1.

Discuss the difference between – State also advantages & disadvantages each:

a. The payback period & the discounted payback period criteria of

capital budgeting.

The payback period measures the time that it takes to recoup the cost of the
investment.
If the cash flows are an annuity, then we can simply divide the cost by the annual
cash flow to determine the payback period
Otherwise, as in the example, we subtract the cash flows from the cost until the
remainder is zero
The shorter the payback period, the better
Generally, firms will have some maximum allowable payback period against which
all investments are compared

Assume that your company is investigating a new labor-saving machine that will cost
$10,000. The machine is expected to provide cost savings each year as shown in
the following timeline:

• If your required return is 12%, should this machine be purchased?

For our example project, we will subtract the cash flows from the initial outlay until
the entire cost is recovered:

Since it will take 0.7143 years (= 2500/3500) to recover the last 2,500, the payback
period must be 3.7143 years

Advantages of Payback Period

• It is easy to understand and apply. The concept of recovery is familiar to
every decision-maker.
• Business enterprises facing uncertainty - both of product and technology -
will benefit by the use of payback period method since the stress in this
technique is on early recovery of investment. So enterprises facing
technological obsolescence and product obsolescence - as in
electronics/computer industry - prefer payback period method.
 • Liquidity requirement requires earlier cash flows. Hence, enterprises having
high liquidity requirement prefer this tool since it involves minimal waiting
time for recovery of cash outflows as the emphasis is on early recoupment of
investment.

Disadvantages of Payback Period

• The time value of money is ignored. For example, in the case of project.
• But this drawback can be set right by using the discounted payback period
method. The discounted payback period method looks at recovery of initial
investment after considering the time value of inflows.
• Investment decision is essentially concerned with a comparison of rate of
return promised by a project with the cost of acquiring funds required by that
project. Payback period is essentially a time concept; it does not consider the
rate of return.

The Discounted Payback Period

The discounted payback period is exactly the same as the regular payback period, except
that we use the present values of the cash flows in the calculation
Since our required return (WACC) is 12%, the timeline with the PVs looks like this:

The discounted payback period is 4.82 years

Note that the discounted payback period is always longer than the regular payback period

Advantage of discounted payback period:

• Consider the time value of money.

• Consider the riskiness of project's cash flow.

Disadvantages of Discounted Payback Period

• The discounted payback period solves the time value problem, but it still ignores
the cash flows beyond the payback period
• Therefore, you may reject projects that have large cash flows in the outlying years
that make it very profitable
• In other words, any measure of payback can lead to a focus on short-run profits at
the expense of larger long-term profits

b. The NPV & the PI criteria of capital budgeting.

The net present value (NPV) is the difference between the present value of the cash flows
(the benefit) and the cost of the investment (IO)
In other words, this is the increase in wealth that the shareholders will receive if the
project is accepted
All projects with NPV greater than or equal to zero should be accepted
NPV is calculated by subtracting the initial outlay (cost) from the present value of the
cash flows
Note that the discount rate is the WACC (12% in this example)

Since the NPV is positive, the project is acceptable

Note that a positive NPV also means that the IRR is greater than the WACC

PI:
The profitability index is the same as the NPV, except that we divide the PVCF by the
initial outlay:

Accept all projects with PI greater than or equal to 1.00

For the example, the PI is: 10, 408.06 / 10,000 = 1.0408
Disadvantages: Problems with mutually exclusive investments.
Advantages:
May be useful when investment funds are limited.
Easy to understand and communicate
Correct decision when evaluating independent projects.

c. The IRR & the Modified IRR criteria of capital budgeting.

The internal rate of return (IRR) is the discount rate that equates the present value of
the cash flows and the cost of the investment
Usually, we cannot calculate the IRR directly, instead we must use a trial and error
process
For our example, the IRR is found by solving the following:
2000 2500 3000 3500 4000
10,000 = + + + +
( 1 + IRR) 1
( 1 + IRR) 2
( 1 + IRR) 3
( 1 + IRR) 4
( 1 + IRR) 5

In this case, the solution is 13.45%

Problems with IRR:
The IRR is a popular technique primarily because it is a percentage which is easily
compared to the WACC
However, it suffers from a couple of flaws:
• The calculation of the IRR implicitly assumes that the cash flows are
reinvested at the IRR. This may not always be realistic.
 Percentages can be misleading (would you rather earn 100% on a $100 investment, or
10% on a $10,000 investment?)

