allows the comparison of various projects with differing initial investment amounts. Note that any project with a positive NPV will, by definition, have a Profitability Index greater than 1.

The Profitability Index is often used to compare two or more mutually exclusive projects. Potential projects might be mutually exclusive in that they represent viable options to accomplish the same task. Other constraints might include a limited capital budget or lack of adequate resources to accomplish multiple projects. The alternative project with the highest profitability index is the most desirable.

Question 7

project screening：
・Payback method

・Time-adjusted rate of return

・Accounting rate of return

The other choices are all screening methods. Note that the payback method and the accounting rate of return do not consider the time value of money.

Answer 7

project　ranking:
Profitability index

    PV benefits
           PI = -------------
                   Cost

Question 8

The profitability index is a variation on which of the following capital budgeting models?

Answer 8

Net present value

Question 9

If the net present value of a capital budgeting project is positive, it would indicate that the:

Answer 9

rate of return for this project is greater than the discount percentage rate used in the net present value computation.

Net present value (NPV) is defined as the excess of present value of cash inflows from a project over the discounted net cash outflows.

A positive net present value indicates that the project’s rate of return is greater than the discount (bundle) rate of interest. Projects promising a positive NPV should be undertaken if funds are available.

Question 10

The accounting rate of return is a capital budgeting method or technique which disregards the time value of money.

Answer 10

It is not a rate used in a net present value analysis.

Question 11

cost of capital, hurdle rate, and required rate of return—describes a rate used in net present value analysis.

Answer 11

Hurdle rate and required rate of return are synonyms.

Question 12

Yipann would be indifferent to the investment at its internal rate of return, i.e., its target rate of return at which the present value of the investment is zero. The average annual cash inflow at the IRR of 24% which gives PV = 0 is (compute the PV of annuity of $1.00 at the end of five periods):

Answer 12

PV average annual cash flow = PV initial cost
(average annual cash flow)(2.7454) = $105,000 (1.0)
= $105,000 / 2.7454
= $38,246

Question 13

Each of the following will affect a company’s return on investment:
raising prices as demand remains unchanged.
decreasing expenses.
decreasing investment in assets.

Answer 13

Return on investment (ROI) focuses on optimal use of invested capital. Net income from the income statement is divided by invested capital from the balance sheet; therefore, raising prices, decreasing expenses, and decreasing investment in assets would all affect ROI.

Question 14

The payback reciprocal can be used to approximate a project’s:

internal rate of return if the cash flow pattern is relatively stable.

Answer 14

Payback reciprocal = 1/Payback period

Where:

Payback = Net cash invested/Annual cash inflow
If the cash flow pattern is relatively stable, the payback reciprocal number serves as a good approximation of a present value of an annuity table factor. Using the payback number and a PV of an Annuity table, it becomes a relatively simple matter to look up an interest rate corresponding to the appropriate number of years’ life of a project. This interest rate will be a close approximation of the internal rate of return.

Question 15

The recommended technique for evaluating projects when capital is rationed and there are no mutually exclusive projects from which to choose is to rank the projects by:

Answer 15

profitability index.

The profitability index is a ratio obtained by calculating the total present value of all future net cash inflows and dividing that by the total cash outflow. This ratio is also called the excess present value index.

This method is considered superior to accounting rate of return, payback, and internal rate of return because it gives full weight to the time value of money and provides a ranking of project profitability.

The profitability index is a more realistic ranking tool than internal rate of return because it assumes reinvestment at cost of capital rather than at the internal rate of return. This is particularly important when capital is rationed.

Question 16

A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

Answer 16

Less than the project’s internal rate of return

The net present value of an investment is calculated by subtracting the initial investment from the present value of the future cash flows. A positive net present value means that the investment should be made, because the cash to be received (taking into account the time value of money) is greater than the initial investment.

By definition, an acceptable investment would also have an internal rate of return that is greater than the required rate of return—or, as the question states it, the required rate of return would be less than the project’s internal rate of return. Weighted average cost of capital has no bearing on this problem.

Question 17

Internal rate of return is the interest rate which will result in a net present value (PV) of zero. Therefore:

Answer 17

PV of Cash Savings = PV of Investment Outlay
$65,000 x PV factor = $200,000 x 1.0
$65,000(PV factor) = $200,000
Then dividing by $65,000:

           PV factor = $200,000 / $65,000
                     = 3.08 Referring to the present value factors in the question, the percentage rates for present value of an annuity indicates that a present value factor of 3.08 would relate to an interest rate of more than 16%.

Question 18

The method that recognizes the time value of money (present and future values) by discounting the after-tax cash flows over the life of a project, given the company’s minimum desired rate of return, is the net present value method. This method determines whether the discounted cash flows of a given project equal or exceed the initial investment.

The internal rate of return, another discounted cash flow method, determines the discount rate at which the present value of the projected future cash flows exactly equals the initial cost of the investment. The IRR is then compared with the desired minimum rate of return.

Answer 18

Payback period is the length of time (“period”) required to recover (“pay back”) the initial cash outlay of a capital project computed as the initial investment divided by the annual cash flow from the investment.

Accounting rate of return is also a non-discounted method computed as the net cash flow less depreciation divided by the investment.

Question 19

Accounting rate of return (ARR) is simply “accounting income” from a project divided by the investment cost of the project.

Internal rate of return (IRR) considers the amount and timing of cash inflows and outflows in calculating a “true” (internal) rate of return on a project.

Answer 19

Concerning the characteristics:

1)Both ARR and IRR consider salvage value—ARR in computation of depreciation expense and IRR as a future cash flow.
2)The primary emphasis in IRR is cash flows. Cash flows are not addressed in ARR.
3)Time value of money lies at the heart of IRR analysis but is not considered in ARR.
Thus, (2) and (3) are advantages of the IRR analysis.

Question 20

The capital budgeting model that is generally considered the best model for long-range decision making is the :

Answer 20

discounted cash flow model because the time value of money (present and future values) is considered.

The payback model and accounting rate of return model are unadjusted rate of return models which do not consider the time value of money.The capital budgeting model that is generally considered the best model for long-range decision making is the discounted cash flow model because the time value of money (present and future values) is considered.

The payback model and accounting rate of return model are unadjusted rate of return models which do not consider the time value of money.

Question 21

When evaluating projects, the discounted breakeven period is best described as

Answer 21

the point where discounted cumulative cash inflows on a project equal discounted total cash outflows.

Question 22

Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?

Answer 22

When there are net cash inflows of sizable amounts early in the project

The real issue here is the reinvestment assumption applied to “recovered funds.” Net present value (NPV) assumes reinvestment at the cost of capital whereas internal rate of return (IRR) assumes reinvestment at the IRR.

NPV makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.

Question 23

A project’s net present value, ignoring income tax considerations, is normally affected by the:

Answer 23

proceeds from the sale of the asset to be replaced.

Calculation of a project’s net present value is accomplished by:

computing the discounted (present) value of all future cash inflows and outflows of the proposed project.
subtracting the present value of outflows from inflows to arrive at the net present value.
Past costs used to calculate the carrying value and depreciation on the asset(s) to be replaced or used on the project are not used in the present value computation. In addition, depreciation is not a cash flow. Expected proceeds from the sale of the asset to be replaced are a future cash inflow, which will affect the proposed project’s net present value.