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Name of the Subject: MBA 622 Financial Management

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MBA 622 - Financial Management

Table of Contents
Part 1 - Evaluate both the projects:............................................................................................1
Part 2 Evaluation of techniques...............................................................................................5
Part 3 - Multiple Choice Questions and Short Answers.............................................................8
References..................................................................................................................................9

MBA 622 - Financial Management

Part 1 - Evaluate both the projects:


Payback period
Project S
Investment
Balance as at first year end
Balance as at second year end
Balance as at third year end

(100)
(30)
20
40

It will take 1 year and [(30 50) x 12] = 7.2 months to pay back which is 1 year and 8
months when we round up.
Project L
Investment
Balance as at first year end
Balance as at second year end
Balance as at third year end

(100)
(90)
(30)
50

It will take 2 years and [(30 80) x 12] = 4.5 months to pay back which is 2 years and 5
months when we round up.
In terms of payback period method we can see that Project S has the shortest payback time
hence Project S is better

Discounted payback period

Project S
Year

Cash Flow

Present Value
Factor = 1/

Discounted
Cash flow

Balance at the
end of each year

(100)
63.63
41.3
15.03

(100)
(36.37)
4.93
19.96

(1+i)n

0
1
2
3

(100)
70
50
20

1
0.909
0.826
0.751

It will take 1 year and [(36.37 41.3) x 12] = 10.57 months to pay back which is 1 year and
11 months when we round up
Project L
Year

Cash Flow

Present Value
Factor = 1/

Discounted
Cash flow

Balance at the
end of each year

(100)

(100)

(1+i)n

(100)

1
1

MBA 622 - Financial Management


1
2
3

10
60
80

0.909
0.826
0.751

9.09
49.56
60.08

(90.91)
(41.35)
18.73

It will take 2 years and [(41.35 60.08) x 12] = 8.26 months to pay back which is 2 years and
9 months when we round up
In terms of discounted payback period method we can see that Project S has the shortest
payback time hence Project S is better

NPV

Project S
Year
0
1
2
3

Cash Flow

Present Value
Factor = 1/(1+i)n
(100)
1
70
0.909
50
0.826
20
0.751
Net Present Value

Discounted
Cash flow
(100)
63.63
41.3
15.03
= 19.96

Balance at the
end of each year
(100)
(36.37)
4.93
19.96

Cash Flow

Discounted
Cash flow
(100)
9.09
49.56
60.08
= 18.73

Balance at the
end of each year
(100)
(90.91)
(41.35)
18.73

Project L
Year

Present Value
Factor = 1/(1+i)n
(100)
1
10
0.909
60
0.826
80
0.751
Net Present Value

0
1
2
3

In terms of NPV project S has a higher NPV value hence project S is better.

Internal rate of return

NPV a
IRR Formula - r a + NPV a NPV b (r br a)
ra lower discount rate chosen / Na NPV at ra
rb lower discount rate chosen / Nb NPV at rb
Project S
Earlier we calculated the NPV for project S, cost of capital (COC) at 10%. Now we are going
to calculate NPV when COC is 20%.
Year

Cash Flow

Present Value
Factor = 1/(1+i)n
2

Discounted
Cash flow

Balance at the
end of each year

MBA 622 - Financial Management


0
1
2
3

(100)
70
50
20
Net Present Value

1
0.833
0.694
0.579

(100)
58.31
34.7
11.57
= 4.58

(100)
(41.69)
(6.99)
4.58

Discounted
Cash flow
(100)
8.33
41.64
46.32
= (3.71)

Balance at the
end of each year
(100)
(91.67)
(50.03)
(3.71)

At 10% - NPV is 19.96 and at 20% NPV is 4.58.


Applying to IRR formula, IRR is = 22.97%

Project L
Year

Cash Flow

Present Value
Factor = 1/(1+i)n
(100)
1
10
0.833
60
0.694
80
0.579
Net Present Value

0
1
2
3

At 10% - NPV is 18.73 and at 20% NPV is (3.71)


Applying to IRR formula, IRR is = 18.34%
At IRR rate is we consider NPV to be zero, therefore higher the IRR lessen the risk of the
project is and therefore Project S is better.

Modified Internal rate of return

MIRR=

Future Value of cash flow


1
Initial Investment

Project S
Year
0
-100

Projected cash flow


Year 1 cash flow compounded at 10% for
two years
Year 2 cash flow compounded at 10% for
two years
Modified cash flow

1
70

2
50

3
20
84.7
55

-100

159.7

MBA 622 - Financial Management

MIRR =

159.7
1=16.88
100

Project L
Year
0
-100

Projected cash flow


Year 1 cash flow compounded at 10% for
two years
Year 2 cash flow compounded at 10% for
two years
Modified cash flow

MIRR =

1
10

2
60

3
80
12.1
66

-100

158.1

158.1
1=16.50
100

Project S has the highest MIRR hence project S can be selected to enhance the outcome.

