Financial Decision Models Pt. 2

Question 1

What are the two types of leases?

Answer 1

finance lease and operating lease

Question 2

What are the two decisions in decision making when it comes to leases?

Answer 2

investment decision: Does the asset give operational benefits? Focus on the NPV of the after-tax operating cash inflows. Discount cash flows using a rate which reflects the operating risk of investment

financing decision: Is it cheaper to buy or lease? Focus on the relative benefits of tax-allowable depreciation from buying by the tax savings from the lease payments. Discount these cash outflows using the after-tax cost of debt

Question 3

T/F: if the PV of the cost of the best source of financing is less than the PV of the operating cash flows then the project should be undertaken

Answer 3

True

Question 4

T/F: financial accounting implications must be considered when making a lease vs buy decision

Answer 4

True; certainly relevant for the managers of a public company as key ratios may be influenced (particularly financial risk indicators such as the firm’s debt-to-equity ratio and interest coverage ratio)

Question 5

T/F: the IRR is the expected rate of return of a project and is sometimes called the time-adjusted rate of return

Answer 5

True; it determines the PV factor (and related interest rate) that yields a NPV equal to zero (the PV of the after-tax net cash flows equals the initial investment on the project); it focuses the decision maker on the discount rate at which the present value of the cash inflows equals the present value of the cash outflows (usually the initial investment)

although the NPV method highlights dollar amounts, the IRR method focuses decision makers on percentages

the targeted rate of return (or hurdle rate) is predetermined and is compared with the compound IRR
accept when IRR > hurdle rate
reject when IRR < hurdle rate

Question 6

What are some limitations of IRR?

Answer 6

unreasonable reinvestment assumption: cash flows generated by the investment are assumed in the IRR analysis to be reinvested at the internal rate of return

inflexible cash flow assumptions: it is less reliable than the NPV method when there are several alternating periods of net cash inflows and outflows or the amounts of the cash flows differ significantly

evaluates alternatives based entirely on interest rates: it evaluates investment alternatives based on the achieved IRR and does not consider the dollar impact of the project

Question 7

What is the payback period method?

Answer 7

the time required for the net after-tax operating cash inflows to recover the initial investment in a project; it focuses decision makers on both liquidity and risk; it is often used for risky investments; the greater the risk of the investment, the shorter the payback period that is expected (tolerated) by the company

formula: net initial investment / average incremental cash flow (where cash flow per period is even)

the net cash inflows are generally assumed to be constant for each period during the life of the project; the payback period is computed at the point of initial investment using after-tax cash flows

if cash flows are not uniform, a cumulative approach to determine the payback period is used; net after-tax cash inflows are accumulated until the time they equal the initial net investment

advantages: easy to use and understand and emphasis on liquidity

limitations: TVM is ignored, total project profitability is neglected, reinvestment of cash flows is not considered, and project cash flows occurring after the initial investment is recovered are not considered

Question 8

What is the discounted payback method (also referred to as the breakeven time method)?

Answer 8

it computes the payback period using expected cash flows that are discounted by the project’s cost of capital; used by companies as an alternative to the non-discounted payback method

the objective of this method is to evaluate how quickly new ideas are converted into profitable ideas; it focuses on liquidity and profit; computation begins when the project team is formed and ends when the initial investment has been recovered; method is often used to evaluate new product development projects of companies that experience rapid technological changes and want to recoup their investment quickly before their products become obsolete

advantages and limitations are the same as the payback method except discounted payback incorporates the TVM; both focus on how quickly the investment is recouped rather than overall profitability of the entire project