FINC2011 Lec 5 Capital Budgeting A

Question 1

What are the strengths of NPV? (3)

Answer 1

1. Makes decision which maximises wealth of shareholders.
2. Takes into account ALL cash flows.
3. Time value of money.

Question 2

What are the weaknesses of NPV? (2)

Answer 2

1. Reliant on quality of forecasts.

2. Unforeseen external changes e.g. Chinese steel price spike.

Question 3

What are the strengths of IRR? (2)

Answer 3

1. Summarises project info into 1 number.

2. Simple number, easily understood, popular method.

Question 4

What are the weaknesses of IRR? (5)

Answer 4

1. Hard to solve when more than 3 cash flows. (Overcome by excel).
2. Confusing decision rule: Investing (prefer higher IRR), Financing (prefer lower IRR). (NPV don’t need to adjust decision rule). (Problem only arises when projects mutually exclusive).
3. Can calculate multiple IRR’s. (Usually when reversal in positive / negative cash flows, quadratic).
4. Scale problem: small scale project with high IRR selected, but actually more efficient use of capital to select large scale project with lower IRR. (Problem arises due to capital rationing). (Overcome by finding combination of projects with highest WEIGHTED AVG PI).
5. False assumption that discount rates are stable, and that all funds are reinvested at the IRR. (NPV can use multiple / account for changing discount rates).

Question 5

What is MUTUALLY EXCLUSIVE? What happens if there is a conflict between NPV and IRR?

Answer 5

When only 1 project can be selected even though 2 or more are acceptable.

NPV > IRR!!!

Question 6

What is CAPITAL RATIONING? What is SOFT rationing? What is HARD rationing?

Answer 6

• Limit set on the amount of funds available for investment.
• Soft: limits imposed by MANAGEMENT.
• Hard: limits imposed by the unavailability of funds in the CAPITAL MARKET. (Extremely rare. E.g. when fear grips the market and no one wants to lend).

Question 7

What are the strengths of PAYBACK PERIOD? (2)

Answer 7

1. Simple easy to use and understand.

2. (Re-)evaluation of project can occur immediately after payback point.

Question 8

What are the weaknesses of PAYBACK PERIOD? (3)

Answer 8

1. Ignores time value of money. (Overcome by DISCOUNTED PAYBACK).
2. Ignores payments after payback point. (E.g. $$$ after few years).
3. Will not choose project that maximises shareholder wealth!!

Question 9

What are the weaknesses of the BOOK RATE OF RETURN? (3)

Answer 9

1. Components reflect tax and accounting figures, not market values or cash flows.
2. Change in accounting policy will affect number, but fundamentals of company has not changed.
3. No benchmark to compare to and make decision.