IF_L4

Question 1

What is Net Present Value (NPV)?

Answer 1

• The NPV rule says you accept projects with a positive NPV
• It measures the value created by a project, considering the opportunity cost of capital

Question 2

How is NPV calculated?

Answer 2

• Formula: NPV = ∑_t=1^T (C_t / (1 + r)^t) − C₀
• Interpretation: Present value of future cash flows minus initial investment

Question 3

What is the Payback rule?

Answer 3

• Accept a project if it recovers its cost within a specified period
• Flaw: Ignores cash flows beyond the cutoff and time value of money

Question 4

Define Internal Rate of Return (IRR).

Answer 4

• The discount rate at which NPV = 0
• If IRR exceeds the opportunity cost of capital, accept the project

Question 5

Why can the IRR rule be problematic?

Answer 5

• Multiple IRRs can occur if cash flows change sign multiple times
• It may ignore project scale (magnitude) and timing
• Reinvestment assumption can be unrealistic

Question 6

What is the Book Rate of Return (Accounting Rate of Return)?

Answer 6

• Ratio of average accounting profit to average book value
• Not reliable for decisions because it uses accounting numbers, not actual cash flows

Question 7

Explain the Profitability Index (PI).

Answer 7

• PI = (Present Value of future cash flows) / (Initial Investment)
• Useful when capital is rationed; higher PI indicates more efficient investment

Question 8

What is Capital Rationing?

Answer 8

• Imposing a limit on available funds for investment
• Soft rationing: internal management limit
• Hard rationing: external market limit on funding

Question 9

Define Working Capital in project decisions.

Answer 9

• Working Capital = short-term assets − short-term liabilities
• Additional investment in inventory/receivables can be a negative cash flow
• Recovered at the end of the project, boosting final cash flow

Question 10

Why are sunk costs excluded from NPV analysis?

Answer 10

• Sunk costs are past expenses that cannot be recovered
• NPV focuses on incremental future cash flows only

Question 11

Explain the concept of Incremental Cash Flows.

Answer 11

• Include all changes in the firm’s future cash flows from taking the project
• Exclude financing costs and sunk costs
• Include opportunity costs and incidental effects

Question 12

When do you use the Equivalent Annual Cost (EAC)?

Answer 12

• To compare projects (or machinery) with different lifespans
• Convert total costs (or net present value) into an annual figure
• Choose the lowest EAC for cost-minimising equipment decisions

Question 13

What is the opportunity cost of capital?

Answer 13

• The return forgone by investing in a project rather than in comparable financial securities
• Acts as the discount rate for evaluating cash flows

Question 14

How do corporate income taxes affect project cash flows?

Answer 14

• Taxes reduce operating cash flow
• Depreciation creates a tax shield, affecting after-tax cash flows
• Always evaluate on an after-tax basis