week 3

Question 1

what is investment project?

Answer 1

The term investment project is interpreted very broadly to include any proposal to outlay cash in the expectation that future cash inflows will result

Question 2

capital expenditure management involves the

Answer 2

planning and control of expenditures incurred in the expectation of deriving future economic benefits in the form of cash inflows

Question 3

capital expenditure process involves

Answer 3

1. generation of investment proposals
2. evaluation and selection of those proposals
3. approval and control of capital expenditures
4. post-completion audit of investment projects.

Question 4

investment proposals: Investment ideas or projects:

Answer 4

¡simple upgrades of equipment,
¡replacing inefficient exiting equipment,
¡plant expansions,
¡new product development,
¡bidding for commercial contracts,
¡entering new markets. or
¡corporate takeovers.

Question 5

types of invesment projects

what are independent investments?

Answer 5

¡Projects that can be considered and evaluated in isolation from other projects.
¡This means that the decision on one project will not affect the outcomes of another project

1. technically feasible to undertake one of the projects, irrespective of the decision made about the other project(s).
2. The net cash flows from each project must be unaffected by the acceptance or rejection of the other project(s).

Question 6

what are mutually exclusive investments?

Answer 6

¡Alternative investment projects, only one of which can be accepted.
¡For example, a piece of land is used to build a
factory, which rules out an alternative project of
building a warehouse on the same land.

Question 7

methods of project evaluation include

Answer 7

Methods of project evaluation include:

1. Payback period
2. Net present value (NPV)
3. Internal rate of return (IRR)
4. Benefit–cost ratio (profitability index)

Question 8

simple project evaluation methods

payback period

Answer 8

payback period, a non discounted cash flow method,
The amount of time required for an investment to generate cash flows to recover its initial cost.

Question 9

simple project evaluation methods

payback period

when is an investment acceptable?

Answer 9

An investment is acceptable if its calculated payback is less than some maximum acceptable payback period
.

Question 10

pros of payback period

Answer 10

1. Easy to understand/simple
2. Adjusts for uncertainty of later cash flows.
3. knowledge of how soon funds in the project will be recouped provides managers with info to facilitation cash budget preparation –> better liquidity management

Question 11

disadvantages of payback period

Answer 11

1. Time value of money (timing of all cash inflows and outflows) and risk ignored.
2. arbitrary determination of acceptable payback period.
3. Ignores cash flows after the point net cash flows = intial outlay, thus, discriminates long term projects and projects that generate large cash flow later

Question 12

advantages of benefit cost ratio

Answer 12

¡Includes time value of money
¡Easy to understand
¡Does not accept negative estimated NPV investments
¡Biased towards liquidity

Question 13

disadvantages of benefit cost ratio

Answer 13

• May reject positive NPV investments
• Arbitrary determination of acceptable payback period
• Ignores cash flows beyond the cutoff date
• Biased against long-term and new products

Question 14

what are discounted cash flow methods

Answer 14

Discounted cash flow (DCF) methods involve the process of discounting a series of future net cash flows to their present values.

DCF methods include:
¡The net present value method (NPV).
¡The internal rate of return method (IRR).

Question 15

projects should be accepted if

Answer 15

they increase shareholders’ wealth

Question 16

postive NPV represents

Answer 16

the immediate increase in the company’s wealth that will result from accepting the project—that is, a positive net present value means that the project’s benefits are greater than its cost, with the result that its implementation will increase shareholders’ wealth

Question 17

If a company implements a project that has a positive net present value, the company will be

Answer 17

more valuable/better off than before it undertook the project, and therefore, other things being equal, the total market value of the company’s shares should increase immediately by the same amount as the net present value of the new project.

Question 18

what is the internal rate of return

Answer 18

The internal rate of return for a project is the rate of return that equates the present value of the project’s net cash flows with its initial cash outlay.

IRR is the discount rate (or rate of return) at which the net present value is zero.

Question 19

decision rule for IRR

Answer 19

The IRR is compared to the required rate of
return (k).
If IRR > k the project should be accepted.