Modified Internal Rate of Interest:

The modified IRR (MIRR) is the average annual rate of return that will be earned on
an investment if the cash flows are reinvested at the specified rate of return (usually,
the WACC)
To calculate the MIRR, first find the total future value of the cash flows at the
reinvestment rate, and then apply the formula:
FVCF
MIRR =N −1
IO
To calculate the MIRR for our example, first find the FV of the cash flows at 12% (the
WACC):

This is the amount that you will have accumulated by the end of the life of the investment
Now, find the average annual rate of return:

Since the MIRR is greater than the WACC, this project is acceptable

2. Explain the following concepts (Give examples):

a. The capital budgeting.

The process of determining whether or not projects such as building a new plant or
investing in a long-term venture are worthwhile. Capital budgeting is the process by
which the financial manager decides whether to invest in specific capital projects or
assets. In some situations, the process may entail in acquiring assets that are completely
new to the firm. In other situations, it may mean replacing an existing obsolete asset to
maintain efficiency.
Example:
A company wants to study the feasibility of acquiring a new machine line. The machine
will cost $350,000 and have a useful period of three years after which it will have no
salvage value. The machine will generate operating revenues of $300,000 and incur
$75,000 in annual operating expenses over the three years. The project requires an initial
payment of investment for about $15,000 in working capital which will be recovered at
the end of the three years. The firm’s cost of capital is 16%. The firm’s tax rate is 25%.
Solution:

Initial Investment is $350,000

Initial Net Working Capital is $15,000

Present Value of the annual operating cash flow after tax

= ($300,000-$75,000) x (1-0.25) x PVIFA(16%,3years)
= $225,000 x 0.75 x 2.2459
= $378,996

Note: The number 2.2459 can be obtained by using an ordinary calculator. Procedure to
be followed:
For Year 1, divide 1 by 1.16 = 0.8621
For Year 2, the calculator screen shows 0.8621, press the = key, you will get 0.7432
For Year 3, the calculator screen shows 0.7432, press the = key, you will get 0.6406
Add up all the three to get 2.2459

Since the asset will not have any salvage value at the end of the third year we need not
calculate the Present Value.
Present Value of the net working capital at the end of the project
= $15,000 x PVIFA(16%,3rd year)
= $15,000 x 0.6406
= $9,609
Net Present Value = ($ 350,000) + ($ 15,000) + $ 378,996 + $ 9,609 = $ 23,605

Since the NPV is positive so it is feasible to purchase the equipment, as it will increase
company's profits.

b. The free cash flow.

Free cash flow is the sum of cash that remain in the balance after paying all company
expenses and investments. It is the cash that is not required for day-to-day operations and
company investment.
Example; On free cash flow calculation:
120,500 L.E Net Cash Flows From Operations
(-) 100,000 L.E Investment in Plant and Equipment
(-) 35,000 L.E Dividends Paid
= (15,000) Negative Free Cash Flow

In the example, the company has a negative free cash flow. The company needs to
analyze their financial position to and find ways that help to cut costs, maximize sales
revenue, overcome expenses, and make proper improvements in their financial position
to help the firm remains stable in the market and can sustain with competition.
 c. The accounting profits.

It is the total revenue minus costs properly chargeable against goods sold. Accounting
profits is higher than economic profits as they omit certain implicit costs, such as
opportunity costs.

For example, if you invest 200,000 LE to start a new business that will make you earn
250,000 LE in profit, the accounting profit would be 50,000LE. While the economic
profit would add implicit costs, such as the opportunity cost of 70,000 LE that are
consumed during that period. So the economic loss of 20,000 LE (250,000 - 200,000 -
70,000).

d. The common stock & the preferred stock and the difference between both
of them.

