Question

Pick 3 and answer

If you were evaluating an investment opportunity, which technique would you use and why?

When evaluating investments, you can get data from engineering, marketing, and sometimes accounting. Do you think any of these organizations have internal biases? If so, as a member of the finance department, how would you deal with them?

You have just discovered that your boss favors payback in evaluating investments. Should you try to talk him out of it or should you go along with his/her desires?

You are comptroller for your company. The CEO is a savvy individual with great instincts for the business. She strongly favors an investment that is only marginally acceptable at best. She has asked you to put together a justification for it. What will you do?

Last year your company financed its investments by selling shares of common stock. This year the plan is to use debt. The after-tax cost of debt is 5%, the cost of equity is 12% and the weighted average cost of capital is 9.5%. The first investment for this year is an expansion project. What cost of capital will you use and why?

Answer 1

WHEN EVALUATING AN INVESTMENT OPPORTUNITY WE LOOK AT THE NPV AND IRR.

NPV IS THE DIFFERENCE BETWEEN THE PRESENT VALUE OF CASH FLOWS AND THE VALUE OF THE INVESTMENT IN A PROJECT . WHEN THE NPV IS POSITIVE, THE INVESTMENT IS GENERATING POSITIVE CASH FLOWS AND ITS A FAVOURABLE INVESTMENT, BUT WHEN IT IS GENERATING NEGATIVE CASH FLOWS THEN ITS NOT A FAVOURABLE INVESTMENT OPPORTUNITY. AN IRR IS THE HURDLE RATE, WHEN THE IRR> COST OF CAPITAL, THEN THE PROJECT IS DESIRABLE, AND WHEN IT IS LESS THAN THE COST OF CAPITAL THEN THE PROJECT IS NOT FAVOURABLE.

BUT THE EBST TECHNIQUE IS THE NPV BECAUSE ;

NPV CAN BE UEED EVEN WHEN THERE ARE NON NORMAL CASH FLOWS, IT IS A MORE REALISTIC APPROCH .

THE PAYBACK METHOD IS THE MOST SIMPLE APPROACH FOR EVALUATING INVESTMENTS, IT DETERMINES HOW LONG WILL THE PROJECT TAKE TO RECOVER IT'S ORIGINAL INVESTMENT. THE SHORTER THE PAY BACK PERIOD THE BETTER IT IS. IT IGNORES THE TIME VALUE OF MONEY UNLIKE THE NPV, IRR AND THE DISCOUNTED PAY BACK METHOD

THEREFORE, I SHOULD TALK HIM OUT.

WACC IS AN APPROPRIATE METHOD, THE EFFECT OF LEVERAGE IS REFLECTED IN THE WACC,

IT IS AN APPROPRAITE DISCOUNT RATE USED TO DISCOUNT THE PROJECTS BOTH FROM THE INVESTOR AND THE COMPANY PERSPECTIVE. LOWER THE WACC, HIGHER THE VALUATIONS FOR THE COMPANY, HIGHER THE WACC LOWER IS THE VALUATIONS FOR THE COMPANY.