MBA 622 - Financial Management

Part 2 Evaluation of techniques

Payback period

The payback period measures the time period (expected number of months or years) it takes
to fully cover the total cost of the investment used. Usual method in this is to subtract cash
flows from the cost until the remainder will be zero. This is usually when companies have a
limit to payback period for all of their investments.
Payback period is easy and can be calculated quickly compared to other methods and will
provide a liquidity measure of the project. It will give a prominent to projects which have
higher cash flows at the beginning than after some more years. This can be important for a
smaller company who have a smaller working capital cycle compared to other companies.
Main drawbacks of this methods are that it ignores the time value of money and also ignores
all cash flows beyond the payback period. A company with a project that exceeds the
predetermined value will not be taken into consideration and these are not based economic
foundation at all. Payback period also doesnt consider risk differences, and this method
calculate using the same way for both riskier and safer projects. This method will make a
company bias towards short-term investment and make it difficult for companies to accept
long term investments.

Discounted payback period

Discounted payback period is more similar to previous methods but it also considers the time
value of money unlike the previous method. In discounted payback period method since time
value of money is considered economic aspects are covered to some aspects where riskiness
of cash flows are considered. But even with that there are number of disadvantages yet in
these methods. Which are:
a. No strong and firm idea given about decision criteria in which it tells about whether
the investment will increase firms value or not.
b. Cost of capital is an estimation used most of the time hence require more analysis to
be done.
c. As in the previous method it ignores the cash flows beyond the payback period.

MBA 622 - Financial Management

Net present value


Net present value is the difference that we take from present value of the cash flows and
investment done at the beginning of the project. NPV is considered as a measure of how
much value will be created or added if a company undertakes and carry on by investing. In
calculating NPV, companies normally use Weighted Average Cost of Capital (WACC) as the
discount rate in calculating present value of each flow. This will enable a company to
determine the increase in wealth as for today which as a result from undertaking a project and
this will enable a management of a company to compare different projects which available at
once and select the best to minimise the risk as well as to enhance the wealth. Usually
projects with higher NPVs will be selected as projects with negative NPVs are considered as
a not good investment. If there are multiple projects to be chosen, multiple projects with
highest outcome can be selected.
Main drawback of NPV can be considered as it requires an estimation of cost of capital when
calculating the NPV of a project. Another problem with NPV is that it is expressed in money
value but not in percentage terms to get a good idea about the investment vs. outcome.

Internal rate of return


Internal rate of return is the discount rate which equates the investment amount to present
value of future cash flows. Or in other words this is about the Cost of Capital rate that gives
the zero value for NPV. IRR is more popular because it can be easily compared with COC.
Also an IRR provides the followings:

a.
b.
c.
d.

Provides details whether it will increase a firms value or not


When calculating IRR it considers all the cash flows or the project such as in NPV.
Time value of money is taken to considerations.
Also considers the risk of future cash flows by considering cost of capital in the
decision rule.

Main drawbacks of IRR method can be considered as:


a. Such as in NPV this method also requires an estimation of the cost of capital in
making a decision where wrong assumptions can lead to false values.

MBA 622 - Financial Management


b. When assess mutually exclusive projects IRR might not give the proper value
maximizing decision and also when there is capital rationing.
c. IRR is not suitable in situations such as the sign of the cash flows of a project change
more than once during the projects life.

Modified internal rate of return


Modified Internal rate of return (MIRR) is more like IRR but in terms of a theoretical
background it is much superior where it solves two main weaknesses of IRR. These
weaknesses overcome in MIRR method are it correctly assumes reinvestment at the projects
cost of capital and also avoids the problem of multiple IRRs being used. Even though MIRR
is not used widely in practice in the society this is considered as the best method to evaluate
projects. Following are clear advantages of MIRR:
a. Provide details about how much value of the firm will be increased by the investment.
b. Considers all types of cash flows, time value of money, and also the riskiness of
different future cash flows.
With that following disadvantages are also can be seen in MIRR:
a. As in some of previous methods in MIRR also it requires an estimation of cost of
capital to make a decision.
b. Might not give the value-maximizing project when there are number of mutually
exclusive projects or when there is capital rationing by the company.

MBA 622 - Financial Management

Part 3 - Multiple Choice Questions and Short Answers


Question
Q1
Q2
Q3
Q4
Q5
Q6
Q7
Q8
Q9
Q10
Q11
Q12

Answer
1
False
2
4
2
3
3
3
1
2
2
3

Q13:
Non- systematic risk (specific risk/diversifiable risk/residual risk) An uncertainty type that
comes when investing in a company or in a certain industry. This can be reduced mainly with
investing in different companies or industries (diversification).
Systematic risk (market risk/un-diversifiable risk) this is a type of risk that is inherent to the
whole market or whole market segment. This is also known as volatility which is due to day
to day fluctuation of stock prices.
Q14
Q15
Q16
Q17
Q18
Q19
Q20

2
4
4
1
2
3
1

MBA 622 - Financial Management

References
Berry,A. (1999), Financial Accounting An Introduction, Second Edition, London: Thompson
Black, G. (2009), Introduction to accounting and finance, Second edition, Essex: Pearson
Education
Gowthorpe,C. (2005), Financial Accounting for non-specialists, London :Thompson
Learning
Kotler, P., Armstrong, G., Saunders, J. and Wong, V. (1999), Principles of Marketing, 2nd
Edition, Cambridge: Prentice Hall
Linzer, R. S. and Linzer, 0.L. (2008), Cash Flow Strategies, San Francisco: John Wiley and
sons
ROSS S, WESTERFIELD RW, JORDAN BD & FIRER C. 2003. Fundamentals of corporate
finance. 2nd ed. Boston: McGraw Hill.
STEYN PG & MARITZ M. 2003. Financial Management of corporate projects and
programmes. Pretoria: Crane field.