Common stock is a Stock in a publicly-traded company that entitles holders to vote in the
annual meeting, to elect the board of directors, and to generally exercise control of the
company. While common stockholders are important in terms of their level of control,
they have the least precedence in the event of liquidation. That is, if the company goes
bankrupt, common stockholders do not receive any money until all bondholders, other
debt holders, and preferred shareholders are paid in full. Likewise, common stock is not
entitled to a guaranteed dividend.
Common stockholders are the residual owners of a corporation in that they have a claim
to what remains after every other party has been paid. The value of their claim depends
on the success of the firm.

Preferred stock is a Capital stock which provides a specific dividend that is paid before
any dividends are paid to common stock holders, and which takes precedence over
common stock in the event of a liquidation. Like common stock, preferred stocks
represent partial ownership in a company, although preferred stock shareholders do not
enjoy any of the voting rights of common stockholders. Also unlike common stock, a
preferred stock pays a fixed dividend that does not fluctuate, although the company does
not have to pay this dividend if it lacks the financial ability to do so. The main benefit to
owning preferred stock is that the investor has a greater claim on the company's assets
than common stockholders. Preferred shareholders always receive their dividends first
and, in the event the company goes bankrupt, preferred shareholders are paid off before
common stockholders. In general, there are four different types of preferred stock:
cumulative preferred, non-cumulative, participating, and convertible. Also called
preference shares.

e. The preemptive right.

The privilege of a stockholder to maintain a proportionate share of ownership in a

corporation by purchasing a proportionate share of any new stock issued. Such
stockholders have the first opportunity to purchase new stock in the firm proportionate to
the percentage of shares already held. And the right granting to shareholders the first
opportunity to buy a new issue of stock; provides protection against dilution of the
shareholder's ownership interest.
For example, if an individual owns 2% of the shares of a company that is coming out
with a new issue of 100,000 shares, the individual is entitled to buy 2000 shares at a
favorable price to maintain the proportionate interest.

f. The over head cost.

Those general charges or expenses in any business which cannot be charged up as

belonging exclusively to any particular part of the work or product, as where different
kinds of goods are made, or where there are different departments in a business; - called
also fixed charges, establishment charges, or (in a manufacturing business) administration
charges, selling charges, and distribution charges, etc.

Examples of overhead costs include:

• payment of rent on the office space a business occupies

• cost of electricity for the office lights
• some office personnel wages
g. The working capital.

Working capital, also known as "WC", is a financial metric which represents operating
liquidity available to a business. Along with fixed assets such as plant and equipment,
working capital is considered a part of operating capital. It is calculated as current assets
minus current liabilities. If current assets are less than current liabilities, an entity has a
working capital deficiency, also called a working capital deficit. Net working capital is
working capital minus cash (which is a current asset) and minus interest bearing
liabilities (i.e. short term debt). It is a derivation of working capital, which is commonly
used in valuation techniques such as DCFs (Discounted cash flows). The difference
between current Assets ($4,000) and current Liabilities ($1,500); the working capital is
$2,500.

h. The incremental cash flow & the incremental cost.

The incremental cash flow meaning cash flows that occur as a consequence of the
decision to precede with the project not total cash flows for the firm.
Incremental cash flow = cash flow with project – cash flow without project

Incremental Cost is the total cost to a company to produce one more unit of a product.
The incremental cost varies according to how many more or fewer units a company
wishes to produce. Increasing production may increase or decrease the incremental cost
because the incremental cost includes all costs such as labor, materials, and the cost of
infrastructure.
For example, if a widget manufacturer increases the number of widgets it produces, it
may need to buy more material, but the costs of labor and factory maintenance remain the
same and are spread out over a greater number of widgets. This may reduce the
incremental cost. On the other hand, if the manufacturer hires more workers and builds
another factory, it will likely increase the incremental cost. It is also known as the
marginal cost.

i. The salvage value.

