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Financial Management
1. Question: What is capital budgeting and What is strategic business plan?
Answer: The process of planning expenditures on assets with cash flows that are expected to
extend beyond one year.
Answer: Strategic Business Plan means a long run plan that outlines in broad terms the firm’s
basic strategy for the next 5 to 10 years.
2. Question: How are project classifications used in the capital budgeting process?
Answer: Project classification schemes can be used to indicate how much analysis is required to
evaluate a given project, the level of the executive who must approve the project, and the cost of
the capital that should be used to calculate the project’s NPV(net present value). Thus,
classification schemes can increase the efficiency of the capital budgeting process.
Answer:
Characteristics Independent Mutually exclusive
Dependency No dependency over other Projects Dependent with relative projects
Acceptance of the If NPV exceeds zero, then project Accept the project with the
project will be accepted highest positive NPV
Rejection Criteria Two or more projects are running Two or more project run at a
parallely ,then calculate NPV and time, if one of the projects
reject which doesn’t exceed Zero. remains negative, then all project
will be rejected.
4. Question: Why is the NPV the primary capital budgeting decision criterion?
Answer: The net present value (NPV) tells us how much a project contributes to share-holder
wealth—the larger the NPV, the more value the project adds; and added value means a higher
stock price.
Net present value uses discounted cash flows in the analysis, which makes the net present value
more precise than of any of the capital budgeting methods as it considers both the risk and time
variables.
A net present value analysis involves several variables and assumptions and evaluates the cash
flows forecasted to be delivered by a project by discounting them back to the present using
information.
Answer: IRR stands for Internal Rate of Return. It is the discount rate that forces the Present
Value (PV) of the inflows to equal the cost. This is equivalent to forcing the Net Present Value
(NPV) to equal zero. The IRR is the estimate value of a project’s rate of return and it is
compatible to the Yield to Maturity (YTM) on a bond.
Answer: We have discussed YTM on a bond in chapter 7. There if we hold the bond to maturity
then we can earn the YTM on investment. The YTM is found as the discount rate that forces the
PV of the cash inflows to equal the price of the bond. This same concept is involved in capital
budgeting when we calculate the IRR.
Answer: For independent project If IRR exceeds the project’s Weighted Average Cost of Capital
(WACC), accept the project and if IRR is less than the project’s WACC, reject it.
For mutually exclusive projects accept the project with the highest IRR, provided that IRR is
greater than WACC. Reject all projects if the best IRR does not exceed WACC.
9. Question: What is Financial Multiple Internal Rates of Return (MIRRs)?
Answer: Multiple IRRs occur when a project has two or more internal rate of return (IIRs). The
problem arises where a project has non-normal cash flow.
11. Question: How many ways the new common equity is raised and what are those?
Answer: The new common equity is raised in two ways
a. By retaining some of the current year’s earnings and
b. By issuing new common stock.
Answer: Modified Internal Rate of Return(MIRR)" is a method used to find the attractiveness of
the investment. This method used in capital budgeting ranking the investment projects. This
method is the same like IRR (Internal Rate of Return)
16. Question: What make NPV profiles to cross and lead to conflicts?
Answer:
Timing differences.
. Project size differences.
18. Question: What is Discount Playback? Difference between Playback and Discount
Playback
Answer: The length of time required for an investment’s cash flows, discounted at the
investment’s cost of capital, to cover its cost.
To counter the criticism of Playback, analysts developed the discounted payback. Here cash
flows are discounted at the WACC; then those discounted cash flows are used to find the
payback.
The regular payback doesn’t consider the cost of capital; it doesn’t specify the true break-even
year. Where, the discounted payback does consider capital costs; but it still disregards cash flows
beyond the payback year, which is a serious flaw.
Answer: Because the NPV method uses a reinvestment rate close to its current cost of capital,
the reinvestment assumptions of the NPV method are more realistic than those associated with
the IRR method. In conclusion, NPV is a better method for evaluating mutually exclusive
projects than the IRR method.
20. Question: What makes a long payback project riskier than one with a shorter
payback?
Answer: Payback and discounted payback provide indications of a project’s liquidity and risk. A
long payback means that investment dollars will be locked up for a long time; hence, the project
is relatively illiquid. In addition, a long payback means that cash flows must be forecasted far out
into the future, and that probably makes the project riskier than one with a shorter payback. A
good analogy for this is bond valuation.