If the required rate of return is the minimum return that investors demand on investments then, other things being equal, accepting a project with an internal rate of return greater than the required rate should result in an increase in the price of the company’s shares.

Question 20

¡Situations where the IRR rule and NPV rule may be in conflict:

Answer 20

nDelayed Investments
nNonexistent IRR
nMultiple IRRs

Question 21

Hence, the number of cash flow sign reversals corresponds to

Answer 21

maximum, but not necessarily the actual, number of internal rates of return.

Question 22

. IRR measures

Answer 22

the average return of the investment and the sensitivity of the NPV to any estimation error in the cost of capital

Question 23

IRR rule and mutually exclusive investments: differences in scale

Answer 23

¡If a project’s size is doubled, its NPV will double. This is not the case with IRR. Thus, the IRR rule cannot be used to compare projects of different scales.

Question 24

For independent investments, both the IRR and NPV methods of investment evaluation lead to

Answer 24

the same accept/reject decision, except for those investments where the cash flow patterns result in either multiple internal rates of return or no internal rate of return. In other words, if a project has an internal rate of return greater than the required rate of return, the project will also have a positive net present value when its cash flows are discounted at the required rate of return—that is, NPV > 0 when r > k, NPV < 0 when r < k, and NPV = 0 when r = k

Question 25

describe normal cases of mutuallly exclusive projects and extreme

Answer 25

the expected benefits from one project are affected by a decision to accept or reject another project.

In the extreme case, where the expected cash flows from a project will completely disappear if another project is accepted, or it is technically impossible to undertake the proposed project if another project is accepted

e.g. choice of one equipment leads to rejection of another

Question 26

one of the problems of IRR

Answer 26

it can be affected by changing the timing of the cash flows, even when the scale is the same.

Question 27

describe economic value added as a method of project evaluation

Answer 27

ndifference between the project’s accounting profit (or operating CFs) and the required return on the capital invested in the project.

Question 28

how can EVA be improved?

Answer 28

improved by increasing accounting profit (or CF) or by reducing capital employed.

Question 29

what is EVA given by

Answer 29

Question 30

what does EVA show?

Answer 30

addition to the company’s wealth created by the investment.

Question 31

real option analysis

management choices are often known as

Answer 31

real options

Question 32

limitations of NPV analysis

Answer 32

the approach treats projects as now-or-never prospects—whereas we know that in reality managers often have significant flexibility in how they manage a project (including when to begin it)

In addition, NPV is limited to a yes-or-no analysis; for example, it implicitly gives no recognition to the fact that, after a project has begun, managers may intervene in the project as circumstances develop.

Question 33

how can the limitations of NPV be overcome?

Answer 33

by real options analysis

Question 34

what are real options

Answer 34

the flexibility that a manager has in choosing whether to undertake or abandon a project or change the way a project is managed

they can choose how to implement a project and manage an ongoing project

Question 35

examples of real options

Answer 35

options to

¡delay investment
¡expand operations
¡abandon operations.

Question 36

calculation of payback period takes into account

Answer 36

Calculation of the payback period takes into account only the net cash flows up to the point where they equal the investment outlay.

Question 37

Consider two projects, A and B, where project A has a net present value (NPV) of $100 and project B has an NPV of $50. If both projects are independent, which project should be accepted?

Answer 37

both as they are both positive, so they both add value to the firm and increase shareholders’ wealth

Question 38

the difference in ranking is caused by differences in

Answer 38

any difference in the magnitude or timing of the cash flows may cause a difference in the ranking of investment projects using the internal rate of return and net present value methods.

Question 39

2 most popular project evaluation methods

Answer 39

NPV and internal rate of return

Question 40

when there are mutually exclusive project with NPV and IRRs that differ, what do you do?

Answer 40

At a required rate of return of 10 per cent, both investments are worth undertaking, but if a choice has to be made between the two investments, then investment B with the larger net present value is to be preferred. This is because B adds more to the company’s value than A. The net present value method will ensure that the value of the company is maximised, whereas the use of the internal rate of return method will not ensure that result.