Estimated residual value of a depreciable asset or property at the end of its economical or
useful life. In all methods for determining depreciation (except the double declining
balance depreciation method) salvage value is deducted from the asset's purchase price.
When the cost of an asset less its accumulated depreciation equals its salvage value, no
more depreciation may be taken.
Example: An appraiser estimates the useful life of a building at 40 years; she also
estimates that the building's salvage value would be $10,000 in 40 years. Consequently,
all but $10,000 of the building cost is to be depreciated over 40 years.

j. The capital spending.

Spending for long-term assets such as factories, equipment, machinery, and buildings that
permits the production of more goods and services in future years. Payments made in
cash or cash equivalents over a period of more than one year. Capital spending is used to
acquire assets or improve the useful life of existing assets.
An example of capital spending is the funding used to construct a factory. In accounting,
capital spending must be capitalized; that is, the expenditure is recognized on a balance
sheet gradually over the course of asset's useful life. Capital spending is recorded as a
liability on a balance sheet. It is also called a capital outlay or, most commonly, capital
expenditure.

k. The useful life of the asset.

The period during which a depreciable asset will be productive. An asset's useful life is
likely to be different than its life for depreciation. It is the length of time that a
depreciable asset is expected to be useable.
For example, if a manufacturing machine costs $1,200 and is expected to be worth $200
at the end of its useful life, its depreciable basis is $1,000. If the useful life span of the
machine is 10 years, the depreciation each year is $100 ($1,000 divided by 10 years).
Thus, $100 can be deducted from the business's taxable net income each year for 10
years.

3. Discuss different types of free cash flows.

In financial accounting, a cash flow statement, also known as statement of cash flows or
funds flow statement, is a financial statement that shows how changes in balance sheet
accounts and income affect cash and cash equivalents, and breaks the analysis down to
operating, investing, and financing activities. Free cash flow is cash flow in excess of that
required to fund all projects that have positive net present values when discounted at the
relevant cost of capital. Conflicts of interest between shareholders and managers over
payout policies are especially severe when the organization generates substantial free
cash flow.Essentially, the cash flow statement is concerned with the flow of cash in and
cash out of the business. People and groups interested in cash flow statements include:

• Accounting personnel, who need to know whether the organization will be able to
cover payroll and other immediate expenses
• Potential lenders or creditors, who want a clear picture of a company's ability to
repay
• Potential investors, who need to judge whether the company is financially sound
• Potential employees or contractors, who need to know whether the company will
be able to afford compensation
• Shareholders of the business.

The statement of cash flows classifies cash receipts and cash payments into operating,
investing, and financing activities. Transactions within each activity are as follows:

• Operating activities include the cash effects of transactions that create revenues
and expenses and thus enter into the determination of net income.
• Investing activities include (a) purchasing and disposing of investments and
productive long-lived assets using cash and (b) lending money and collecting the
loans.
• Financing activities include (a) obtaining cash from issuing debt and repaying
the amounts borrowed and (b) obtaining cash from stockholders, repurchasing
shares, and paying dividends.
• Operating activities is the most important category because it shows the cash
provided or used by company operations.
• Cash provided by operations is generally considered to be the best measure of
whether a company can generate sufficient cash to continue as a going concern
and to expand.
• The following are typical cash receipts and cash payments within each of the
three activities--operating, investing, and financing.
• Types of Cash Inflows and Outflows

Operating activities – income statement items

o Cash inflows:
 From sale of goods or services.
 From interest and dividends received.
o Cash outflows:
 To suppliers for inventory.
  To employees for services.
 To government for taxes.
 To lenders for interest.
 To others for expenses.

Investing activities – changes in investments and long-term assets

• Cash inflows:
o From sale of property, plant, and equipment.
o From sale of investments in debt or equity securities of
other entities.
o From collection of principal on loans to other entities.
• Cash outflows:
o To purchase property, plant, and equipment.
o To purchase investments in debt or equity securities of
other entities.
o To make loans to other entities.

Financing activities – changes in long-term liabilities and stockholders’ equity

• Cash inflows:
o From sale of equity securities (company's own stock).
o From issuance of debt (bonds and notes).
• Cash outflows:
o To stockholders as dividends.
o To redeem long-term debt or reacquire capital stock
(treasury stock).